2008 Monthly Newsletters
November 2008 - WACCy Problems: When is the Use of a Weighted Average Cost of Capital (WACC) Appropriate?

I recently had an inquiry from a business appraiser in Puerto Rico (he had heard me speak in several business appraisal conferences) asking how to appraise a business for an SBA loan. He was trying to figure out what rate to use for the debt portion of the Weighted Average Cost of Capital (WACC). This question led to the following discussion regarding whether or not the WACC was appropriate for this type of appraisal.

There are a number of methods available to business appraisers to compute the cost of capital when valuing a business. When valuing equity directly, many appraisers use some type of a build-up method to derive their discount or capitalization rate. When valuing equity indirectly, i.e. valuing investment capital (the total sales price of the business regardless of how it is funded versus the equity in the business), the appropriate rate to use is the Weighted Average Cost of Capital, often referred to as the WACC. Equity is typically valued indirectly when the subject business has an atypical capital structure and it is reasonable to expect that a willing buyer would change it.

In simple terms, the WACC is comprised of a cost of equity component and a cost of debt component. The weighted cost of each of these components at market value is combined to obtain the WACC. Inherent in the concept is the assumption that the equity owners of the business are not personally responsible for the debt nor are personal assets required to be pledged for the debt.  

There is some debate as to whether or not it is appropriate to assume that a buyer would change the capital structure when valuing a company. I am not as concerned with this issue as I take into consideration the size and strength of the company being valued. I believe that many appraisers are using the WACC inappropriately to value the investment capital of very small companies. Very small companies and small companies rarely have the ability to borrow funds without the owners pledging personal assets, often personal real estate, and providing a personal guarantee of the debt. If a personal guarantee and pledge of personal assets are required, does the debt component (which is lower than the cost of equity) really represent the actual cost of capital for that portion of the business’s investment capital? No. In my opinion, the requirement of a personal guarantee and pledge of personal assets results in the same cost of capital as the equity component. Some might debate the issue if only a personal guarantee is required, however, what is the difference of borrowing funds personally and contributing them to the business as capital and borrowing funds in the business name and providing a personal guarantee of the debt? 

If the real cost of the debt, including personal guarantees and pledge of personal assets, is not considered in the valuation of closely held businesses, I believe that we often overvalue the subject business.

The concept of the WACC and valuing investment capital or equity indirectly is theoretically sound and very appropriate when the business is large enough and strong enough to borrow funds from lending institutions without personal guarantees or pledge of personal assets. I believe this concept is very appropriate for use in valuing large privately owned businesses of the size often called “middle market” companies. Middle market companies are those with annual revenues in the $20 million and up range, however, sometimes companies with smaller annual revenues are included in this category. 

When valuing small and very small businesses, we must consider the cost of personal guarantees and pledge of personal assets. The equity in these smaller companies should be valued directly as the use of the WACC in valuing the equity indirectly will typically result in overvaluing them. 

My answer to the appraiser asking what rate to use for the debt in the WACC was to not use the WACC at all. Instead, I suggested that he value the company using what is called a build-up method to estimate the cost of capital and value the total assets of the business, i.e. the likely selling price, as if it were debt free. In this way, the value of the business entity is the same whether a buyer pays all cash from his or her pocket or borrows some or most of the purchase price from a bank in conjunction with personal cash.

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 both real estate and businesses including machinery & equipment. 
December 2008 - Valuation Issues and the IRS

There are a number of situations that might require a business or real estate appraisal to be submitted to the Internal Revenue Service. In such cases, it is important to make sure that the appraisal is well documented and written by a highly qualified appraiser.  

Often, the IRS appraisal reviewer is experienced and knows what to look for, however, there are also times when, the IRS Officer who becomes involved knows little, if anything, about appraisals. When this occurs, the appraiser becomes a “teacher” and must be able to explain things clearly without “stepping on toes.” I have taught quite a few IRS Officers in classes over the years for The Institute of Business Appraisers. I have found most of them to be reasonable and willing to learn, however, there have been a few that refused to consider anything but what they already believed. The key issue generally seems to not to be “what is the number?” but instead, “can the appraiser explain why the number is right?”  

Currently, we are working on a business valuation case where the business owes the IRS payroll withholding taxes and is trying to negotiate a settlement. As part of the process, the business had to be appraised. The IRS’ Settlement Officer in this case has very little understanding of basic business valuation theory. The following are a few of the questions we were asked and our responses: 

IRS – “The appraisal does not contain audited financial statements; this is a fundamental aspect of an appraisal; the audit statement must be provided by an independent accountant.”


RESPONSE – The company valued has annual revenue of about $1 million, historically with losses or nominal earnings. Apparently, the IRS Officer does not understand the various types of financial statements typically prepared for small businesses. It is very rare indeed for a small business to have audited financial statements. They are simply too expensive. The vast majority of small businesses do not pay for audited statements, therefore the hypothetical buyer and seller discussed in the definition of Fair Market Value do not consummate transactions based on an analysis of audited financials. In fact, often the only financials reviewed before a small business is purchased are tax returns, therefore, tax returns are generally sufficient for an appraiser to perform a business appraisal.


IRS – “Generally a 20-30% premium is recognized for control when the Taxpayer own 100% of the stock.”

RESPONSE – This statement is completely false. Premiums and discounts are only applicable when the level of value desired is different from the data available. Each of the methods used in our report measured a “controlling” value directly, therefore a control premium was unnecessary.  


IRS – “There are several approaches and methods used in valuing a business. The standard of value that is acceptable by the IRS is Fair Market Value as stated in Revenue Ruling 59-60. The Rule-of-Thumb is sometimes used in valuing businesses.”

RESPONSE – We followed Revenue Ruling 59-60 throughout our report and used the Fair Market Value standard of value. We also used Rules of Thumb as a “sanity check” to verify that our value conclusion was reasonable. We disagree that rules of thumb are appraisal methods – they are too arbitrary and generally result in a wide range.  

A good example of the arbitrary nature of rules of thumb is one that has been used for accounting firms. Accounting practices sell between 40% and 125% of annual revenue.

As illustrated by the questions we were asked, it is clear that the assigned IRS reviewer is not very familiar with business appraisals. We have seen similar problems arise with real estate appraisals as well. The more thorough and well supported the appraisal, the better chance of it surviving a challenge by the IRS or other reviewers.

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 both real estate and businesses including machinery & equipment. 
October 2008 - Has the Stock Market Value Disappeared OR Are Stocks on a Moonlight Madness Sale?

The current financial panic has the news media and most politicians in an uproar. Of course, the largest noise is made by those trying to affix blame for the problem. Who created the mess is of little interest to most Americans. The reality of there being a mess, on the other hand, is. I, along with many others, have been expecting this disaster. Why, you may ask? Let me give a couple of anecdotal examples of things that convinced me that some lenders would be in trouble:

1. Several years ago my daughter and son-in-law informed me that they were going to buy a house in South Nampa. I was surprised because six months earlier they had needed a co-signor to lease an apartment. I was completely taken back when a few months later, they bought a house in Nampa. The developer was allowed to pay the closing costs and they “qualified” for a 100% loan. Neither of them had been working in the same job for a year and they had no savings. They got the loan and the house.

2. A couple of years ago I decided to get a line of credit secured by a house that we have converted to an office building. All of the lenders originally approached refused to do the loan because a business occupied the property and it was still technically zoned residential even though the City of Parma considers the area to be commercial and allows commercial use. Some lenders told me if I could get an appraiser to state that it was a house and not occupied by a business I could get a loan. However, that would be lying so I did not do that. I received an invitation in the mail from Washington Mutual to apply over the phone for a loan. I thought this was a novel idea. I applied and while on the phone they used an AVM (Automated Valuation Model) and told me “no problem” as the property was worth 150% of what I knew it to be worth. They did everything through the mail never having any appraiser actually look at the property.

Both of these examples illustrate part of the problem. Many worse examples can be found by asking around or from reading the news. Some lenders did some really stupid things. Others bought securities secured by horrible loans. Could and should anyone have seen this coming? Yes, many of us in the appraisal industry have been expecting the problems. Some accounting rules dealing with fair value and mark-to-market have contributed to problems.

Now the big question! Is the economy ruined and will it never recover? Of course not! We as a nation have done many stupid things over the years. All of us remember the dot.com era of not many years ago. At that time, investors threw money at any business plan that sounded good – never mind if there had never been a profit generated. Lots of people lost a lot of money. In 1980s, we had the Savings & Loan crisis caused largely by lenders getting into the development business and losing lots of money. The economy has always had its ups – and its downs. Each time we have a “major” problem some people, including the media, lose confidence in our overall system. Yet, within a year or two things have improved and the losses and problems are all but forgotten.

Most companies in America are doing quite well and will continue to do quite well. When nervous and foolish people dump their investments at rock bottom prices, knowledgeable investors are perfectly willing to buy. I still remember a professor who taught the investing course at Brigham Young University talking about a few times when the stock market goes on “Moonlight Madness Sale”! He gave us several examples of how he and others hugely profited at these times.

I am confident that within a relatively short time, the stock market will have recovered and will go on to new heights in the near future. Whether or not the country enters a recession is a concern, but not something worth worrying about. Successful businesses and business leaders make whatever adjustments are necessary and move on. 

Should you wish to discuss any of these issues, I would be happy to do so. 

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 2008 - Appraisers: Report the Market or What the Market Should Be?

Appraisers, by their very nature, are opinionated people and they must be able to make decisions and support them. Appraisers that regularly do assignments for litigation are very opinionated people who must also be very confident and present their position well. These tendencies are very helpful to appraisers in doing their jobs, however, they can get in the way of doing what they should do in performing an appraisal. Appraisers MUST remember that it is their job to report the market for the subject of the appraisal, i.e. what a willing buyer would pay and a willing seller accept as of the effective date NOT report what they personally believe the value should be! 

There are many different standards of value that can be used in any given appraisal assignment, however, I have yet to see one that states the appraiser should state his or her opinion of what the value should be. All of these different standards of value relate to market participants. The most commonly used standards of value typically involve a hypothetical and knowledgeable willing buyer and seller each acting without any special motivations as of a specific date. In short, the appraiser’s assignment is to “mirror the market”.

With the help of computers and numerous software programs, appraisers can now apply many sophisticated methods and model innumberable scenarios as part of the appraisal process. It is not uncommon to see elaborate statistical models and other very complicated programs used to develop value conclusions for business entities or real estate properties. As programs and appraisal templates have become more complex and detailed, it seems to me that common sense is sometimes lost. Appraisers need to consider their value conclusions in the light of “does it really make sense”? I have an advantage that many appraisers do not share – I sold businesses and real estate as a broker for over twenty years. I have also owned and sold businesses, real estate, and developed real estate. Dealing with actual buyers and sellers instead of hypothetical individuals is a real awakening. Appraisers that have not had “real market” experience should consider talking to market participants, i.e. brokers, buyers, sellers, and/or developers to see if what they have concluded to as a value makes sense. Although I have real market experience, I practice what I preach – I verify my conclusions as it is so easy to impose your own beliefs while making what should be an objective analysis.

Real Estate Appraisal Example

I recently was asked to review a real estate appraisal of a subsidized housing apartment project. The appraisal assignment required the appraiser to determine numerous conclusions of value under a variety of scenarios. Of particular interest to my client was the Hypothetical Value “As Is” as if the property were rented to market tenants without benefit of the Government Subsidies versus the Hypothetical Value “As Renovated” as if the property were rented to market tenants without benefit of the Government Subsidies. Substantial renovations are required by the government entity, however, the property could be operated just fine “as is” if it were outside of the subsidized housing program. The appraiser concluded a huge difference between these two values by crunching numbers without, in my opinion, considering real market evidence. Both of these scenarios were hypothetical as they did not exist and would likely never exist thus complicating things. The underlying questions were “would a market tenant care whether or not the renovations being required by the Government entity providing the subsidy were made or not? Would the expenses of operating the property really be much different with our without the renovations outside of the subsidy program?” In my opinion, things really would not be much different in either scenario and thus the values should have been about the same. I checked with a few brokers in the area that were familiar with the apartment market and they concurred with me.

Business Appraisal Example

There are numerous business appraisal examples where what actual market participants would likely do is ignored. The best examples are those where minority interests in an operating business are being appraised. I often see appraisers calculate huge discounts for lack of control and lack of marketability for a minority interest without considering whether or not the willing seller would accept the concluded value. For example, let’s consider a ten percent interest in an operating company that has been in existence for thirty years, is profitable, but does not distribute any cash to minority shareholders and is not likely to do so. The ten percent interest will only receive funds when the company is sold which is not considered a likely option for many more years. If the company is valued at $1,000,000, clearly the ten percent interest is worth less than $100,000. However, how much less? Would a “typical willing buyer” pay $50,000 for the interest? How about $10,000? Would the “typical willing seller” accept $10,000? Probably not. What would the “typical willing seller” accept for the ten percent interest? The answer is dependent on many factors, all of which should be discussed in the appraisal assignment.

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.
August 2008 - Capitalization Rates and Risk

Last month, I discussed the difference between business and real estate capitalization “cap” rates. As a follow up to the topic of cap rates, I thought it would be useful to discuss cap rates and how they relate to risk. This is easiest when discussing real estate, but the same principles apply in business cap rates and discount rates.

Again, just what is a cap rate and what does it measure? A cap rate represents the percentage applied as a divisor to a one-year income stream that is indicative of the value that both a typical buyer and seller would agree upon. In simple terms, it is the rate that a buyer requires for both the annual income from a property plus the profit, (typically from appreciation), and what the buyer expects from an eventual sale of the property. It is critically important to realize that the cap rate includes both annual income and anticipated future appreciation! Cap rates change over time based on overall economic conditions, national and local, and they are particularly influenced by prevailing rates of return on alternative investments as well as the perceived risk associated with the specific real estate property.  

A number of factors should be considered when selecting a cap rate to be applied to a specific property in order to obtain an indication of value. It is not simply enough to look at cap rates from the sale of other properties in the same category as the property in question, however, this is often all that is done in practice. In order to understand how this should work, looking at an example will be helpful.  

Let’s assume we are valuing a small neighborhood shopping center with 10,000 square feet of building – five tenants each with 2,000 square feet of space, built last year, and located on a busy street in a nice town across from a Wal-Mart. The “subject” is fully leased with one national tenant, one national franchise restaurant (local franchisee), and three “mom and pop” local businesses. Each lease is for five years and is at “market” rent.

The following are a number of “comparable” sales that could be used to extract a capitalization rate that would be considered applicable to our subject:

  • An older medium sized shopping center with 35,000 square feet of building space in an old area of town with 25% vacancies. A cap rate determined by dividing the net operating income by the sales price for the center of 14%. 
  • A 5,000 square foot restaurant building three blocks away leased to a national restaurant chain for 20 years. A cap rate determined by dividing the net operating income by sales price for the building of 6.5%.
  • A 15,000 square foot neighborhood shopping center built seven years ago on a good street in a city twenty miles away with seven tenants on month-to-month leases. A cap rate determined by dividing the net operating income by the sales price of 9%.
  •  A regional shopping center in a city twenty miles away with a cap rate determined by dividing the net operating income by the sales price of 7%.
  •  A 20,000 square foot neighborhood shopping center built twenty-five years ago three miles away on a less busy street with a mixture of lease expiration dates and most leases with rents considerably less than market rates. The center has not been well maintained, but due to its low rents, it is ninety-five percent occupied with a cap rate determined by dividing the net income by the recent sales price of 10.5%.

If these are all of the sales that have occurred in the last year or so, it may be all of the information available. What is the appropriate cap rate for the subject? A tough question.

To further complicate things, cap rates that are extracted from sales are based on the income and expenses associated with each sale. It is important to consider the vacancy rate used and whether or not the expenses used to arrive at each cap rate included all appropriate expenses or whether they may have been higher than normal for a number of reasons. Often, there are a number of unknowns involved which could result in differences in cap rates derived from sales comparables.

The selected capitalization rate used to value a property is driven by the risk associated with achievement of the expected income stream. Factors that influence the risk are the quality of tenants, the length of leases, the relationship of rents to current market rents, i.e. are the rents above the market rate? (If so, the tenant may be looking for ways out of the lease). Are the rents below the market rate? (If so, how long are the leases? Are the leases assignable?) What is happening in the area? Many more factors are often considered as well. 

Once the capitalization rate has been selected, its suitability can be checked by a technique called the Band of Investment approach. This methodology involves the use of typical rates of return on equity and available financing for similar properties. If the indications of a suitable capitalization rate vary significantly from the capitalization rate extracted from the market, it may mean that additional considerations are warranted to see if perhaps the extracted rate should be adjusted.

The capitalization rate is very sensitive. A small change in the cap rate results in a large difference in the indication of value. For this reason, it is wise to use both a cost approach and a sales comparison approach to support the value conclusion reached using the income approach. The appraiser’s judgment and experience greatly influences the quality of virtually all valuation conclusions reached. 

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 2008 - Business vs. Real Estate Cap Rates

It is not uncommon to see an inexperienced business appraiser, particularly one who has a real estate background or is familiar with commercial real estate properties, use a real estate capitalization rate to value a business entity. When this occurs, the business is typically significantly overvalued. 

For many years it seems like the capitalization rate (cap rate) that was used for many real estate commercial properties was ten percent. It is still used as a “rule of thumb” by many real estate brokers and property owners. Over the last few years, we have seen cap rates in many real estate appraisals drop significantly from this old bench mark resulting in higher values. Now as real estate financing has tightened up, cap rates are rising resulting in somewhat lower values as investors are demanding higher returns.  

Just what is a cap rate and what does it measure? A cap rate represents the percentage applied as a divisor to a one-year income stream that is indicative of the value that both a typical buyer and seller would agree upon. In simple terms, it is the rate that a buyer requires for both the annual income from a property plus the profit, (typically from appreciation), and what the buyer expects from an eventual sale of the property. It is critically important to realize that the cap rate includes both annual income and anticipated future appreciation! Cap rates change over time based on overall economic conditions, national and local, and they are particularly influenced by prevailing rates of return on alternative investments as well as the perceived risk associated with the specific real estate property.  

The income stream used in real estate valuations is net operating income – a pre-tax income stream. The income stream used in business valuations is net cash flow – an after-tax income stream that is also adjusted for non-cash expenses, capital expenditures, changes in working capital and changes in long-term debt. Cap rates applied to value real estate and those applied to business income streams are very different. They simply cannot be used interchangeably at all. However, often we see a real estate appraiser or someone familiar with real estate appraisals try to value a business using a real estate cap rate. When a business appraiser tries to value a real estate property, the cap rate is, of course, generally ten percent.

Business and real estate cap rates also come from different places. A real estate cap rate is often “extracted from the market” meaning real estate appraisers collect a number of sales for which income information is known so that cap rates can be calculated. Using a number of similar property sales, the “market” cap rate can be extracted. The only problem with this approach is that it essentially guarantees that the sales comparison approach and the income approach are going to match because the same data is used for both – this could be either good or bad. What it does mean is that when the same data is used to develop both approaches, the approaches do not “check” each other – they give you the same answer. We generally use another method called the band of investment approach to “check” our data to see if it is reasonable. The band of investment techniques use equity and mortgage investment rates to estimate a cap rate for a property. This tool also has a problem: it is extremely sensitive to small adjustments and thus answers can easily be skewed if the appraiser is not careful. Business cap rates are typically “built-up” using a risk free rate, a rate for the overall stock market as a whole, a size premium for smaller publicly traded stocks, and then a subjective specific company risk premium estimated by the appraiser. This methodology is also extremely sensitive to small adjustments. This is why other business appraisal methods must be used to support conclusions reached using a cap rate.

If this discussion makes you uncomfortable, it has accomplished its purpose. A valuation constructed using only one approach is often difficult to support. This is why generally three approaches to value: the market or sales comparison approach, the cost or asset approach, and the income approach are used to estimate the value of a property or a business interest. Often, a lender requests a “best single approach” valuation to save money – I think that this is a mistake as one approach has no checks to make sure it is accurate. This is similar to trying to identify a line with a single point – no one knows if it is correct or not. As we were all taught in geometry class, it takes at least two points to identify a line. More than one approach should be used to value real estate or a business interest unless the required data is simply not available. 

The following examples illustrate simple applications of cap rates for both a business and an income generating commercial real estate property:
Commerical Property Example Chart
In this example, both the commercial property and the business have the same value of $700,000. The cap rates are very different numbers and they are applied to different income streams, yet the values are the same. Does this mean that an investor would look at these two investments as identical? Certainly not! Although the indicated value is the same, they would each very likely have completely different risks and potential benefits associated with them.

It is important to understand where a cap rate comes from and its applicability to the income stream to which it is applied. If the process is not understood and applied correctly, value conclusions will not be meaningful.

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 2008 - Business Exit Strategy Planning

Business owners often spend years building up a successful business without giving much, if any, thought as to what will happen to the business when the time comes for them to exit. Events such as personal or family member illness or death in addition to voluntary retirement can result in a need to exit the business. Business owners need to develop a plan that will work for them. Business Exit Strategy Planning is best done early – well before an event occurs that makes an exit necessary. I believe that it is very important to have the business owner’s professional advisors involved, particularly the firm’s attorney and CPA, in the process as a number of legal and tax issues must be examined and important decisions made. It is generally necessary to have the business appraised as part of the planning process.

The typical methods for exiting a successful business include the following:

  • Children take over the business
  • Sell to partner (Buy-Sell Agreements)
  • Sell to key employee(s)
  • Sell to all employees (ESOP)
  • Sell to outside, independent third party
  • Keep the business – hire professional management
  • Take the company public (Initial Public Offering or IPO)
  • Liquidate the business

Each of these options has some advantages and disadvantages. The following are brief comments to consider about each of the typical exit options:

Children take over the business

This option has several issues that must be considered. Are the children interested in running the business? Are they capable of doing so? If more than one child is involved in the business, who will be in charge? How will compensation between them be determined? If some children will take over the business and others will not, how will that be worked out to be fair to all children?

Sell to partner (Buy-Sell Agreements)

Is the sale mandatory? How will it be funded? How is the price set? Is the price updated regularly as the business changes? If done with a formula, will the formula work over time? Will the formula be challenged by heirs or a spouse as unfair?

Sell to key employee(s)

Do the key employees have the financial ability to buy the business? If the sale is done with little or no down payment, what will keep the buying employees from walking away if the business develops problems? Will the seller’s family members agree that the price was fair? Will the key employees walk away without paying the full price and open a competing business?

Sell to all employees (ESOP)

An Employee Stock Ownership Plan (ESOP) can be very attractive as laws establishing them provide some great tax incentives involving a deferral of the sales price if the business qualifies. ESOPs generally result in increased employee productivity and can be a great benefit to employees. However, ESOPs are expensive and the company must have enough employees to make it worthwhile. The process is generally too expensive for firms with less than fifty or so employees.

Sell to outside, independent third party

The company must have good financial records and have the ability to transfer management to a buyer. It is generally important to keep any potential sale confidential so that employees, customers, and competitors do not cause the business difficulties. A good, well qualified business broker is generally very helpful in locating qualified buyers and in maintaining confidentiality.  

Keep the business – hire professional management

If the business is large enough, this can be a good option. However, finding, monitoring, and retaining professional management can create issues. 

Take the company public (Initial Public Offering or IPO)

This is only an option for fairly large companies and is very expensive as audited financial statements are required and large fees must be paid to an underwriter. Most companies will not qualify for this as an option.

Liquidate the business

Occasionally, this is the best option as some businesses are worth more dead than alive. A business appraisal will reveal whether or not this should be considered.

Each of these options require a lot of thought and planning. Coordination with the firm’s professional advisors is also critical.

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 2008 - Precision vs. Accuracy

The purpose of an appraisal is generally to determine the “value” of something using some specified standard of value typically “as if” the subject of the appraisal changed hands often between a willing and able buyer and a willing and able seller in terms of cash equivalency. An appraiser uses his or her special knowledge, experience, and training together with data gathered regarding the subject and comparables to develop an estimate of the subject’s worth as of the specified date following the selected standard of value. Inherent in this process are typically numerous assumptions and often a number of subjective decisions and judgments. When possible, appraisers use a cost approach, a market approach, and an income approach. Sometimes, multiple methods within one or more of these approaches are applied. Each of the indicated values generated by the methods used must then be reconciled into a final value conclusion.

Appraisals, by their very nature, can be accurate or inaccurate, but they cannot be very precise. The definition of precise that I am talking about, according to Webster’s Dictionary is “minutely exact”. According to the Appraisal Institute, precision is defined as “how finely something is measured. The more digits, the more precise the measurement is. For example, a distance that is measured to the nearest tenth of a foot is more precise than one measured to the nearest foot.” What I mean by accurate is “free from error” or “reliable”. The Appraisal Institute defines accuracy as “how close the specified number is to reality. The digits are meaningful. In the previous example, if the measuring tape was properly manufactured and has not shrunk or stretched, the numbers “2”, “3”, and “4” from the tape are all meaningful because they convey accurate information. If the tape has stretched by one-half percent, the number “3” is precise because it was read off of the tape, but it is not meaningful because it is incorrect.”

It is virtually impossible to measure anything with perfect accuracy. An infinite number of digits can exist to the right of the decimal point for each measurement. The same principal applies to value indications derived in an appraisal. The accuracy of any indication of value is totally dependent on each component that went into the process. If a side of a building is measured at 33 feet, two and 5/8 inches, what is the appropriate number to use? I would typically round the measurement to the nearest foot or on smaller measurements, perhaps the nearest half-foot. Suppose a simple building is measured at 33 feet, two and 5/8 inches by 93 feet, seven and 3/8 inches. What should the stated square footage be? I would call it 3,102 square feet having rounded the measurements to 33 feet by 94 feet. However, it could also be called 3,100 square feet or 398.625 inches by 1,123.375 inches or 3,109.75944 square feet. Later on, after applying all of the data gathered, this square footage would be used to help determine estimates of value. During this process, typically a number of subjective decisions are made each of which lessens the precision of the process, however, as it is the appraiser’s job to “mirror the market” meaning to determine value according to how market participants would view it.

I cannot help but laugh when I see an appraisal conclusion stated something like the following:

Nineteen Million Seven Hundred Eight-Six Thousand Seven Hundred Thirty-Six Dollars and 22 Cents
$19,786,736.22

Knowing all of the subjective decisions that went into the appraisal process, a conclusion stated with this much precision is ludicrous and misleading. An appraisal conclusion simply cannot be accurately stated to this level of precision. Instead, rounding to what is determined to be “significant digit” should be employed. A “Significant Digit” is a digit “that is believed to contribute accuracy, not simply precision, to a measurement.  

In the above example, the value conclusion could be stated accurately a number of ways depending on the data used in the assignment and the level of adjustments required to arrive at the conclusion. I would typically state such a value conclusion as follows:

Nineteen Million Eight Hundred Thousand Dollars
$19,800,000

This type of statement is accurate, but not so precise as to mislead the reader into thinking that the data available and the processes applied allowed the result to be stated as precisely as shown above.  

Valuations can and should be “accurate” meaning that they should be reliable in that they should fairly represent what market participants would pay or receive for the subject property as of the effective date of the appraisal following the selected standard of value.

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.
April 2008 - Lease Issues and Business Value

Many businesses do not own the real estate they occupy. Instead, the premises are typically leased. A lease is a written agreement that transfers the right to use and occupy real property for a specified period of time in return for rent. Leases often include many other provisions, some of which can be quite complicated, that may affect the value of the business occupying the site.  

Business appraisers must carefully consider the implications that the lease has on business value. There are many. I have chosen to discuss of few of them in this article.

First, an outrageous, but real example. A few years ago a retail store located in a regional mall was put up for sale. It had been in the mall for quite a few years and had been very successful. Due to large amounts spent for advertising and good business practices, the retail store’s revenue and profits had grown each year and it appeared to be highly desirable as a business purchase. A buyer was found that made an acceptable offer on the business and both the buyer and seller were happy. Only one problem existed. The real estate lease was expiring in less than a year and it turned out that the regional mall had a new jewelry store in mind for the space that was willing to pay a much larger rent. When the buyer applied to assume the lease and requested a renewal of the lease, the mall told them that the lease would not be renewed. The pleadings of the seller and references to long-term loyalty including spending lots of dollars to bring customers to the mall were to no avail. The lease was not renewed, the business relocated outside the mall but it never regained profits anything like what they were while in the mall and it eventually went out of business. As shown in this example, the failure to be able to renew and transfer the lease eliminated what had appeared to be a significant business value.

Lease issues that must be considered when valuing a business include, but are not limited to, the following:

  • Remaining term of the lease
  • Renewal options
  • Transferability
  • Below or above market rent
  • Percentage rent or other participation clauses
  • Default provisions
  • Ownership of leasehold improvements
  • Requirements to restore premises to original condition

The remaining term of the lease is usually the easiest potential problem to spot. Usually, the expiration date of the lease is clearly defined. Some businesses are easier to move to a new location than others. The easier it is to relocate a business, the less impact on the value due to the lease. Conversely, the more difficult to move the business, the greater the impact on the value related to the lease.

Renewal options can be tricky. Many leases spell out specific formulas or fixed amounts for the rent for each renewal option, however, quite a few leases call for vague and ambiguous rent provisions for the renewal periods. A clause that calls for an agreement to agree on the future rent is not very worthwhile and cannot typically be relied on to assure renewal of the lease. A reference to market rent at the time of renewal can also be a problem. If the business is highly dependent on the location and market rents soar for any number of reasons, the future market rent may be so much higher than current rent as to eliminate all or much of the business profits. Estimating future market rents five or more years down the road is difficult as well. Such a renewal option increases the risk of achieving the forecasted business income stream effectively reducing the value of the business.

Transferability issues are relatively obvious. They can cause huge problems as shown in the example. Often, the lease calls for landlord approval of transfer of the lease with approval “not to be unreasonably withheld.” Other times the lease gives the landlord a great deal of discretion regarding transferability of the lease again effectively reducing the value of the business.

Below or above market rent may affect the value of the business substantially. A long-term lease with below market rent that is clearly transferrable may increase the value of the business, however, should the property be foreclosed upon, the lease may be extinguished eliminating this increased value. If a business is paying above market rent, the business is often motivated to relocate and thus reduce this expense or may be able to renegotiate the lease if relocation is a strong possibility. These factors are challenging to deal with in business valuations.

Percentage rent or other participation clauses must be taken into consideration especially when forecasting future revenues. Some leases, particularly long-term leases for businesses like restaurants, have a clause that requires the tenant to pay a certain percentage of gross revenue if that amount exceeds the basic rent.

Default provisions can create uncertainty especially if a business has difficulty avoiding some provision that could be used by the landlord to get out of the lease.

Ownership of leasehold improvements is generally specified in the lease. Many businesses include leasehold improvements on their balance sheet, however often at the termination of a real estate lease they become the property of the landlord. Even if they really do belong to the tenant, are they worth anything if the tenant leaves the location – can they be removed and used elsewhere? Usually, the leasehold improvements have no value as they cannot be removed and used elsewhere; they are simply on the company’s books and the cost is being recovered by depreciating them.

Requirements to restore premises to original condition can be particularly onerous depending on the nature of the business and the amount invested. If some environmental issues are involved and total clean-up is required, the cost of the remediation is sometimes larger than the value of the business enterprise.

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 2008 - S Corp Valuations & Gross v. Commissioner

In the now famous court case entitled Gross v. Commissioner,[1] a very profitable Pepsi Cola distributorship that paid out large amounts as distributions to its shareholders was valued by the taxpayer’s expert using the then standard valuation technique of tax-affecting the income stream “as if” the entity were a ‘C’ corporation. This technique was disallowed by the court causing an upheaval in the valuation profession. Since this time, this valuation concept has been studied, reported on, and analyzed by many valuation experts. Several valuation models have been developed which are now commonly used to value minority interests in ‘S’ corporations especially when the report is prepared for tax purposes. Tax-affecting the income stream “as if” the entity were a ‘C’ corporation is generally considered perfectly appropriate when valuing a 100% control interest in the entity, but it certainly is not appropriate when valuing a minority interest in an ‘S’ corporation.  

Whether or not a minority interest in an ‘S’ corporation or a ‘C’ corporation is worth a different amount has been the subject of many arguments and articles in the business valuation profession since the Gross v. Commission case was first published. Since then, several more cases have strengthened the IRS’s resolve to disallow tax-affecting the income stream when valuing minority interests in ‘S’ corporations.  

The basic concept underlying the valuation of a minority interest in an ‘S’ corporation is fairly simple: “if you have to pay income taxes on the income you receive from an investment, you end up with less in your pocket than if you didn’t have to pay taxes. Therefore, all things being equal, if one investment has taxes levied on it, and the other does not, an investor would choose the one that does not.”[2]  

‘S’ corporations were originally authorized by congress so that small business corporations that elected this status could be taxed in the same manner as partnerships effectively doing away with the double taxation problem that ‘C’ corporations have, i.e. income is taxed at the corporate level and then dividends paid out to shareholders from after-tax income is taxed again to the shareholders. The creation of ‘S’ corporations eliminated the dividend tax that the individual shareholder must pay. In fact, the shareholders of ‘S’ corporations pay the income tax that a ‘C’ corporation would have paid personally on their share of the income, whether or not cash is actually distributed, at personal income tax rates. Currently, personal and corporate income tax rates are substantially equal so the real benefit to the investor is that the investor does not have to pay dividend tax on any amount distributed to them from an ‘S’ corporation.  

An additional benefit of an ‘S’ corporation when less than 100% of profits are paid out to shareholders is that the earnings not paid out will increase the shareholders basis in their investment and lessen the eventual capital gains tax that will have to be paid when the investment is actually sold. Some ‘S’ corporation models attempt to quantify this benefit by making a number of subjective assumptions regarding the likely holding period of the investment and generally use a different risk rate to discount this future benefit as the risk of receiving it is much higher than the benefit of not paying dividend taxes. Unless a transaction is expected in the near future, the present value of this benefit is generally immaterial. Investors in closely held companies typically have a long investment horizon, often estimated at approximately fifteen to twenty years. Under the fair market value standard of value, a typical investment holding period is assumed, therefore, this possible benefit is often not given any weight in many valuations.  

Depending on the amount of cash distributions relative to the amount of income tax that must be paid by the shareholder personally, the value of ownership interests in ‘S’ corporations may be worth less than an otherwise similar ‘C’ corporation, may be worth the same, or may be worth more. For example, some ‘S’ corporations pay out less cash to shareholders than the shareholder will have to pay personally in income taxes for the investment, some pay out just enough to cover the personal income tax liability, and others pay out more than is necessary to pay the personal income tax liability.  

Since the Gross v. Commission case was decided, a number of valuation models have been developed to value minority interests in ‘S’ corporations. Among these models, the one that we believe best presents the value in an understandable manner is the model developed by Chris Treharne, ASA, MCBA, BVAL in his article entitled “S Corps: Follow the Cash” presented at the 2006 Institute of Business Appraisers conference and based on the article entitled “Valuation of Minority Interests in Pass-Through-Tax Entities” published in Business Valuation Review in September 2004.[3] The following tables illustrate how this model works using an example with combined Idaho and Federal tax rates:  









As shown in this example, the value of an Idaho entity with the facts shown that distributes only enough earnings for the shareholders to pay the associated income taxes is worth about the same, a 100% distributing ‘S’ corporation investment is worth more, and an ‘S’ corporation that distributes nothing requiring the shareholders to come out of pocket to pay the associated income taxes is worth a lot less than an equivalent ‘C’ corporation.
February 2008 - Valuing Professional Practices

Valuing a professional practice presents some additional problems not generally encountered in most other valuation assignments. Examples of professional practices include: physicians, veterinarians, dentists, optometrists, chiropractors, lawyers, accountants, engineers, architects, insurance, and appraisers though there is bound to be another category or two that I have inadvertently left off this list. The size and number of professionals in the practice impacts the valuation assignment. One of the most difficult assignments is to value a single-practitioner practice.

Key issues that must be examined are such things as practice goodwill vs. personal (or professional) goodwill, expected future earnings, level of competition, referral base, types of patients or clients, work habits of the practitioner, fee schedules, practice location, practice employees, marketability of the practice, and perhaps most importantly is the ability to transfer the patient/client or referral base. Another important factor is the ‘typical’ amount that would have to be paid to replace the practitioner(s) with another professional of equivalent experience and ability. This amount is often called “reasonable compensation.” Determining and supporting this amount is key to any professional practice valuation. Earnings in the practice in excess of reasonable compensation are what drive value in the practice. Lack of earnings in excess of reasonable compensation may mean that the practice has no real value. Conversely, substantial earnings in excess of reasonable compensation often results in a large practice value.

An example of a professional practice with little practice value is a neonatal neurosurgery practice (brain surgery on infants). Such a practice is entirely dependent on referrals from other neurosurgeons around the country and such referrals are based on the personal reputation and experience of the doctor – a good example of personal or professional goodwill. If the neonatal neurosurgeon with the reputation and experience were not there, the practice would not exist – the only value would likely be the value of furniture, fixtures, and equipment. This type of highly specialized practice is not very transferrable; hence little practice value even though the practitioner likely makes a gazillion dollars a year in salary!

On the other hand, a general practice physician or general practice dentist practice has value as it is transferrable. An actual sale may require an earn-out based on the percentage of patient retention over a specified period. Generally, the selling doctor’s name stays on the door along with the new doctor’s name for a period of time even though the selling doctor may never visit the practice after the sale. There are numerous sales of such practices that can be used as data points in appraisal as part of the market or sales comparison approach.

Larger practices with many professionals working in them tend to be easier to value than single-practitioner practices. Such practices tend to have less risk associated with their income streams than do smaller practices; hence they tend to have larger values. For example, an engineering firm with ten or more professionals, a contingent of support personnel, and a large and diversified client base will likely have less risk associated with its future expected income stream than a one-person engineering firm with one or two large clients.  

Many factors must be examined during the valuation of a professional practice and “wrinkles” abound that complicate the process.  

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 2008 - Conservation Easements

Conservation easements have become an important estate planning tool along with fulfilling other purposes such as preserving agricultural property, land for public use, land for wildlife preservation, forest land, scenic views, trails, and gardens. When set up properly, taxpayers can deduct the value of the conservation easement as a non-cash charitable contribution for income tax purposes.

Many people have become concerned that family owned property will not be able to be maintained as it has been for future enjoyment. For example, many family farms or ranches cannot be passed from one generation to the next due to either estate taxes or increased values due to speculation for future development that result in the land becoming too expensive to continue its agricultural use. Creation of a conservation easement is one way to ensure that the family farm or ranch can be continued. This can also work for properties in the mountains with great views and for many other property types.

A conservation easement is a legal agreement between a landowner and an eligible organization that restricts future activities on land to protect its conservation values. The easement is recorded so that it runs with the land. The donee or holder of the easement must be a government agency or a private nonprofit organization, usually a 501(c)(3) land trust, with the capacity to monitor the easement often into perpetuity. It should be noted that most donee organizations typically require a cash contribution as well as donation of the easement to assist them with the expense of managing the easement as conservation easements for income tax purposes must be made into perpetuity—a very long time!

For income tax charitable contribution purposes, the value of the easement is typically determined by valuing the land as of the date of donation before it is encumbered by the easement and again as of the date of donation “as if” encumbered by the easement. The difference between these two values represents the value of the easement or the amount of the deduction. IRS rules must be followed carefully by the appraiser as well as the attorney that sets up the documents. One wrinkle that must be addressed according to the IRS rules is possible enhancement of contiguous family owned parcels (CFOPs) and other potentially enhanced properties (PEPs). The appraiser must determine whether or not the value of contiguous parcels that are owned by the taxpayer or blood relatives are enhanced by the creation of the conservation easement. Also, any other parcels in the area—the area is not clearly defined by the regulations—that are owned by related entities in which the taxpayer has a controlling interest must also be examined to see whether or not the creation of the conservation easement results in value enhancement.

The key to valuing conservation easements is to correctly identify the highest and best use of the property in both the before and after situations. Then comparable property sales with the same highest and best use in the before and after situations must be located, properly and persuasively analyzed in order to support the value conclusion. If the highest and best use in the before situation includes possible division in a subdivision, the appraiser must also include a well supported subdivision analysis.

Since often large amounts of charitable contribution deductions are taken by taxpayers, the Internal Revenue Service has become very interested in valuations of conservation easements. IRS representatives have stated that these appraisals are usually carefully reviewed, often including having an IRS appraiser visit the site, visit each of the comparable properties and review the appraiser’s work in some detail. If the report is not conducted properly, the IRS will adjust the amount of the allowable deduction and often comes after both the taxpayer and the appraiser for penalties.

Due to concerns regarding improperly prepared appraisals for conservation easements, a week-long training course entitled “Valuation of Conservation Easements” has been created for appraisers and those involved with conservation easements by the Appraisal Institute, the American Society of Appraisers, the American Society of Farm Managers and Rural Appraisers, and the Land Trust Alliance. The IRS was also very involved in the course development and reviewed the materials. Each of the organizations has required that appraisers who wish to be on their approved list for valuing conservation easements must take the course and pass an examination. I have recently completed the course and taken the exam.
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