This post recalls an appraisal review assignment of mine from many years ago. In the last seven posts, we have explicitly talked about appraisal review from a broad perspective, it is appropriate to discuss one specific case where appraisal review was key to arriving at a settlement through a bitterly fought buy-sell agreement dispute.
This summary will focus on only one of several review issues involved in the case for the sake of brevity. The case occurred fifteen years ago. I will nevertheless speak of the parties in general terms.
The Preamble to the Uniform Standards of Professional Appraisal Practice begins:
The purpose of the Uniform Standards of Professional Appraisal Practice (USPAP) is to promote and maintain a high level of public trust in appraisal practice by establishing requirements for appraisers. It is essential that appraisers develop and communicate their analyses, opinions, and conclusions to intended users of their services in a manner that is meaningful and not misleading. (emphasis added)
Appraisers must deliver their services “in a manner that is meaningful and not misleading.” The individual standards of USPAP provide more specific guidance, but this initial guidance from the preamble is overarching. A key review issue in the case under discussion was that I concluded that the report being reviewed was misleading to intended users.
Background of the Case
A buy-sell agreement was triggered and one company was required to sell an operating entity (“the subject entity”) to a second company at a price to be determined by the valuation process found in the buy-sell agreement.
Company 1, the seller, had hired an appraiser (First Appraiser). Company 2, the purchaser had also hired an appraiser (Second Appraiser). The two companies agreed on a Third Appraiser who was required to issue a draft report for review by the parties. The draft appraisal was required to be compliant with the then-prevailing ASA Business Valuation Standards. Since the Third Appraiser was an ASA (Accredited Business Appraiser, credentialed by the American Society of Appraisers), the report was also required to be compliant with the then-prevailing Uniform Standards of Professional Appraisal Practice.
Company 1 hired me as a Review Appraiser to review the draft report of the Third Appraiser.
The story evolved as follows.
- Company 1. The first appraiser was an ASA with good background and experience in valuation. The First Appraiser concluded that the fair market value of the subject entity was on the order of $200 million, reflecting EBITDA of about $20 million and an EBITDA multiple of 10.0x based primarily on a guideline public company analysis. There was no debt, so the equity value was about $200 million.
- Company 2. The Second Appraiser was a business broker specializing in companies similar to the subject entity and had little or no valuation background or experience and held no valuation credentials. The Second Appraiser concluded that the fair market value of the subject entity was on the order of $400 million, based on similar EBITDA and strategic analysis.
- Third Appraiser. The Third Appraiser issued a draft report that concluded that the fair market value was about $320 million. We will discuss it in more detail in the next section.
What made this interesting was that the Third Appraiser’s conclusion was to be averaged with the appraiser’s conclusion closest to his. This meant that if he concluded exactly $300 million, the overall conclusion would be $300 million. However, a conclusion just above $300 million would be averaged with the Second Appraiser’s $400 million conclusion, $350 million as a working estimate. If the Third Appraiser’s conclusion was just under $300 million, it would be averaged with the $200 million conclusion of the First Appraiser and would yield a working estimate of $250 million. There was likely more than a $100 million swing in the process conclusion depending on whether the Third Appraiser’s conclusion was above or below $300 million.
We have written about this quirky type of buy-sell agreement process before. The pressure was on the Third Appraiser. And the review appraiser (me).
Misleading Use of Observed Control Premiums
The Third Appraiser employed a discounted cash flow method and the guideline public company method. For reasons of brevity (and memory), we will not discuss the DCF method. In using the guideline public company method, the Third Appraiser relied on two observed control premiums to develop a control premium to be applied using the guideline public company method. At the time, appraisers relied on control premium studies prepared by Mergerstat Review. The studies were prepared and published each year in a book, which summarized the control premium paid in public acquisitions by industry, size, and a variety of other indicators.
The publisher also published information on individual change-of-control transactions. This publication was sold in the form of Notebooks with 1-2 pages of specific information on the purchasers and sellers for each transaction. This publication was not as well-known as the annual books of control premium studies. The Notebooks provided information on relevant valuation ratios for the transactions, including ratios like enterprise value to EBITDA and enterprise value to revenue (actually, they used market value of total capital back then). We dealt with the available information at the time. The relevant “control premium” information is summarized in the next figure.
The Third Appraiser used the Mergerstat Review book and found two relevant transactions for companies in the same business as the subject entity. They had control premiums of about 50% and 70% and an average premium of about 60%. I say “about” because these numbers are in order of magnitude from memory. The files are long-gone pursuant to our document retention and disposal policies.
Recall the previous discussion of restricted stock studies where we showed that restricted stock discounts are not valuation ratios and contain no meaningful valuation information. We will show this to be true about control premiums as well in a future post. Please accept this as true until that post is published, or read Chapter 2 in Business Valuation: An Integrated Theory Third Edition (Mercer and Harms).
When I examined the same transactions in the Mergerstat Review Notebook, the EBITDA multiples were about 10x and 12x for the two transactions with an average of about 11x. In order not to be misleading (and incorrect), the Third Appraiser should have employed the guideline transactions method using a multiple of 11x, or converted the control premium to 10% based on the difference between the 11x EBITDA multiple from the transactions and the 10x EBITDA multiples from his guideline public company method. As corrected, the conclusion in the draft report is shown in the next figure.
The Third Appraiser obtained a $200 million marketable minority value by applying his guideline public company multiple of 10x to his estimated Capitalizable EBITDA. He then applied a non-economic 60% control premium to obtain the draft conclusion of $320 million. Had he applied the economic valuation ratio of 11x or a control premium of 10%, his conclusion would have been about $220 million, which is greatly different than $320 million! The result was a large and misleading overvaluation of the subject entity by the Third Appraiser.
To put a fine point on this analysis, if $320 million from the Third Appraiser is averaged with the $400 million conclusion of the Second Appraiser, the process conclusion would be $360 million. If the corrected conclusion of $220 million is averaged with the $200 million conclusion of the First Appraiser, the process conclusion would be $210 million. That is a difference of $150 million, a gross over-valuation, and very misleading to the intended users of the Third Appraiser’s draft report. And yes, I concluded that the draft report failed to comply with applicable valuation standards, citing chapter and verse.
The story is much longer and has many more details. However, the discussion so far is adequate for purposes of illustration.
Both sides conducted mock jury trials. That is the only mock trial I have ever participated in and it was a fascinating process. Company 1 had three jury panels for the mock trial. Company 1’s panels agreed with my review analysis. They found that the Third Appraiser’s conclusion reflected a gross overvaluation and failed to meet the valuation standards he was required to comply with. Company 2’s mock trial jury panels concluded similarly. I never learned the actual results of Company 2’s mock trials but heard the results were similar to those of Company 1. Within a relatively short time after the mock trials concluded, the case was settled on a basis favorable to my client, Company 1.
The Third Appraiser blindly applied an average control premium and obtained a faulty and misleading result. He insisted he was making valid valuation judgments. When exposed to appropriate review, those judgments were found to be misjudgments. Had he considered the actual economics of his guideline transactions, he would have reached a much lower conclusion and the buy-sell agreement process would have been concluded much earlier.
I had already published the first edition of the Integrated Theory (2004) when this matter was in process. It was helpful in explaining why the Third Appraiser’s analysis was incorrect. The current edition will be helpful to readers of this blog who are in a position to review appraisals performed by other appraisers.
Until next time, be well!