Deja vu is a feeling of already having experienced a present situation.  In my initial review of Valuing a Business Sixth Edition (VAB6) by Shannon Pratt/American Society of Appraisers, I was reminded that I had reviewed a significant number of the studies summarized in Chapter 19 back in 1997, when my book, Quantifying Marketability Discounts, was published. In this and a few future posts, I’ll share what I believe is the most complete analysis of the historical restricted stock studies that are still relied upon by many business appraisers.

An Aside. VAB6 represents the collective efforts of many business appraisers, who, under the auspices of the American Society of Appraisers, developed this sixth edition to maintain its place in the valuation literature and to honor Shannon Pratt.  I was one contributor to VAB6. Jeff Tarbell and I wrote Chapter 36, “Valuation Provisions in Buy-Sell Agreements.” Several colleagues at Mercer Capital also contributed to the book.

There were nine published restricted stock studies in 1997 when Quantifying Marketability Discounts was published.  A tenth study by Management Planning, Inc. was published as a chapter in that book.  The ten studies are shown in the following table.

These restricted stock studies have been heavily relied on by business appraisers in efforts to develop marketability discounts for illiquid minority interests of businesses for many years.  A focus on their averages have been the primary source of the unsupported notion that marketability discounts should be on the order of 35%, plus or minus a bit, without reference to the characteristics of illiquid interests being valued.  A few quick observations about the table, from the perspective of 2022, include:

• They were published a long time ago, or between about 25 and 50 years ago.
• With the exception of the first study, the SEC Institutional Investor Study, the sample sizes were all quite small.
• The overall average and median are about 32% to 33%, with the highest being 45% and the lowest being 24%.
• The available standard deviations are high relative to the averages for the studies where this analysis was possible.
• The range of observed discounts was very wide, indeed.  The low discount was a negative 30%, which is actually a premium.  The high discount was 91%.

As a prelude to reviewing these studies in a series of posts, it is appropriate to review the status of SEC Rule 144 at the time these studies were performed.  This is important because the restricted stock transactions were regulated by SEC Rule 144. This review is as of 1997 and pre-April that year when the initial period of restriction for restricted stock transactions was lowered from two years to one year.

SEC Rule 144 Pre-April 1997

Rule 144 consists of a Preliminary Note followed by paragraphs (a) through (k). When all conditions of Rule 144 have been met, an investor can dispose of securities without compliance with the registration requirements of the Securities Act of 1933.[1]

The following discussion of Rule 144 should be considered a layman’s attempt to explain this important statute and its implications for restricted stocks.

According to the Preliminary Note of Rule 144:

Rule 144 is designed to implement the fundamental purposes of the Act, as expressed in its preamble: To provide full and fair disclosure of the character of the securities sold in interstate commerce and through the mails, and to prevent fraud in the sale thereof * * * The rule is designed to prohibit the creation of public markets in securities of issuers concerning which adequate current information is not available to the public. At the same time, where adequate current information concerning the issuer is available to the public, the rule permits the public sale in ordinary trading transactions of limited amounts of securities owned by persons controlling, controlled by or under common control with the issuer and by persons who have acquired restricted securities of the issuer.[2] [Italics in the original; bold emphasis added.]

The exemptions of Rule 144 are generally not applicable to anyone deemed an underwriter under the rule or to anyone who is deemed to be involved with a distribution of the securities in question. In determining when a person is deemed not to be engaged in a distribution, Rule 144 suggests that several factors be considered:

First, the purpose and underlying policy of the Act to protect investors requires that there be adequate current information concerning the issuer, whether the resales of securities by persons result in a distribution or are effected in trading transactions. Accordingly, the availability of the rule is conditioned on the existence of adequate current public information.

Secondly, a holding period prior to resale is essential, among other reasons, to assure that those persons who buy under a claim of a section 4(2) exemption have assumed the economic risks of investment, and therefore, are not acting as conduits for sale to the public of unregistered securities, directly or indirectly, on behalf of an issuer….

A third factor, which must be considered in determining what is deemed not to constitute a distribution, is the impact of the particular transaction or transactions on the trading markets….The larger the amount of securities involved, the more likely it is that such resales may involve methods of offering and amounts of compensation usually associated with a distribution rather than routine trading transactions….[3]

With regard to the holding period for restricted securities, several provisions apply. While the provisions go into much greater detail than we will discuss here, at paragraph (d)(1), we find the following general rule:

(d)(1) General rule. A minimum of two years must elapse between the later of the date of the acquisition of the securities from the issuer or from an affiliate of the issuer, and any resale of such securities in reliance on this section for the account of either the acquiror of any subsequent holder of those securities, and if the acquiror takes the securities by purchase, the two-year period shall not begin until the full purchase price or other consideration is paid or given by the person acquiring the securities from the issuer or from an affiliate of the issuer.[4] [emphasis added].

In general, a purchaser of restricted shares of a public company has a minimum two year holding period before the restrictions placed by Rule 144 will lapse. Investors in restricted securities must therefore consider themselves subject to the risks of equity ownership for at least two years without a practical means of selling those shares.[5]

Even when the two year minimum holding period for restricted shares has elapsed, the shares are generally subject to additional restrictions on the volume of securities that can be sold. Paragraph (e) discusses limitations on the sale of securities by affiliates of a company. If restricted securities are sold by an affiliate of an issuing public company, the amount of shares that can be sold is subject to the following rules:

If restricted securities are sold by an affiliate of a publicly traded issuer, the volume of sales within the preceding three months of a sale or series of sales cannot exceed the greater of:

(e)(1)(i) One percent of the shares or other units of the class outstanding as shown by the most recent report or statement published by the issuer; or,

(e)(1)(ii)  The average weekly reported volume of trading in such securities on all national securities exchanges and/or reported through the automated quotation system of a registered securities association during the four calendar weeks preceding the filing of notice required by paragraph (h)…; or,

(e)(1)(iii)  The average weekly volume of trading in such securities reported through the consolidated transaction reporting system contemplated by Rule 11A3-1 under the Securities Exchange Act of 1934 (§240.11A3-1) during the four-week period specified in paragraph (e)(1)(ii) of this section.[6]

Generally, sales by non-affiliated persons must follow the same rules, unless otherwise excepted by paragraph (k) which states:

(k) Termination of certain restrictions on sales of restricted securities by persons other than affiliates. The requirements of paragraphs (c), (e), (f), and (h) of this rule shall not apply to restricted securities sold for the account of a person who is not an affiliate of the issuer at the time of the sale and has not been an affiliate during the preceding three months, provided a period of at least three years has elapsed since the later of the date the securities were acquired from the issuer or from an affiliate of the issuer….[7]

In other words, the restrictions of Rule 144 lapse for non-affiliates three years after the purchase date.

Affiliates are also subject to Rule 144A, which deals with private resales of securities to qualified institutional buyers (who are deemed to be knowledgeable and not in need of the protections of Rule 144).[8]  Affiliates are also subject to Rule 145, which is designed to provide protection by registration under the Securities Act of 1933 to persons offered securities in certain business combinations.[9]  An affiliate can also sell if its shares are the subject of an effective registration filed by the issuing company with the SEC.

The bottom line of this analysis of Rule 144 is that restricted stock is subject to restrictions under Rule 144, but that the restrictions are modified at the end of two years, and the restricted shares can be sold, subject to the volume limitations noted above. The restrictions lapse completely after the end of the third year following purchase for non-affiliates.

The restricted stock studies discussed below involved the purchase of restricted shares by non-affiliated, closed-end mutual funds. Therefore, the restrictions were expected to lapse within two-to-three years. In other words, the restricted shares were expected to become at least partially marketable within two years of their purchase, and freely tradable within three years.

We have provided this somewhat lengthy discussion of Rule 144 as an important point of differentiation with nonmarketable minority interests of closely held companies. This point of comparison will be considered in more depth in future posts.

Conclusion

With this background on pre-1997 SEC Rule 144, we will begin to review the restricted stock studies listed in the table above.  I hope readers of this blog will find this look-back at the commonly referenced studies interesting and helpful.

With only minor editing, this and the future posts will reflect my views of the studies at the time that Quantifying Marketability Discounts was published in 1997.  To the extent that I comment from a current perspective, I’ll note that at the time.  We will begin with a review of the SEC Institutional Investor Study in the next post.

In the meantime, be well!

Chris

[1] Hicks, J. William, Securities Law Series: Resales of Restricted Securities, 1994 Edition (Deerfield, Ill., Clark Boardman Callaghan, 1994), p.93.

[2] 17 CFR Ch. II (6-1-93 Edition) §230.144.

[3] Ibid

[4] Ibid

[5] There are certain exceptions or exemptions under Rule 144, but those are beyond the scope of this discussion.

[6]Ibid. Rule 144 has been updated since the late 1960s; however, the basic rules were sufficiently similar during the period the restricted stock studies (discussed below) were performed, at least for purposes of this analysis.

[7] Ibid

[8] 17 CFR Ch. II (6-1-93 Edition) §230.144A.

[9] 17 CFR Ch. II (6-1-93 Edition) §230.145.

In a post last week, I wrote about appraisal review, indicating that this important topic would be a new focus for ChrisMercer.net.  In that post, I addressed appraisal review, not as something mechanical that appraisers do, but much more broadly.  With this post, we begin to look at the standard of value of fair market value through the lens of appraisal review.

Fair market value is an important standard of value. However, most valuation texts spend very little space in discussing the topic.[1]  The discussions are typically brief and have a slant to gift and estate tax valuation.  Some authors apparently assume that all appraisers should know about fair market value.  Copies of Revenue Ruling 59-60 of the Internal Revenue Service and other rulings are often provided.

I suppose I must put myself in the category of writers who have not written a great deal about fair market value.  I wrote an article many years ago titled “Fair Market Value versus the Real World.”  A version of that article found its way into the first edition of Business Valuation: An Integrated Theory, but not the third edition.

In RR 59-60 we find a working definition of fair market value.  However, fair market value has broader applicability than the gift and estate tax arena and needs to be addressed more broadly.

In particular, a deep understanding of fair market value and the logical implications of the definitions and interpretations is important to the concept of appraisal review.  How can we review an appraisal of the fair market value of any subject interest if we lack an in-depth understanding of this, the most commonly applied standard of value?

As we begin our examination of the standard of value known as fair market value, it is appropriate to examine what is meant by three terms.  The first, of course, is the concept of standard of value.  The next concept is that of the premise of value.  The third concept is that of the levels of value.

We address the first two of these terms in this post and will examine the third in the next post.

Standard of Value

Standard of value is defined in the ASA Business Valuation Standards of the American Society of Appraisers as:

The identification of the type of value being used in a specific engagement; e.g., fair market value, fair value, investment value.[2]

The term, standard of value is not defined in the Uniform Standards of Professional Appraisal Practice (USPAP) and is mentioned only once in the 2020-2021 Edition – in Advisory Opinion 29, “An Acceptable Scope of Work.” However, USPAP does require the determination of the “standard (type) and definition of value” both in conducting and reporting business appraisals.[3]

A quick aside.  In looking up a link to USPAP, I found the following notice on The Appraisal Foundation website.

The Appraisal Standards Board voted on February 19, 2021 to extend the effective date of the current 2020-21 USPAP through December 31, 2022. 

In Standards Rule 9-2(c) of USPAP, we find the requirement:

(c) Identify the standard (type) and definition of value and the premise of value.

Standards Rule 10-2(a)(vii) then states regarding reporting for business valuation:

(vii) State the standard (type) and definition of value and the premise of value and the source of the definition;

Comment: Stating the definition of value also requires any comments needed to clearly indicate to the intended users how the definition is being applied.

USPAP requires not only that the standard (type) of value be stated, but also that appraisers should indicate to their readers how the standard of value is being applied in each appraisal.  Is the standard statement of the definition of fair market value and a recitation of the basic eight factors (you know the list – to be discussed in a later post) adequate to describe how fair market value is being applied?  I think more is required.  And if more is required in the conduct of an appraisal, more is required in the review of appraisals.

Premise of Value

USPAP refers to the standard of value as the “type” of value.  USPAP also requires that the premise of value be noted.  While the term “premise of value” is not defined in USPAP, a discussion of the concept makes its meaning clear for business appraisal in Standards Rule 9-3, Premise of Value:

STANDARDS RULE 9-3, PREMISE OF VALUE

In developing an appraisal of an interest in a business enterprise with the ability to cause liquidation, an appraiser must investigate the possibility that the enterprise may have a higher value by liquidation of all or part of the enterprise than by continued operation as is.  If liquidation of all or part of the enterprise is the indicated premise of value, an appraisal of any real property or personal property to be liquidated may be appropriate.

Comment: This Standards Rule requires the appraiser to recognize that continued operation of a business is not always the best premise of value because liquidation of all or part of the enterprise may result in a higher value.  However, this typically applies only when the business interest being appraised is in a position to cause liquidation.  If liquidation of all or part of the enterprise is the appropriate premise of value, the scope of work may include an appraisal of real or personal property.  If so, competency in real property appraisal (STANDARD 1) or personal property appraisal (STANDARD 7) is required.

Per USPAP, the appraiser must specify the premise of value as well as the standard of value.  Premise of value is defined in the ASA Business Valuation Standards as:

An assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation; e.g., going concern, liquidation.

The discussion of premise of value in USPAP above makes it clear that appraisers should determine whether a business is worth more as a going concern than in liquidation, or whether it is worth more in liquidation than as a going concern.  In some forty years of conducting business appraisals, I have employed the liquidation premise of value in only a few instances.  I am not aware of any additional premises of value other than going concern and liquidation.

The great majority of fair market value determinations are based on the going concern premise of value.  This fact has additional implications, which we will discuss further below.

The requirements of the ASA Business Valuation Standards are like those of USPAP and mandate, in “BV-I General Requirements for Developing a Business Appraisal,” at paragraphs II.B.9, II.B.10, and II.B.11, that the definition of an appraisal assignment include:

II.B.  In developing a valuation of a business, business ownership interest, security, or intangible asset, an appraiser must identify and define, as appropriate:

9. The standard of value applicable to the valuation (e.g., fair market value, fair value, investment value, or other)

10. The premise of value (e.g., going concern, liquidation, or other)

11. The level of value (e.g., strategic control, financial control, marketable minority, or nonmarketable minority) in the context of the standard of value, the premise of value, and the relevant characteristics of the interest (emphasis added)

Both USPAP and the ASA Business Valuation Standards require the specification of both the standard of value and the premise of value for any business appraisal. We have now briefly examined the term of standard of value.

In the next post, we will discuss the conceptual “levels of value.”  The levels of value are critical to the concept of appraisal review because differences in assumptions regarding the appropriate level of value for subject interests is one of the leading causes of major differences in appraisal conclusions.

Until next time, be well!

Chris

Footnotes

[1] There is a lengthy discussion of fair market value in a recent book.  See Fishman, Jay E., Pratt, Shannon P., and Morrison, William J., Standards of Value: Theory and Applications Second Edition (Hoboken, NJ, John Wiley & Sons, 2013).  See Chapter 2, “Fair Market Value in Estate and Gift Tax,” pp. 35-88.

[2] ASA Business Valuation Standards published by the American Society of Appraisers, last revised November 2009.

[3] 2020-2021 Uniform Standards of Professional Appraisal Practice (USPAP), promulgated by The Appraisal Foundation.  Unless otherwise noted, all references to USPAP are to the 2020-2021 edition.

Day 400 came and went a week ago and I did not write about it as I was getting ready to fly to Florida for a couple of weeks.  But the walking string continues well into its second year of 2,500 miles and 5.2 million steps, with an average of 12,800 steps and 6.1 miles per day.

While the walking string preceded it, there is another string of days we have all been living through.  We issued WFH notices to all our folks at Mercer Capital 317 days ago.  That is hard to believe.  For the most part, our professionals are still working from home and there is no near-term end in sight. This makes things like walking and paying attention to our health even more important than otherwise. That’s why utilizing products such as an n95 mask should be given great importance.

Sitting in Port Orange, Florida is a good time to reflect on the past year-plus of walking. For those who don’t know Florida geography, Port Orange is 2.5 miles south of Daytona Beach and about 50 miles northeast of Orlando.  The Daytona Beach area is host to one of the finest pickleball facilities in the nation.  It opened in June (with masks and social distancing, of course).  See Pictona here.

In no particular order, a few thoughts come to mind regarding walking 407 days in a row:

1. It makes me feel good to know I’m doing something positive for my health.
2. I do enjoy the benefits of being in better shape now than at the beginning of the walking string on December 15, 2019.
3. I appreciate that I’ve encouraged a number of friends and acquaintances to begin their own daily walking routines.
4. The weight loss of 13-14 pounds has been encouraging and, I hope, good for overall health.
5. The focus on health has helped me me choose a more balanced diet and to watch caloric intake. Not eating out for months also helped, I’m sure.  I instituted my “one plate per meal rule” early during the pandemic.
6. Thinking about walking is just something that I do.  When I wake up each morning, I check the weather and think about my schedule and what I will have to do each day.  Sometimes that is a three mile walk before breakfast.  That is a very good way to start a day! A few times it has been a four mile walk at the end of the day.  Every day though, I try to focus on being sure that I get up and about and move throughout the day.
7. Gratitude is what I feel for avoiding a string-ending injury or illness.
8. I’m grateful that I’ve been able to play a good bit of pickleball, weather and location permitting.  And I plan to play more, as much as I can, in the future.
9. We are 317 days into the WFH era.  I can say that walking has certainly helped me maintain a healthy mental attitude during this unprecedented time we are in.
10. I’m also grateful to be able to share this story on my blog and on LinkedIn.  I hope it encourages others to begin to focus on the simple act of walking regularly.
11. I’m hoping that I’ll be able to walk my miles/steps tomorrow.  I have not placed any pressure on myself to keep this thing going (well, maybe a little bit!), but I certainly want to keep it up as my health and circumstances permit.

This afternoon, I stopped by Pictona and was talking with a pickleball friend, Paul.  I mentioned my 407 days of walking and he said that today was his 770th consecutive day.  Now that is inspiration!

Let me know if there are some thoughts here that you find helpful.  Feel free to comment on the blog down below.  If you are reading this on LinkedIn, then feel free to comment there.

Lagniappe

This has nothing to do with walking, but it is time to obtain your personal copy of Business Valuation: An Integrated Theory Third Edition.  Travis Harms and I will be doing a three part webinar series with Business Valuation Resources beginning in February. When you get your book, we hope you will write a thoughtful review on Amazon.com!

Be safe and be well until next time.

Chris

Beyond a shadow of a doubt, if you own stock in a closely held or family business today, there will come a time in the future when you do not own or control it. This Valuation Video examines the Business Ownership Transfer Matrix that dictates that you will sell or transfer your shares, either partially or totally, and either voluntarily or involuntary.  If you don’t plan ahead, the Law of Unintended Consequences may come into play. When you transfer stock involuntarily, you lose control over what happens, and things can happen that you didn’t intend.  Promises may not be kept, estate taxes may be maximized, control may shift unexpectedly, and on. So plan ahead!

Beyond any shadow of doubt, if you own stock in a closely-held or family business today — if your clients own stock in closely-held or family businesses today —there will come a time when they will NOT own it or control it. The question is, how will they transfer that stock? How will they sell that stock?

This Valuation Video — I’m Chris Mercer — could be called “The Ownership Transfer Matrix and the Law of Unintended Consequences.”

If you have stock in a closely-held company, you’re going to transfer it, either partially or totally, and either voluntarily or involuntarily. There’s really no way out of the boxes. Now, there are a number of ways that you can transfer stock and some of them are in the boxes.

For example in the voluntary/partial transfer, you can have a company repurchase some stock, or give it to the children. Selling to other owners would be a possibility. A sale to an ESOP would be another possibility. And you might even do a merger and keep some stock so that you get partial liquidity, perhaps. On the total side, you can sell the business for cash or for notes or whatever. You can do an installment sale to the children. You can do an ESOP or you can do a company repurchase of stock and you can get liquidity. You’ll have partial liquidity or total liquidity.

Now, what happens in the partial/involuntarily box? You might divorce and have to give up some of your stock. You might have a shareholder dispute, and legally the stock is taken away from you in a squeeze-out merger, for example. Now on the involuntary side and with total transfer, if the horse you’re riding falls down or dies, you’ve got to get off. Well, you’re going to die someday, and I’m going to die someday. And when death occurs transfer occurs, shareholder disputes, and buy-sell agreements.

Now, there’s no way out of those boxes. I will say, these little bullets up here indicate where appraisals are needed or required in a lot of these transfers. And they’re desirable in the remainder of the transfers. So if you’re going to plan to transfer your stock, if you’re going to plan on how to manage the wealth that you have accumulated, you might as well get a regular appraisal — and maybe for your buy-sell agreements, for example, I’ve written books about that.

So if you don’t plan, what happens is that the Law of Unintended Consequences can come into play. What is the Law of Unintended Consequences? You can click here to know more. Those are the things that happen when you don’t do what you think you want to do, when you defer and wait. For example, if you die unexpectedly you may have promises unkept to your other shareholders or to your children. A control appraisal will be required if you still have control of the company — that’s for estate tax purposes — and you’ll have more estate taxes than necessary. The buy-sell agreement that you have in place may be in operation, and that may change control, and you didn’t intend for that to happen. The estate may lack sufficient liquidity if you died unexpectedly. Alternatively, you can become disabled. You can divorce with the help of www.pnwfamilylaw.com/spokane-family-law/divorce/. In a recent case, a gentleman had a lot of stock in a successful closely-held business. He was divorced. They didn’t have a lot of other assets. So he lost half of the stock because he couldn’t afford to buy it. He couldn’t control it. So you can lose significant value when you can’t afford to keep the stock.

Missed opportunities because of lack of preparation. And an unexpected offer could come along, in which case the stock may not be where you want it. You haven’t given it to your children or put it in a foundation. You haven’t given it away. You haven’t done what you want to do and you may have promises unfulfilled.

I said you’ll give up your stock voluntarily or involuntarily. If you don’t plan, chances are that you may find yourself in a position where you’re going to do something voluntarily, but you’re under distress, or you’re under a little bit of motivation, or under pressure to get something done. You can see here if you need an attorney.

So in this Valuation Video, we have talked about the Law of Unintended Consequences and the Ownership Transfer Matrix. We have four boxes up here. You can’t get out of the boxes. You’re going to transfer your stock, one way or another, so you might as well plan for it in advance — a regular appraisal of your business is an excellent tool in managing the wealth and helping you to decide when and how to make transfers.

Chris Mercer here from Mercer Capital’s worldwide headquarters in Memphis. I look forward to talking with you about the Ownership Transfer Matrix, or the Law of Unintended Consequences, or business valuation in general. Give me or any of the professionals at Mercer Capital a call and we’ll be happy to work with you.

Until the next time, good day!

WARNING. Portions of the great majority of buy-sell agreements (or relevant portions of operating agreements) addressing the valuation of interests when trigger events occur are seriously flawed. As a result, they are destined to create time-consuming, expensive, and emotional disputes between buyers and sellers when they are triggered. Most attorneys and business owners do not seem to believe me, but recent experience only reinforces the need for this warning post.

Recent Problems Identified

I have had the opportunity to read several buy-sell agreements over the course of the last weeks. The message of this post is simple:

The valuation mechanisms of every one of these agreements are seriously flawed.

When I say the valuation mechanisms are flawed, what I mean is that given the “words on the pages” of the agreements, there is a high likelihood for dispute between the parties when trigger events occur, and experienced lawyers from leppard law would agree with me. Issues found in reading these agreements recently include:

1. Standard of value (i.e., should be fair market value) not mentioned or defined, so there was no guidance regarding the type of value to be provided by appraisers.
2. Agreement called for 30 days to provide an opportunity for the parties to agree on value. What this really does is to provide an opportunity for the parties to get really upset with each other.
3. Confusion (i.e., different language in two or more places) regarding whether the valuation pertains to the interest subject to the agreement or to a pro rate share of the value of 100% of the equity of the business. This confusion virtually assures a dispute will occur.
4. Unrealistic timeframes for the selection of appraisers. One agreement basically set up a “race” to select the first appraiser. The party who did not select the first appraiser had only seven days to appoint the second appraiser. If the second party was not successful, the first party’s appraiser would be the exclusive appraiser, and the second party would not have appraisal representation.
5. Qualifications for appraisers to be selected were not provided, leaving open the selection of literally anyone as an appraiser for a valuation process.

There were other issues, but the picture is clear. Every one of the agreements I read recently is almost assured of creating a dispute between buyers and sellers in the event of a trigger event. Attorneys from the Contant Law, P.C. may be able to offer solutions in such cases.

Let me be clear. The agreements were drafted by competent and well-meaning attorneys in every case. The problem is that they were using buy-sell agreement templates where the valuation provisions had not been reviewed by competent valuation professionals. In my 35+ years of experience, I have not yet seen a single valuation template that provides for a valuation mechanism that has a good opportunity of working without problems.

Act Now for a Solution

This philadelphia truck accident lawyer that the only solution for the emerging valuation problems embedded in the great majority of buy-sell agreements is review and revision. The review must be performed by competent valuation professionals working in conjunction with counsel for companies. The business owners must be involved, as well, because they must agree to amend their agreements. For example, if there is an accident, car accident lawyer serving the Chicago area will be able to provide legal advice or the Miami car accident injury attorney might be able to help or give you a second opinion.

Too many business owners and attorneys seem to think that the kinds of problems I have mentioned will occur only to someone else or someone else’s company, If you need legal help form experts you may want to get more info at the link. The problem, however, will occur with your company or your client’s company when trigger events occur.

To facilitate resolving the latent issues in your buy-sell agreement, I make the following offer.

For the first two attorneys (or business owners) who respond to this offer, I will read the valuation portions of one buy-sell agreement. We will then schedule a complimentary half-hour telephone session in which I will provide my comments and observations regarding problems or issues identified (from business and valuation perspectives). I will then provide suggestions for how to address the latent problems with the valuation mechanisms. If a business owner answers this offer, the telephone session will need to be scheduled jointly with corporate counsel.

To claim this, email me at mercerc@mercercapital.com.

If you are the third (or later) to respond to this offer, I will call you and discuss a workable arrangement to provide the review that I have outlined above.

New Books on the Way

• An Attorney’s Handbook for Buy-Sell Agreements (in production).  This book provides guidance based on 30-plus years of dealing with buy-sell agreements. Importantly, it provides for the first time ever, anywhere, draft template language for the valuation portions of buy-sell agreements that will work for clients or companies.  You will not want to miss this book!
• Business Valuation: An Integrated Theory Third Edition (with Travis Harms). The draft is due to the publisher (Wiley) shortly and will be available subject to their publication schedule. This book updates the Integrated Theory of Business Valuation and will include the Integrated Theory on an equity basis and on an enterprise (total capital) basis, as well. This book will be must reading for all business appraisers and anyone interested in business valuation.

E-mail me if you would like to be notified when these books become available.

In the meantime, be well!

Chris

When most people think about buy-sell agreements, they think about shareholders and companies entering into agreements.  However, corporations also enter into buy-sell agreements.

Many years ago, a large oil company entered into a partnership with a much smaller, private company to develop and run truck stops across the country.  The private company contributed its existing truck stops at their estimated values to the partnership.  The oil company contributed an equivalent amount of cash, which provided the initial growth capital for the joint venture.

The partnership was owned on a 50%-50% basis, and ran and grew successfully for many years.

Then, one day, the big oil company announced a combination with another large oil company that many market participants referred to as a merger of equals.

One or both of the joint venture partners pulled out the partnership agreement and read its Section 9.7, which said, in its entirety:

Section 9.7 Option
If the controlling interest in a Partner or an Affiliate of a Partner which controls the Partner is sold to a third party, then the other Partner shall have the option to purchase the Partnership at its appraised value as a going concern.  If the parties are unable to agree on an appraiser, one shall be appointed by the American Arbitration Association.  The appraisal shall be completed within 90 days from the date of appointment of the appraiser.  The other Partner shall exercise its option within 30 days of the appraiser’s report.  Closing shall occur within 90 days from the date such option is exercised.

Oil prices were depressed at the time, as were gasoline and diesel prices.  Joint venture earnings were at a low point.  The private company thought it was a good time to purchase the other 50% of the joint venture, and exercised its option under Section 9.7.

The now very large merged oil company did not want to sell its interest, since the joint venture provided a large customer for its refined products, and they were satisfied with the joint venture’s operations.

The First Arbitration

The large oil company read the first sentence of Section 9.7 and said that no change of control had occurred and therefore, the option was not triggered.  The sentence stated:

If the controlling interest in a Partner or an Affiliate of a Partner which controls the Partner is sold to a third party, then the other Partner shall have the option to purchase the Partnership at its appraised value as a going concern.

The large oil company argued that there had been no change of control.  Rather, they had engaged in a merger of equals, so there was no change of control.  The private company disagreed.  There was an arbitration on the sole issue of whether there had been a change of control.

After a process that extended well beyond a year, the arbitration panel ultimately concluded that, indeed, there had been a change of control as result of the merger of the two oil companies, and that the option of Section 9.7 had been triggered.

This led to the need to determine the Partnership’s “appraised value as a going concern.”

Other Issues to Be Resolved

I don’t recall whether the parties agreed on a business appraiser or whether there had been an arbitration on the point.  My recollection is that the parties had agreed on an appraiser.  So one point of contention was either avoided or had been resolved by the time I became involved.

I’ve written, in Chapter 14 of Buy-Sell Agreements for Closely Held and Family Business Owners, that six defining elements are required to specify the valuation process when appraisers are called for pursuant to buy-sell agreements.  The elements, with brief comments, follow.

1. The standard of value. The standard of value was not specified in Section 9.7.  It merely called for the Partnership’s “appraised value as a going concern.  The normal standard of value for buy-sell agreements, fair market value, had not been specified.  However, the parties, in conjunction with the selected appraiser, agreed that the standard of value should be fair market value.
2. The level of value. The level of value, like financial control or nonmarketable minority, was not specified in Section 9.7.  Again, with some guidance from the selected appraiser, the level of financial control was agreed to by the parties.
3. The “as of” date. Note that there is no specification of the “as of” date in Section 9.7.
4. Qualifications of appraisers. Qualifications of business appraisers include, among other things, their experience, training,  credentials, and specific industry experience, if applicable.  Note that Section 9.7 is silent regarding experience requirements for a selected appraiser.  In this case, the parties had agreed to a credentialed business appraiser holding the Accredited Senior Appraiser (ASA) designation of the American Society of Appraisers.  He had some industry experience and more than a decade of appraisal experience.
5. Appraisal standards to be followed. The appraisal standards to be followed were not specified in the agreement.  However, because the parties agreed on an ASA-designated appraiser who was required to comply with the Uniform Standards of Professional Appraisal Practice (USPAP) and the ASA Business Valuation Standards, this defining element was met.
6. The funding mechanism for transactions. There is no specification of a funding mechanism in Section 9.7.  We will see that this was an important omission.

The “as of” date for the valuation was not specified.  As time progressed following the precipitating merger of the two oil companies and the first arbitration to determine if a change of control had occurred, industry conditions and the profitability of the joint venture were improving.

The parties continued to operate the joint venture as before, and normal decisions regarding reinvestment and distributions were made.

The determination of the “as of” date, therefore, was important.  The private company who wanted to purchase the oil company’s interest argued that the valuation date should be the date they exercised their option.  The oil company argued that the appropriate valuation date should be as close to closing as possible.

Ultimately, there was a second arbitration on the sole issue of determining the appropriate “as of” or valuation date for the required appraisal.

A well-known business appraiser friend of mine had been retained as an adviser to the oil company’s counsel as they worked through the first arbitration and towards the second one.  He suggested to the counsel that, because of my specific experience with buy-sell agreements and my publications on the topic, I would be a helpful addition to the team for the second arbitration.  By the time I was retained, the precipitating merger was more than two years in the rearview mirror.

The private company hired a nationally known appraiser for the arbitration regarding the valuation date.

Preparation for the second arbitration took many months.  Reports were issued, followed by rebuttal reports.  At last, it was time for the second arbitration, which lasted about a week.

The following summarizes a lengthy and hard-fought process before a panel of experienced arbitrators.

• A couple of facts
  • As noted, substantial time had passed since the precipitating merger. Industry conditions and the joint venture’s performance were improving.
  • While there were no appraisals, simplistically, everyone knew that the value of the joint venture was significantly higher at the time of the second arbitration than when the private company exercised its option to purchase.
• Positions of the parties
  • My client, the oil company, argued for a later valuation date. They had experienced all the risks of the business, had continued to run the business (or their role in management), had shared in distributions during the interim, and were fully invested during the entire valuation process.  I wrote an extensive report that looked at all sides of the arguments and at the entire partnership agreement.  I concluded that the appropriate valuation date should be as close to closing as possible.
  • The private company argued very loudly that the valuation date should be the date of their option exercise. They exercised the option, and that should be the date.  The other expert attempted to refute the logic of my report and concluded that the valuation date should be the option exercise date.

The Second Arbitration 

• There was extensive testimony from a number of valuation experts, other experts, and company management.
• When the testimony was over, I felt that the weight of the evidence supported the position of a later valuation date.
• The arbitration panel, after some time for deliberation, reached the conclusion that the valuation date should be as close to any proposed closing of the transaction as possible.

The Valuation and the Aftermath

After the issue of the valuation date was resolved, the retained appraisal firm went through its normal appraisal processes.  They issued a valuation report that concluded the joint venture was worth several hundreds of millions of dollars.  I looked at the report for my oil company client, and concluded that both its approach to the valuation and its ultimate conclusion were reasonable.

The private company, which had exercised an option to buy the oil company’s 50% of the joint venture more than three years before, attempted to arrange financing for the purchase.  In the final analysis, they were unable to arrange satisfactory financing and therefore were unable to close on the purchase of the oil company’s share of the joint venture.

The appraisal process, which began when the private company exercised its option under Section 9.7, ended.  There was no transaction.

The joint venture continued to operate for a number of years following the end of the valuation process.  The bigger oil company and the private company remained partners.

The Rest of the Story

As noted, the valuation process triggered by Section 9.7 of the partnership agreement of the joint venture lasted for more than three years.  The process was disruptive for the joint venture and its management.  It was certainly disruptive for the management of the private company.  It was probably a minor nuisance to the bigger oil company, given its size.

Based on discussions at the time with counsel for the oil company, they estimated that legal and expert fees for the appraisal process, which did not include the cost of the actual appraisal, totaled more than $6 million.

Section 9.7 had a total of 108 words.  That clearly was insufficient to specify a reasonable valuation process for the option/buy-sell agreement.

Just because companies are big does not mean that they are immune to the problems faced in buy-sell agreements everywhere.

Think how simple the process would have been if Section 9.7 had called for a Single Appraiser, Select Now and Value Now valuation process.  There would have been regular appraisals during the early years of the joint venture and everyone would have known the value at the time of the merger.  The issue regarding the valuation date would have been resolved by the ongoing valuation process.

The big oil company and the private company would have been better off.  The joint venture would have been better off.

The only folks who would have lost out with an appropriate valuation process for Section 9.7 were the many attorneys and appraisers who worked for three years during the process.

Perhaps, since I and Mercer Capital were part of that process, I should not complain.  My conclusion, however, remains the same.  The Single Appraiser, Select Now and Value Now process is the best valuation process for most buy-sell agreements.

Be well,

Chris

Reminder

Valuation is important for business owners for many reasons.  One of these reasons is for the operation of buy-sell agreements.  If you are thinking about your buy-sell agreement (and you should be), then take a look at Buy-Sell Agreements for Baby Boomer Business Owners, my Kindle book on the topic.

I’ve priced it at $2.99 so you won’t have to think about the expense.  So click on the image of the book.  You will be taken to Amazon.  Then buy the book.  Don’t be mislead by the price.  It is a full-length book.  If you like it, as most readers have, please take a few minutes and review the book on Amazon!

Additionally, my two most recent books are available in an Ownership Transition Bundle.  The bundle, priced at $35 plus s/h, has been attractive to many business owners, appraisers, and attorneys.

Three friends, including Austin, who had been in the investment business got together to start an independent firm.  They took on a couple of outside investors in order to be able to start the business with some scale.  Because they had outside investors, they implemented a buy-sell agreement immediately.

The business did well for going on two decades, and was growing and profitable.  Austin was a key player on the team.

The shareholders got together every year and estimated the value of the business for their buy-sell agreement.  They memorialized their agreement in what they called a certificate of value.

The shareholders and investors were optimistic and just knew that their business was quite valuable.  They made calculations each year as a basis for their certificate of value.

One day, quite unexpectedly, Austin died in a freak accident. His wife, also his estate’s executor, was charged with determining the value of the deceased shareholder’s shares in the business for estate tax purposes and with addressing the company’s buy-sell agreement and its certificate of value.

Given her husband’s death, the executor, his wife, had some misgivings about his former partners and the certificate of value.  Remember what I often say about the fact that, when one owner dies, his interests, or those of his estate, diverge from the interests of the company and remaining shareholders.

Mercer Capital was retained by the estate to determine the fairness, or reasonableness, of the current certificate of value price.

Unlike in the case of William’s father (see the previous post), where the fixed price agreement was never re-determined,  Austin and his fellow owners had re-set the certificate of value price every year and had done so again just a few months before his death.

We looked at the company and its financial statements, as well as the history of its certificate of value.  We looked at the industry and at available information on recent transactions.  It became clear that the certificate of value price had been set at what, in valuation terms, is called a strategic value.

The value was not an appropriate value for purposes of their buy-sell agreement, but rather, what the owners hoped the company might be worth if and when they sold it to a strategic acquirer.  But the certificate of value said what it said, and the agreement was operative and binding on all parties.

We quietly advised Austin’s wife, as the saying goes, to “take the money and run.”  And she did.  The company had some insurance on Austin’s life and paid the remainder of the certificate of value price in a long-term note.

The certificate of value price was more than fair for Austin’s wife.  The shareholders had been betting, all along, that none of them would ever die, but Austin was wrong, and he won the bet.  The company and the other owners substantially overpaid for his interest, and Austin’s widow fared very well.  They accepted lower than normal returns on their investments for many years.

Moral of the Story

I’ve said many times that, if you are so foolish as to have a fixed price buy-sell agreement, it is necessary to reset the price on a regular basis.  What I should have said is that if the price on a fixed-price buy-sell agreement is reset regularly, it is absolutely necessary that it be a price that is appropriate for all shareholders, whether they are future buyers or sellers under their agreements.

We will address the solution to this buy-sell agreement problem in a subsequent post.

Until then, be well!

Chris

Reminder

Valuation is important for business owners for many reasons.  One of these reasons is for the operation of buy-sell agreements.  If you are thinking about your buy-sell agreement (and you should be), then take a look at Buy-Sell Agreements for Baby Boomer Business Owners, my Kindle book on the topic.

I’ve priced it at $2.99 so you won’t have to think about the expense.  So click on the image of the book.  You will be taken to Amazon.  Then buy the book.  Don’t be mislead by the price.  It is a full length book.  If you like it, as most readers have, please take a few minutes and review the book on Amazon!

Additionally, my two most recent books are available in an Ownership Transition Bundle.  The bundle, priced at $35 plus s/h, has been attractive for many business owners, appraisers, and attorneys.

;

Below is the video, Corporate Finance Basics for Directors and Shareholders, as well as the transcript from the video. In this presentation, Travis W. Harms, CFA, CPA/ABV, senior vice president of Mercer Capital, offers a short, yet thorough, overview of corporate finance fundamentals for closely held and family business directors and shareholders.

For more information on Mercer Capital’s family business advisory services and other strategic financial consulting services, click here. Enjoy the presentation and feel free to share it. 

Be well, 

Chris 

Hi, my name is Travis Harms, and I lead Mercer Capital’s Family Business Advisory practice. I welcome and thank you for taking a few minutes to listen to our discussion, “Corporate Finance Basics for Directors and Shareholders.”

Corporate finance does not need to be a mystery. In this short presentation, I will give you the tools and vocabulary to help you think about some of the most important long-term decisions facing your company.

To do this, we review the foundational concepts of finance, identify the three key questions of corporate finance, and then leverage those three questions to help think strategically about the future of your company. We also heard about Jerome Myers coach for financial consultants and we wanted to learn more about this.

The cyber security platform for Azure can help secure your company’s data. There are many levels of cybersecurity available in the market. It is better to know the comparison of it vs ot security before choosing the best service to protect your data on the online platform.

Let’s start with the fundamentals of finance: return and risk.

Return measures the reward for making an investment.  Investment returns come in two different forms: the first, distribution yield, is a measure of the annual distributions generated by an investment. The second, capital appreciation, measures the change in the value of an investment over time.  Total return is the sum of these two components.

This is important because two investments may generate the same total return, although in very different forms.  Some investments, like bonds, emphasize current income, while others, like venture capital, are all about capital appreciation.  Many investments promise a mix of current income and future upside.

The most basic law of corporate finance is that return follows risk.

The above chart compares the expected return required by investors and the risk of different investments.  Since investment markets are generally efficient, higher returns are available only by accepting greater risk.

But what is risk?

Simply put, risk is the fact that future investment outcomes are unknown.  The wider the distribution of potential outcomes, the greater the risk.

While both investments represented above are risky, the dispersion of outcomes for the investment on the right is wider than that on the left, so the investment on the right is riskier.  Because it is riskier, it will have a higher expected return.  Now, whether that higher return actually materializes is unknown when the investment is made – that’s what makes it risky.

For a particular company, the expected return is referred to as the company’s cost of capital.  From a corporate finance perspective, the company stands between investors (who are potential providers of capital) and investment projects (which are potential uses of the capital provided by investors).  The cost of capital is the price paid to attract capital from investors to fund investment projects.

When evaluating potential investment projects, corporate managers use the cost of capital as the hurdle rate to measure the attractiveness of the project.

Next, we will move on to the three essential questions of corporate finance.

Corporate managers and directors should always be thinking about three fundamental corporate finance questions:

• First, what is the most efficient mix of capital? This the capital structure question – what is the mix of debt and equity capital that minimizes the company’s overall cost of capital?
• Second, what projects merit investment? This is the capital budgeting question – how does the company identify investment projects that will deliver returns in excess of the hurdle rate?
• And third, what mix of returns do shareholders desire? This is the distribution policy question – what is the appropriate mix of current income and future upside for the company’s investors?

Let’s start with the first question: what is the most efficient mix of capital?

You can think of the company’s assets as a portfolio of individual capital projects – that is the left side of the balance sheet.  The right side of the balance sheet tells us how the company has paid for those investments.  The only two funding options are debt and equity.  Because debt holders are promised a contractual return and have a priority claim on the assets and cash flows of the company, debt is less expensive than equity, which has only a residual claim on the company.

You can think of the company’s assets as a portfolio of individual capital projects – that is the left side of the balance sheet.  The right side of the balance sheet tells us how the company has paid for those investments.  The only two funding options are debt and equity.  Because debt holders are promised a contractual return and have a priority claim on the assets and cash flows of the company, debt is less expensive than equity, which has only a residual claim on the company.

If debt is cheaper than equity, you might assume that a company could reduce its cost of capital by simply issuing more and more debt.  That is not the case, however.  As the company uses more debt, the risk of both the debt and the equity increase.  And, as we said earlier, greater risk will cause both debt and equity investors to demand higher returns.

Eventually, because the cost of both components is increasing, the overall blended (or weighted average) cost of capital increases with increasing reliance on debt.  The goal of capital structure analysis is to identify the optimal capital structure, or the mix of debt and equity that minimizes the company’s cost of capital.

Now let’s move on to the second question: what investment projects should the company devote capital to?  At the strategic level, management’s job is to survey the landscape of potential investment projects, choosing those that are strategically compelling and financially favorable.

From a financial perspective, a potential investment project is attractive if the return from the expected cash flows meets or exceeds the hurdle rate, which is the cost of capital.

The appropriate pace of investment for a company is therefore related to the availability of attractive investment projects.

If attractive investment projects are abundant, the company should reinvest earnings into new projects, and, if yet more attractive projects are available, borrow money and/or issue new equity to fund the investment.  If attractive investment projects are scarce, however, the company should return capital to investors through debt repayment, distribution of earnings, or share repurchase.  We can now begin to see how the three questions are related to one another.  Capital structure decisions are always made relative to the need for investment capital.

This inter-relationship is illustrated above within the context of the two components of total return we discussed earlier.  Distribution yield provides a current return to shareholders from cash flow not reinvested in the business, while the cumulative impact of reinvested cash flows is manifest in the capital appreciation component of total return.

This leads us to the final corporate finance question, which relates to distribution policy: what mix of returns do shareholders desire?

While the operating performance of the business ultimately determines total return, the board can tailor the components of that return to fit shareholder preferences better.

We’ve primarily been looking through the rearview mirror to assess what the company has done in the past; now it’s time to look through the windshield and think prospectively about capital structure, capital budgeting, and distribution policy going forward.

First, capital structure.  In the long-run, the optimal capital structure will balance the cost of funds, flexibility, availability, and the risk preferences of the shareholders.  Now, that last factor – shareholder preferences – should not be overlooked.  Family businesses should not be managed for some abstract textbook shareholder, but rather for the actual family members that own the business.

For example, while an under-leveraged capital structure reduces potential return on equity, it also reduces the risk of bankruptcy.  Some shareholders may view this tradeoff favorably even if it can be demonstrated to be “sub-optimal” from a textbook standpoint.

Second, capital budgeting.  The attractiveness of investment opportunities should be evaluated with reference to future – and not past – returns.  Beyond the threshold question of whether such opportunities are in fact available, managers and directors should also consider financial and management constraints under which the company is operating and the desire of shareholders for diversification.

Be aware of that when you handle financial information you are exposed to cyber attacks, however, with this privileged access management system can help you to minimize the attack surface dynamically.

Since family business shareholders lack ready liquidity for their shares, they may have a greater desire to diversify their investment holdings away from the family business.  In other words, they may favor foregoing some otherwise attractive investment opportunities in order to increase distributions that would help shareholders diversify.

Third, distribution policy.  The appropriate form and amount of distributions should reflect shareholder preferences within the context of capital budgeting and capital structure decisions.  Perhaps most importantly, a clearly communicated distribution policy enhances predictability for shareholders, and shareholders like predictability.

Family business shareholders should know which of the four basic options describes their company’s distribution policy.

Finally, to recap, each of the three questions relates to one another.

The company’s capital structure influences the cost of capital, which serves as the hurdle rate in capital budgeting decisions.  The availability of attractive investment projects, in turn, determines whether earnings should be retained or distributed.  Lastly, distribution policy affects, and is affected by, the cost and availability of marginal financing sources.

For a deeper dive into some of the topics we talked about, we have several whitepapers and other resources that you can download from our website.

The good news is that you do not have to have an advanced degree in finance to be an informed director or shareholder.  With the concepts from this presentation, you can make relevant and meaningful contributions to your company’s strategic financial decisions.  In fact, we suspect that a roomful of finance “experts” can actually be an obstacle to the sort of multi-disciplinary, collaborative decision-making that promotes the long-term health and sustainability of the company.  Our family business advisory practice gives directors and shareholders a vocabulary and conceptual framework for thinking about and making strategic corporate finance decisions.

Again, my name is Travis Harms and I thank you for listening. If you’d like to continue the discussion further or have any questions about how we may help you, please give us a call.

Travis W. Harms, CFA, CPA/ABV

(901) 322-9760

harmst@mercercapital.com