Many years ago, I wrote a column for the Business Valuation Review that the editor, Jay Fishman, FASA, called “Mercer’s Musings.”

In this blog and with this post, I reintroduce “Mercer’s Musings” because I would like to reflect on a number of seemingly unsettled issues in the business valuation world.

This first musing relates to the need (or not) to comply with the Uniform Standards of Professional Appraisal Practice promulgated by The Appraisal Foundation in gift and estate tax appraisals prepared for the Internal Revenue Service.

In a previous post on this blog, I wrote:

… appraisers who must follow USPAP, and that includes all members of the American Society of Appraisers and any appraisers conducting appraisals for gift and estate tax purposes or for other purposes involving the federal government, these standards apply. The rules apply, practically, to almost all appraisers, including those holding ABV and CVA designations (emphasis added).

I said “practically” because I had not seen a specific requirement for business appraisers to follow USPAP; however, I did rely on the advice of a number of prominent gift/estate tax attorneys who had advised me that following USPAP was, in their opinion, required for IRS-related appraisals.

Some have said that I am wrong on this point. Let’s address this.

Upon a bit of research, it is clear that any (real estate) appraiser who performs appraisals of properties for mortgages must comply with USPAP.  That, apparently, is a fact.

Regarding business appraisers, I cannot find a direct requirement that USPAP be followed.  However, I can say that a number of high-end gift and estate tax attorneys have suggested to me that the requirement exists.

It is clear that appraisers holding the AM, the ASA, and the FASA designations from the American Society of Appraisers must comply with USPAP for all appraisals rendered, including those related to gift/estate taxes. We must also comply with the ASA Business Valuation Standards and the Principles of Appraisal Practice and Code of Ethics of the American Society of Appraisers.

The question for today is: Should appraisers credentialed by the other two major credentialing societies in the United States, i.e., the AICPA (ABV designation) and NACVA (CVA designation), comply with USPAP in gift/estate tax-related appraisals?

This is a different question than: “Are all appraisers required to comply with USPAP…”

Qualified Appraisals and Qualified Appraisers

According to § 1.170A-17(a)(1) of the Internal Revenue Code, which defines the term “qualified appraisal” for charitable gifting appraisals as:

(a) Qualified appraisal —

(1) Definition.

For purposes of section 1.170(f)(11) and §1.170A–16(d)(1)(ii) and (e)(1)(ii), the term qualified appraisal means an appraisal document that is prepared by a qualified appraiser (as defined in paragraph (b)(1) of this section) in accordance with generally accepted appraisal standards (as defined in paragraph (a)(2) of this section) and otherwise complies with the requirements of this paragraph (a).

(2) Generally accepted appraisal standards defined. For purposes of paragraph (a)(1) of this section,generally accepted appraisal standards means the substance and principles of the Uniform Standards of Professional Appraisal Practice, as developed by the Appraisal Standards Board of The Appraisal Foundation. (emphasis in original, bold added)

The term qualified appraiser is also defined as:

Qualified appraiser.  A qualified appraiser is an individual with verifiable education and experience in valuing the type of property for which the appraisal is performed.

1. The individual:

a. Has earned an appraisal designation from a generally recognized professional appraiser organization, for the type of property being valued; or

b. Has met certain minimum education requirements and 2 or more years of experience in valuing the type of property being valued. To meet the minimum education requirement the individual must have successfully completed professional or college-level coursework obtained from:

i. A professional or college-level educational organization,

ii. A professional trade or appraiser organization that regularly offers educational programs in valuing the type of property, or

iii. An employer as part of an employee apprenticeship or education program similar to professional or college-level courses.

2. The individual regularly prepares appraisals for which they are paid.

3. The individual is not an excluded individual (defined later). (bold in original, emphasis added).

Examining the Definitions

Qualified appraisers must deliver qualified appraisals according to the cited regulations for appraisals for the IRS pertaining to charitable giving.  Many attorneys suggest that the definitions are also relevant for gift/tax-related appraisals.

It is clear that appraisers holding credentials of the American Society of Appraisers must comply with USPAP and the ASA Business Valuation Standards of the ASA. It is also clear that appraisers holding the ABV (Accredited in Business Valuation) credential of the AICPA must comply with the Statement on Standards for Valuation Services (VS Section 100).  Similarly, appraisers holding the CVA (or predecessor designations) of the National Association of Certified Valuation Analysts (NACVA) must follow its Professional Standards.

Recall the last paragraph in the definition of “qualified appraisal” from above:

(2) Generally accepted appraisal standards defined. For purposes of paragraph (a)(1) of this section, generally accepted appraisal standards means the substance and principles of the Uniform Standards of Professional Appraisal Practice, as developed by the Appraisal Standards Board of The Appraisal Foundation. (emphasis in original, bold added)

To help address the question, I again consulted with several prominent tax attorneys. One attorney I talked to said there appears to be some “wiggle room” in the definition of qualified appraisal quoted above. There is a small difference between saying that a qualified appraisal must comply with USPAP and the actual language in the regulation.

Another attorney I consulted said any appraiser who does not comply with USPAP “is asking for a Daubert methodology challenge” and any appraiser who does not follow USPAP is “opening himself or herself up to ‘admitting’ that he or she did not comply with USPAP.”

The first question this attorney said he would ask an appraiser not complying with USPAP, even though complying with another set of standards, is:

Question: “Does your appraisal report comply with the Uniform Standards of Professional Appraisal Practice?”

If your response to the question is “No,” it could be problematic.

If your response is “No, but I don’t have to comply,”, it might still be problematic.

You would have to “prove” to the Court that the standards you followed were a) “generally accepted appraisal standards,” and b) that those standards “conform to the substance and principles of the Uniform Standards of Professional Appraisal Practice, as developed by the Appraisal Standards Board of The Appraisal Foundation.”  

An appraiser who chooses not to comply with USPAP is open to questions comparing his or her standards with those of USPAP.  For example, USPAP’s Standards Rule 9-4(d) states:

(d) An appraiser must, when necessary for credible assignment results, analyze the effect on value, if any, of the extent to which the interest appraised contains elements of ownership control and is marketable and/or liquid.

Comment. An appraiser must analyze factors such as holding period, interim benefits, and the difficulty and cost of marketing the subject interest.

Equity interests in a business enterprise are not necessarily worth the pro rata share of the business enterprise interest value as a whole.  Also, the value of the business enterprise is not necessarily a direct mathematical extension of the value of the fractional interests.  The degree of control, marketability and/or liquidity or lack thereof depends on a broad variety of facts and circumstances that must be analyzed when applicable. (bold in original, italics added)

Suppose an appraiser complying with other standards and not USPAP was asked: “Do your standards contain “…the substance and principles of the Uniform Standards of Professional Appraisal Practice, as developed by the Appraisal Standards Board of The Appraisal Foundation?”

It took just a couple of minutes to determine that there is no mention of a holding period, interim benefits, or distributions in either the AICPA’s SSVS or NACVA’s Professional Standards.  The only mention of dividends in the Professional Standards is in a list of factors from Revenue Ruling 59-60.  There are two mentions of dividends in SSVS, in definitions of equity cash flow and invested capital net cash flow.  This is not a criticism of either set of standards.  However, a non-complying appraiser is open to the obvious question:

“Did you not comply with USPAP to avoid this very specific guidance?”

Conclusion

So my last question in Mercer’s Musings #1 is my answer to the first question above:

“If I held an ABV credential or a CVA credential and did not hold the FASA designation, why wouldn’t I insure that my tax-related appraisals comply with USPAP?”

Appraisersi emptor.

As always, comments are welcome.

Until next time, be well!

Chris

My walking journey began December 15, 2019, or three years, eleven months, and a couple of days ago.  I had no idea this journey would last going on for four years now.  But it has.  The journey has had a few phases.

• Initially, I was fixated on 10,000 steps per day, which was my minimum goal for a few months.  I met that goal for 450 consecutive days until an injury slowed me down for a couple of days.
• When I realized that 10,000 steps was, given my step length, just short of 5.0 miles, I raised the goal to a minimum of 5.0 miles per day, every day.
• When an occasional injury or illness caused me to fall a bit short for a day, I felt disappointed in myself.  Finally, I changed the goal to a minimum of 35 miles per week or an average of 5.0 miles per day.

I’ve been on the last “program” for quite a while now, and it sits well with me.  For example, a couple of nights ago, I drove to my club to put in the last couple of miles to achieve the “minimum.”  I took my jacket off and hung it up, opened my locker, and stood there for a minute.  I realized it was okay to go over and have dinner a bit earlier.  I only walked 3.6 miles that day.  That’s okay because with the normal days logged the rest of the week on my Fitbit Sense 2, I ended the week with 39 miles or an average of 5.6 miles per day for the week.

September was a light month.  I tore or twisted my right meniscus on August 28.  Needless to say, after a cortisone shot and an exercise regimen from an ortho doc, my walking was curtailed a bit.  I averaged less than 4 miles per day until late in September when I began to be able to walk more normally.  Since then, I’ve averaged about 5.5 miles per day.

Unfortunately, I still lack the confidence in my knee to play pickleball much, so that area of my life has suffered.

What Walking Has Done for Me

The COVID-19 pandemic hit in mid-March 2020, almost exactly three months into my walking journey.  All of our lives were impacted by work-from-home mandates, masks, painful lines, no in-person church, no pickleball, and much more interference with our daily lives.  I kept walking.

During the pandemic, I instituted my “one plate per meal” rule and eliminated seconds and most desserts.  I still honor that rule for most meals, and it has been beneficial.  I wrote that post at the end of April 2020, 135 days into my walking.  There were some other “rules” as well that are timeless if adjusted to the present.  Take a read or watch the video.

When I started the walking journey, I weighed in at 212 pounds, and it might have been a pound or two more.  My blood pressure and cholesterol were out of whack, and I felt rundown.  I didn’t take care of myself very well during 2019.

While many folks were experiencing the “pandemic bulge,” I was dropping weight.  Depending on the day, I weigh between 192 and 195 pounds (193 pounds this morning).  That’s the equivalent of four 5-pound bags of flour I’m not carrying everywhere.  Needless to say, despite being four years older, my energy level is much improved, and my blood pressure and cholesterol are at levels that make my doctor smile.

A Bit More About Walking

I’ve written a number of posts as my walking journey has evolved.  I addressed the questions “Where do you walk?” and “When do you walk?” in this post at 1,000 Days.  The bottom line is that I walk anywhere and everywhere.  If the weather is horrible and I have no indoor options, I do a form of running in place that is effective.  I’m at the point now where I’m always looking for opportunities to walk an additional few minutes several times each day.

At 450 days, I asked four questions about walking and answered them as best I could.  The questions were and are:

• Why should anyone walk?
• What does it take to develop a walking program?
• What are some strategies to keep walking?
• Is a walking program right for you?

My nearly four-year walking journey has been beneficial for me both physically and mentally.  It is just easier to have a good mental attitude when one feels healthy and in good shape.

Let me end with my statistics at 3.93 years (1,435 days):

• 8,728 miles (or about 90% of the way from the top of North America to the tip of South America}
• 18.4 million steps
• 6.1 miles per day over the entire period
• 13,877 steps per day
• 42.6 miles per week for 205 weeks

Yes, I do keep a spreadsheet where I record mileage and steps so that I can create these stats.  It is fun and also motivating.

As always, comments are welcome on this post.  If you want to talk about walking, give me a call or email, and we will set something up.

And be well as the long Holiday Season begins this week.

Chris

I recently read a post on Chad Barr’s blog, Timeless Wisdom to Unlock and Thrive, that offered up some short and timeless nuggets of wisdom for those of us in the professional services world – and elsewhere, as well. Some of that wisdom included quotes by the following:

Steve Jobs: “Start with the customer experience and work backwards.”

Archimedes: “Give me a place to stand and I will move the world.”

Mark Twain: “The secret of getting ahead is getting started.”

Chad offered up a quote of his own, and the entire post (it is short) is a great read.  I commented on Chad’s post and repeat my effort at timeless advice now for younger (or older) professionals of every stripe.

Mercer Capital was “founded” (I love that word) over 40 years ago.  Most of the significant advances I have made in one professional services business (business valuation and financial advisory) since that time flow from one basic concept. Most professionals end up billing on the order of 60% to 70% of their time (unless you are in a sweatshop, and I hope not). To me, all time is equally valuable. When we bill, we generate revenue. When we are not billing, we do not generate revenue directly. A major differentiator among consultants of many stripes is the effectiveness of their use of non-billable time. My advice to young professionals for years has been:

Chris Mercer: “Always have at least one or two projects in process (writing, speaking, or other development) so that when billable activity slows, you can ‘fall back’ immediately to the highest priority/value project to move it along until billable activity resumes.”

Takeaway: Fall-back activities have enabled me to create eight books, chapters in a number of other books, hundreds of articles and speeches, and hundreds more blog posts over the years. While I was not paid directly for this time, those efforts have generated many millions of dollars of revenue for Mercer Capital. Develop a “fallback” mentality and execute on it.

In the meantime, be well.

Chris

Walking has become part of my daily life.  Some readers have been following my posts about walking for quite a while.  My current journey began 3 1/2 years ago on December 15, 2019.  As 2019 was drawing to a close, I realized that I had not been taking care of myself.  My weight had risen to 212 pounds, which was the highest it had ever been.  My cholesterol, blood pressure and a few other vital indicators were not in appropriate ranges.  I decided to change and began a journey of walking and other exercise that has changed my life for the good.  My initial goal was 10,000 steps per day, which I soon revised to 5.0 miles per day. In the last 3 1/2 years, or 182 weeks, or 1,278 days, my summary walking statistics are:

Yes, I do record my statistics every day on a spreadsheet.  I’ve walked 7,893 miles since the beginning for a total of 16.6 million steps.  My averages include 13,024 steps per day and 6.2 miles per day.  This morning, I weighed 196 pounds, which is still a few pounds higher than my longer-term goal, but the improvement is significant over the 3 1/2 years.  All those numbers that doctors look at have also improved significantly and are within normal ranges, thankfully.

Last month, I changed my personal goal statement to that of walking a minimum of 35 miles per week, or an average of 5 miles per day.  This change gave me “permission” to have an off day every now and then and still be able to meet the minimum weekly goal.  Looking back over the past 182 weeks, I have “failed” the weekly test only six times, and the average mileage for those six weeks was 31.2 miles per week.

Why Do I Walk and Play Pickleball?

At this point, I walk because I walk.  I walk to help keep on moving.  My observation is that as many older folks (older than me, of course!) stop moving and lose flexibility, the aging process accelerates.  And weakness and lack of flexibility contribute to falls which, as I understand it, are one of the largest contributors to accelerated deaths.  I plan to keep on walking and moving.

When I wake up in the morning each day, I begin to think about how and when I will walk to achieve five miles.  Of course, on days when I can play pickleball, it is a bit easier.  And I do play pickleball several times per week.  Depending on the competitiveness of play, my Fitbit Sense records about a mile of steps in two or three 11 point games.  On a good day, I’ll pick up three miles, plus or minus, on the pickleball courts.  The rest, as they say, is easy.  At this point, I play pickleball because I play pickleball.

I played in a men’s 3.5 doubles scrambler last evening at Pictona.  Pictona has 49 pickleball courts and 13 of them are covered.  We have visitors from all over the state of Florida and, indeed, the nation, so there is no shortage of competition.  My partner and I took Silver (that’s like Avis used to be) in the event.  By the way, at 75, I was the oldest participant in the event.  My partner was a young 51 years of age.  I had a couple of pictures taken during the competition just to prove that I do get out there.

Where Do I Walk?

I walk wherever I am.  When I travel, I make time to walk.  A few months ago I spent a long weekend in New York City visiting my son and his fiancé.  Walking is easy in NYC because it is an essential way of getting around.  For the four days I was there, I averaged over 8 miles per day.  When I travel on business, I make time in the morning or evening or both to take a couple of long walks – wherever I am, and whatever the weather is.  Layovers and delays at airports provide good opportunities to walk.  If I’m with someone, I’ll leave my roller bag.  If I’m alone, I’ll just push it along while walking.  I’ve walked many miles in airports.  When the weather is bad, I walk in hotel workout facilities, on large floors, in malls or large stores in downtown areas.  I walk in my neighborhoods in Memphis and Florida.  If all else fails, I will run in place.  It is harder and boring, but when it is time to walk, I walk.

The Magic of 10,0000 Steps?

Is there any magic to walking 10,000 steps (or about 5 miles per day for men)?  I don’t know for sure, but walking has worked magic for me.  It seems that many of the people who say this level of walking is not necessary are overweight healthcare providers.  Seriously. the magic is not in a particular number of steps or miles.  The magic is in regular movement.  Many years ago, a running coach told me the magic was in FOG, or “feet on the ground.”

Your mileage may vary, but in my “medical” opinion, a beginning point is to acquire a Fitbit, Apple Watch, or other smart watch that will count your steps.  I recommend the Fitbit Sense 2 because it looks good to me, works like a charm, and only needs recharging every four days or so.  I’m wearing mine in the pictures above – don’t want to miss any steps!

Wear the watch for a couple of weeks in the normal course of life.  At the end of that time, see what your average daily step count has been.  It does not matter if it is 1,500, 2,500, 4,000 or more steps per day.  This is what you are doing in the normal course of time.

Whatever the number is, if you think that the benefits are worth the effort, add 1,000 steps per day to your baseline and try to achieve that over the next couple of weeks.  Then do that again and again until you are comfortable walking 6,000 steps, or 8,000 steps, or 10,000 steps per day.  And just think about incorporating the necessary walking time into your day to achieve your new goals.

For me, the magic is in the walking on a regular basis and in adjusting my time and energy to walk.  Where will the magic be for you?

Please feel free to share your thoughts.

Chris

This post was originally written for Mercer Capital’s Family Business Director Blog and offered advice to family business directors based on my observations following the failure of Silicon Valley Bank on March 10, 2023.  This failure was followed by Signature Bank on March 12, 2023, and First Republic Bank on May 1, 2023.  All three banks failed because of deposit withdrawals in excess of the banks’ abilities to fund them.

• Silicon Valley Bank was taken over, or at least substantial assets and liabilities were assumed, by First Citizens Bank & Trust Company (Raleigh, North Carolina).
• Signature Bank was taken over by Flagstar Bank (United Community Bancorp)
• First Republic Bank was taken over by JP Morgan Chase.

As of today, May 19, 2023, the regional banking crisis may or may not be over but the SPDR® S&P Regional Banking ETF (KRE) remains almost 40% below its pre-Silicon Valley Bank high in early February.

Silicon Valley Bank was the first failure and, in many ways, offers some very important lessons for private business owners and directors.  With modest editing, I’ll repeat the original post now.

Introduction

The failure of Silicon Valley Bank will be talked about for years.  What really happened?  What caused SVB to fail?  Was it just the long-term Treasury Securities that everyone has talked about.  Well, no.  SVB was on a self-imposed path to destruction that had been in place and waiting for an adverse change in the economy or a rising interest rate environment to kick it into oblivion.

There are lessons to be learned for family business directors from this recent event.

A Short Digression from SVB?

This post comes from a different perspective than most who will write about the failure of Silicon Valley Bank.

In 1985, Mercer Capital was in two businesses, problem bank consulting and business valuation.  By 1987, we had worked our way out of the consulting business and were solely a valuation firm.  But there are some memories from our consulting days that are relevant to SVB.

I went to a board meeting of Park Bank of Florida in St. Petersburg in the latter part of 1985 to meet with its board of directors.  They had recently announced loan problems and losses and were seeking to hire a consulting firm to help them work through their problems.  Mercer Capital was retained.  Some recollections from that time include:

1. Park Bank had grown very rapidly, increasing total assets from $8 million to $750 million in eight years.
2. The bank went public in 1982.
3. The bank was “profitable” and attractive for those eight years, up to the time that they announced underlying asset quality problems.
4. Management and the directors prided themselves on being creative bankers and, in retrospect, thought they were smarter than other bankers.
5. The bank’s board and management were rather cocky, bragging in marketing campaigns about the bank’s sophistication and elitism.
6. The board and management literally “bet the bank” on their alleged creativity and ability to structure loans “better” than other banks.

The general attitude was different when I met with the board.  They were looking for help and Mercer Capital was retained.  I basically lived in St. Petersburg for several months while we attempted to help management address complex problem loans and to gain control over operating expenses.

Unfortunately, the problems were so deep that a workout was not possible.  In 1986, the FDIC closed Park Bank of Florida.  At the time, it was the sixth largest bank failure in history.

The Lessons

There are several lessons for family business directors from the failure of SVB (and Park Bank of Florida).  We summarize the lessons now, which include:

1. Don’t grow too fast.
2. Don’t grow staffing too fast.
3. Don’t smoke your own stuff.
4. Don’t make “bet the company” decisions.

 There are undoubtedly more lessons to be learned, but four is a manageable number.

Don’t Grow Too Fast

Unless you are a budding Amazon with almost unlimited and believing public and private funding, you cannot grow indefinitely without the prospects for reasonable returns.  Business value is ultimately a function of expected cash flow and its growth and the risks of achieving that expected growth.

SVB was in a race against the banking industry to collect deposits for its balance sheet.  Deposit liabilities are the major source of funding for most banks, and their deposits get deployed into loans, investments and other earning assets.  Let’s look first at total assets.

SVB had total assets of $209 billion at year-end 2002, making it the 16^th largest bank in the country (out of 4,116 banks) at that time.  SVB grew its total assets from $56.1 billion at the end of 2018 to $209 billion at the end of 2021, or at a compound annual growth  (CAGR) rate of 55% per year.  Those are just numbers, but let’s look at them.

SVB grew assets some $13.8 billion in 2019.  To put this in perspective, Sandy Spring Bank, the 107^th largest bank in the nation, had that many assets at year-end 2019.  But Sandy Spring Bank accumulated its $13.8 billion in assets over more than 150 years, not one year.

SVB grew its assets at higher rates and larger dollars in 2020 and 2021.  The bottom line is that SVB was growing its assets each year at amounts equal to some of the largest banks in the country after their many years of historical growth.

The nation’s 4,116 banks grew assets at a 12% CAGR in the three years ending 2021 (versus 55% for SVB).  The focus is on growth to 2021 because growth ceased for SVB in 2022 and slowed significantly for the banking industry as well.

When I was consulting, I talked about the “Law of the Double.”  When a company doubles in size, it is necessary for its management, accounting, finances, human relations, systems, and everything else to adapt to the larger size.

If a company doubles in size in ten years, or at a CAGR of just over 7%, change is evolutionary and occurs for the most part without much pressure.  When a company doubles in size in two years, as SVB did from 2018 to 2020, the internal pressures on systems are incredible, and those pressures got even worse when the bank grew its assets another 83% in 2021.

Silicon Valley Bank grew too fast to maintain proper controls at all levels of the organization.

Don’t Grow Staffing Too Fast

Hiring good people is difficult for almost all businesses when employment is tight or not.  Hiring many good people at the same time is even more difficult.  Take a look at the employment growth at SVB and think in terms of hiring at your company, regardless of its size.

SVB hired 322 net new employees in 2019, 623 employees in 2020 and 2,440 employees in 2021.  Imagine the internal resources necessary to identify and hire that many employees.  Given the numbers above, SVB hired 3,385 employees in three years and grew staff at a CAGR of 30%.  The banking industry staffing grew at a 2% CAGR over the same period.

Assuming no turnover in the 2,818 employees at the end of 2018, this means that employment more than doubled, that well more than half of all employees had less than 2.5 years’ experience, and about 40% of all employees had been with the bank for less than one year.

SVB had very little of what I call “institutional memory.”  How could management train so many new employees?  How could management instill any sense of corporate culture with so much change?  The answer is, they could not.

This kind of growth in a banking business is a precursor of future problems.

Silicon Valley Bank grew staffing too fast.

Don’t Smoke Your Own Stuff

Silicon Valley Bank was founded in 1983 and grew to become a $56 billion bank over the next nearly 40 years to 2018.  Assuming they started with $100 million in total assets, that represented an 18% CAGR over the period.  To put this growth rate in perspective, had SVB grown at 18% per year from 2018 to 2021, it would have been a $92 billion bank, rather than a $209 billion bank.

Management had to believe they had a better mousetrap than other bankers.  The board of directors had to have bought into that mousetrap to allow such uncharacteristic and unprecedented growth.

But money is all green.  Loan and deposit markets are competitive.  Loans are made on the basis of price, service, and quality.

1. Pricing relates to the interest paid by borrowers. Other things being equal, banks offering lower interest rates get the loans.
2. Service is defined by how bankers treat their customers. Service and relationships are important, but they only go so far.
3. Quality is a function of the structure and collateral for loans. Unfavorable structures and inadequate collateral from a bank’s viewpoint can help it gain loan market share.

The bottom line is that growing loans faster than the market for a sustained period of time (33% CAGR to 2021) increases the probability of future problems for a bank.  There has been little talk about loan quality issues at SVB.  It will be interesting to see how the portfolio performs under the new ownership of First Citizens, which needs to hope that the assets were purchased at a sufficient discount to preclude future losses.  Don’t be surprised if there are future problems.

A bank’s management and directorate had to be smoking some of their own dope to believe that it could sustainably outgrow its industry by a large margin.

Silicon Valley Bank’s management and directorate were smoking their own stuff.

Don’t Make “Bet the Bank (Company)” Decisions

Faced with interest margin pressures in the “zero interest rate environment” leading up to the end of 2021, SVB management had options.  Banks are required to engage in what is called “asset-liability” management.  They are required to consider the impact of future interest rate changes on their interest-earning assets and their interest-paying deposits.

When I was Assistant Treasurer of First Tennessee National Corporation in the latter 1970s (now First Horizon), we had to model the impact of interest rate changes for incremental strategies involving loans, investments, or deposit liabilities.  For some of the younger readers, this was before the advent of the personal computer, so we did this modelling by hand.  Strategies that the Finance Committee considered to be too risky were not approved.  The goal of asset-liability management then, as now, is to develop stable and reasonably defensive earning streams.

On October 1, 2011, the common stock of SIVB, SVB’s parent, peaked at $717 per share.  The price then began a steep decline, reaching a low of $230 per share before rallying to $302 per share at the end of 2021.  Management and the board were under tremendous pressure to generate performance that they hoped would stabilize the stock price.

They made the wrong decision.  They took the nearly $100 million in deposit growth from 2021 and put the majority of it into long-term term Treasury securities with maturities in excess of ten years.  At the time that SIVB’s stock price peaked in October 2021, the 10-year U.S. Treasury bond yield was on the order of 0.70%, just off the record low a few days before of 0.64%.

The pressure for yield at SVB and banks in general was historic in nature.  Over a fairly short time in late 2021 and early 2022, in the face of enormous margin and earnings pressure, management elected to invest more than $80 million in long-term (10-year or more maturities) Treasury securities at an average yield of about 1.75%.  The result is in the next figure.

SVB management bet that interest rates would not rise in late 2022 and into 2023.  And they made the bet with about 40% of the bank’s balance sheet.  When rates rose, the bank was not in a position to benefit from reinvesting shorter maturity securities nor in a position to avoid the earnings pressure of low rate, long-term investments in a rising rate environment.  To put things clearly, when rates began to rise, short-term deposit liabilities rose rapidly with no corresponding ability to offset increased deposit expenses by reinvesting maturing assets into higher yielding assets.

The offending securities in the figure above are called “held-to-maturity” and are accorded treatment such that they can be carried on the balance sheet at cost.  However, they do have market values and those are shown above.  The held-to-maturity securities had a cost basis totaling $91 million and a market value of only $76 million at year-end 2022.

There is an inverse relationship between interest rates and bond prices.  When rates rise, bond prices fall.  When maturities are long, bond prices fall a great deal.

The unrecognized loss of $15 million approximated SVB’s equity capital of $15.5 million.  When these financials were disclosed, as the old saying goes, “the jig was up.”

SVB “bet the bank” on an interest rate forecast that few believed in at the time.  And lost.

SVB Failed

The FDIC shut Silicon Valley Bank down on March 10, 2023.  There is talk about a “rush to justice” and that if SVB had had just a little more time it could have weathered the massive deposit outflows that ultimately caused its failure. You see, all the “friends of the Bank” who had massive amounts of uninsured deposits with SVB rushed to get them out as word began to emerge of potential liquidity issues.  Only 3% of SVB’s deposits were under the FDIC limit and therefore insured.  That means that 97% of the deposits were uninsured.  At First Tennessee, we used to call such deposits “hot money.”  It would move in a moment for a slightly higher interest rate.  And it for sure moved out of SVB at a pace that literally broke the bank.

From my perspective, the Silicon Valley Bank had already failed or had failure in its future regardless of the action of the FDIC on March 10^th.

That is not the case for the vast majority of family businesses.  Nevertheless, it is good to take our lessons from whence they come.

Recap for Family Business Directors

What are the lessons for family business directors who are not on the board of Silicon Valley Bank, but of a variety of kinds and sizes of companies around the nation?

We recapped them above, but in summary:

1. Don’t grow too fast. It is hard enough to keep eyes on the ball when growing at market rates for your industry.  The problems are exacerbated if your company is trying to grow at greater rates than your competitors or your industry.  And remember the Law of the Double.  Your management, systems and everything have to adapt to handle that growth.  If you double too quickly, you may not be able to adapt.
2. Don’t grow staffing too fast. This lesson is a subset of the first one, but it warrants separate attention.  Rapid growth of staff decreases average experience, requires substantial training, and dilutes the institutional memory.  It also makes it difficult to inculcate your company’s culture into the new staff.
3. Don’t smoke your own stuff. When things are going well, it is easy to begin to believe that your group is “above average” like all the children in Lake Wobegon.  When managements begin to think this way, it becomes difficult to bring your normal level of judgment and scrutiny to major decisions.  Recall that sage warning that “pride goeth before the fall.”
4. Don’t make “bet the company” decisions. Important decisions must be made, of course, and they always have some risk.  However, companies should avoid, to the extent possible, those individual decisions that can put the entire company at risk.  You’ll know one the next time you see one.

There are, indeed, lessons for family business directors and private company business owners and directors from the failure of Silicon Valley Bank.  Are we suggesting that you should not grow?  Of course not.  But good growth is planned growth that preserves markets or margins or both.  And don’t make “bet the company” decisions.

Comments are welcome.  In the meantime, be well.

Chris

My most recent post, titled Fair Market Value and the Nonexistent Marketability Discount, generated quite a discussion when posted on LinkedIn. In the last week or so it has received 5,600 impressions (whatever those are), 41 Likes, and 29 comments. Most of the discussion has been productive and welcomed!

The post provided a solid rationale that there is no such thing as a marketability discount for controlling interests of companies. One of the questions asked relates to the distinction between lack of marketability and lack of liquidity.  Some would like to say that companies are marketable – they can be sold, but they are not liquid.  And so a discount for lack of liquidity might be appropriate.

This post examines these two concepts, marketability and liquidity, or the lack of one or both in the context of fair market value determinations of controlling ownership interests of private companies.

Important Definitions

The Sixth Edition of Shannon Pratt’s Valuing a Business (with the ASA Educational Foundation) was published in late 2022.  Let’s refer to the book as Pratt’s Sixth Edition.  Chapter 19 is titled “Discounts for Lack of Liquidity and Lack of Marketability.” (p. 419)

The Introduction of Chapter 19 contains the following paragraph:

“These two concepts of lack of liquidity and lack of marketability are related but distinctly different.  As with all valuation adjustments, it is important to identify the base of comparison to which the adjustment relates.  The prior edition of this book defined how liquidity and marketability could be differentiated.  Since that edition, the discussion about these two concepts has evolved.  This chapter presents current thinking on the subject.  No doubt these concepts will continue to be refined.” (P. 420) (emphasis added)

A section of the chapter called “Liquidity and Marketability – Closely Related But Not the Same” introduces the discussion of marketability versus liquidity.  (p. 423)  There are two subsections titled “Liquidity” and “Marketability,” respectively.  Regarding liquidity, the text states:

“The cost of the relative illiquidity of marketable securities is embedded in its price.[1]  In most cases, there is no need for an analyst to adjust the price of a marketable security for the cost of illiquidity.  Indeed, it is embedded in the pricing information from this market, which often forms the basis of comparison in valuing a subject interest.” (P. 421)

[1] Transaction costs also rise with illiquidity.  However, in most circumstances, transaction costs are not factored into the appraisal of the subject interest since the pricing information of frequently traded comparable securities is not adjusted for these factors.”

The International Valuation Glossary – Business Valuation (“the Glossary”) provides definitions of liquidity and marketability and their related discounts.  These are quoted in Pratt’s Sixth Edition.

Liquidity — the ability to quickly or readily convert an asset, business or investment to cash at minimal cost. (P. 422)

Marketability — the ability to quickly or readily convert an asset, business, or investment to cash at minimal cost that reflects the capability and ease of transfer or salability of that property.  Marketability is also affected by, among other things, the particular market in which the asset is expected to transact and the characteristics of the asset. (P. 423)

Discussion of Definitions and Base Values

Both definitions begin with “the ability to quickly or readily convert an asset, business, or investment to cash at minimal cost”.  That is the entire definition of liquidity.

The definition of marketability expands on that concept by adding that marketability “reflects the ease of transfer or salability of that property.”  The definition is further refined to discuss the particular market in which an asset is expected to transact and the characteristics of the asset being valued.

The expansion of the definition of marketability is important in that it provides more than just the quick conversion to cash.  Looking at the entire definition of marketability, I believe that the likely meaning of the ease of transfer is the relative ease of transfer or salability in the particular market and given the characteristics of the asset, e.g., a controlling ownership interest, being valued in relation to the market for entire companies.  After speaking with one member of the committee that created the Glossary, I believe that my interpretation is on-point.

Many appraisers, including the drafters of Chapter 19, want to equate the “liquidity” represented by cash in three days with the “illiquidity” of the time it takes to sell controlling interests.  They suggest that a discount for lack of liquidity is needed because of the time it takes to sell.  There are problems with this reasoning, as pointed out in my last post.

• The definition of fair market value, the standard of value employed in most appraisals, calls for a hypothetical transaction to occur on the valuation date.  All marketing, due diligence and documentation has occurred before or on the valuation date and a hypothetical transaction occurs on the valuation date.  Importantly, the transaction occurs for cash and/or cash equivalent consideration.  There is no “marketing” after the valuation date.  It has already occurred. It is simply incorrect to suggest that a controlling interest should be discounted because of marketing time after the valuation date.
• The concept of marketing before the valuation date is analogous to the concept of exposure time in real estate appraisal.  Exposure time is defined in the Uniform Standards of Professional Appraisal Practice (USPAP) as the: “estimated length of time that the property interest being appraised would have been offered on the market prior to the hypothetical consummation of a sale at market value on the effective date of the appraisal.”There are no concepts of  “marketability discounts” or “illiquidity discounts” in real estate appraisal because it is clear that a property has been assumed to have been on the market for a sufficient time and that appropriate effort has been expended before the valuation date so that the assumed hypothetical transaction reflected by the appraisal (for cash or its equivalent) can occur on the valuation date.The same holds true for fair market value determinations of controlling interests of businesses.  There has been (assumed) sufficient “exposure time” (marketing, due diligence, and documentation) and effort that the hypothetical sale contemplated by the definition of fair market value can occur on the valuation date for cash or its equivalent.  There can be no “marketability discount” or “illiquidity discount” based on time or expense to market companies after the valuation date. 
• As noted above, the cost of any illiquidity of publicly traded securities is reflected in their transaction prices.  When trades occur, we only see one price, the transaction price.
• The very same logic pertains to the sale of controlling interests in companies.  Appraisers use transaction multiples from transactions in similar companies with the guideline transactions method.  Only one price is observed when private company transactions close: the price agreed to by buyers and sellers.  If a transaction had noncash consideration, it is up to the appraiser to put that on a cash-equivalent basis before calculating multiples.  Any cost of illiquidity in the sale of companies is reflected in their prices, just as with publicly-traded securities.
• There is no relevant base value from which either a discount for lack of liquidity or for lack of marketability might be taken.  And no discount has any meaning unless the base value from which it is taken is defined.

Pratt’s Sixth Edition recognizes this fact and considers four possible base values.  I quote and then comment below each possible base value.

“If the appropriate standard of value is fair market value, the price ultimately expected to be reached between a willing buyer and a willing seller – before the costs and risks listed above are considered – is a benchmark from which the discount for lack of liquidity could be taken.” (emphasis in original) (pp. 457-458)

This first suggested base value does not hold water in fair market value determinations.  The price that (hypothetical) willing buyers and sellers agree on for a business is its fair market value.  It is certainly not the benchmark from which an illiquidity discount for a controlling interest should be taken.  Any effect of illiquidity is reflected in the agreed upon pricing.  The price agreed to by a willing buyer and a willing seller is, well, the price.

“The price one might receive in an initial or secondary public stock offering (i.e., the publicly traded equivalent value).” (p. 458)

The price in a potential IPO is simply irrelevant for the great majority of private businesses.  Most companies will never have the size or characteristics to make them attractive public candidates.  They may nevertheless be quite attractive companies.  Further, in IPOs, normally only a small portion of companies are offered to the public.  That is different than placing the entire company on the market.  This is not a relevant base value.

The “publicly traded equivalent value” is a hypothetical concept.  Appraisers value companies at the marketable minority level (financial control), which is also called the “as-if freely traded” value.  It is a hypothetical price at which appraisers assume would be the price at which a private company’s shares would trade if there was a free and active market for its shares.

The as-if freely traded value is not  a benchmark from which a discount for illiquidity for controlling interests might be taken.  The as-if freely traded value is coincident with financial control value, so there is no reason to apply any discount for lack of liquidity.  See the levels of value chart in a prior post.  And see both of the levels of value charts in Pratt’s Sixth Edition (at p. 55 and p. 389).  No such discount is reflected on either chart.

“The price achievable in a private sale of the entire closely held business enterprise.” (p. 458)

If a company achieves a price in a private sale of the entire business, That is the price and value of the business.  This value does not represent a benchmark level from which an illiquidity discount for controlling interests might be taken.

“A control transaction of a publicly funded company.” (p. 458)

Frankly, I am not sure what this means. But it is not a base or benchmark value from which an illiquidity discount for controlling interests might be taken.

None of the base values proposed in Pratt’s Sixth Edition (and in prior editions) will serve as a base value from which a discount for illiquidity for controlling interests might be taken.

Three Examples            

We can discuss the concepts of liquidity and marketability in the context of three specific examples.

The expansion of the definition suggests that marketability may differ for different assets that trade in different markets.  Consider three assets:

1. 1,000 Shares of META Platforms (Facebook). META is trading in the vicinity of $210 per share as I write. An investment of 1,000 shares would have a market value of $210,000.  An investor owning 1,000 shares could issue a sale order today and have cash in her brokerage account in a very short time.  An investor who wants to buy 1,000 of META could place an order and acquire ownership of the asset effective almost immediately.  With either of these transactions (buy or sell), I would pay no brokerage fees if I executed in my Schwab account.  I would not even have to worry about stock certificates since Schwab acts as a custodian for my interests.

What does an investor acquire when purchasing 1,000 shares of META?  He acquires a literal “stock certificate” representing a very, very small but pro-rata claim on all the cash flows of the company, and is the pro-rata beneficiary of any future dividends or stock repurchases.  The shareholders have collectively delegated to or allowed control by METAs management and the board of directors.

The current market price of $210 per share represents the current consensus pricing (per share) for all of META in the market today.  The market is highly liquid.  And META shares are marketable.  And current pricing certainly represents freely-traded pricing (marketable minority)  and financial control pricing.  It is the base price to which any strategic or synergistic premium might be applied — if a potential purchaser expected such benefits.

2. META Holdings, Inc. (the entire company). The market capitalization of META is about $550 billion as I write. I might be able to handle an investment of 1,000 shares of META, but I am not the market for the entire company.  That market is quite limited, but it exists, and is international in nature.  As big as META is, someone or ones would step up if META were “on the market.”If Mr. Zuckerberg were to decide to sell META, it would likely take some time to find a buyer or consortium of buyers.  But what would happen in the meantime?  The company would continue to operate and, hopefully, continue to create value for all its shareholders.  META shares would continue to trade, undiscounted because of any potential sale. There is no discount for lack of liquidity or lack of marketability. If Mr. Zuckerberg and the META board of directors were to talk with potential suitors, rest assured that no suitor would suggest that a discount for lack of marketability or a discount for lack of liquidity is appropriate.  Mr. Zuckerberg would laugh at such a suggestion.Is META, the company, liquid according to the definition of liquidity above? No, it would not be likely to be sold or converted to cash quickly in one day or two or three.  Does anyone care?  Not really.  To reiterate, there is no discount for lack of liquidity or lack of marketability.
3. XYZ Company (100% of equity).  XYZ is a successful professional services firm with revenues of about $25 million, an EBITDA margin of 16%, and no debt.  Earnings are about $4 million and have been growing each year.  There is little seasonality to its earnings and distributions are made on a quarterly basis to its owners.Assume that it will likely take about a year to identify an appropriate buyer and to negotiate and close a sale.  The board commences a sale process.  At the end of three months of “marketing,” the company makes a distribution of $1 million from its earnings to its owners.  At the end of six months and nine months, the same thing occurs. All of this occurs during the marketing period.Assume the XYZ board closed its sale one year after its “marketing” began.  Its owners would take their last $1 million distribution at or just before closing.  And they would receive $30 million cash at closing (7.5x EBITDA).What is the buyer purchasing?  Well, clearly, the buyer desires to step into the shoes of XYZ’s owners and enjoy the benefits of its expected cash flows into the future.  That’s what they just paid for.  There is no discount for lack of illiquidity or marketability.  And there is no basis, in an appraisal of the same company, to apply any discount for future marketing efforts.  In an appraisal, the hypothetical transaction occurs on the valuation date just as the assumed closing of the XYZ sale occurred on the valuation date.

Wrapping Up

In my last post, I concluded that no marketability discount is applicable to controlling the ownership interests of businesses.  In this post, I reached the same conclusion.  Further, there is no discount for illiquidity applicable to controlling interests of businesses.

If someone is able to define different levels from the base value of financial control/marketable minority in terms of differences in expected cash flow, growth, and/or risk, then we can talk about such a discount.

To date, no one has done so.

As always, I welcome your comments on this post. If you’re reading this on LinkedIn, please do comment there.

As always, be well!

Chris

Business owners and their advisers sometimes fixate on the multiples, usually of EBITDA, obtained in transactions.  Normally, these are transactions involving other businesses and other owners.  To maximize business value, however, that focus is misplaced.  The reason is simple:

All that any business owner can hope to achieve in a sale is the maximum multiple of EBITDA available in the marketplace for his or her business at the time it is offered for sale.

Worry About the EBITDA Multiple?

The maximum multiple (or, in reality, range of multiples) at a point in time is a function of numerous factors including:

• Conditions in the stock market
• The level of interest rates and the availability of financing
• Conditions in the relevant economic markets (national, regional, local…)
• Industry conditions
• Current interest of competing strategic buyers in similar businesses
• Availability of investment funds in private equity funds focused on similar businesses
• When irrational buyers abound
• The level of earnings and conditions in the business being sold

Except for the last item in the list above, factors influencing the level of multiples available in the market at a point in time are outside the influence of a company’s owners and management.

Assume for this discussion (and simplicity) that the target range of multiples for a particular business at a point in time is from 6x EBITDA to the maximum of 8x EBITDA.  This range is set.

Focus on EBITDA?

Company owners and managers should focus on building the level, sustainability, and expected growth of their earnings to maximize the value of their businesses.  The basic idea is to have the company in a good or optimal position at all times so that at the time a sale is initiated, earnings are optimal and the outlook for earnings is favorable. Employers who are looking for some tips on how to improve employee experience should have a peek at this website.

In addition, if your business faces an employment tribunal, hiring an employment tribunal service for employers can take all of the stress out of preparing your business for an employment tribunal. They can help making sure your business complies with statutory requirements, so nothing is left standing between justice being served and ensuring your businesses compliance standards are upheld!

There are many more ongoing opportunities to work on increasing EBITDA for any company than there are for increasing the multiple.  Rather than worrying about his or her EBITDA multiple, the business owner (or director) could work on (or cause others to work on) one or more of the following:

• Work on increasing revenue  
  • Increase sales of existing products or services to existing customers.
  • Sell existing products or services to new customers in new markets.
  • Create new products to sell to existing customers (and new customers).
  • Omit lines of products or services that are losing money.
  • Expand productive selling locations, When you’re looking for office suites that are centrally located, be sure to call Execu-Suites.
  • Increase sales force if appropriate.
  • Add new locations.
  • Acquisitions that fit and do not increase risk materially.
• Improve cost of sales or cost of goods sold
  • Work on improving pricing on purchases
  • Enhance the product creation processes, consider using blister pack for your packaging
  • Work or invest to increase productivity of the label
  • Invest appropriately to increase manufacturing or distribution efficiencies
  • Consolidate facilities
  • Reorganize management
  • Fix any deferred maintenance or investment issues
• Improve operating expenses (absolutely or relatively)
  • Lower personnel costs if possible, or
  • Lower personnel costs per unit/product/service
  • Work to reduce occupancy costs
  • Eliminate known redundant expenses
  • Make solid investments in research and development
  • buy quality backlinks to attract more users
  • Reorganize management
  • Increase productive use of the internet and social media
  • Enhance technology to improve efficiencies
  • Work on systems to better organize efforts
  • With the help of Laravel development agency in the UK, develop and implement new ideas for selling and marketing
• Other ideas to consider
  • Work on diversifying customer base to reduce risk
  • Diversify products/services to reduce risk
  • Diversify suppliers to reduce risk
  • Work on obvious “window-dressing” to enhance the appearance of facilities for employees, visitors, and prospective buyers

While all this work is going on to increase EBITDA, or to increase the EBITDA margin with growing sales, it can also be helpful to rationalize a company’s balance sheet.  We can talk about that on another day. If your business requires a better internet connection to fuel your operations, data such as leased line comparison are essential.

Wrapping Up

My father gave me some excellent advice as a young man when I’d say “I wish” about something.  He’d say, “Chris, wish in one hand and work with the other one and see which hand gives you the best results.”  It taught me to quit wishing for good things, like good EBITDA multiples.

The key to obtaining the best price for your company—or your clients’ companies—is to work on the businesses over time to increase earnings, or EBITDA, rather than worrying about what multiple might be available in the marketplace.  Once a business is on the market, it is too late to work on it.  We began by saying:

All that any business owner can hope to achieve in a sale is the maximum multiple of EBITDA available in the marketplace for his or her business at the time it is offered for sale.

We end by saying further:

To achieve the maximum multiple of EBITDA available in the marketplace for a business at a point in time, the best strategy is to have been working to enhance EBITDA before that time.

While the following comment in this post has nothing to do with EBITDA, my new book, Buy-Sell Agreements: A Handbook for Attorneys, will help preserve, position, and transfer ownership of businesses.  While written for the attorneys who must draft buy-sell agreements, the book will be valuable for business appraisers, business owners, accountants, financial planners, and other advisers to businesses.

Send me an email to receive notification of its availability, hopefully near the end of the first quarter.

mercerc@mercercapital.com

And please call with any questions about the applicability of the ideas in this post to the value of your clients’ businesses or if you are a business owner or director, to the value of your business.

901-685-2120

Be well,

Chris

Q: Would the appraiser for a LLC, that holds only rental real estate, use a real estate appraiser or a business valuation appraiser to value the business?

Answer:

Most real estate appraisers shy away from valuing equity interests such as LLC minority interests.

In most cases, if the valuation is other than a pro rata share of the net asset value (per the agreement), a real estate appraiser would provide an appraisal of the underlying rental property (in your example).

The business appraiser would then consider that appraised value in his or her determination of value of the entity or of the interest in the entity.

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For more information on this topic and other topics related to buy-sell agreements, check out Buy-Sell Agreements for Closely Held and Family Business Owners.

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This series, “Ask Chris Mercer,” is derived from the Q&A session of the May 16, 2012 webinar, “Buy-Sell Agreements” sponsored by WealthCounsel and attended by over 600.  

If you have a question for Chris, feel free to email him directly here.