While working on the valuation of a series of promissory notes recently, I recalled a case involving my very first note valuation. It reminded me once again that if an appraiser (or any professional) desires an object lesson in humility, he or she just needs to look at a report (or other work product) prepared 30 years ago.

The Case

The case related to valuing a two-thirds interest in a promissory note issued in 1997 by a private company called St. Regis Paper Company, which was subsequently acquired by Champion International, a publicly traded company.

The appraisal I wrote just over 30 years ago went to Federal District Court, where the client (an estate), filed a suit seeking a refund of estate taxes paid (Evelyn T. Smith, Executrix of the Estate of Verna Mae Taylor Crosby v. United States, 923 F. Supp. 896 (1996)). Mrs. Crosby died on April 28, 1988, holding a substantial interest in a promissory note.  My estate tax appraisal was issued January 20, 1989.

The Note

The promissory note in question was issued by St. Regis Paper Company in the amount of $10,312,000 to a Mississippi timber owner, Mr. L.O. Crosby, Jr., in May 1977 (“the Note”). As I wrote in a report so many years ago:

[…] Mrs. Crosby inherited her interest in the Note upon the death of her husband in 1978.  The remaining one-third interest in the Note was bequeathed to an unrelated charitable organization.  St. Regis Paper Company was subsequently acquired by Champion [Champion International Corporation, a publicly traded land and timber company]  in November 1984.

For starters, the estate held a two-thirds undivided interest in a larger, single page note.  The Note carried a stated rate of interest of 6% per annum. The principal was payable in twenty equal annual installments of $515,600 each, and the interest was payable in twenty unequal, but rising annual payments for the life of the Note. The principal balance of the Note as of April 28, 1988 was $5.2 million, plus accrued interest since the beginning of the Note, totaling $3.3 million. The face amount of the note was, therefore, $8.5 million. Mrs. Crosby’s two-thirds undivided interest in the Note (principal plus accumulated interest) was $5.7 million at face value at the date of her death.

The Note Valuation

The first step in valuing the Note was to determine an appropriate discount rate. The most comparable Champion public debt was trading at 10.09% yield to maturity at the valuation date. To this base rate, we added a 100 basis point premium for the Note’s lack of protections relative to the comparable Champion public debt. This provided a discount rate of 11.09%.

We (and I should say I) discounted the remaining scheduled cash flows (principal and interest). The balance on 100% of the Note was $8.5 million. The sum of the present values of the discounted cash flows to the maturity of the Note was $6.3 million.

The estate’s two-thirds of the Note represented a present value total of $4.2 million (66.7% x $6.3 million) as of the valuation date.

The valuation, however, did not end there. I then discounted the Note by 20% for its lack of marketability, or illiquidity. I quoted a 1981 book by Shannon Pratt, Valuing a Small Business: The Analysis and Appraisal of Small Closely Held Companies (Dow Jones Irwin, 1981) (out of print) as follows:

Discounts on the letter stocks, compared to their freely trading counterparts, were the least for NYSE listed stock, and increased, in order, for ASE listed stocks, OTC reporting companies, and OTC non-reporting companies.  For OTC nonreporting companies, the largest number of observations fell in the 30 to 40 percent discount range.  Slightly over 56 percent of the OTC nonreporting companies experienced discounts greater than 30 percent on the sale of their restricted stock compared with the market price of their free-trading stock.  A little over 30 percent of the OTC reporting companies experienced discounts over 30%, and over 52 percent experienced discounts of over 20 percent.

Based on this totally irrelevant evidence pertaining to issuances of restricted stock (equity) by public companies, I concluded that a discount for illiquidity of 20% was appropriate for the Note. The conclusion from my report therefore concluded that the fair market value of the two-thirds undivided interest in the Note was $3,348,500.

I recall making a calculation that the internal rate of return on this conclusion was on the order of 18%, but there was no mention of this in my appraisal report. I sent the report to counsel for the estate, the estate filed an estate tax return, and I forgot about this brief episode of valuing a promissory note.

What Happened Next?

I heard nothing about the appraisal or the estate for several years. Sometime in late 1994 or early 1995, I learned that the Internal Revenue Service had challenged our (my) appraisal and that the IRS claimed that the estate owed more than $400 thousand in estate taxes and another $300 thousand in interest.

The estate paid the taxes and interest and sued Uncle Sam for a refund in Federal District Court.

When I heard about the matter again, the IRS had hired an expert who had valued the Note considerably higher than my conclusion and the matter was headed to court.

I remember looking at the file and reading my report as soon as counsel for the estate called me and thinking, “Oh, Shi-what! What did I do with that note valuation back in 1988?  Restricted stocks don’t have anything to do with promissory notes.”

Well, I probably wouldn’t be telling this story unless there was a happy ending. Because of new evidence not available in 1988, I got a chance to write an addendum to the original report in 1995. I had apparently learned a few things about note valuation between 1988 and 1995. The ending will have to wait for another day.

Concluding Thoughts

I’ll say again, as I wrote in my first article for Business Valuation Review—in 1988—that if you want an object lesson in humility, just read something you wrote many years ago.

If you have any note valuation needs, please don’t consider this email as describing our current methodology or practice. As a result of the case noted above, we’ve received many calls for note valuations over the years. We did get better between 1988 and 1995 when the case went to trial and we are better still today.

New Books on the Way

1. 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!
2. 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:

mercerc@mercercapital.com

Be well until next time,

Chris