My last post described an early promissory note valuation that provided me with an object lesson in humility. This post is the follow-up to show that it is possible to learn from such lessons and to lay the groundwork for future growth. The ending of this two-part series is happier than its beginning!
Recall the Case and the Promissory Note
The case was a tax refund matter in which I testified in Federal District Court, 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 on January 20, 1989.
The promissory note was issued by St. Regis Paper Company, a private company, to Mr. L.O. Crosby, Jr. in May 1977 for $10.3 million. At Mr. Crosby’s death in 1978, his wife received a two-thirds undivided interest in the note, with the remaining one-third going to a charity. St. Regis was acquired by Champion International, a public company, before Mrs. Crosby’s death.
Mercer Capital (me) valued the note in early 1989 following Mrs. Crosby’s death. The last post provided my object lesson in humility. I valued the cash flows from the note at something close to a market rate for comparable (to Champion) public debt and then, believe it or not, took a totally irrelevant 20% (equity) marketability discount to arrive at a conclusion.
In late 1994, when the estate matter percolated towards trial, I looked at the note valuation for the first time since 1989. I had spent much of the interim time working on discounted cash flow valuation and developed the Quantitative Marketability Discount Model. I was appalled at what we had done.
A Second Chance
Life sometimes provides second chances. It turns out that the undivided two-thirds interest that we valued in 1989 was actually a separate note issued following Mr. Crosby’s death. This became known long after we issued our report in 1989. The amount of principal and accrued interest was $5.7 million at the date of Mrs. Crosby’s death.
Since the separate note issuance was favorable to its value, I suggested to counsel for the estate that we provide an addendum to the original report to reflect the change in information. He agreed.
This was a good thing for two reasons. First, my original valuation was horrific. Second, the Justice Department (this was a federal case) had hired an expert who valued the note at substantially more than my original valuation. The Government said that the estate owed $700 thousand in taxes and interest. The estate had paid the taxes and filed suit for a refund.
The New Promissory Note Valuation
By 1995, we had developed early versions of the Quantitative Marketability Discount Model (QMDM), and I had been working with discounted cash flows, required returns and expected holding period premiums for several years.
At that point in time, we had had occasion to value a few promissory notes, and I had some ideas of how to approach the addendum to the Estate of Crosby note valuation. I knew we had to develop an appropriate discount rate and that the place to start was, as in the original appraisal, with the most similar public debt of Champion.
There was, and is still, little market evidence to provide detail for assumptions, so we used our experience with the QMDM and broke the elements of difference between Champion’s public debt and the note into bite-sized pieces that we could talk about. The discount rate development looked like the following.
Beginning with the 10.09% yield to maturity of the most comparable debt of Champion, we added increments of return for the judgmental elements that cause the estate’s note to differ from Champion’s public debt.
We provided a 50 basis point incremental yield due to the note’s lack of registration and marketability.
We allocated an additional 400 basis points of incremental yield for basic credit, legal, and documentation shortfalls and divided it as in the table above. The Addendum had a footnote that stated the following:
The sum of 400 basis points in yield adjustment for documentation, credit, and legal uncertainties is critical to the valuation. The publicly traded unsecured notes of CIC as of the valuation date had what has come to be called “anti-junk protection.” As noted in the original appraisal, neither CIC nor any subsidiary could mortgage or pledge any property without securing the then-outstanding debentures equally. Without this protection, a debtor could borrow against its assets to the detriment of unsecured, unprotected debt such as the Note.
An additional increment of 100 basis points was provided for the lack of divisibility and the out-of-ordering payment structure and was allocated into two parts.
The resulting yield was 15.59%. We then made an adjustment to convert annual payments to a semi-annual equivalent (the basis for pricing public debt), resulting in a yield of 16.20%. Given the inherent imprecision in the judgments made, we rounded the required return to 16.00%.
The implied internal return in the original appraisal was 18.0%, so this conclusion seemed reasonable at the time.
We then proceeded to value the note with a discounted cash flow analysis similar to the following.
The notes irregular cash flows were discounted at the discount rate of 16.00%, resulting in a total present value of $3,553,222. This conclusion was $205 thousand higher than the original appraisal (last post), which made sense given the enhancement to the note that was subsequently discovered.
What Happened in Court?
The matter of the promissory note valuation went to trial in Federal District Court in Gulfport, Mississippi.
The basis of my valuation is outlined above. The opposing expert provided an appraisal of the note that was summarized by the Court as follows. He:
…selected a Champion bond with an effective interest rate of 9.6%. He then added a 0.5% to his starting point to compensate for the differences in the publicly traded debt of Champion International and the promissory note of the estate, coming to an interest rate of 10.1%. This was then converted to an effective annual yield of 10.36%, which he used in determining his valuation of $4,300,000.00.
The opposing expert selected a Champion public debt offering with a lower yield than I used (9.6% versus 10.1%). He then added only a 50 basis points premium basic lack of registration and marketability. He also converted his yield to an annual basis, resulting in a discount rate of 10.36% relative to my discount rate of 16.0%. Finally, his conclusion was $4.3 million relative to my Addendum’s conclusion of $3.55 million.
The Court did not find the opposing expert’s lack of consideration of the note’s lack of protection, documentation, and illiquidity caused by its large size (his value or mine) to be credible.
I had obtained the several hundred page indenture agreement for the public debt of Champion and brought it to court. While under cross-examination, I had the brilliant idea of holding that document up in my right hand (the judge was on my right) and the one page note in my left hand. I then let the weight of the indenture document lean me toward the judge, illustrating by the literal “weight of the evidence” that investors would clearly prefer the protections of the indenture over those (none) of the single page note.
So the end of the story that began with a to-be-forgotten note appraisal is better than the beginning. The court held that the fair market value of the note was $3.55 million, or my conclusion in the Addendum of my report.
That decision, Evelyn T. Smith, Executrix of the Estate of Verna Mae Taylor Crosby v. United States, 923 F. Supp. 896 (1996), has been referenced by numerous writers and speakers over the years, and it has been the source of many calls regarding note valuations.
If you have questions about the value of any promissory note or another debt instrument, please give me a call at 901-685-2120 or an email at email@example.com.
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:
Be well until next time,