Mercer’s Musings #1 addressed the topic of compliance with USPAP and the Internal Revenue Service.

This second musing addresses the use of restricted stock studies to support marketability discounts in gift and estate tax appraisals prepared for the Internal Revenue Service (or for anyone, for that matter).  This musing is addressed to all appraisers, regardless of which valuation credential(s) they hold.  Chapter 8 of Business Valuation: An Integrated Theory Third Edition (by Mercer and Harms) (“Integrated Theory 3”) contains a detailed discussion regarding restricted stock transactions.  I’ll try to be brief but effective in this musing.

Restricted Stock Transactions

Figure 8.1 from Integrated Theory 3 defines and illustrates a Restricted Stock Discount (RSD) for a hypothetical public company issuing restricted shares in a private offering.

The exhibit is fairly basic and illustrates a single, hypothetical restricted stock transaction involving a publicly traded company that issued restricted stock on a given date.  What do we know based on this restricted stock transaction?

• The restricted stock transaction occurred at $15.00 per share.
• PubliCo’s unrestricted shares sold at $20.00 per share at the time of the transaction.
• The restricted stock transaction occurred at a price that was $5.00 per share lower than the freely trading shares ($20.00 – $15.00).
• The restricted stock transaction was 25% lower than the price of PubliCo’s otherwise identical but freely trading shares.
• PubliCo’s unrestricted shares closed at a price $5.00 per share higher than the restricted stock transaction price.
• PubliCo’s unrestricted shares closed at a 33.3% premium to the restricted stock transaction price.

These facts are all we know about this restricted stock transaction.  There is absolutely no economic information in this or any restricted stock transaction.  An RSD simply measures the difference between two prices.  RSDs are not value drivers like EBITDA, gross profit, number of cases, or any other value drivers.

If there is no economic information in a single restricted stock transaction, how much economic information is there in an average of 30, 50, 400 restricted stock discounts in the tired and old restricted stock studies?  The answer, of course, is none.

Restricted Stock Studies

There are perhaps 20 or more restricted stock studies of one kind or another.  Sixteen of the most prominent studies are summarized in the following figure, which is based on Exhibit 8.15 of Integrated Theory 3.

The figure highlights six studies at the top.  Note the range of averages and medians.  These studies, based on restricted stock transactions occurring up through 1982, or more than forty years ago, were the basis for what I call a long-lasting “appraisers’ folly” regarding restricted stock discounts.  These six studies and their bare statistics created the myth that restricted stock discounts “tended” to be in the broad range of 25% to 45% and in the narrower range of 35% to 45%. And more than a few appraisers use these stale and tired studies to guess at marketability discounts in 2024.  Nevertheless, most appraisers have never read the studies, which are referenced in Exhibit 8.15 of Integrated Theory 3.

The total number of restricted stock transactions noted in the figure above is 1,647, not accounting for transactions that were examined in multiple studies.  About 80% of all transactions in the studies occurred between 1966 and 2006, or going on twenty years ago.  Only about 275 transactions have been examined since 2006.  Both the studies and the transactions are “old and cold.”  The pricing and discounts of these ancient studies have nothing to do with private company valuation in 2024.

Restricted stock analysis is a very weak form of guideline public company analysis.  What would you (or a court) say if I created a guideline public company group for a valuation as of December 31, 2023, consisting of companies that existed twenty years ago, and based my analysis on multiples calculated as of December 31, 2003?  Even assuming almost perfect “comparability” of the group with my subject company, you would call me crazy — or worse.  The pricing and multiples from 2003 have no bearing on the value of my private company in 2023.

It has been argued that restricted stock discount analysis is a method “accepted” by the IRS and the Tax Court that has been used for years.  Whether such analysis is “accepted” or not, the old data has no relevance for valuations occurring at the present.  If you disagree with this rather strong statement, feel free to comment on this blog with your rationale for such relevance.

If there is no economic evidence in one restricted stock transaction, there is none in the 1,647 transactions summarized in the figure above.

A Hypothetical Valuation Situation

Let’s assume that all the restricted stock information available to an appraiser (or you) is contained in the figure above.  If you have more evidence not included above, feel free to use it.  Now assume the following example to determine marketability discounts for 10% interests in two companies that are identical except as noted in the figure below.  The valuation date is January 31, 2024.

Looking at the valuation characteristics of the Companies:

• Company A and Company B have identical discount rates and long-term growth rates (and cap rates and price/earnings multiples).
• They also have identical net (after-tax) earnings and, therefore, values at the marketable minority/financial control (MM/FC) level of value (Lines 1 to 6 above).

The hypothetical calls for the determination of appropriate marketability discounts for two 10% interests, one in Company A and the other in Company B.  Looking at the valuation characteristics of the two interests, we note:

• They have identical values at the MM/FC level of value (Lines 7 and 8 above).
• Company A’s annual dividend for the 10% interest is $100,000, which provides a 10% expected dividend yield based on the MM/FC value of the interest.  The dividend will be paid quarterly, so the mid-year discounting convention is assumed.
• Company B’s annual dividend for the 10% interest is $30,000, which provides a 3% expected dividend yield.  This dividend is paid at the end of each year, so the end-of-year discounting convention is assumed (see these assumptions on Line 11).
• The expected growth in value of Company A over the expected holding periods is 3% (Line 12), which is identical to the long-term expected growth in value for Company A (Line 2) [Line 1 (13%) minus Line 10 (10%), or (3%)], The expected growth in the dividend is 3%, or the same as the expected growth in value of Company A (Lines 12 and 13).
• The expected growth in value for Company B over the expected holding periods is 9% (Line 13).  Given that the discount rate for Company B is 13% (Line 1) and that the expected dividend growth and growth in value for Company B is 9% (Lines 12 and 13),  we can assume that there are sufficient agency costs (e.g., excess owner compensation) to lower the overall base return for the interest from 13% (the discount rate for Company A is 13%) to 12% (for Company B).
• Now assume that we desire to estimate marketability discounts for the two 10% interests assuming expected holding periods of five and ten years for each interest (Line 14).  Liquidity will occur at the end of each of the expected holding periods at the MM/FC level.
• The hypothetical assumes that the appropriate required holding period return (i.e., the discount rate for the holding period) is 18% for the interest in Company A.  That represents a 5% premium to the discount rate for Company A itself.  This is because holding a 10% interest in business entails more risk than Company A itself.  Assume for purposes of the hypothetical that this 5% “holding period premium” is reasonable and supported by market evidence (including from the restricted stock studies above).
• The assumed required holding period return for the interest in Company B is 19.5%, or 1.5% greater than the comparable interest in Company A. The investment in the 10% interest in Company B is a riskier investment than the comparable interest in Company A.  The annual dividend is much lower and, although expected growth is greater, the return on expected growth in value is deferred, leaving the greatest portion of return to the end of the expected holding period.  Think time value of money.

While Companies A and B are identical as noted above, the 10% interests in them represent two distinctly different investments.  The interest in Company A is a high cash flow and slow growth investment.  The interest in Company B is a more rapidly growing investment with a much smaller dividend yield (and modest agency costs).

Recall the guidance from USPAP Standards Rule  9-4(d) noted in Mercer Musing #1.

(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…

If any reader is able to articulate cogent reasons for the marketability discounts applicable to the 10% interests in Companies A and B for five and ten-year expected holding periods using only the information in the studies above, I will personally donate $1,000 to St. Jude Children’s Research Hospital in his or her honor.  Given the facts assumed in the hypothetical, appraisers cannot “analyze the effect on value, if any,” of the differing valuation characteristics of the two 10% interests using a qualitative analysis.  The hypothetical provides two different sets of cash flows, two different risk profiles, and two separate expected holding periods.  Think about the discounted cash flow method for companies.

What Does SSVS (VS 100) Say?

It has been said that holders of the ABV and CVA designations are not required to follow USPAP.  What are they required to do?  We examine SSVS issued by the AICPA:

Statement on Standards for Valuation Services (VS Section 100) issued by the AICPA states the following about the application of discounts (Paragraphs per Standards, emphasis added):

.40

During the course of a valuation engagement, the valuation analyst should consider whether valuation adjustments (discounts or premiums) should be made to a pre-adjustment value. Examples of valuation adjustments for valuation of a business, business ownership interest, or security include a discount for lack of marketability or liquidity and a discount for lack of control. An example of a valuation adjustment for valuation of an intangible asset is obsolescence.

.63

This section should [formatting changed]

(a) identify each valuation adjustment considered and determined to be applicable, for example, discount for lack of marketability,

(b) describe the rationale for using the adjustment and the factors considered in selecting the amount or percentage used, and

(c) describe the pre-adjustment value to which the adjustment was applied (see paragraph .40).

Looking at the figure summarizing the restricted stock studies above, it would appear to be difficult or impossible to make a reasonable determination of the appropriate marketability discounts.  Following this guidance from SSVS, an appraiser could:

a. Identify the need for a marketability discount.

b. Describe a rationale for using a marketability discount.  For example, referencing a levels of value chart, the appraiser could say that the rationale for using the discount for lack of marketability is to recognize the difference in valuation characteristics between the pre-adjustment value ($10,000,000 for both companies at the marketable minority/financial control level of value) and the nonmarketable minority level of value, which is appropriate for an illiquid, minority interest of a business.  The appraiser would run into a problem, however, when trying to describe the “factors considered in selecting the amount or percentage used.”  There is no ability to do this from the data provided.

c.  As noted in b., describe the pre-adjustment value.

There is simply no information in the restricted stock studies (summary statistics or information on companies paying dividends) to enable an appraiser to satisfy the basic requirements of SSVS as quoted above.  Let me provide the following caveat.  I am not a CPA and do not hold the ABV designation.  Neither do I hold the CVA designation (I do hold the ABAR designation of the NACVA).  I have, however, studied and worked to develop the ASA Business Valuation Committee (as a member of the Valuation Standards Committee for nearly thirty years and as its Chair for several years) and the International Valuation Standards of the IVSC as a member of its Professional Board for a number of years.

The fact that appraisers have “guessed” at marketability discounts for decades using the filters above does not make such guessing correct or standards-compliant for the Internal Revenue Service or for any other purpose.

Determining the appropriate marketability discounts for 10% interests in Companies A and B must be, at least substantively, a quantitative exercise.  While the marketable minority/financial control values are equal and the companies have almost identical earnings and risk profiles, the subject interests have significantly different valuation characteristics and expected cash flows over the (assumed) five and ten year expected holding periods.  To the best of my knowledge and understanding, these differences cannot be realistically examined qualitatively.  Appropriate quantitative assumptions must, of course, be made; however, those assumptions must be made considering common sense, informed judgment, and reasonableness, the trilogy of considerations from RR 59-60.

ASA Business Valuation Standards

The ASA Business Valuation Standards provide fairly specific guidance on the application of premiums and discounts in “BVS-VII Valuation Premiums and Discounts.”

II. The concepts of discounts and premiums

C. A discount or premium is warranted when characteristics affecting the value of the subject
interest differ sufficiently from those inherent in the base value to which the discount or premium
is applied.

D. A discount or premium quantifies an adjustment to account for differences in characteristics
affecting the value of the subject interest relative to the base value to which it is compared.  (bold in original, italics added)

These ASA standards make clear that the reason that valuation discounts and premiums exist is to recognize the impact on value of “characteristics affecting the value of the subject interest”, which may vary between an illiquid minority interest and the equity value of the business as a whole.

An appraiser limited only to the information summarized above about restricted stock studies would, like an appraiser attempting to follow SSVS, not be able to meet the requirements of these basic standards.  At least that is my interpretation based on the quoted standards and the data limitations using restricted stock studies to determine marketability discounts.

What’s an Appraiser to Do?

Determining the appropriate marketability discounts for 10% interests in Companies A and B must be, at least substantively, a quantitative exercise.  Granted, appropriate assumptions must be made, but they must be made while remembering the trilogy of common sense, informed judgment, and reasonableness from RR 59-60.  We will address this basic quantitative derivation of marketability discounts for Companies A and B in Mercer Musings #3.  Feel free to comment, either on the blog post directly or on LinkedIn when the post is published there.

In the meantime, I hope you are well.

Chris

Business Valuation Resources conducted a survey regarding the Discount for Lack of Marketability (DLOM) over the period from June 30 – July 28, 2021.  There were 202 responders to the survey, which was the second such survey (the first was in 2018).

BVR Survey on Methods Used for Estimating a Discount for Lack of Marketability (DLOM) July 2021.

The DLOM Survey consisted of nine questions and a tenth which invited comments from respondents.  In this post, we examine the survey results to try to interpret what they mean.

While there were 202 responders to the survey, several of the questions were “select all that apply,” so there are multiple responses from individual responders for several questions.  I will interpret and comment as we walk through the questions.

I hope you will take some time to read this post to the end and comment. I take what some appraisers think are wild positions and I am critical of the “theory” used by many appraisers, particularly with respect to the DLOM.

Q1: Which of The Following Methodologies or Tools Do You Use to Estimate a Discount for Lack of Marketability (DLOM)?

The responses are summarized below.

The “winner” by a substantial margin for methodologies and tools used was restricted stock (discount) studies (RSDs).

Virtually all responders use them in some form or another, with 90% picking them.  That is astounding to me in that most of the studies were done about 40 to 50 years ago.  More on that later.

Even more amazing, 45% selected the pre-IPO studies as a tool of choice.  It is simply not possible to relate a pre-IPO discount to an IPO price in any meaningful way.  The differences between a pre-IPO price and an IPO price are numerous and make it impossible to infer anything meaningful about an appropriate DLOM for a private company today.  As enumerated in Business Valuation: An Integrated Theory Third Edition (Mercer and Harms) on page 325:

• Expected cash flow enhancements as result of the IPO
• Expected risk reductions from the new capital raised
• Higher growth expectations (new capital)
• The IPO “pick-up” in multiple that often occurs
• The selection of a DLOM in the pre-IPO valuation
• The issuance of new shares in pre-IPO stock splits
• Sale of new shares to raise new capital, providing dilution for the shareholders prior to the IPO
• The passage of time between the pre-IPO transaction and the IPO itself

I’ll go out on a limb and say that the use of pre-IPO transactions in DLOM determinations should cease immediately.  But appraisers continue to use them, apparently.  Some 52.5% of all responses selected RSDs or pre-IPO studies.  I would think that younger, financially trained appraisers would rail at this.  And one did in response to Question 10:

The restricted stock studies are next to worthless.  As a younger analyst in the field (9 years experience), I find it kind of amazing the profession uses them.  If they were performed now/today, no one would.  With the huge range of discounts and the limited information available, it’s amazing [that] valuation professionals don’t get crucified on litigation cases regarding reliance on RSS…imagine if someone used guideline multiples knowing as little about the guideline group as we have data on the studies.

Right on, young friend!  And if these observations are right regarding RSDs, they are right on by a factor regarding pre-IPO studies.

In third place, 48% of responders selected option pricing models.

That was interesting because I seldom see appraisals where option pricing models are used.

In fourth and fifth place in the survey for Question 1 is the Johnson/Park empirical method (Partnership Profiles) and what the survey called “Mercer’s Quantitative Marketability Discount Model (QMDM).”  The Johnson/Park method yielded responses from 27% of responders and the QMDM had a 22% response rate.  The encouraging thing about these results is that almost half of the responses (99) indicated use of a quantitative, income approach method in determining DLOM.  BVR pointed out that the response for the QMDM marked a doubling from the 11% response in the first DLOM Survey in 2018.

Q4: If You Use Restricted Stock Studies, Which Studies Do You Use?

The responses are summarized below.

The Stout/FMV “study” garnered a 76% response rate.  From the answers to subsequent questions, the majority of these responses appear to be focused on the former study published by FMV Opinions published in 2004 and not to the Stout Restricted Stock Study and DLOM Calculator (available at BVResources.com).  The Willamette study, which dates back to the 1980s and the early 2000s, garnered a 37% response, and Pluris Data had a 22% response.  The remainder of the responses were received by academic studies that, with the exception of Herzel and Smith, garnered single digit responses.

The “standard” studies from the 1980s and early 1990s were not mentioned by name, but I suspect that the responses to Question 2 indicate considerable reliance on the old and dated restricted stock studies, a view that is supported by the responses to Question 5.

Q5: If Using Restricted Stock Studies, What Overall Approach Do You Use?

The responses to Question 5 are shown below.

The choices were the “benchmark average approach” and the “restricted stock comparative analysis approach.”  The benchmark average approach garnered a 63% response and the restricted stock comparative approach had a 37% response.  The focus on the benchmark average approach suggests that many more appraisers are using the benchmark approach than are using a more quantitative comparative approach with one of the available RSD databases.

This response is consistent with my informal survey of reports of other appraisers where it is common to find that the main DLOM method is to list a few restricted stock studies and their averages and specify a range (usually 25% to 45% or so) and then pick a discount from within the range.  This tells me that many appraisers have not advanced in their thinking about DLOMs since Shannon Pratt first outlined the “method” in the First Edition of Valuing a Business in 1981.  The younger generations of appraisers will have to change that.

More than a third of responders said they use restricted stock comparative analysis.  The answer choice described the method as: “The DLOM is based on a comparison of financial characteristics of the subject company to restricted stock that also takes market volatility into account, including a Mandelbaum discussion.”  This would seem to suggest that a good number of appraisers are using the Stout data base or the Pluris data base.  Users of these databases should read Chapter 8 of Business Valuation: An Integrated Theory.

Q6: Do You Consider the Ten Mandelbaum Factors?

The responses are shown below.

The great majority of appraisers responded by indicating that they regularly or sometimes consider the Mandelbaum Factors.  After establishing a benchmark range as the first factor (Judge Laro used 35% to 45% in Mandelbaum), there are nine so-called Mandelbaum factors, and several of them are not relevant to determining marketability discounts. The factors are:

1. Financial statement analysis. This analysis is part of the development of the marketable minority value for a business and does not relate to the DLOM.
2. Company’s dividend policy. This factor is definitely relevant, but no amount of “Kentucky windage” can discern the impact of no expected distributions relative to a 1% annual yield or a 10% annual yield relative to any benchmark range.
3. Nature of the company, its history, its position in the industry and its economic outlook.  I’m sorry, Judge Laro, but these factors are part of the business valuation and do not pertain to the DLOM.  I had a few conversations with him over the years prior to his passing.
4. Company management. Same as prior comment.
5. Amount of control in transferred shares. Illiquid minority shares seldom have any control over management.  That is the same position that public company minority shareholders are in. If a block had some element of control, it would perhaps decrease risk a bit and decrease the DLOM, but again, “Kentucky windage” won’t help determine how much.
6. Restrictions on transferability of stock. Restrictions on transfer tend to increase risk.  The “benchmark” shares of public companies were restricted for two years, almost absolutely, and longer, effectively.  “Kentucky windage” won’t help ascertain the impact on value, however.
7. Holding period of the stock.  This is definitely an important factor.  Other things being equal, the longer the expected holding period, the greater the period of risk, and the greater the DLOM.  However, once again, there is no way to gauge the impact of a longer holding period relative to any benchmark range by “Kentucky windage.”
8. Company’s redemption policy. If a company has a regular policy of redeeming shares, the may be nearer-term opportunities for liquidity, which would shorten the expected holding period and might lower the DLOM.  However, this is a quantitative matter and not one of judgment.
9. Costs associated with making a public offering. For most private businesses, there is virtually no likelihood for going public.  This is essentially an irrelevant factor in DLOM determination.  Further, the costs of going public were not an issue for the public companies issuing restricted shares so many years ago.  They were already public.

Five of the nine Mandelbaum factors pertain to value at the nonmarketable minority level.  The other four do not.

Should we ask questions that highlight risks and expected distributions and holding period expectations?  Of course.  However, Mandelbaum analysis is unsupportable except by “in my opinion,” or “in my judgment.”  The questions from the Qualitative Method from the AICPA Practice Aid are a better start for gauging and assessing risks.

I wrote about the Mandelbaum case in Quantifying Marketability Discounts in 1997 and pointed out all of the above and more.  Judge Laro specified a benchmark range of 35% to 45% in the case more than 25 years ago.  He did not, however, suggest how to gauge any factor as suggesting a relatively higher or lower discount.  He did not have to.  He was the judge.

The last question for today’s post pertains to a DLOM applicable to a controlling interest.

Q8: Would You Apply a DLOM to a 100% Interest in a Private Company?

The responses are summarized below.

73% of the responders answered “Yes” or “Maybe” to this question.  Only 27% answered “No.”  Confusion still reigns in the profession regarding this question.

No valuation discount has any meaning unless the base value from which it is taken is defined and specified.  When we value businesses at the marketable minority or financial control levels, we determine base values at that level.  To develop values at the nonmarketable minority level, we apply appropriate marketability discounts.  That’s what the BVR Survey has been addressing up to Question 8.

When appraisers use versions of the Capital Asset Pricing Model to develop values for a businesses, the values are at the marketable minority level of value or the synonymous financial control level.  They have valued 100% of the cash flows of these businesses based on the risks associated with those future cash flows.  The result is the same when the guideline public company method is used.

If cash flows have been appropriately normalized, the value of 100% of a business has been determined.  If that is the desired result, appraisers already have the financial control value. There is no reason to apply a DLOM to that value when valuing a 100% interest.

Consider the following three observations.

• When determining fair market value of a 100% interest of a company, appraisers attempt to mirror the hypothetical negotiations of hypothetical willing buyers and sellers who are negotiating regarding the expected cash flows of the business, their expected growth, and the risks associated with achieving those cash flows.  Fair market value is the intersection of their hypothetical negotiations and a hypothetical transaction occurs on the valuation date for cash or cash-equivalent consideration.  There is no marketing time after the valuation date.  That’s already been done.  There are no risks associated with the marketing, because they have already been experienced and accounted for.  There is no reason for applying a DLOM for a 100% interest.
• Assume an appraiser has developed a value of 100% of a business at the financial control level of value after examining the expected cash flows, their growth, and the risks associated with achieving them.  If he or she applies a DLOM to the interest, it is tantamount to saying that the risk in the base valuation was understated.  That’s all that can change.  It is the same company with the same expectations for cash flow.  We addressed this observation in the last post on this blog.  If a company has been properly valued, there is no reason for a DLOM for a 100% interest.
• When developing indications of value at the financial control level using the guideline transactions method, know that every observed transaction had a closing date prior to which all marketing and negotiating had been accomplished.  The multiples from those transactions considered that fact and reflected all aspects of the negotiations leading to the closing.  Sellers maintained control over their cash flows during the marketing period and any cash on the balance sheet was likely considered in the pricing.  Observations of actual closed transactions should inform appraisers that there is no reason for a DLOM for a controlling interest.

The DLOM for a controlling interest is nothing more than a “discount for convenience.”  I have said this for years.  If an appraiser cannot explain the DLOM for a 100% interest in terms of differences from a base value in expected cash flow, growth, or risk, then he or she had better refrain from using one.  And the differences cannot be explained, because there are none.

Here’s to hoping that the 148 appraisers who answered “Yes” or “Maybe” to Question 8 have an opportunity to read this post.  They might have to change their minds.

Wrapping Up

Thanks to BV Resources for conducting the DLOM Survey and for sharing it with the appraisal profession.  The major takeaway from my review of the Survey is that our profession has a long way to go in terms of understanding what DLOMs, or marketability discounts, really are.

They are not some magic thing that appraisers apply based on “Kentucky windage.”  They only exist to the extent that there are differences from the base value in terms of expected cash flow, growth and risk.

DLOMs do not exist because a handful of restricted stock studies were published 40 or 50 years ago.  The discounts in the studies reflected differences in risk between the restricted shares and the public shares of the issuing companies.  See Chapter 8 of Business Valuation: An Integrated Theory Third Edition (Mercer and Harms).

See also my recent article in the Summer 2021 Issue of Business Valuation Review, which covers much of the same ground and more.  If you are a member of the American Society of Appraisers, the edition has been sent out and is available electronically.  If you are not, email me at mercerc@mercercapital.com and I will be sure that you receive a copy of the article.  I’ll post it on LinkedIn, as well.

New Review

Will Frazier has written a review of Business Valuation: An Integrated Theory in the Summer 2021 Issue of Business Valuation Review.  If you are a member of the American Society of Appraisers, it is available to you.  If you are not, email me at mercerc@mercercapital.com and I will send a copy of the review to you.  I have already posted it on LinkedIn.

Be well,

Chris

The role of the third appraiser is always to bring resolution to buy-sell agreement valuation processes.  The question is how the third appraiser’s conclusion will be used to bring pricing resolution.  There are a few ways:

• Regardless of the conclusions of the first two appraisers, the third appraiser’s conclusion can be determinative for the process.
• The third appraiser’s conclusion can be averaged with the conclusions of the first two appraisers to yield the conclusion for the process.
• The third appraiser’s conclusion can be averaged with the conclusion of the first two appraisers closest to it.

The first two solutions are fairly straightforward and understandable.  The third solution, however, creates an unintended consequence that has caused problems for a number of buy-sell agreement valuation processes.  Call this consequence a “quirk” that I’ve never seen anyone talk about or write about. Consider the following figure.

In the figure above, assume that Appraiser 1 has reached a conclusion of fair market value for a buy-sell agreement valuation process of $100 per share.  Appraiser 2 reached a conclusion of $200 per share.  The differences are not always this dramatic (although sometimes they are), but they show up well on the figure. The principles are the same with smaller differences.

In the appraisal process, the third appraiser is designated as the reconciler.  Their conclusion will be averaged with the closest of the conclusions of the other two appraisers.  The italicized words sound simple and logical; however, they mask important dynamics and implications for the third appraiser and for all parties to similar agreements.  Let’s look at the potential outcomes for the third appraiser and for the parties.  The third appraisers is the  green-dashed line above, and the implied final prices are reflected by the solid line.  Now assume the following about the third appraiser’s conclusion.

• Appraiser 3 concludes $100 per share, agreeing with Appraiser 1. The conclusion is averaged with that of Appraiser 1 and the final price is $100 per share. See this at the lower left of the figure above.
• Appraiser 3 concludes up to $149 per share. At $149 per share, the final price is $124.50 per share (the average of $100 and $149).  Note that the final price is a simple average of the conclusions of Appraisers 1 and 3 up until a price of $149 per share is reached (actually $149.99 per share at the extreme).
• Alternatively, Appraiser 3 concludes $200 per share, agreeing with Appraiser 2. The conclusion is averaged with that of Appraiser 2 and the final price is $200 per share.  See this at the upper right of the figure above.
• Appraiser 3 concludes down to $151 per share. At $151 per share, the final price is $175.50 per share (the average of $200 and $151).  The final price is the simple average of the conclusions of Appraisers 2 and 3 down until a price of $151 per share is reached (actually $150.01 per share at the extreme).

The undiscussed dynamics of this “logical and simple” averaging process is that a $2.00 per share swing in the third appraiser’s conclusion (from $149 per share to $151 per share) creates a 41% change in the final price. That small $2 per share change results in an increase in the final price by $50.00 per share, or from $124.50 per share to $174.50 per share.  The percentages are different but the result is the same if the change is from $151 per share to $149 per share.

Left unstated in all similar agreements I have seen, what happens if Appraiser 3’s conclusion is $150.00 per share? It is equally close to the $100.00 per share and $200 per share conclusions of both Appraiser 1 and Appraiser 2, respectively.  Presumably the parties could agree to average all three conclusions and conclude the process at $150.00 per share.

This kind of valuation process places a great deal of pressure on the third appraiser.  Assume that his conclusion is honing in on $140 per share.  That would yield a final price of $120 per share (average of $100 and $140).  However, a small change in one assumption could push the conclusion up 9% to $152 per share, which would yield a final price of $176 per share (average of $100 and $152), or 47% higher than at the lower potential conclusion.  Rest assured, Appraisers 1 and 2 and their clients become aware of the math behind the figure above and will be lobbying with the third appraiser to reach a conclusion above $150 per share (midpoint) or below it based on their respective points of view.

Consider a couple of other alternatives for the third appraiser as reconciler.

• Appraisers 1 and 2 set the range. If the third appraiser reached a conclusion of, say, $60 per share, or $40 per share below the $100 per share conclusion of Appraiser 1, the average would be $80 per share, or outside the range of Appraisers 1 and 2 and below it.  Similarly, if the third appraiser reached a conclusion above $240 per share, the final price would be outside the range and above it.  For this reason, many agreements state that, regardless of the conclusion of the third appraiser, the conclusions of Appraisers 1 and 2 will set the range for the final price.
• All three appraisal conclusions are averaged. Occasionally, an agreement will state that the final price will be the average of all three appraisers.  This option is most often not considered because it is thought to provide undue influence on the final price of an outlier conclusion from Appraiser 1 or 2 on the low or the high side.

The role of the third appraiser is always to bring the valuation process to conclusion. With the third appraiser as the reconciler, the third appraiser is not necessary in most valuation processes if the first two reach similar conclusions (say, within 10% of each other). The third appraiser is brought in to resolve larger differences and to cause the process to reach a conclusion by reconciling with one or both of the first two appraisals.

This quirk exists in numerous buy-sell agreements “out there” in the world.  It generally goes unrecognized until an agreement is triggered.  Then, it becomes painfully obvious to the parties that they have a ticking time bomb on their hands.

There has to be a better way to resolve buy-sell agreement pricing.  And there is.  One such process is found in my book, Buy-Sell Agreements for Closely Held and Family Business Owners (available for purchase).  It is called the Single Appraiser, Select Now and Value Now process.

I hope you are all staying well and safe during these pandemic times.  Until next time, be well.

Chris

Buy-sell agreements can go bad if all parties to them do not pay attention to their terms before signing them.  This is particularly true in the New York case of Yakuel v. Gluck, which was filed in early May in the Supreme Court of New York County.  Thanks to Peter Mahler for his post about the case which called it to my attention.

Petitioner is Yakuel, the 65% owner of Agency Within LLC (“the Company”).  We will use Yakuel and the Company interchangeably. Respondent is Gluck, who owned the remaining 35% of the Company’s member units.  The Company was formed on February 20, 2015, and apparently achieved fairly rapid success. According to its website, Within is a performance branding company.

The Company says about itself:

Working with VC backed startups and Fortune 100 companies alike allows us to see around corners. This spectrum of challenges keeps us highly adaptable within a constantly changing media landscape.

Background

An amendment to the original operating agreement was signed on March 23, 2018.  Presumably, this amendment was negotiated between Gluck and the Company; however, a reading of this case suggests that either this did not happen or that Gluck was not paying attention.  The amendment describes a valuation by a single appraisers as follows:

For purposes of this Amendment, “Fair Market Value” shall mean, as of the date of determination, the fair market value of such fully vested Units reduced by appropriate valuation discounts to account for the minority interest represented by the Units, the lack of marketability of such Units, and such other applicable valuation discounts. The Company shall obtain an appraisal (the “Appraisal”) of the Fair Market Value by engaging a third party appraisal firm, whose appraisal will be final and binding on all parties and the cost of which shall be borne by Gluck and the Company on a 50-50 basis.

The amendment called for an appraisal if a triggering event occurred that would be conducted by “a third party appraisal firm, whose appraisal will be final and binding on all parties, and the cost of which shall be borne by Gluck and the Company on a 50-50 basis.”  The appraiser selection process was as follows.

• Five large accounting firms were named as potential appraisers in the amendment
• Each of Gluck and the Company got to veto one of the firms, and they did so
• The Company was then entitled to select the appraiser from the remaining three firms.  The Company selected PwC which was apparently “the firm which has offered to perform the appraisal at the lowest cost.”

Section 3(f) of the amendment gave the Company certain rights, including:

• The right to exercise the option to purchase “at any time.”  In fact, the option was exercised by the Company on May 11, 2018, or less than two months after the execution of the amendment.
• The right to exclude Gluck from the affairs of the Company and from entering its business offices.

The sole right accruing to Gluck was the right to receive the purchase price of his units as determined by the appraisal described in the amendment.

Presumably, the parties negotiated this amendment with its appraisal process; however, it is not apparent that Gluck was a party to the negotiation, or else he was not paying attention to an amendment that gave Yakuel the unfettered right to exercise the option to purchase Gluck’s shares and to summarily fire him.

Litigation Ensued

Not surprisingly, litigation followed in July 2018.  This litigation led to a stipulation in which the Company agreed in good faith to allow Gluck to participate in the appraisal process.  Gluck also agreed to participate in the process “in good faith, without delay or obstruction.”  Those agreements did not last long.  Justice Cohen wrote:

The Peace Treaty did not last.  Yakuel contends that he held up his end of the bargain and permitted Gluck to participate in the appraisal process, including by providing information and arguments to PwC with respect to the valuation.  Gluck vigorously disagrees.  According to Yakuel, Gluck’s “bad faith and litigious approach to the appraisal process eventually caused PwC to halt its work and threaten to quit,” and Gluck’s obstructive behavior “forced the Company to exercise its right under Section 3 of the Amendment to exclude him from the appraisal process.

The Court did point out that it was less than clear that the rights accorded to the Company under this section would apply to the very appraisal process for determining the purchase price.

Not surprisingly, PwC did not like being in the middle of this situation.  Early in the process, PwC raised the issue that both parties should be subject to their engagement letter to avoid any “perception of a conflict.”  Yakuel’s response was negative and that the Company should be the only party to the letter.  PwC tried again, expressing discomfort about proceeding “without agreement from all parties” and agreement on the information that would be provided to the appraisers.  Yakuel again refused to change the scope of the engagement.

The Court pointed out that Yakuel and Gluck had widely different views of the same set of facts.  Gluck contends that he was never interviewed by PwC and did not have the opportunity to submit information to PwC for consideration.  He also claims he was not allowed to discuss information submitted by the Company to PwC.

PwC ultimately provided an appraisal with a conclusion.  Peter Mahler writes about the appraisal:

In March 2019, PwC issued its written appraisal determining the value of Gluck’s 35% interest as of December 31, 2018. Unfortunately for us, all financial information is redacted from the copy of PwC’s appraisal publicly e-filed with the court, including its conclusion of value.

According to Gluck, Yakuel refused to provide Gluck with a copy of the PwC appraisal for five months even while he tried to force Gluck to close on the repurchase. In August 2019, Yakuel filed a petition to confirm the appraisal award. Gluck responded with a cross-petition to vacate the award.

We have no idea what the PwC appraisal conclusion was, but it set the purchase price for Gluck’s 35% interest in the Company.  Gluck claims that the appraisal process was unfair and that it was influenced by Yakuel to devalue his interest by “tens of millions of dollars.”

Peter Mahler discusses the Court’s analysis of the standard for confirming or vacating the appraisal award.  Read about that here.  However, after everything we’ve written about so far, the beat will continue to go on.  The Court denied both Yakuel’s motion to confirm the award and similarly denied Gluck’s motion to vacate the award.  The parties were ordered to appear for a status conference in June to discuss the continuation of the litigation.

Business and Valuation Questions Raised

When parties agree on valuation processes in buy-sell agreements, they can agree on almost anything.  Apparently, this was the case in Yakuel v. Gluck.

1. Why would Gluck have agreed to an amendment that would put both his investment in the Company and his employment in obvious jeopardy?  What was his consideration for giving up so many of his rights of ownership and employment?
2. How did Yakuel get Gluck to agree to a valuation process where he had no real say in the selection of the appraiser, if and when, or more likely when, he would be fired?
3. Why didn’t Gluck, or his attorney if he had one, ask that there be an initial appraisal to see what its conclusion would be before he signed the amendment?  That is why I recommend for single appraiser agreements?  In this case, the agreement specified that the appraiser should consider the minority nature of Gluck’s shares and take into account, potentially, a minority interest discount, a discount for lack of marketability, and other unnamed discounts.  This amendment was a ticking time bomb for Gluck from the moment it was signed.
4. Why would anyone agree to have accounting firms, even the largest in the nation, perform appraisals without insuring that the persons retained to do the appraisal had appropriate valuation credentials and experience?  That may well have been the case regarding PwC, but appraisal credentials and experience should always be specified in buy-sell agreements.
5. The folks at PwC are big boys and girls.  Nevertheless, the amendment was designed to create discomfort for any appraiser retained.  Gluck was clearly an intended user of the required appraisal, and yet he was not made a party to the PwC engagement letter.  It appears on this point that the folks at PwC did the best they could.  I cannot comment on the appraisal for reasons noted above.
6. Why would Gluck agree to pay 50% of the cost of the appraisal when it was clearly set to devalue his interest and insure that whatever purchase price he received would be offset by half of the appraisal fee. Yakeul shifted costs to Gluck in the amendment and retained all of the benefits of the repurchase in that following the transaction he would own 100% of the units outstanding.

In the next post, I’ll outline a superior single appraiser valuation process.  This process is clearly superior to the process we’ve just reviewed in Yakuel v. Gluck.  It is outlined in my book, Buy-Sell Agreements for Closely Held and Family Business Owners.

Be safe and be well!

Chris

Kashmiry v. Ellis is a recent Ohio appellate case regarding the buy-sell agreement portion of a shareholders’ agreement. The case reinforces a number of things I have been “preaching” about for years. If a buy-sell agreement has provided for an annual valuation by agreement of the parties, then the parties must reach agreement annually.  If the agreement then provides for a valuation mechanism to determine the price following a trigger event, then the valuation process should be clearly defined and workable.

• I have long advocated the use of what we call the Single Appraiser, Select Now and Value Now process to replace annual agreements by owners — because they virtually never get together to agree on anything, much less the buy-sell agreement price.
• Failing that, I advocate the Single Appraiser, Select Now and Value Later mechanism, so the parties know who the appraiser will be and there can be communication regarding the kind of value.
• In either case, the definition and kind of value should be clearly specified in the agreement.

Overview of the Case

RKA was an insurance agency in Ohio.  EIA was a smaller agency.  The owners (Kashmiry and Ellis) agreed to merge their agencies and that Ellis would become an employee and minority shareholder of the merged RKA. The stock purchase agreement required Ellis to turn over his book of business to RKA in exchange for seven shares of RKA stock.  Ellis acquired another 14.4 shares of RKA stock in consideration of a promissory note to Kashmiry in the amount of $107,838.14, or about $7,500 per share.  Both parties agreed to this $7,500 per share price.  The total of 21.1 shares represented about 20% of the outstanding shares of RKA common stock.

Observation: The “valuation” at the time of the merger was based on relative values of both RKA and EIA at a revenue multiple of 1.25x, so there were no discounts in the pricing at the time of the merger.

The transaction as stated or implied by the Court’s decision is summarized below.

After some five years of employment with RKA, Kashmiry, as majority shareholder, terminated the employment of Ellis. There were several aspects of the case at trial and on appeal.  This post addresses only the valuation issue.

• The shareholders agreement provided that, in the event of the termination of Ellis, he would be deemed to have offered all of his stock to Kashmiry, who would have 30 days to complete a purchase of the stock.
• If Kashmiry did not purchase the stock personally, then Ellis was obligated to offer the stock back to RKA and RKA was obligated to purchase the stock based on an “agreement price.”

There were two methods for determining the agreement price.

• All the shareholders would convene and unanimously agree on the agreement price, which would be the fair market value of the shares.  A certificate of valuation was to be signed. If there was no certificate of valuation for more than a year at the time of a trigger event, then a second method would be used.
• The second method, if applicable, provided that the board of directors of RKA would appoint a qualified appraiser who would determine the agreement price after considering a number of specific factors in the appraisal process.  Those factors included the following: a) all relevant business valuation standards, b) Revenue Ruling 59-60, c) other factors deemed appropriate by the qualified appraiser (not defined), and d) “…giving great weight to any prior valuations of the shares of the Stock which have been agreed upon by the Stockholders.” This appraisal was to be provided within 90 days of the trigger event.

Following the termination of Ellis, RKA hired a qualified appraiser [I cannot find the appraiser based on a Google search], who provided the required appraisal, but several months after the 90-day deadline.  The appraiser testified that she prepared a detailed valuation report that took into account many factors, including company background and history, general economic and industry conditions, and the financial performance of the company.

She also took into account the lack of control and lack of marketability of the 14.4 shares (about 13.6% of the shares outstanding — the other 7 shares were handled differently).  She testified that she gave the original purchase price of $7,500 per share little or no weight.  The appraiser valued 100% of RKA stock at $405,000.

The valuation by the appraiser appointed by RKA is summarized as stated or implied below.

The trial court concluded its valuation as follows:

When the parties first valued the shares of stock in 2009 an arbitrary multiplier [of revenue – 1.25x] was agreed upon.  No discounts were made for minority shareholder, nor corporate control or marketability, et cetera.  Therefore, the court finds that the value of said shares of stock [relying on language calling for giving “great weight to prior transactions] as of August 15, 2014, were at the same value as originally agreed upon by the parties, i.e., $7,500 per share.

It is likely that given the appraiser’s valuation at such a steep discount to the original transaction pricing, that the trial court was attempting to find an equitable conclusion.  The appellate court made a similar observation.

The Appellate Court’s Reverses the Trial Court on Valuation

There were other issues but on the key issue of valuation, the appellate court reversed the trial court and remanded the matter to the trial court for another look at valuation.  The appellate court stated:

…the trial court ignored the plain language of the parties’ agreement and, instead of determining that the 2009 agreed-upon valuation was one factor that should have been given more weight by the appraiser, substituted the 2009 purchase price arbitrarily as the 2014 valuation.  Based upon the trial court’s reasoning, it appears the trial court was attempting to reach an equitable result in this matter. “It is not the responsibility or function of [the] court to rewrite the parties’ contract in order to provide for a more equitable result.” [citation omitted]

I can find no record of a revised opinion by the trial court.  There is a good likelihood that the parties settled the matter after the appellate court’s decision.

Lessons to be Learned from Kashmiry v. Ellis

We can make a number of observations and point out lessons to be learned from this appellate case.

1. If you (or your clients) enter into a bad buy-sell agreement, don’t expect that the courts will fix the problems for you.
2. It is clear that the parties entered into the arrangement with a merger on a similar basis, i.e., merging 100% of both RKA and EIA together based on a revenue multiple and without any discounts.  The buy-sell agreement should have stated this fact in unambiguous terms.  It is clear from the testimony of the appraiser and the calculations above that the appraisal considered the minority nature of the block of stock and discounted its conclusion significantly.
3. The definition of value in the agreement should state the standard of value (fair market value) and the level of value (financial control versus nonmarketable minority), and any other instructions the parties wanted to provide the appraiser.  It should have stated the required qualifications for the appraiser.
4. The appraiser could have performed a relative value analysis of her conclusion and that implied by the original transaction.  It would have been clear that even at the 100% equity level, she was valuing the stock at about half the value of the original transaction ($405,000 in 2014 versus an implied $801,000 in 2014).  A reconciliation of those disparate valuations should have been a portion of her appraisal.  Instead, she gave that transaction little or no weight.
5. The shareholders’ agreement called for setting an annual agreement price to be memorialized in a certificate of value.  As so often happens,  the agreed upon certificate of value was never updated.  The lesson is that if you are going to depend on an agreed upon value on an annual basis, you had better update that agreement each year.
6. The second way in which the agreement price could be set was with an appraisal process.  However, that process was never tested, and in its debut, it showed significant flaws.
7. The parties would have benefited from employing the Single Appraiser, Select Now (i.e., 2009) and Value Now (2009) valuation mechanism that I have written about in my book, Buy-Sell Agreements for Closely Held and Family Business Owners.  There would have been an annual or every-other-year reappraisal in the interim, and the valuation process would have been known.  An appraiser would have been selected in 2009 to provide an appraisal and it would have been clear that the appraisal should be performed on a financial control, i.e., undiscounted basis.
8. In the alternative, the parties could have employed the Single Appraiser, Select Now (i.1., 2009) and Value Later (2014, following the trigger event). With the selected appraiser’s help, they would have defined fair market value appropriately and avoided the issue of the surprise (to the seller) discounting in the appraisal.

The bottom line about buy-sell agreements is that the parties and their counsel need to address issues like raised above in advance of trigger events and at the time their agreements are set in place.  The next best time to accomplish this is now, with a revision of your agreements before a trigger event occurs.

Please do call me (901-579-9700) or email me (mercerc@mercercapital.com) to discuss any valuation or buy-sell agreement issues in confidence.  In the meantime, be well!

Chris

I have been advocating single appraiser valuation processes for buy-sell agreements for many years. This video relates the story of the genesis of the idea that has led me to write four books on buy-sell agreements and to participate in buy-sell agreement processes all around the nation.

Hello, Chris Mercer here at ChrisMercer.net and MercerCapital.com.

I remember the experience well – it was late 1988 or early 1989 because of the weather. We were located at 1503 Union Avenue in Memphis, Tennessee. The phone rang and an attorney that I knew called and he said, “Chris, I need you to value the Catfish Company.” That’s not the name of the company, but we’ll call it the “Catfish Company.” I said, “Well, give me some information and I’ll see what I can do about getting a proposal.” He said, “No, you don’t understand, Chris. You’re going to value the Catfish Company. There’s a buy-sell agreement and the buy-sell agreement says the appraisal in the event of the death of an owner will be done by Mercer Capital Management Inc. That’s you, isn’t it?” I said, “Yes, it is.” I said, “Okay, well, tell me what happened.”

He said, “You know George don’t you?” and I said, “Sure.” “Well, George just died.” And yeah, that was really tragic. “George owned 25% interest in the Catfish Company. He invested in that company a number of years ago, and when the shareholders got together, they created a buy-sell agreement and they agreed George knew you and another of the shareholders knew you and I knew you and so we agreed that you would be the appraiser in the event that there was a trigger event.” I said, “Well, that’s great.”

I got signed up and got the buy-sell agreement and the buy-sell agreement said that the appraiser would determine the fair market value of the interest. Well, the fair market value of the interest in appraisers’ levels of value chart would be the value of a non-marketable minority interest, but other reference documents – documents referenced in the buy-sell agreement – suggested very clearly that the shareholders wanted a financial control value. In other words, everyone would be created equal, or treated equal, in the event of a trigger event. Well, I got the shareholders together and I pointed out this issue and they said – well, Chris, you don’t need to make that decision. What we want you to do is give us the financial value and the non-marketable minority value which I did and then they resolved the issues apparently satisfactorily to all the parties.

At the end of that exercise, I knew a couple of things. One, I was hooked on buy-sell agreements because it was pretty nice to get a phone call for Mercer Capital to do an appraisal but I knew a couple of things.

Number one: it’s a good idea to select the appraiser first when you create a buy-sell agreement. Why is that? Because it eliminates all disagreement, or all potential future disagreement, over the selection of the appraiser. And number two: it’s a good idea to have the appraiser involved at the outset because you would avoid issues over language in the documents like this.

So, I knew then that I was hooked on buy-sell agreements and I began talking about buy-sell agreements and I’ve written about buy-sell agreements a number of times.

As a matter of fact, I wrote a book in 2007 “Buy-Sell Agreements: Ticking Time Bombs or Reasonable Resolutions.” A little bit later another book, “Buy-Sell Agreements for Closely Held and Family Business Owners.” There’s even one out on a Kindle version, and now, I’ve got a new book on buy-sell agreements. It’s geared primarily to attorneys but appraisers and business owners will want it because it talks in more depth about buy-sell agreements than anything that I’ve ever written and number two, it provides the language that will enable attorneys to create buy-sell agreements that are crystal clear if this is the value that’s wanted or if this is the value that’s wanted.

In any event, I knew when I was hooked on buy-sell agreements. I’ve been hooked ever since.

If you have a question about a buy-sell agreement, please give me a call. I look forward to talking to you about it.

Be well,

Chris

901.685.2120  |  mercerc@mercercapital.com

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

EBITDA is at the same time the most discussed and most maligned measure of business cash flow.  Simply put, EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization.  The problem with EBITDA is that too often analysts or market participants or writers want to think that there is a single measure of cash flow that will reveal all, bringing Utopia to valuation. This post notes 11 things that EBITDA is not or will not do—and compares other cash flow measures according to the same criteria. Utopia does not exist and there is no valuation elixir. Sadly, we actually have to analyze companies to value them or buy them or sell them.

The “Naughty 11” Problems with EBITDA

Googling “problems with EBITDA” yields 2.2 million results in 0.47 seconds. After reading down a few pages, I developed a list of eleven things that EBITDA is reputed not to do.  So business appraisers, business owners, and other market participants should beware.

The “naughty 11” are summarized in the following table.

Let’s look at the problems with EBITDA by the numbers from the table above.

1. EBITDA is not a GAAP (generally accepted accounting principles) measure.  For that, some folks give EBITDA a bad name.  It is nowhere to be found on audited financial statements.  Analysts actually have to select from the income statement the components that add to EBITDA. This post talks about how to “find” EBITDA.
2. EBITDA does not measure asset intensity.  That’s what some observers say.  However, one can look at the amount of depreciation and amortization in a calculation of EBITDA.  Then one can compare that amount with other companies. The relative amount of DA (depreciation and amortization) in EBITDA is actually a partial measure of capital intensity (or asset purchase intensity). One could also look at the balance sheet.
3. EBITDA does not tell anything about liquidity on a company’s balance sheet.  Now that’s a big problem.  One might actually have to look at the company’s balance sheet to determine its degree of liquidity.
4. EBITDA does not tell anything about debt levels on a company’s balance sheet.  One might look at the amount of interest expense in EBITDA and draw some inferences, but the exact amount of debt will never be revealed by EBITDA.  One might have to look at the company’s balance sheet to determine how much debt it has.
5. EBITDA does not reveal a company’s working capital needs.  That’s true.  One can analyze EBITDA until the cows come home and never learn how much working capital a company will need in the next period, or should have had in the current period. I like to look at the balance sheet and cash flow statement to begin to assess working capital needs, so I never expected EBITDA to inform me about working capital.  Others apparently do.
6. EBITDA does not reveal a company’s need for capital expenditures to replace existing plant and equipment as it wears out.  I’m old fashioned in this regard.  I like to look at a company’s historical balance sheets and talk to management about the need for replacement capex. EBITDA does, however, through DA, give an amount that was depreciated in the current (or historical) periods.  That DA can give a glimmer of current and future needs, especially when examined in light of capex showing on the cash flow statement.
7. EBITDA certainly does not reveal management’s intentions for reinvestment of current and future cash flows into capital expenditures to achieve future growth initiatives. Financial statements are based on history. The only way to understand a company’s future growth plans is to ask management about them.
8. EBITDA does not tell anything about the expenses of management or owner perquisites that have flowed through a company’s income statement. I’ve never understood this criticism because normalizing income statements for above-market compensation is a normal part of our valuation processes.
9. EBITDA does not reveal anything about non-cash items of income or expense (other that DA).  Again, I have to admit that this criticism is true.  Non-cash items usually show up on the income statement and on the cash flow statement.  If an expense does not require cash, the cash impact has to show up somewhere. We employ normalizing adjustments to examine the impact of such items on EBITDA and at other levels of the income statement.
10. EBITDA does not reveal anything about non-recurring items of revenues or expenses. We often find indications of such items on a company’s income statement or cash flow statement. However, we always ask management about non-recurring or unusual items for consideration in our analyses.
11. Finally, EBITDA may not be a useful measure of cash flow because it can be manipulated by unscrupulous (or motivated) parties.

So there we have the “naughty 11” problems with EBITDA. The discussion has made clear that EBITDA cannot reveal, at least directly, information about a company’s balance sheet or its cash flow statement. Nevertheless, EBITDA continues to get a bad rap from some writers and analysts.

Are the “Naughty 11”  Applicable to Other Cash Flow Measures?

The “naughty 11” are summarized in the figure above.  The list could be made longer, but eleven is a nice number and is enough.  We subjected several other possible measures of cash flow to the same “naughty 11” test.

The figure below shows the results of this testing in relationship to EBITDA.  The additional measures are EBIT (sometimes called operating income), NOPAT (net operating profit after taxes), Operating Cash Flow (NOPAT plus depreciation and amortization), and Debt-Free Net Cash Flow (or net cash flow to capital providers).

The interesting thing about this figure is that virtually all of the cash flow measures fail the same “naughty 11” test that we applied to EBITDA above.  EBIT, which on some financial statements is called operating income, could be a GAAP measure, but sometimes it is not.  And EBIT does not appear on income statements as EBIT.

When we move over to the far right of the figure, we see that we can get some partial information about working capital and capital expenditure needs.  But these needs do not come from any financial statement. They are developed by management or a business appraiser or a market participant based on what? Their reviews of the historical financial statements, knowledge about markets and discussions with management.

Looking at rows #8 to #11 in the figure, we see that no cash flow measure will reveal anything about owner perquisites, non-cash items, or non-recurring items absent thoughtful adjustment by analysts. Finally, every (any) measure of cash flow can be manipulated by the unscrupulous.

What is the Solution for the “Naughty 11”?

We have already revealed the solution for every problem in the “naughty 11” list for EBITDA.  There is no substitute for analyzing EBITDA and a company’s historical income statements, cash flow statements, and balance sheets. There is no substitute for thoughtful discussions with a company’s management regarding its past and expectations for its future.  These statements are as true for the cash flow measure known as EBITDA as they are for every measure of cash flow in the figure above or that anyone wants to devise.

In the next post, we will look at why many analysts focus on EBITDA as a beginning point for their cash flow analyses.  We will also see why, despite its bad press, substantial attention is paid to valuation based on EBITDA.

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

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 mercerc@mercercapital.com.

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

Fixed price buy-sell agreements are not good.  I’ve written about two fixed price agreements that went to litigation.  Namerow v. PediatriCare Associates, LLC and Estate of Cohen v. Booth Computers, Memorandum Decision, C.A. Docket No. BER-C-135-08 (N.J. Super. Ct. Aug. 4, 2009

Actually, both “fixed price” cases involved something of a formula that basically set the price at a fixed amount.  The cases did not go well for either of the plaintiffs who sought court assistance in “fixing” fixed price agreements that yielded “unfair” results.

I’ve said many times that no formula agreement can be written that will provide reasonable valuation calculations over time under all circumstances involving a company, its industry, the national economy, conditions in the financial markets, and more.

Thanks to Paul Hood for identifying a true formula case to make the point.  We have the case, Roth v. United States, 511 F. Supp. 653 (E.D. Mo. 1981) and the appeal, St. Louis County Bank, Executor of the Estate of Lee J.sloan, Deceased, Appellee, v. United States of America, Appellant, 674 F.2d 1207 (8th Cir. 1982).  The case is obviously dated, but the point of this post should be clear.

The Original Case

Prior to gifts made in 1956, Lee J. Sloan owned all but one of the 466 shares outstanding of Sloan Moving & Storage Company. At that time, he made gifts of 36 shares each to five children and related parties.

In 1964, all of the shareholders entered into a shareholders’ agreement that called for the company or the other owners to purchase the shares of any owner in the event of death.  The formula price for any buyout was a multiple of 10 times the average of the last five years’ net earnings per share.  At the time, the company had been profitable for many years and the formula yielded a positive amount.

The company continued its profitable business until 1972 when it sold all of its operating assets and changed its name to L.J.S. Investment Company.  It used the proceeds of the sale of assets to invest primarily in real estate assets.

Prior to the sale, the highest formula price had been $1,061.15 per share in 1966, and the low price was $597.00 per share in 1970.  With the company’s change of business, its real estate assets generated depreciation and other expenses, and the company recorded net losses.  The formula value fell to $0 per share in 1971.

At the time of the Lee J. Sloan’s death in 1976, the formula price was zero.  For federal estate tax purposes, the estate valued his shares at $850 per share (their book value at the time), paying estate taxes of $36,383.06.

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At a later time and in reliance upon the formula, Sloan’s estate filed a suit in Federal District Court seeking a refund of the estate taxes paid with the filing of the estate return.  In the cited decision, the Government is seeking partial summary judgment.

Based on the facts that were presented, the District Court appeared to believe that the original formula was entered into for valid business reasons, and yielded reasonable results at that time.  It was binding on the parties in life or death.

In a short Memorandum decision, the District Court denied partial summary judgment, effectively validating the formula and its zero value.

The Case on Appeal

The Government appealed the case.  The appellate court seemed to agree with much of the facts of the case as noted in the District Court’s decision.  However, there were facts that, per the appellate decision, were subject to differing interpretations.  On this basis, the District Court’s decision was reversed and remanded for further proceedings, requiring the trier of fact to decide which interpretation of historical facts was more persuasive.

There is no record of any decisions in this matter, so perhaps it settled on some basis between the estate and the Government.

Conclusion

In this matter, a long-standing formula, i.e., 10 times the average net earnings of the last five years, was essentially affirmed by the District Court.  As noted, the formula yielded a zero value at the time of Mr. Sloan’s death at a time when book value, an alternative measure of value, was substantially positive.

What would happen today if a formula that yielded an apparently unreasonable result was tested in a court?

I don’t know, but if the agreement containing the formula was reasonably entered into and it at least made sense at that time, I’m guessing that courts would be reluctant to change it, just as the two courts in the fixed price cases noted at the outset were so reluctant.

What should attorneys and business owners do?  Once again, I mention what I call the Single Appraiser, Select Now and Value Now valuation process.  It’s better to substitute a workable process for one that almost certainly won’t work consistently in the future.

My new book contains a detailed discussion of this process as well as draft template language to facilitate its use in buy-sell agreements.

Email me at mercerc@mercercapital.com to be included in notifications regarding its publication (hopefully by the end of first quarter 2019!)

In the meantime, be well!

Chris