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Seller’s Price, Buyer’s Terms

By Rand Curtiss | Published: January 22, 2012

How many times have you encountered situations like this? A business has multiple owners. One or more is to be bought out. The problem is that either there is no buy-sell agreement whatsoever, or the agreement does not stipulate a buyout price / formula, terms of payment, or level of value (whether premiums and discounts for control / marketability will apply).

Well, duh, probably every buyout you have handled has at least one of these problems, or your expertise would be unnecessary … so I will venture to say that every single one of them involved at least one!

Assume the business – all shareholders as a group, not the buyer(s) or seller(s) – has engaged us to provide objective, independent, and constructive valuation advice. Assume we have helped everyone come to agreement on enterprise value – the value of 100% of the equity or capital of the business (and that this value reflects any changes in compensation or anything else that will occur because of the buyout). If this cannot be achieved, there is no way a deal can be made on a rational basis (that is, with our quantified advice. (When engaged for this type of transaction, my letter states that if there is no agreement on enterprise value, my work is complete, I am ineligible for retention by anyone in any legal action or further engagement, and if called to deposition or testimony, I will be retained in advance by the business).

Now the owners have agreed on enterprise value: the first of the three issues is resolved. The next two are the level of value and payment terms. Remember that this is an actual transaction unbound by a buy-sell agreement – so the standard of value is investment value, not fair market or fair value. (Fair market value might be relevant if the owners are family members, but I am going to assume they are not, just for simplicity. Fair value would be relevant if dissenting shareholder litigation ensues, but my engagement precludes me from involvement in that other than to testify as to what I did in the current engagement.)

The point is that the investment value standard means that the level of value (whether discounts and premiums apply) and the payment terms are negotiable, not stipulated. What counts is not what the appraiser says, but whether the parties can agree. This is CRITICAL! All the appraiser can do is offer objective advice. The parties decide whether to take it or not. When I give advice, I try to suggest processes and procedures, not specific numbers because numbers just hang everyone up.

At this point, I like to meet with the parties in person or in a conference call – the key is for all to be present, not for me to speak to one side or the other privately (which could risk my credibility).

First, I tell the sellers that they probably expect to receive their pro rata (I explain this term) percentage of the value of the business in cash. After all, if the whole business were sold, that is what they would receive. They might also feel this way if they bought in on a pro rata basis. Despite that, they are minority shareholders who suffer from lack of control and marketability (and I explain each of these), so a third-party cash buyer would pay them less than pro rata value. I also acknowledge that this might be something they had never thought abou. The bottom line is that the cash value of their individual interests is less than pro rata value. (Now I have upset but softened up the sellers a little.)

Now I turn to the buyers and tell them that the sellers do not have to accept any discount, and that the idea of a discount or a high one may be a deal-breaker. If the buyers want to make a deal, they are going to have to make the buyers willing to accept it. (Now I have upset but softened up the buyers a little.)

[Note: at no time have I disclosed how big a discount I think might apply. As you will see below, I will have done some calculations, but now is not the time for me to opine anything! Remember, the goal is to get the parties to agree. Numbers do not help, ideas do.]

At this point, I say that we can progress in a number of ways. One, the parties can just haggle. If they want to do that, I will excuse myself. On the other hand, I have an idea they might want to pursue. Would they like to hear it? (Of course!)

I propose a compromise that I call “seller’s price, buyer’s terms.” What this means is that the sellers receive their pro rata share of value – whatever number of dollar bills that is – but that the buyers get to structure the transaction to pay money out over time. For example, the buyers might accept a payout over three to five years.

[Note: I am keeping it extremely simple at this point. First, I am proposing simple seller term financing: if the payment term is 4 years, the sellers get 20% down and 20% annually for the next four years at yearend, with no interest. If the business has extremely risky prospects, I may later broach an earn-out. Also, not being an attorney, I will not get into issues of guarantees and security.)

If the parties are amenable to this, I present those three- to five-year (or whatever) payout schedules in the context of a pro forma company financial projection that assesses how easily company cash flow to equity can service the obligations.

Then I compare the present value of the payments over time (usually discounted at the company’s cost of equity capital, assuming that the payments will be subordinated to bank debt so that the payments come out of cash flow to equity; this can vary with case facts and circumstances) and compare it to the undiscounted amount. This indicates the total discount. A perceptive seller might counter that the discount rate should be the cost of debt. That is reasonable if bank financing is available, and suggests a much lower discount, which gives more room for negotiations. THEN I compare these discounts to those calculated using our traditional LOCD and LOMD methodologies.

Now I am done: I have given the parties objective, quantifiable bases to negotiate, and the rest is up to them.

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The Case of the Unclear Standard of Value

By Rand Curtiss | Published: January 20, 2012

I do very little damages valuation work, and as a result, I am always extremely careful to make sure I understand and confirm the standard of value that applies to those matters.

In a recent case, plaintiffs were squeezed out of minority interests in a public company (domiciled in Delaware) that was acquired. The attorney advising them failed to file the appropriate paperwork on a timely basis to allow them to exercise dissenters’ rights. As a result, they were forced to accept the (cash) tender price. To his credit, the attorney admitted his error and advised his former clients to seek legal representation to claim damages incurred due to his malpractice. They did so, and the malpractice attorney who took the case called me for help.

My first question was “What damages are the plaintiffs claiming?” The answer was the lost opportunity to receive a potentially higher price by filing a dissenting shareholders’ suit. This helped a great deal: when I Googled “fair value in Delaware, the first entry that came up was a wonderful piece by none other than Chris Mercer, which can be found at:

http://valuationspeak.com/fair-value-statutory/statutory-fair-value-1-an-introduction/

Chris artfully describes the Delaware fair value standard in these words:

“…take the fairly common cases of a squeeze-out merger or a reverse stock split. The effect of either transaction is to attempt to force minority shareholders to receive the consideration offered by the controllers. If the right to dissent is triggered, affected owners can dissent to the transaction and petition the courts in their states to determine the fair value of their shares.

Fair value in such situations is a willing buyer, unwilling seller concept.

Fair market value is an objective standard. Fair value, on the other hand, is an equitable standard. Equitable is defined in YourDictionary.com as: “Fair, under widely held moral principles, often embodied in court precedents; or referring to a remedy available in a court of equity.”

A “court of equity” is defined in Wikipedia.com (footnotes omitted) as:

… A court that is authorized to apply principles of equity, as opposed to law, to cases brought before it.

These courts began with petitions to the Lord Chancellor of England. Equity courts “handled lawsuits and petitions requesting remedies other than damages, such as writs, injunctions, and specific performance.” Most were eventually “merged with courts of law.”

United States bankruptcy courts are the one example of federal courts [that] operate as courts of equity. Some common law jurisdictions–such as the U.S. states of Delaware, Mississippi, New Jersey, South Carolina, and Tennessee–preserve the distinctions between law and equity and between courts of law and courts of equity.
The point of this seeming diversion to talk about fair market value, equity, and courts of equity is to illustrate that there is potential tension between objective valuation standards and the standard of fair value as it might be interpreted based on equitable considerations by a court.

As a business appraiser, I can provide objective valuation evidence to a court in a fair value proceeding.

As a business appraiser, I cannot consider equitable issues in providing valuation evidence unless instructed by a court.”

THAT is extraordinarily on-point advice, and I thank you, Chris!

Now I knew what the standard of value was and how to interpret it: my job was to act as though I were the expert in a dissenting shareholder suit and to do the same thing (determine fair value according to Delaware law) in the damages case.

I discussed this with the attorney and he was in agreement with me. From additional research, I knew that I would be able to use the Market and Income Approaches, and had a game plan for the valuation and more than enough data to do the job right. Everything was copacetic…

Until a couple of nights later, when I woke up, as I often do, with a new thought. I knew I could develop a supportable fair value of the minority shares…but there was a twist. Just because I opined it, was there not a risk that the judge who heard the case might come to a different conclusion? What if the expert on the other side did a good job and came up with a lower value? The judge might not accept my opinion of value. Was this an additional risk? If so, was it relevant to my opinion? How would I assess it and adjust my opinion for what I called “judge risk?”

Fortunately, I have friends who do a lot of damages work. They told me that judge risk is not part of the damages opinion. I confirmed that with the attorney.

It is now a week later, I am in the middle of my engagement, and have slept well since that fateful night. I hope to keep doing so, but I never know, my subconscious seems to run 24/7!

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The Fab Five

By Rand Curtiss | Published: January 17, 2012

Most “Old Economy” industrial businesses I have valued recently were hurt by the 2008 recession, while most “New Economy” technology businesses were early-stage ventures that were evolving rapidly. In neither case were historical financial results of much use in forecasting results. Nevertheless, I dutifully gathered, analyzed, and reported them.

I started wondering about the source of the rule about considering five years of historical results. I learned this in my appraisal courses, and the earliest citation I can find is in Revenue Ruling 59-60, Section 4, Paragraph 2(d). In 1959, after a very tranquil decade, a five-year look-back was certainly useful. Today, not so much!

Revenue Ruling 59-60 has certainly stood the test of time. Most of its guidance remains valid today. I think its most perceptive suggestion is that appraisers use “common sense, informed judgment, and reasonableness” (Section 4, Paragraph 3.17).

My valuation teachers recommended that I reread Revenue Ruling 59-60 often. I do so. Every reading gives me new insights!

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Write for the Most Important Reader

By Rand Curtiss | Published: January 13, 2012

I write different reports for different readers. Before I start writing, I ask myself “Who is the most important reader of this report?”

In a price allocation for financial reporting, the most important reader is the client’s auditor, who will almost certainly be knowledgeable about valuation. In a selling price analysis for a small business, the most important reader is the prospective buyer, who may not know anything about valuation. Tax-related valuations fall in the middle: IRS agents have varying knowledge levels.

I write to the knowledge level of the most important reader. I write more briefly and cogently to knowledgeable readers than I do to those with less knowledge, for whom I add explanatory details and highlight crucial assumptions and explanations in bold type. There is a tradeoff between brevity and clarity: briefer reports may not be as understandable as longer ones, but longer ones risk wasting knowledgeable readers’ time. I designed my report templates for less knowledgeable readers. I reduce or eliminate explanatory details for knowledgeable ones.

I ask all readers whether my report was too brief or long, and whether it provided sufficient explanation. The ongoing feedback allows me constantly to tweak my templates to achieve brevity and clarity.

Here are useful recent reader comments that led me to (I hope) be briefer and clearer:

1. An IRS agent mentioned that, with the publication of the IRS DLOM Job Aid for Valuation Professionals, they are aware of the relevant market studies’ strengths and weaknesses. If I cite them in a summary table (rather than regurgitating all of the details), that is all they need. (THEN they can challenge my conclusion!)

2. A sophisticated CFO asked me to explain the table row and column labels and calculation formats in my report. He was kind enough to suggest changes. The improved version was something I never would have developed myself!

3. Another CFO’s comment was exceptionally illuminating. He understood my report (a Section 409A valuation for option grants) and proved it by asking sharp, relevant questions. Then he said that the most important readers of the report were the company’s directors, many of whom had little valuation knowledge. He did not want me to expand my report, but he did ask me to go through it with him in detail so that he could answer anticipated questions. He also asked me to attend the board meeting, and he did such a great job with his explanations that I had nothing to add!

4. In an estate tax valuation, the attorney said right up front that she was a stickler for language, demanded that everything be just so, and told me to expect to go through perhaps half a dozen revisions (just on language). She was certain that the estate tax return was going to be audited (because of issues unrelated to the business I was appraising) and wanted a “bulletproof” report. She understood that no appraisal is bulletproof because there are always subjective judgments, but she wanted to make sure there were no other (admittedly nit-picking) weaknesses. I appreciated her candor: we went through 17 revisions, but I knew what to expect, that it was not personal, and the report that emerged was, at least in language, one of the best I have ever produced!

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No Way!

By Rand Curtiss | Published: January 12, 2012

I am valuing a construction contractor located here in Northeastern Ohio, where construction activity is way down and will remain that way for many years, barring a miracle. Most authorities expect it to grow perhaps 1% annually on trend, with huge cyclical swings. My client’s revenues ranged from $1.8 to $3.0 million during the last five years, and exhibited no pattern whatsoever. In the middle of the recession (2009), revenues peaked at $3 million, and they dropped to $2.4 million last year. Most of its jobs are very small, lasting maybe a month and contributing no more than 5% of annual revenue. When I asked the owner to estimate 2012 revenue, as expected, he just laughed and said “No way!”

This is a classic case of a business whose revenues cannot be projected with any confidence whatsoever. No willing buyer would believe them or pay for any highly speculative growth; the business’s backlog is maybe 3 months of contracted revenue at any time.

All we can do in situations like this is to look at history and take an average of some sort to estimate a “typical” year’s performance. That’s how a buyer would value the business. This is where the single-period capitalization model is preferable to a multi-period discounting model. We are assuming that the future will be like the past: highly volatile, and that is all we can say about it!

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Nobody’s Perfect!

By Rand Curtiss | Published: January 11, 2012

I found a small logical inconsistency in my general-purpose valuation report template (that lays out all three approaches to value).

Until now, when I calculated the liquidated value of a business, I often made a small (5% of liquidated value) deduction for expenses (such as sales commissions). Upon reflection, I think that was wrong. In the Market Approach, I do not take a deduction for these expenses (even though the premise of the approach is a sale of the business). In the Income Approach, I also do not take a deduction (because the premise is that the interest will be held indefinitely, not sold). It is inconsistent to take the deduction in one approach and not the others.

I still believe, of course, that deductions for income and capital gains tax liabilities should be taken under all approaches when indicated (even for “S” corporation distributions to cover shareholders’ personal income tax liabilities). I also believe that, under the Asset Approach, deductions for delayed receipt of asset sale proceeds (based on fixed asset appraisers’ input) as well as asset value erosion (uncollectible receivables, bad inventory, etc.) are still appropriate.

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The Cost of Capital is Forward Looking: Redux

By Rand Curtiss | Published: January 11, 2012

I have written about this before, but it is so important that it is worth repeating: the cost of capital is forward-looking.

The cost of capital – be it weighted average, debt, preferred stock, or common stock – is the rate of return that investors require to compensate them adequately for the risk of providing that form of capital (buying securities or lending) to a company. Because it is required to induce them to invest, it is – by definition – expected. It reflects their assessments of the risks confronting a business and its ability to generate satisfactory expected returns. Because the future is not certain, there is always uncertainty about any security’s rate of return. Even “riskless” U.S. Treasury Bonds have uncertainties: the real rate of interest, the rate of inflation, maturity risk (which is why longer-term bonds usually have higher yields than shorter-term bonds), and (perhaps during last year’s paralyzing debt ceiling debate) default risk.

If we were working with publicly traded securities, the task of determining the cost of capital would be much easier than it is for private securities. For bonds with fixed coupon interest rates, we can project the amounts and timing of interest and principal payments. Using current market prices, we can then compute their yields to maturity, which are the internal rates of return. That is the cost of public bond capital! If we use the Gordon Growth model, we project dividends (estimated by Wall Street consensus, albeit with more uncertainty) and calculate the cost of capital as the IRR using the current market price as the investment. That is the cost of public preferred and common stock capital!

In the private market, we do not know the value of the stock (or debt, for that matter) so we cannot use the IRR procedure. Instead, we project future returns (dividends or interest and principal) and estimate a discount rate (the cost of capital) to arrive at a (DCF-based) price. However, the discount rate is forward-looking, and not known with certainty.

THE BIG ASSUMPTION WE MAKE, whether using a build-up or CAPM, is that we can USE HISTORICAL DATA, WHICH ARE REALIZED RETURNS, to ESTIMATE EXPECTED RETURNS. If we use a build-up, we use Ibbotson and Duff & Phelps data or perhaps Private Cost of Capital survey data for our risk premiums. If we use CAPM, we look to beta data (!) based on HISTORICAL relative volatility.

I am not going to argue that this is correct, because it is not (will the future REALLY be like the past?), but I believe that this data gets us in the ballpark of reasonable costs of capital. It is the best we can do, since we do not possess crystal balls.

Whenever I am challenged on my cost of capital conclusions, I am willing to give a little (e.g. agree with someone who is within plus or minus 2% of my estimate using the same baseline data such as Ibbotson) because of the inherent uncertainties of estimating the future cost of capital, particularly the company-specific equity risk premium. I do not worry about sophisticated tweaks (such as the mid-year convention, supply-side cost of capital, adjustments to historical data to reflect expectations, and so forth) for the simple reason that they build on fundamentally imperfect estimates of the cost of capital and do not make it any more accurate.

As Clint Eastwood said, “A man’s got to know his limitations.” With regard to estimating the cost of capital, my masculinity is indisputable.

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Valuing Buy-A-Job Businesses

By Rand Curtiss | Published: January 10, 2012

A colleague called for help valuing what she called a “buy-a-job” business. The literature uses the term, and I have heard it many times, but I asked her anyhow, “How do you know it is a buy-a-job business?” I am glad I did, because her response was terrific:

“You cannot expect a buy-a-job business to generate return on a new owner’s equity.”

Wow, that says it in a simple sentence! As I thought about it, her response implies that:

1. If you calculated cash flow to equity with fair market compensation for the owner (and employed family members) and deducted debt service (interest and principal payments) based on the purchase price and terms, there would be little or none until the debt is (fully) repaid, and then only enough to maintain equity. Therefore, there is no return on equity.

2. Even if there is return on the CURRENT owner’s equity, it is not probable (or possibly feasible) that their personal goodwill (knowledge, reputation, customer relationships, etc.) could be transferred to the buyer, which in the limit implies an infinite discount rate (level of risk of associated cash flows) or zero capitalization rate for those intangible assets.

Alternatively, the buyer would have to pay the current owner such a high salary to keep working in it (or a covenant not to compete) that there would be no cash flow left over. Therefore, there is no return on equity.

I can also think of two other reasons why a business might be buy-a-job:

1. The outlook for the industry, region, or business is unfavorable and probably not fixable. (Since TV’s are so cheap that replacement is inexpensive, I would not want to be a TV repairperson.)

2. Perhaps return on equity is contractually restricted. Many professional practices have buy-sell agreements that do this. You get “your equity” when you retire, but it might not be calculated on a fully unrestricted (percentage of the value of the firm) basis.

The answer to her question follows directly from her apt definition. Since there is no cash flow to equity, we cannot use the Income Approach (based on cash flow to equity). We have to estimate a multiple of discretionary earnings or another ownership benefit stream – highly subjective, but doable. I prefer to rely on the Market Approach and hope to find a sufficiently large sample for statistical confidence.

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School Days, School Days

By Rand Curtiss | Published: January 10, 2012

I have taught undergraduate macroeconomics at a local university for the last three semesters. It has been a wonderful experience – and a quite fortuitous time to be studying and teaching the subject, which leads the news almost every day. It has also given me a chance to catch up on developments in the field, which have been numerous since my undergraduate days as an economics major, which ended during the Dark Ages (in 1972).

This term I am teaching a graduate corporate finance course and having another wonderful experience for the same reasons, in addition to the fact that I can illustrate its principles with cases and examples from my appraisal career.

As I planned the course and studied the materials, however, I realized that I had never been formally educated in the Capital Asset Pricing Model (CAPM) for the simple reason that it was not widely taught during my college and graduate days. It was invented in the 1960s and not fully developed or taught while I was a full-time student. I picked up CAPM knowledge along the way, in a rather piecemeal fashion, not through any formal academic program. There were (and are) several gaps in my knowledge.

If you find yourself in this situation, I suggest reading Fundamentals of Financial Management Concise by Brigham and Houston. I have been studying and teaching from this e-book, and find it indeed a concise explanation of the subject that has filled in many gaps for me.

My study of the book has also raised an issue that I have not resolved. One CAPM principle is that investors can eliminate company-specific risk (which we measure by the company-specific equity risk premium) through proper diversification. This makes perfect sense to me if we are talking about an investor owning a portfolio of (publicly traded) securities. On the other hand, most of my business owner clients hold their wealth primarily in their businesses and residences, and have relatively small (if any) portfolios of other investments. It is not clear to me that any of them consider their businesses, residences, and investments as a CAPM-type portfolio that can be diversified to reduce or eliminate company-specific risk. Food for major thought…

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On IRS Audits, Independence, and Objectivity

By Rand Curtiss | Published: January 4, 2012

As time goes by and I put more IRS audits under my belt, I am modifying my approach to dealing with them. Three facts are driving this:

1. Our professional standards require that we remain independent and objective. We can advocate for our opinion, but not for the cause of our client. Regardless of how independent and objective I am, there is always the risk that I will be perceived as advocating for the client, not my opinion.

2. The client’s appropriate advocate – usually their attorney – does not have objectivity and independence constraints. In addition, many of them are familiar with the most frequent appraisal issues, and are able to negotiate effectively because of these facts.

3. It is hard for me, in a live meeting or telephone conversation involving the IRS, the client’s advocate, and me, to avoid getting involved in negotiations, even though I make clear that I cannot do so. In the best case, everyone understands this. My involvement is limited to explaining and defending my opinion on its merits. In these cases, I do that, and then leave the meeting or call. The attorney dukes it out with the IRS. In worse cases, they start negotiating in my presence and draw me in, inadvertently or advertently, which is a no-no.

Here is an example from a recent audit. There were two points of contention:

1. A real estate partnership was valued on a liquidation basis. Both sides agreed on this premise, as well as on the values of the assets and liabilities. The partnership was cash flow negative, and the real estate appraiser who valued those assets had assumed values based on a one-year exposure (selling) time. I deducted from the appraised value one year of cash outflow (using the previous complete fiscal year’s outflow as a proxy). Any willing buyer would incur this cash outflow, as would an owner (seller), so it was a relevant, logical, and justified deduction from value. The IRS took the position that they “would not allow” this deduction based on certain statutory grounds (which I did not understand, not being an attorney.) This issue had big stakes: a large value adjustment, since the outflow deduction was $750,000 on a pre-deduction value of about $8 million.

2. A minority interest in an investment partnership (not the real estate partnership) was to be valued. I deducted a 32% combined discount for lack of control and marketability, justified with benchmarking and the QMDM. The IRS did not quarrel with the relevance of a discount, but took the position that they “would not allow” a discount greater than 27% based on “previous cases.” (I am not sure whether they meant Tax Court cases or previous settlements.) This issue had small stakes: a rather small value adjustment, since the 5% difference in discounts was worth about $60,000 on a pre-discount value of about $1.2 million.

Do you see my problem? In both cases, I had prepared and strongly supported my opinions concerning the controversial issues – the deduction of the cash flow and the size of the discount. The IRS was able to cite no independent market data, facts, circumstances, assumptions, or methodologies that would support their position. They were simply drawing lines in the sand: an apparent legal on the deductibility of the cash outflow and a wholly arbitrary one on the size of the discount. There was no way that I , while maintaining independence and objectivity, could respond to their statements other than to say “Please provide independent market data, facts, circumstances, assumptions, and methodologies that support your position,” a polite way of saying “Prove it!” In the absence of proof, I had nothing to say, and did not.

It would be easy to fall into the trap of saying to the IRS “You have made a totally unsupported claim contrary to my well-supported, independent, objective opinion.” In other words, I was at an insurmountable impasse with the IRS. I could say nothing else.

This is where the client’s advocate should take over. Anything that leads to bridging the gap between the positions is negotiation, which I will not be involved with because of my independence and objectivity.

Now I can get to the crux of my modified position. The first part is to just do my job – no change there – explain my opinion and reasoning and answer questions about it, including challenges to my market data, facts, circumstances, assumptions, and methods. If there is a flaw in any of them, I will modify my position accordingly. If not, I am done.

The second part is to act as a non-testifying expert in court would act: to help the attorney (the client’s advocate) make their case. This should be done BEFORE meeting with the IRS and (if an impasse is reached), in a caucus with the attorney. In both, I educate the attorney on the potential (or actual) issues so that they can defend them. I will point out, for example, assumptions that could be reasonably modified if there is going to be a negotiation. In the above case, I suggested that for negotiation purposes a shorter exposure time (six months, and thus lower cash outflow) could be proposed BY THE ATTORNEY. I also suggested that THE ATTORNEY offer to split the difference on the valuation discount. This armed the attorney with all the relevant information I could provide, and suggested negotiating points. If I do this job well, the attorney is in a strong position to negotiate (deciding to stick to the original position, make a deal, or capitulate) and I remain “above the fray,” which is where I must be! In this case, the IRS accepted both positions after some further obfuscation, and the case was settled.

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