BV practitioners ‘split’ on applying an S corp premium
More than half (54%) of respondents to last week’s poll on valuing pass-through entities (PTEs), such as S corporations, say they do not apply a “premium” to account for the difference between the data on publicly traded C corps, from which they derive the cost of capital, and the subject PTE, to which they will apply it. “I consider actual taxes/tax rate paid by the entity,” said one respondent, who reflected the consensus of this camp. “No phantom imputation.” Others said the driving question is: “What do buyers do?” Commented one, “Our position is that in the real world, buyers tax affect an investment … in terms of using after-tax cash flows as the metric for value.”
At the same time, just under one-third (29%) of those who do not apply a PTE premium adjust the discount rate instead. “This seems to be where the new Fannon/Sellers paper is going,” said one, “but there is no definitive way to determine how big an adjustment should be made.” (Another respondent believes this is the way the IRS is going, too.) “Interestingly,” noted another:
When I had my report reviewed to obtain my ASA in 1994, I prepared a DCF on which I did not tax affect but rather adjusted the discount rate.… The report was rejected on that basis; I still believe today that you cannot adjust the discount rate and get an adequate answer.
Among the 46% of survey participants who still apply an S corp premium, by far the most commonly used models were the ones by Van Vleet (checked off by 31%) and the Delaware Chancery (20%). “Yes, Fannon and others have provided sound and better analyses to do this,” commented one, “but so far, all the tax-affecting analyses still contain many assumptions and are too complex for everyday use.” Most business appraisers make “countless” assumptions, this commentator added, and “don’t consider tax affecting any more serious of an assumption than the company-specific premium, the WACC weightings, the discounts, etc.” We’ll have more from the survey results next week.
Taking a current look at an ongoing controversy: On Thursday, May 10, join Eric Barr(Fischer Barr & Wissinger) for The Pass-Through Premium: A New Perspective on an Old Issue, which takes a fresh look at how entity structure, applicable tax rates, and business performance impact the credibility of an ultimate value conclusion.
How far have we come since “the last millennium?”
There’s a beautiful reflection on the advancements in business valuation practice in yesterday’s ASA Business Valuation E-Letter. The comments come from Bill Quackenbush, previous editor of the E-Letter, and frequent instructor in the BV201-204 series:
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Cases added to BVLaw valuation case law database this month
A sampling of new cases added to the BVLaw database where litigation resolved around issues of business valuation include:
In re Greater Southeast Community Hospital Corp., 2012 Bankr. LEXIS 618 (Feb. 22, 2012)
In fraudulent conveyance action, court admits errors in its own discounted cash flow valuation of hospital, but denies motion to reconsider, finding the trustee has the burden to present competent expert evidence regarding reasonably equivalent value.
Experts: Neil Demchick (plaintiff); Kevin Moss (defendant)
Judge: Teel Jr.
State/Jurisdiction: federal/ Washington, D.C.
Court: U.S. Bankruptcy Court
Type of case: bankruptcy
SIC code and industry: 8062 General Medical and Surgical Hospitals
Carlton Energy Group, LLC v. Phillips, 2012 Tex. App. LEXIS 1299 (Feb. 14, 2012)
Court of Appeals reinstates full $66.5 million award for tortious interference with contract to develop natural gas reserves, even though this amount exceeded the valuation by plaintiff’s expert and was most likely derived from defendant’s industry report at the time of the breach.
Experts: Peter Huddleston and Henry Crichlow (plaintiff)
Judge: Jennings
State/Jurisdiction: Texas
Court: Court of Appeals
Type of case: breach of contract
SIC code and industry: 1311 Crude Petroleum and Natural Gas
Wandry v. Commissioner, T.C. Memo. 2012-88 (March 26, 2012)
Tax Court upholds defined value clause in transfers of family LLC interests, overruling IRS’s public policy concerns, among other arguments.
Experts: none
Judge: Haines
State/Jurisdiction: federal
Court: Tax Court
Type of case: federal tax
SIC code and industry: 6733 Trusts, Except Educational, Religious, and Charitable (personal trusts, estates, and agency accounts)
Caluori v One World Technologies, Inc., 2012 U.S. Dist. LEXIS 25508 (Feb. 27, 2012)
Court affirms expert’s use of prior lump sum settlement agreement in calculating reasonable royalty for infringement damages under the market approach, after showing that no other licenses existed and the settlement agreement directly related to the patent-in-suit.
Experts: Stephen P. Heath (plaintiff); Richard Bero (defendant)
Judge: Snyder
State/Jurisdiction: federal/California
Court: U.S. District Court
Type of case: IP
SIC code and industry: 5251 Hardware Stores
University of Pittsburgh v. Varian Medical Systems, Inc., 2012 U.S. Dist. LEXIS 17162 (Feb 10, 2012)
District court finds that entire market value rule applies only when unpatented features are combined with patented invention, denying this and numerous other objections by defendant to plaintiff’s reasonable royalty calculations.
Experts: John Hansen (plaintiff); Bruce McFarlane (defendant)
Judge: Schwab
State/Jurisdiction: federal/Pennsylvania
Court: U.S. District Court
Type of case: IP
SIC code and industry: 8093 Specialty Outpatient Facilities, Not Elsewhere Classified
In re Marriage of Gelman, 2012 Wash. App. LEXIS 353 (Feb. 21, 2012)
A medical partnership’s exclusive contract to provide anesthesiology services to a hospital is an intangible asset, but since buy-sell agreement limits wife’s interest to $1.00, the court finds she has no ownership interest in the business and the contract is not a distributable marital asset.
Experts: Steven Kessler
Judge: Spearman
State/Jurisdiction: Washington
Court: Court of Appeals
Type of case: marital dissolution
SIC code and industry: 8011 Offices and Clinics of Doctors of Medicine (except mental health specialists, HMO medical centers, and ambulatory surgical and emergency centers)
Some great CPE coming up in May for financial analysts
Just as the busy tax season ends—the busier BV conference season begins. Book your professional education, networking, and travel calendar now for any of these May offerings:
- On May 7, the ASA and its New York City Chapter host the 20th anniversary of the Current Topics in Business Valuation, to be held in New York City. Sessions will cover effective tactics related to IRS audits, selecting the optimum capital structure for a subject firm, navigating the WACC versus the IRR in business combinations, and an analysis of quantitative DLOM models outputs. For more information, click here.
- On May 10-11, the AICPA/AAML will once again sponsor their biennial national conference on divorce in Las Vegas. As in prior years, each session will feature an attorney and a BV appraiser speaking to both the legal and valuation sides of a particular issue; for more information and a complete conference agenda, click here.
- On May 15, the national ASA hosts its 7th Annual Fair Value Conference, to be held at the Los Angeles offices of PricewaterhouseCoopers. The roster of speakers includes nationally recognized experts such as Ben Couch (FASB), Tony Aaron (Ernst & Young), and Jon Isler and Adam Smith (both from PwC). To register, click here.
- On May 17, the Los Angeles Chapter of the ASA hosts the U.S. Tax Court Cases Symposium, a multidisciplinary event to be held in Cerritos, Calif. Offering “the inside scoop” on what goes on inside the federal Tax Court, the event will feature speakers from the IRS as well as appraisal experts Dennis Webb (Primus Valuation) and Carsten Hoffman (FMV Opinions) and attorney Chuck Morris (Albrecht & Barney). To register, click here.
New, reduced price for remaining segments of BVR’s Healthcare Symposium
Earlier this week, BVR’s Online Symposium on Healthcare Valuation continued with Part 4:Valuation of Medical Laboratories, featuring Curtis Bernstein, Kyle Rudduck (both Altegra Health), and Amy Graham.
Since BVR is now one-quarter of the way through the 2012 Online Symposium on Healthcare Valuation, new subscribers may register for the remaining programs at a just-reduced price. They will also receive access to the Healthcare Desktop Learning Center, an online library of all past BVR healthcare webinars. For more information, click here.
Can business appraisers help private companies transition to IFRS?
To date, just a limited number of companies have decided to switch to IFRS, but “2012 may be remembered as the year when IFRS were adopted by U.S. private companies,” says a new article in Business Finance. Various factors will play into the management decision, critical among them the realization that the cost of the transition is “definitely not as expensive as it would be for a public company.”
Financial executives should manage any transition to IFRS as a project with “specific responsibilities, tasks and milestones,” the article recommends. In particular, “efforts made by the AICPA to incorporate IFRS to the CPA exam will lead to young professionals becoming more knowledgeable about these topics than was the case a few years ago.”
New paper proposes ‘better’ approach to stress-testing bank assets
Under the proposed Dodd-Frank Wall Street Reform and Consumer Protection Act, banks with more than $10 billion in assets may be required to conduct annual stress tests on their loan portfolios. Given the current credit environment and increased pressure from regulatory authorities, even banks with assets under $10 billion—as well as insurance companies—are considering implementing systematic stress-testing programs, says a new white paper by DebtX, “Stress Testing and Fair Market Value: Increased Transparency for Risk Management and Regulatory Examinations.”
“By estimating each loan’s market price under a variety of market conditions, lenders can improve upon stress-testing methodologies that rely on collateral values, indirect measures or undisclosed valuation techniques,” says the introduction. To illustrate its valuation methodology, the DebtX paper also presents two mark-to-market stress-testing scenarios that use loan-by-loan valuations based on loan sale trade data.
New Deloitte white paper focuses on ERP myths
The recent economic crisis should also prompt investors and financial managers to revise their views of the equity risk premium, say Stamos Nicholas and Greg Forsythe (both Deloitte), in their new white paper called “Are You Mispricing the Investment Risk?”:
Since the 2008 financial crisis … we have found that managers sometimes do not fully account for the dynamic and variable nature of equity risk premiums when estimating a cost of capital and evaluating potential investments. A common practice by some has been to solely rely on unadjusted historical ERP statistics or anecdotal support for a chosen ERP. Without appropriate analysis and inquiry, these practices can lead to an incorrect pricing of risk in prospective projects.
CFOs and others may want to reexamine how they typically value investments by “dispensing with the myth of the static ERP,” the authors conclude. They also cite the benefits of implied ERPs (versus historical estimates) and remind readers that “ERP varies by country markets.”
Nath’s article prompts discussions on ERP, too–plus size effect, and more
“Has anybody read Eric Nath’s ‘The Biggest Valuation Myth’ … mentioned in a recent BVWire,” asks Michael Molder (Philadelphia) to members of LinkedIn’s BV Professionals group (registration required). “Any thoughts?”
“Yes, I have read it,” says Toby Tatum (Alliance Business Appraisal), who adds that he has “modified my income approach template narrative with [a] quote from his article to introduce and support my size effect adjustment to the discount rate.” Tatum has also written his own article, “A New Method to Develop a Discount Rate for Small Businesses Using SBBI Data,” posted at his website.
To date, there are nearly 50 comments in the LinkedIn discussion thread, with most participants commending Nath for his “profound insights” and for “putting together a great paper” that is well worth the read. As a reminder, Nath’s article on how traditional methods may not reliably quantify the equity risk premium (ERP) is available at his website.
Federal Circuit permits discovery of negotiations related to patent licenses—after expert opens the door
After initiating lawsuits against several large cell phone providers for infringing patents related to its 3G technology, the plaintiff settled with all the defendants except AT&T. When AT&T tried to get copies of those settlement licenses, including any information surrounding their negotiation, the trial court initially ruled that only the agreements themselves were relevant and discoverable. But when the plaintiff’s expert issued his damages report, it included reliance on a statement by one of the plaintiff’s executives (made during deposition) regarding the negotiated licenses. AT&T renewed its motion to compel, and this time the court ruled that the expert’s reliance had effectively “opened the door” to discovery of the negotiations, since Rule 26 FRCP requires disclosure of all the bases of an expert’s opinion. Moreover:
Documents related to negotiations could shed light on why the parties reached their royalty agreements and could provide guidance on whether some or all of the licenses could be considered a basis for calculating a reasonable royalty between AT&T and [the plaintiff].
The plaintiff sought an interim review, and last week the U.S. Court of Appeals for the Federal Circuit ruled that settlement negotiations related to reasonable royalty and damage calculations were not subject to a specific evidentiary privilege. In particular, “as a matter of fairness, [the plaintiff] cannot at one and the same time have its expert rely on information about the settlement negotiations and deny discovery as to those same negotiations.” Read the complete digest of In re MSTG, Inc., 2012 U.S. App. LEXIS 7092 (April 9, 2012) in the May 2012 Business Valuation Update; the Federal Circuit’s opinion will be posted soon at BVLaw.
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