New model says any fractional discount above 30% merits serious consideration and support
In a presentation that sparked 20 minutes of debate at the 3rd annual National IRS Symposium sponsored by the ASA’s Los Angeles Chapter in L.A. last week, IRS Engineer Team Manager Neil Mills-Mazer introduced a model that addresses his “pet peeve” in the area of fractional interest discounts: the “minority premium.” (Reminder: The views and opinions expressed are those of the presenter and do not necessarily reflect the views and opinions of the IRS.)
Briefly—consider the owner of a 99% undivided interest in a $2 million property. (Thus, the 99% owner can claim $1.98 million of the property, the 1% owner, $20,000.) Mills-Mazer has seen a 99% owner claim a 35% discount for his fractional interest. Yet—even a 1% discount for the majority interest would be worth $19,800, or nearly enough to pay off the minority owner, in effect giving the latter a 99.8% “premium,” Mills-Mazer explained. More importantly, how can the majority interest claim a higher discount than what it would cost to buy-out the minority owner at a substantial premium?
Mills-Mazer’s model takes similar calculations through several levels of minority interests, and concludes that even when ownership is 50/50, the maximum fractional interest discount that should be considered is 30%. Audience questions abounded. For instance, why is there empirical market data that suggests fractional interests trade at discounts of 30% and higher? Aren’t the facts and circumstances of many such holdings much more complicated than the IRS model suggests? Perhaps the most critical question went to U.S. Tax Court Judge James Halpern, who was asked for his thoughts on the model. “Read my decision in Holman v. Commissioner,” he responded (in which FLP provisions permitting the buy-out of LP interests placed a natural cap on marketability discounts). Even more critical: “Would a 99% owner ever be willing to sell at a 30% discount? Not if he can buy out the 1% owner at the equivalent of a 1%-2% discount,” Halpern said.
We’ve invited Mills-Mazer to present his complete fractional interest model and analysis in a future Business Valuation Update. Stay tuned for more analysis and debate…
More bombshells from the ASA-IRS Symposium
Just a few more of the “show-stopping” statements from Symposium speakers:
(Reminder: The views and opinions expressed are those of the presenter and do not necessarily reflect the views and opinions of the IRS.)
- A firm stance on tax-affecting. “I can answer this in a second,” said Miles Friedman, Associate Area Counsel in the IRS Office of Chief Counsel, giving his opinion on the always-debated topic of whether to tax-affect pass-through entities. “The [court] cases say no, the IRS says no,” he said. “Any questions?”
- Expect more Daubert motions. The IRS’s success in excluding the taxpayer’s expert before trial in the recent Boltar decision (see BVWire #103-3) may be just the beginning. “I think you will see more of these [Daubert]motions,” Friedman said, “probably from both sides, hopefully with the effect of improving the overall quality” of expert reports.
- Will enforcement ‘crush’ appraisers? “It’s no secret that the IRS has ongoing problems with valuation,” said Dennis Webb (Primus Valuations), conference organizer. “And they are accumulating tools to deal with appraisers,” such as Sec. 6695A penalties and an increasingly experienced staff. “The enforcement area is getting scarier, and... parts of our profession could be crushed out of existence. It’s time to change our thinking,” Webb said. “We don’t have to overdo tax benefits; they are real.” And without change, “the IRS will prevail.”
- Which appraisers will never get a 6695A penalty? Those who attend professional conferences such as the ASA Symposium. “You care about your craft,” said Peter Crane, IRS Senior Appraiser. In his opinion, “If you follow your professional standards, do your due diligence, follow the commonly accepted methods of your peers, you will never have to worry about penalties.”
- More guidance on penalties, FLPs. The Service has been promising to issue guidance on Sec. 6695A’s “more likely than not” standard for a while; that is still in the works, and should be final by the end of this year, Crane said. And look for the long-promised update of FLP Appeals Settlement standards “any day now,” according to John Schooler, IRS Appeals Team Manager. BVWire will alert readers the moment both releases appear.
DE Chancery recommends not 1, not 2—
but 3 approaches
Remember our recent report regarding the Delaware Chancery Court’s recommendation in the In re Hanover case to use more than one valuation methodology in business appraisal actions? (See BVWire #98-1) Well, now a new “entire fairness” decision expands on the dicta in Hanover. Even if the DCF is a commonly accepted and perhaps even “generally preferred” valuation methodology, the DE Chancery said, (in an opinion written by Vice Chancellor Chandler, who also wrote Hanover), “it is only reliable when it can be verified by alternative methods…or by real world valuations, including especially, valuations performed by potential third-party buyers,” the court explained:
Thus, it is preferable to take a more robust approach involving multiple techniques—such as a DCF analysis, a comparable transaction analysis…and a comparable companies analysis…to triangulate a value range, as all three methodologies individually have their own limitations.
In this case, the plaintiff’s expert had rejected a comparable companies and comparable transactions analysis, because he said their conclusions were “absurdly low” in comparison to his DCF. The court ended up rejecting his DCF in its entirety, however, because its “outlier” results reinforced the court’s concerns that it lacked credibility; so did its rejection of management projections and protracted growth assumptions. Read the entire digest of S. Muoio & Co., LLC v. Hallmark Entertainment Investments, 2011 WL 863007 (Del. Ch.)(March 9, 2011) in the June 2011 BVUpdate; the court’s decision is currently posted at BVLaw.
|Special Report from the
AICPA Family Law Conference:
Appraisers who educate are most likely to earn the affection of their lawyer clients
BVWire was in Las Vegas last week covering the first annual AICPA Family Law Conference (a great success judging from the buzz of conversations and jam-packed session rooms!). We had the chance to sit down with Tom Burrage (Burrage & Johnson CPAs) during one of the breaks. He described a recent analysis he had done on his client database and engagement history: “I found that only 10% of my divorce engagements end up in the courtroom. And when I introduce a neutral expert into the mix (either court appointed or one shared between the two attorneys), that percentage goes down to about 5%." Tom and BVWire wonder whether other practitioners would see similar results? Share your stats with us at email@example.com and as always we will report on the findings.
And on the role of financial experts in educating attorneys and judges, Tom Burrage and Michelle Gallagher (Gallagher & Associates CPAs) described themselves as the translators of the numbers for the word smiths.
Michelle gave a great example of how experts can endear themselves to attorneys. During a recent divorce engagement that involved a restaurant franchise, the attorney asked why she wasn't using the market approach. "I gave him 10 pages from BVR's Guide to Restaurant Valuation that discusses in detail that very topic. He told me he loved me." Tom and Michelle concurred that aside from translating, experts do well to take their educational role as seriously as possible.
How important are BV credentials when testifying in family law matters?
Differing opinions surfaced at another session during the AICPA Family Law Conference. In his presentation “Key Considerations in Family Law Engagements,” Tom Hilton (Anders Minkler & Diehl) told the audience “in my humble opinion, without specialty credentials you are at a distinct disadvantage.” Hilton used a case study in which a judge took into consideration that the opposing expert didn’t have a specific business valuation credential–a fact pointed out by the expert. Because Federal Rule of Evidence 104 sets forth preliminary questions concerning the qualification of expert witnesses and the court’s gatekeeper role regarding the admissibility of evidence, “credentialing is extraordinarily important,” Hilton adds.
Gary Leeman, CPA approached BVWire during the break after the session. He mentioned that while the AICPA encourages its members to become an ABV, not having the designation doesn’t mean the CPA is not competent to perform a valuation. Though the AICPA’s distinction may be lost on opposing counsel, Leeman believes those litigators: may attempt to show an opposing expert is not qualified because of the lack of a designation offered by the AICPA. This is exactly the opposite of the AICPA’s position….the engagement output is what is to be attached – not the expert.
Fundamental trends in professional services firms are creating opportunities for BV
And, at a third session at the AICPA Family Law Conference last week, Ron Seigneur (Seigneur Gustafson) told the audience that professional services firms, such as accounting and law practices, are in a state of transition. Professionals have made money over the years, are getting older, and are now asking themselves: Who are we? Where are we headed? Who is along for the ride and who is driving?
“We’re seeing a huge issue in the Denver market with law firms– a lot of upheaval,” he says Seigneur. “This month two large and established law firms are dissolving, and there are disputes over partnership agreements. Lawyers never quite want to resolve buy sell agreements because they want to keep their options open. And law firms are litigious and fight over things, which present opportunities for us.”
Marketing to divorce lawyers? Here are
Randy Kessler (Kessler Schwarz & Solomiany) asked and answered the question “How do I get in the door to meet divorce lawyers?“ at the AICPA Family Law Conference last week. Here is his advice:
- Ask us to lunch
- Offer to bring lunch in for the lawyers and staff and discuss financial issues divorce lawyers need to know
- Come to lawyers’ seminars and meet us
- Write articles for us, for our clients, for our blogs, for our CLEs.
Kessler also thinks the use of video and social media is an effective way to market your practice and expertise. He and his partners have been asked to speak on divorce issues on many news and talk shows, including Dr. Phil. Check out the videos on Kessler’s website.
Damodaran on the Skype and LinkedIn valuations
In his usual cogent style, Aswath Damodaran (NYU Stern School of Business) expands on the recent valuations of Skype and LinkedIn to discuss the issues in valuing young growth companies. In his blog Musings on Markets he explains:
The value drivers for Skype - revenue growth, target pre-tax operating margin and survival - are generally the constants you worry about with young, growth companies. In the Little Book of Valuation, in the chapter on valuing young growth companies, I argue that these value drivers also should give you indicators of value plays in young, growth companies.
Aswath suggests you take “your favorite young, growth company for a qualitative spin around this track and see if it passes the test” with the spreadsheet that he used for the valuation of Skype.
And…join valuation expert Mike Pellegrino (Pellegrino & Associates) for “Valuation of Early Stage Technologies: Tools, Methods & Case Examples,” a two-day intensive in which attendees will learn how to correctly assess IP value in early stage companies through case studies and hands-on examples.
Upcoming CPE opportunities
May 26th: “Pass Through Entity Valuation Update: The Significant Impact of Academic Research on the Debate”
To date, the ongoing debate regarding S corporation and pass-through entity valuation has been fueled by an increasing body of knowledge and research in the professional appraisal community and a growing collection of court rulings that, at times, seem to contradict research findings, while the insights provided by academic research have often fallen by the wayside. On May 26, BVR welcomes expert appraiser Nancy Fannon (Fannon Valuation Associates) and Keith Sellers (the LaGrange Eminent Scholar of Business Valuation at the University of North Alabama), for an in-depth look at academic research with regard to pass-through entities and what these findings mean for the professional appraiser.
June 7th: The New Minority Share Exchanges: What do they Mean for Private Company Value and Strategy,”
This free webinar, sponsored by BVResearch (a joint project of Aranca and Business Valuation Resources), examines private company share exchanges and what they mean for businesses. Featuring appraiser Neil Beaton (Grant Thornton), banker Susan Casey (Square 1 Bank), venture capitalist Lawrence Lenihan (FirstMark Capital), attorney Chip Lion (Morrison Foerster), and Jeff Thomas, Senior Vice President with SecondMarket, one such private company exchange, this webinar will show the unique perspective of each party involved with private company financing and the changes they view as private company exchanges grow.
The S.F. Bay Area is the place to be on June 3rd
Thinking of visiting San Francisco? Why not come in a day early and attend one of the two great business valuation related conferences held in the Bay Area:
- The 25th Annual Valuation Roundtable Seminar, with sessions on the macroeconomy, estate and gift taxes, and ESOPs. Held at the Orinda Country Club. Contact Casey Swarts at firstname.lastname@example.org or 415-288-9500.
- CalCPA Education Foundation’s business valuation conference, with sessions on company specific risk, cost of capital in private equity markets, and gauging unsystematic risk. Held at the Sir Frances Drake Hotel in S.F. Click here for more information.
BVWire will be reporting on both conferences.
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