Dollar-for-dollar discounts accepted in lengthy divorce
It’s been seven years since the wealthy Wechslers filed for divorce in New York. Their single largest asset: Wechsler & Co., Inc., a private C Corp holding company with a net asset value (NAV) of nearly $71 million. All three experts on the case (a neutral appraiser as well experts for each of the parties) agreed that this was the appropriate “baseline” value for the company that held only securities (but ceased trading on all but its own accounts as of the divorce filing). At trial, both the neutral expert and the husband’s expert urged the court to apply Dunn v. Comm’r (5th Cir. 2002) to account for embedded taxes. That is, consistent with the Dunn case and the NAV method, the court should assume a sale of the company on the valuation date (date of divorce filing) and reduce its baseline value by 41.74%—the combined, effective rate of state and federal taxes.
By contrast, the wife’s expert offered the Tax Court’s decision in Jelke v. Comm’r (2005), which rejected dollar-for-dollar discounts for embedded taxes but was then on appeal to the Eleventh Circuit. Notably, the wife’s expert did not ask the divorce court to apply the IRS’s approach in Jelke, which essentially determined a present value of taxes due on the assets over a projected sales period. Rather, her expert calculated the historical rate of annual taxes paid by the holding company by comparing its average annual taxes to its average annual gross revenues (i.e., before expense and overhead deductions). The trial court, in a “comprehensive, thoughtful and painstaking 129-page opinion,” adopted this approach—reducing the baseline value by an 11% historical rate, and the husband appealed.
There were many reasons for rejecting the ‘historical approach.’ Both the neutral and husband’s expert “vehemently” disagreed with this approach. The 11% historical tax rate was a “meaningless percentage to apply to the capital gains,” ignoring the difference between an effective tax rate and an incremental rate. Neither expert had seen this approach before—nor had the wife cited any authority for its use. By the time of appeal, the Fifth Circuit had also reversed Jelke and adopted Dunn. To complicate matters, the IRS had challenged many of the company’s compensation deductions, which if successful would “skew” the historical approach. (In fact, the IRS obtained a substantial reduction of the compensation claims in Wechsler & Co. v. IRS (Tax Court 2006)).
For these reasons and several more, which the New York appellate court articulates in its own thoughtful, comprehensive opinion, it reduced the baseline value of the company by the combined effective rate of 41.74%, citing not only Dunn and Jelke but also Valuing a Business by Shannon Pratt and Alina Niculita (5th Ed. 2008), available at BVResources.
Look for a complete abstract of Wechsler v. Wechsler, 2008 NY Slip Op 7983 (October 21, 2008) in the December 2008 Business Valuation Update™. Keep in mind: the full-text of all court cases, from Dunn and Jelke to reasonable compensation and divorce are available at BVLaw™.
AICPA/ASA goes live with handouts for BV conference
There’s literally just a couple of weeks to go until the much anticipated AICPA/ASA National Business Valuation Conference 2008 in Las Vegas.Now’s the time to start pulling together all you’ll need to make the most of the event. We noted last week that as part of the AICPA/ASA Conference “Eco-Friendly” Initiative, registrants can access speakers’ handouts in advance of the meeting. The information went “live” this past Monday, so log on now to take a look and plan your personal agenda. On another note: astute Wire readers let us know that we inadvertently flubbed the conference date in last week’s issue. That said, please know that the dates for the meeting are November 10-12. See you in Vegas!
Professional services firms: Data to enhance valuations
Client relationships are paramount—or so says data outlined in Top Dollar: How to Achieve Premium Valuation for Your Professional Services Firm, a recent survey of business valuation experts conducted by Hinge, Inc., a Reston, Virginia-based consulting firm. The surveyors—who interviewed both acquirers of professional services firms and BV experts—found that the following factors (ranked in order of importance) are key to coming in with premium valuations:
1. Strength of existing client relationships. Survey respondents note that factors at play typically include such “intangibles,” as the length and quality of the relationship.
2. Technology. The surveyors contend that for, “firms that possess a truly proprietary process, or to a lesser extent, patents or intellectual property, there is a greater prospect for a premium valuation. Technology, however, must produce a true market advantage. It can’t be a generic process or an easily duplicated software solution branded with a clever name.”
3. Quality of management team. Among other things, the data show that the possibility of retaining talented senior management adds value. Interestingly, respondents didn’t see the presence of rainmakers as having a positive impact on value. Why? The sense is that clients are more loyal to those who brought them in than they are to the firm itself.
4. Marketing strategy. Value-added considerations included: a unique niche or specialization that is sustainable over time; a defensible competitive advantage; and a niche that fills a void for the acquiring firm.
5. Financials. Respondents rated the quality of earnings highly, yet they told pollsters that believable and verifiable projected growth rate is the “single most influential number” for premium valuations.
6. Employees. Why so low on the list? Every employer claims to have superior employees.
7. Profile/image. The surveyors concede that the low ranking of this factor may be misleading. Indeed, they add that “most managers of professional services firms recognize that key elements of brand, such as reputation and marketplace visibility, are essential to maintaining future growth.”
Another take on FAS 157 and mayhem in the financial markets
Not surprisingly, last week’s hearings by The Committee on Oversight and Government Reform, entitled “The Financial Crisis and the Role of Federal Regulators,” concluded that no one single factor lead to the current financial crisis. However, those who believe that the mark to market accounting is at least partially at fault for the meltdown will find the comments offered by Representative Stephen Lynch, (D-MA) of interest. Lynch noted that there is but one way to describe the current problem: valuation risk and the inability to market participants to value products.
According to Lynch, “accurate information for the markets is really its life’s blood. If we don’t have that, we will never gain back the trust that we need in these markets.” He offered the example of Bear Stearns: “We had a financial report by Bear Stearns on the way down, just as they were about to be forced into a sale. In their report they said…we currently have $19 billion in complex derivatives on our books, the value of which is not readily observable…The instruments they had are just too complex, and the market had basically gone away for those instruments.” You can take a look a preliminary transcript of the hearings or listen to Lynch’s comments online.
Appraisal firms ‘likely to face scrutiny’ in securities litigation
“There are numerous potential parties on all sides of failed financial institution litigation,” says a new article, "Failed Financial Institution Litigation: Remember When?", by Richard Bernstein and John Oller, both partners with the international law firm of Willkie Farr & Gallagher, LLP. “Possible plaintiffs run the gamut from the several federal agencies involved in the regulation of the banking industry to the DOJ, SEC and private shareholders of bank holding companies.”
The list of potential defendants may run even longer, the authors say, from the obvious (officers and directors of the failed institutions) to the more creative: auditors, investment banks, attorneys, accountants—and yes, appraisers.
According to the piece, “Banks regulators during the S&L crisis often targeted professionals that serviced failed institutions, particularly audit firms, law firms, and appraisers. It is unlikely that today’s regulators will be less aggressive with respect to these parties. Appraisal firms are particularly likely to face scrutiny in the present environment given the housing slump and subprime crisis. Allegations of collusion between banks and appraisers have received attention in recent months.”
Is there a silver lining for BV experts? While the authors don’t differentiate between real estate and other appraisal disciplines, our recent poll of BV experts finds many of them agreeing there will be closer scrutiny of BV work product, both in future litigation and future engagements.
“The problems today will be the basis of a lot of future litigation that will need valuation experts,” agrees Gilbert Matthews of Sutter Securities Incorporated. Many of these cases will relate to the sub-prime crisis and its fallout. “This crisis is more like a hand grenade than a rifle—it impacts lots of folks within the vicinity of where it hits. A great deal of this litigation will relate to corporate and personal damages, and much of it will deal directly with valuation issues.”
Like so much in life, it’s both good and bad. “I believe this litigation will be a two-edged sword for BV practitioners,” says Grant Thornton’s Neil Beaton. ”On the good hand, BV practitioners who perform litigation support will most likely see increased demand for their services as more complex cases begin to enter the courts. BV professionals with a financial services background such as banking or brokerage will benefit the most. On the [other] hand,” he adds, “I believe we will see more litigation against BV practitioners who have performed FAS 142 impairment tests and got sideswiped by the crises.”
For a complete round-up of all comments by BV experts—including industry insiders, like Bill Quackenbush, Jay Fishman, Jim Alerding, Jeffrey Tarbell and Ron Seigneur, see “What Will the Wall Street Meltdown Mean to the BV Profession?” in the November 2008 issue of Business Valuation Update™.
In addition, on November 20th, Mike Mard, a managing director of The Financial Valuation Group and Tony Yanez with Willkie Farr will jointly present on FASB Update: Convergence, Volatility and Potential Liabilities. You can view the agenda and register for this special Teleconference here.