IRS withdraws Wandry appeal
Last week the IRS voluntarily dismissed its appeal of Wandry v. Commissioner, according to the Tax Court’s case docket.
As BV appraisers and estate and gift advisors will recall, the original March 2012 decision in Wandry was a solid win for the taxpayer in upholding a defined-value clause against arguments by the IRS on legal as well as public policy grounds. The Tax Court issued its ruling as a memorandum opinion, however, which doesn’t bind the court or parties to similar disputes in the future. When the government subsequently filed its notice of appeal to the 10th Circuit, many experts hoped a “final” decision would result in authoritative precedent—for or against formula-value clauses—in at least one federal jurisdiction.
The IRS doesn’t indicate any reason for its voluntary dismissal. This means that the validity of formula-value clauses is still one of those issues in the estate and gift tax arena—like the treatment of pass-through entities and discounts for lack of marketability—that remains largely unsettled.
‘What’s the difference between a duck?’ Appraisers split on how to treat officer comp in DCF
Perhaps this is why they call business valuation an art: Precisely 50% of respondents to our most recent online survey—on the “settled but unsettled” aspects of a DCF analysis—treat excess officer compensation as a normalizing adjustment. Nearly the same number (46%) treats it as a “control” adjustment. “It depends,” says one participant, on whether the interest you are valuing is a controlling or minority. But still another participant points out that the character of the payments is the pivotal issue:
If you have a number of officers receiving substantial excess compensation—which are really substitutes for distributions—then it is a normalizing adjustment. If the excess officer compensation goes beyond owner/officers, then it can be a control adjustment.
“I would like to know how one determines whether officer compensation is ‘excess,’” comments another survey-taker. “One could simply compare to industry averages, but if performance is better at firms with higher officer compensation, [then industry data] may be misleading.” The question probably merits more research to determine the true relationship between compensation and performance “before deciding which road to take.”
And yet, “What is ‘normal’ is not necessarily synonymous with a market level of compensation,” says another. “Typically, a control interest could change compensation to a market level or to/from a ‘normal’ level.” Even then, does it really matter what you call the adjustment, “as long as the cash flows, discount rate, and ownership interest are all [adjusted] on the same basis?” Or, as still another participant puts it—perhaps only semi-facetiously: “What’s the difference between a duck?”
One thing is 100% clear. “Surveys like this are very useful for our community,” writes Ty Taylor (Asset Analytics). “Thank you for your efforts.” Likewise, we thank everyone who participated in the survey and will publish more results—and comments—in the coming weeks (and see additional item, below). We also thank Rod Burkert (Burkert Valuation), who helped formulate the questions and will provide a complete overview and analysis for the next (December 2012) Business Valuation Update.
Fama/French study international size effect and find ... none
In their new article, “Size, Value, and Momentum in International Stock Returns,” the dynamic academic duo of Eugene F. Fama (Univ. of Chicago) and Kenneth R. French (Tuck School of Business) examine international stock returns to determine the value, size, and momentum patterns among average returns for developed markets. According to the article summary by the CFA Institute, the authors’ findings indicate “no size premium in any region during the last 20-plus years.” The article abstract adds:
The authors observe higher average returns of value stocks relative to those of growth stocks in four regions (Asia Pacific, Japan, Europe, and North America). The value premiums decrease as stocks increase in market capitalization (size). Momentum is also present in every region (except Japan), and it decreases with increases in size.
The article just came out in the Journal of Financial Economics, Vol. 105, No. 3 (Sept. 2012), and should be available for purchase at the CFA Institute website (see link above). Our thanks to Michael Crain (The Financial Valuation Group)—whose own work on the size effect has generated substantial interest in the BV community—for alerting us to the new study.
Did the DE Chancery draw a ‘bright-line rule’ requiring normalization of capex/depreciation in terminal values?
Should depreciation equal capital expenditures (capex) in the terminal year? Yes, say nearly half (44%) of respondents to our DCF analytics survey—but only 29% say “no.” The remaining 27% fall somewhere between the absolutes, saying the answer turns on assumptions of company growth and inflation, as these comments reveal:
- “A steady growth assumption implies that the company will always be expanding its capital base, even if only slightly. Not to mention that inflation would cause future replacement cost to always exceed historical cost.”
- “Expenditures should slightly exceed depreciation so as not to deplete the asset base and allow for inflation.”
- “In an economy with an expectation of inflation that is greater than zero, capital expenditures will typically exceed depreciation because replacement of assets will likely be greater than historical cost (depreciation). This is true even for a company with no real growth (units of product/service). If the company is expected to have real growth in perpetuity, then the difference between capital expenditures and depreciation would typically be even greater than in a no-growth scenario.”
The Delaware Court of Chancery might also fall on the side of “it depends.” In a current statutory appraisal action, the expert for the minority shareholders submitted a late, supplemental report in which he normalized cash flows for his terminal value. (In an earlier report, he simply presented this as an alternate approach without relying on it.) To support the last-minute change, the minority shareholder argued that the recent decision In re Appraisal of Orchard Enterprises, Inc. “established a Court of Chancery valuation preference, bordering on a bright-line rule,” for this approach.
“Orchard did no such thing,” says Vice Chancellor Laster, in a letter ruling. Instead:
Orchard recognized that ‘typically’ normalization of capital expenditures and depreciation in the terminal value calculation is appropriate. And it is for many (likely most) mature companies. Early stage ventures and capital-intensive businesses, however, can endure extended periods, longer than the traditional five-year [DCF] projection period, during which capital expenditures outpace depreciation. For such a company, rote normalization after five years would be inappropriate, and Orchard does not require normalization when the operative reality of the company calls for a different approach” (emphasis added).
The court also excluded the expert’s 11th hour “alternative” DCF approach, saying the concept of normalizing cash flows “is not novel” and he should have considered this in his original analysis.
Read the complete digest of IQ Holdings, Inc. v. Am. Commercial Lines, Inc., Case No. 6369-VCL (Aug. 30, 2012) in the December Business Valuation Update; the court’s letter ruling will be posted soon at BVLaw.
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The future of BV in court: A broker makes the case for a transactions‑based world
Last week’s item on the future of valuation litigation (the article in The Business Lawyer crediting market evidence over theoretical valuation models) “grabbed my attention,” writes Ed Davis, CPA/CVA. “I am a ‘broker who also does valuations,’” primarily for the buy side of the private business community with gross revenues between $1 million and $35 million, he says, “the typical family business.” Davis usually prepares a market estimate and then does “the research and the math just to establish a reasonable range of expected offers to present/review with our sellers.” He adds:
I've had the benefit of working with very credible associates who have been in the transaction market for 30+ years. I must admit, when I sit and talk with my valuation associates—all smart, hard-working people—I find my transaction world is very different than their world (valuations only, no transactions). We're learning to live with each other—but it is different.
Does his world make a difference with judges? When Davis and his transaction associates are engaged for expert witness work, “the judges, knowing our backgrounds, really seem to listen to what we say (good or bad).” Indeed, in a recent case, a judge told one of Davis’s colleagues, “This person has been doing deals for over 30 years: I'm very interested in what he has to say.”
“Kind of entertaining, really,” Davis comments. Or is it? Email your thoughts on the future of BV in litigation to the editor.
How to protect your FVS practice against malpractice
The good news: The vast majority—93%—of respondents to a recent poll of BV and accounting firms said that in the past 10 years, they have never had to defend a malpractice suit in their forensic and valuation services (FVS) practice. Only 4% of respondents had experienced one or two claims over the prior decade; 3% had taken on three to five claims; but none had fought six or more claims.
What were the participants’ top three worries regarding the risk of an FVS malpractice suit?
- Not being provided with important information (52%);
- Lawyers who don't communicate well or don’t provide the complete story (51%); and
- The client's or a lawyer's unrealistic expectations for a specific result (47%).
Interestingly, non-CPAs who practice in the forensic arena worry more about collecting fees or not having adequate insurance coverage, but CPAs are troubled by deadlines and client expectations. The survey also breaks down responses by firm location and specialty in family law/litigation consulting.
Are you at risk of committing malpractice in the FVS world? For the answer—plus complete survey results—you’ll have to attend the session by Michael Corso (Henderson Franklin Starnes & Holt), Michael Crain (FVG), and Gail Markham (Markham Norton Mosteller Wright & Co.) at the 2012 AICPA Forensic & Valuation Services Conference in Orlando, Fla., on November 11-13. To register, click here.
IVSC renews vows with international accounting federation
Last week, the International Valuation Standards Council (IVSC) and the International Federation of Accountants (IFAC) renewed their memorandum of understanding (MoU), first signed in 2009.
The agreement to renew “represents an ongoing commitment by both the IVSC and IFAC to strengthen cooperation between the two organizations,” says Roel Campos, interim chairman of the IVSC board of trustees. “It demonstrates the cohesive and united approach of the IVSC, IFAC, and its independent standard-setting boards to maintaining standards as global markets continue to develop.” The IVSC should soon be posting the official announcement at its website.
Which is more difficult: predicting the next president or determining valuation discounts?
Well, at least we can make the latter less challenging, to wit:
Before the election, join Jim Alerding (Alerding Consulting) and Jim Ewart (Dixon Hughes Goodman) on November 1 for Control Premiums & Discounts for a review of current, on-point legal cases as well as all the factors—such as business operations, income, and goodwill—to help make this difficult determination as objective and supportable as possible.
Following the election, on November 8 join William Frazier (HFBE) and Ashok Abbott (West Va. Univ.) for Part 2 of BVR’s Online Symposium on Estate & Gift Tax as they present the Non-marketable Investment Company Evaluation Method (or NICE), an income-based approach for valuing equity interests in closely held investment entities (FLPs, S corps, LLCs, etc.) that sidesteps any determination of marketability/minority discounts.
To determine the next president, BVR simply encourages everyone to go out and VOTE!
Valuation Research Group wins international award
The Valuation Research Group (VRG) accepted an award for “Valuation Firm of the Year” at the 2012 International M&A Awards & Summit this month in Manhattan.
“The International M&A Advisor Awards recognize the leading firms, deal teams and deal-makers whose activities set the standard for cross-border transactions,” says a VRG release. This year, over 228 nominees representing over 400 companies competed for the award, as adjudged by an independent committee consisting of 14 cross-border industry experts from the largest private equity, accounting, and law firms.
Message for our East Coast readers
As we go to press, Hurricane Sandy is wreaking havoc in the northeastern United States, and our thoughts are for the safety and well-being of all those affected by the storm: May all our subscribers and their families and friends emerge with homes and health unscathed.
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