Debate on tax affecting plays out in new divorce case
The debate on the valuation of S corporations has “bedeviled the professional appraisers’ community for some time,” notes the Massachusetts Supreme Court, which just issued its opinion in Bernier v. Bernier (Sept. 14, 2007). On one side of the debate are the Tax Court decisions in Gross v. Commissioner (affirmed by the 6th Circuit in 2001) and its progeny, which generally disavow tax affecting S corporation earnings. On the other side is Del. Open MRI Radiology Assocs. v. Kessler (2006), in which the Delaware Chancery Court performed its own tax affecting analysis in a statutory fair value appraisal action.
In the Bernier divorce, “the debate over tax affecting played out in the diametrically opposed positions taken by the parties’ experts.” The husband’s expert treated the couple’s S corporations as if they were C corporations, applying a 35% “average” tax rate to earnings to reach a $7.85 million valuation. The wife’s expert declined to apply C Corp rates to arrive at a $16.4 million value. The trial judge—citing Gross and an old IRS training manual—adopted the “tax affected” value of the husband’s expert. But the reliance on the training manual was “misguided” according to the Mass. Supreme Court, and the application of Gross incorrect. After reviewing the case law and pertinent literature, it “generally” adopted the Del. Radiology valuation metric. “Careful financial analysis tells us that applying the C corporation rate of taxation to an S corporation severely undervalues the fair market value of the S corporation…” For a copy the Court’s careful and comprehensive analysis, click here.
After Del. Radiology, did Bernier 'get it' right?
After the Del. Radiology decision, Nancy Fannon (Fannon Valuation Group) commented that the Delaware Chancery Court finally “got” the essence of the argument that appraisers had been making for years, “that is, it’s the avoidance of the DIVIDEND TAX, not the deduction of the income tax, which is the issue.” (See BVWire™ #45-4.)
But despite the allusion to a fair market valuation of the S corporation interests, the Bernier Court emphasized the “equitable” nature of the divorce action, where one party retains and the other is entirely divested of a marital asset. In this context, “the judge must take particular care to treat the parties not as arm’s-length hypothetical buyers and sellers in a theoretical open market but as fiduciaries entitled to equitable distribution of their marital assets.” Does Bernier leave the door open to cases such as Dallas v Commissioner (2006), in which the Tax Court distinguished its holding from Del. Radiology based on the fair market value vs. fair value/appraisal context? Email your insights and expert intelligence to the editor.
Major ‘shakeout’ in VC industry, credit markets crunched:
Just the tip of a financial ‘iceberg’?
Recent layoffs by commercial lender CapitalSource, Inc. are just the “tip of a giant iceberg,” according to a new posting at PEHub (Sept. 14, 2007). Executive recruiters are saying “to expect many more—and larger layoffs—in the loan markets, and in a variety of other industries that rely on leveraged buyouts,” reports editor Dan Primack. “It could become one of the fall’s largest financial stories.”
This dire prediction comes at the same time as a “major shakeout” in the Venture Capital industry. A recent analysis by OVP Venture Partners first takes a look at the VC firms still registered in the market: This number has fallen only 15% since 2006. But then it looks at the number still active in the market—and there were only 597 venture firms that made at least one new deal in 2006, compared to 1,156 six years ago. “This is more like a 50% drop,” says OVP. “We think that is the big, so far unwritten, story. The U.S. venture industry has been cut in half. That certainly qualifies as a major shakeout.” Primack agrees, “The industry is becoming unsustainable, and it shows.”
Private equity buyers continue to outbid strategic buyers
“The larger portion of financial buyers is increasingly setting value,” according to Jeremy Busch (TorQuest Partners, Toronto), who spoke to the sold-out Eastern Regional CICBV conference in Montreal at the start of the month. The trend could modify the assumptions in fair market value and fair value assessments. But, the way Busch and his TorQuest team of private equity managers see it, value is still a function of steady cash flow (for debt service); a defensible market position; low working capital requirements; a strong management team; and the potential for improving margins. So while some PE executives may downplay DCF-based valuations in favor of workable exit multiples, it appears that PE money still follows—and values—the same corporate attributes.
Fair market value still creating quite a buzz
“I seem to have stirred up a hornet’s nest with the discussion of fair market value,” admits Mike Pellegrino, referring to the continuing BVWire debate. “In my view [and as Dexter Draff pointed out last week] what folks are in effect valuing when they perform M&A is not necessarily fair market value of a company but investment value.” Motivations are different, as are timing requirements. Investor knowledge may be different, too. “All of these factors dictate why the closing price for a transaction is something other than intrinsic value.
“We as a profession are generally asked to opine as to the fair market value of a company, NOT the investment value,” Pellegrino adds. Yet the general profession “intermixes the two constantly, and (I speculate) generates investment values more often than not.” For example, many practitioners use public and private transactions data to generate comparable values to establish subject company FMV. “However (as Draff pointed out), many of those transactions use an investment value standard to arrive at a price for the acquisition target that accounts for synergies, necessity for a deal, etc. The accounting profession has struggled for years with how to address the premium or discount,“ Pellegrino says, “lumping the balance into goodwill as it had no other place to put it.”
The bottom line, in his opinion: “BV professionals commit what amounts to measurable error—and perhaps gross error, over time—by mixing and misapplying value standards.” Pellegrino recently applied his theory in “Valuing Early-Stage Companies,” Valuation Strategies, May/June 2007 (reprinted at his website). He is currently working on extending his initial research to the broader BV community, for publication in the Business Valuation Update™, and welcomes “new thoughts and ideas.” Email the editor. (We also assume that Mr. Pellegrino would welcome the correct spelling of his name, which we misspelled in prior editions. We regret the error, and have corrected it in online versions of the BVWire.)
Industry-specific series begins with valuing banks
BVResources is launching the first in a continuing series of industry-specific, business appraisal teleconferences with “Valuing Community Banks,” on September 26, 2007 with Kevin Sellers and Douglas Southard. The experts will provide an update on the banking industry, present new sources of relevant data, and provide “real time” answers to attendee questions on everything from applying appropriate valuation methods to developing this profitable niche. To register, click here. In the future, look for BVR industry-specific teleconferences on Valuing Automobile Dealerships, with Kevin Yeanoplos, and more on valuing community newspapers, and valuing investment advisors/financial planning firms.
ASA expands accommodations for near sold-out crowd
The American Society of Appraisers has just picked up more hotel rooms (at conference rates) to accommodate the swell of attendees to arrive in San Diego from October 29-31 for this year’s Advanced Business Valuation Conference. Also new: the ASA just announced keynote address by Ed Trott, two-term FASB board member, who will speak on SFAS 157 Fair Value Measurement and related issues, likely to include the need for valuation standards and the recent formation of the FASB’s valuation resource group. (If his remarks at the April roundtable on FASB’s Invitation to Comment on Valuation Standards are any indication, Trott may have some interesting views on “client bias” and analysts’ reliance on management projections; see BVWire #57-4.)
Only a handful of spots are left at the conference and the hotel, so book your place now by clicking here. The cut-off date for special hotel rates is September 24, 2007. And take note: there are just a few sponsorship opportunities and conference ad space still available; for more information, contact Samantha Bowerman.
AICPA posts National BV Conference agenda
If you can’t make San Diego in October, then shoot for New Orleans in December, where the AICPA is hosting its National Business Valuation Conference from December 2-4. The Institute has just posted registration information and an overview of sessions, which cover FIVE tracks this year: hot/emerging issues, fair value, fundamentals, litigation, and niche. The conference will kick off with a keynote presentation on the “Economic of Disaster,” on the continuing economic impact of hurricanes Katrina and Rita. For more information, click here.