DE Chancery declares merger price more reliable than DCF analysis

It’s no secret that the Delaware Court of Chancery has a strong liking for the discounted cash flow (DCF) analysis in fair value determinations. For this reason, a decision in which the court expressly rejected the DCF method in favor of the actual merger price—which recently happened—is sure to merit extra attention.

Revenue stream ‘in flux’: The case involved a merger and a group of dissenting shareholders that asked the court for a statutory appraisal of their interest. The target owned and managed “iconic” entertainment assets, including a business that owned rights to “American Idol” and “So You Think You Can Dance.” A major issue for the company—and the case—was how to handle “the maturation” of the “American Idol” franchise. After the show peaked in the ratings in 2006, it began to decline for five seasons. Also, around the time of the merger, the contract between the company and the show’s network distributor, Fox, was about to expire. The company had only limited leverage in the negotiations because Fox owned a perpetual license to renew its exclusive contract to broadcast the show. At the same time, company management believed that, with fewer shows available that had mass appeal, the value of “American Idol”was still going up, and, therefore, the company might extract a higher license fee from Fox in the future.

Ultimately, the company signaled to the market that it was for sale. When potential buyers expressed an interest, management created five-year projections. The CFO instructed the preparer to assume that revenues under the to-be-negotiated “American Idol” contract would increase by some $20 million each year. Whether the additional $20 million per year was a “genuine prediction” of future revenue or merely a “marketing ploy” with which to generate a high bid became a pivotal question for the valuation experts both sides retained. The eventual buyer paid $5.50 per share.

The petitioners’ expert used a DCF analysis as well as “guideline” analyses to appraise the stock. He concluded it was worth $11.02 per share. In contrast, the company’s expert relied solely on the DCF method to compute a $4.41 value per share—$1.09 below the sales price. Much of the “gulf” in value stemmed from the experts’ use of different figures in their cash flow projections. The petitioners’ expert wholly adopted the revenues appearing in the management projections, whereas the company’s expert ignored the projected $20 million annual increase and instead assumed Fox fees would grow at 4% per year for five years. Neither treatment was reliable, the court found. When the merger took place, the future revenue streams related to “American Idol,”the company’s primary asset, were “in a state of flux.” Therefore, the court could have “little confidence in the reliability of using or excluding the estimated $20 million increase in revenues.” For this reason, it found the DCF analysis was not the appropriate technique in this case. Instead, it looked to the actual merger price, which resulted from a sales process that was “thorough, effective, and free from any spectre of self-interest or disloyalty.”

Find a discussion of Huff Fund Investment Partnership v. CKx, Inc., 2013 Del. Ch. LEXIS 262 (Oct. 31, 2013), in the January issue of Business Valuation Update; the court opinion will be available soon at BVLaw.

IPCPL discussion on LinkedIn

The BVR LinkedIn group has a number of interesting discussions, including an ongoing thread about the implied private company pricing line (IPCPL). This is a new approach designed to be more reliable in estimating the cost of capital for a privately held business and eliminate the inherent problems in comparing public and private data. An article explaining the new model was featured in the September issue of Business Valuation Update. In response to the interest, BVR has posted the article on its website as a free download.

Database questions: Some of the LinkedIn discussion centers on the underlying transaction data used by the model. The concern is that the data will likely require some adjustments or massaging, so the question is: What is being done to the transactions database in this regard?

Two of the IPCPL developers and authors of the BVU article, Bob Dohmeyer (Dohmeyer Valuation Corp.) and Peter Butler (Valtrend LLC) responded. “We use a very large sample size of 500 transactions that represents an unbiased, and relatively tight estimate of Ko,” says Dohmeyer. “We do provide a statistical analysis in the article of how potential data noise from the transactions is minimized.” Butler adds: “Of course, the transactions need some ‘massaging.’ It is what it is. Listen to the webinar [see below] and make up your own mind if you think the adjustments/assumptions are problematic relative to the many problems with using publicly-traded data—particularly if you are still guessing as to an appropriate CSRP. The law of large numbers also helps with the ‘massaging.’”

Learn more: Butler is referring to a recent webinar (archive available) BVR conducted with Dohmeyer and Rod Burkert (Burkert Valuation Advisors LLC), another of the IPCPL developers and authors. They explain their new approach and address a number of questions and concerns.

Valuations high for private firms, says new Pepperdine report

The value of privately held businesses is very high right now, according to the 2014 Capital Markets Report from Pepperdine. This annual report benchmarks both the current climate and projected outlook across multiple market segments for lending, investing, and acquiring capital.

The effect of the economy continues to be a problem. “The cost of economic uncertainty on the private capital markets and privately-held businesses is nearly incalculable,” says Dr. Craig R. Everett, director of the Pepperdine Private Capital Markets Project and assistant professor of finance at Pepperdine University’s Graziadio School of Business and Management. Current low interest rates means affordable capital for small-business expansion, but access to the funds remains a challenge for small firms. “On the other hand, there appears to be an abundance of private equity capital currently on the sidelines looking for quality deals,” says Everett. “Valuations are very high right now, making it a seller’s market for owners of businesses with strong financials and healthy growth trends.”

Other interesting findings:

• According to investment bankers surveyed, the top three reasons for deals not closing were valuation gap (26%), unreasonable seller or buyer demand (21%), economic uncertainty (12%), and insufficient cash flow (12%);
• Almost half (46%) of venture capitalists surveyed are targeting information technology, and another 11% are planning to invest in basic materials and energy; this is a change from the 2013 PPCMP report in which 33% said they were targeting information technology and 23% were planning to invest in healthcare or biotech; and
• Approximately 41% of angel investors surveyed base valuations on gut feelings when valuing privately held businesses.

Dealing with tricky valuations for physician pay

In a past BVWire, we reported on a hospital that got into serious regulatory trouble over the fair market value of physician compensation. While federal and state regulations require that physician compensation be commercially reasonable and at fair market value, there is very little regulatory guidance for meeting these valuation standards. Nevertheless, regulators are cracking down on healthcare providers that pay physicians amounts that exceed fair market value thresholds.

A new white paper from the Advisory Board Co. discusses how to structure physician compensation packages that are compliant. One step is to deconstruct total compensation. Physician employment agreements are multidimensional, so the definition of “total compensation” is the key factor in determining fair market value. It includes not only base salary, but also additional financial incentives, such as signing bonuses, retention bonuses, and educational loan repayment. Plus, physicians are often paid separately for responsibilities beyond traditional clinical duties. Payments for these extra responsibilities must be evaluated for fair market value separately, based on the nature, frequency, and scope of services provided.

The white paper says that surveys with compensation data are a good starting point to benchmark an acceptable pay range. Also, you need to prepare extensive documentation of compensation methodology and decisions. Also, it advises that healthcare providers use outside valuation experts early in the process. One reason for this is that regulators feel that valuation methods developed internally are susceptible to manipulation, so they will receive more intensive scrutiny.

Speaking of the use of surveys, there’s a webinar coming up: The Use and Misuse of MGMA Data in Healthcare Valuations (December 17). You’ll learn how to properly and effectively utilize the wealth of data provided by the Medical Group Management Association (MGMA) in such areas as physician compensation, practice performance, and reimbursements. The webinar features Timothy Smith (American Appraisal) and Meghan Wong (MGMA) and is Part 12 of BVR’s 2013 Online Symposium on Healthcare Valuation.

New AICPA valuation guides

The AICPA released the final version of its new accounting and valuation guide, Testing Goodwill for Impairment, which focuses on practice issues related to the qualitative assessment and the first step of the goodwill impairment test. The AICPA also has a webinar scheduled on this guide on December 18 (1 p.m.-3 p.m. EST)

Another guide, Assets Acquired to Be Used in Research and Development Activities, was just released and provides nonauthoritative guidance and illustrations regarding the initial and subsequent accounting for, valuation of, and disclosures related to acquired intangible assets used in research and development activities (IPR&D assets).

Also, BVWire has learned that the AICPA is updating the Business Valuation in Bankruptcy Practice Aid, published in 2002. The new aid, expected in the first quarter of 2014, will be updated for new GAAP, have an increased focus on valuation issues specific to distress situations, and will contain eight new sections.

Goodwill impairment survey still open

We need you! Researchers at the Albers School of Business and Economics at Seattle University are conducting a research project on the important issue of fair value judgments. Please put aside about 20 minutes of your time to take a survey that entails reading a brief case and responding to questions. BVWire feels that this project is a valuable contribution to existing research, and the researchers intend to share the results with the business valuation community as well as publish the results in an internationally recognized academic journal. To participate, click here. Thanks for your help!

New BVR special report on valuing auto dealerships

The improving landscape for auto dealerships means that business appraisers should be prepared for an increased demand for auto dealership valuation. Key Trends Driving Auto Dealership Value: A BVR Special Report discusses the unique characteristics and considerations important to both owners who are looking to increase and maintain their competitiveness and the valuation professionals who appraise auto dealerships for buy/sell purposes, gift and estate, and expert witness testimony.

What’s in the December issue of Business Valuation Update

Here’s what you’ll see:

• Some Key Takeaways From the ASA Advanced BV Conference. BVU attended the recent ASA event in San Antonio and got a sneak preview of the upcoming classic book on cost of capital, heard a rundown on the latest key Tax Court cases, learned how healthcare reform is transforming valuations in this industry, and much more.

• The Impact of Real Estate on the Valuation of an Auto Dealership (Adam Lawyer,CPA/ABV/CFF). Depending on how real estate is recorded in the financial statements of an auto dealership, it can have a vital impact on each of the three approaches to valuation.

• Recap of the IRS Valuation Summit 2013 (David Rosenthal, MAI, FRICS). Important developments in valuation practices in the trust and estate world were discussed at this event, presented by the Southern California Chapter of the Appraisal Institute and the CFA Society.

• Margin Pressure and Competition Are Limiting Community Bank Values (BVR Editor). An interview with Karen Kline, ASA, director of valuations at Sheshunoff & Co., who gives her insight on the current value drivers of community banks.

Find an extended discussion of all these issues--plus a digest of the latest court cases--in the December edition of Business Valuation Update (subscription required).

Holiday season brings CPE cheer

There’s an abundance of CPE events coming up:

Advanced Workshop on Fractional Interest Valuation (December 12): This intensive, four-hour workshop addresses the challenges in valuing divided and undivided interests across all asset classes and how to overcome these obstacles. Click here for a free preview of the presentation slides. Featuring: Dennis Webb (Primus Valuation)

Market-Derived Patent Data: What Data Is Important and How Does It Impact Value? (December 19): Information provided by the U.S. Patent Office on assignments, applications, grants, and other economic events can provide an invaluable resource for appraisers tasked with appraising intangible properties. Learn how these data can provide key market-based benchmarks and comparables on the economic life, utility, and value of an intellectual property. Featuring: Mike Pellegrino (Pellegrino & Associates)

The 2014 Online Symposium on Fair Value Measurement: Throughout 2014, this special series of monthly webinars will examine the ever-evolving practice of calculating, analyzing, and presenting a fair value determination. From professional standards to guidance and research from the top minds in the profession, the 12-part symposium will address what every appraiser needs to know in this rapidly evolving field. First up will be:

Overview of Fair Value Accounting (ASC topics 820, 805, 350 and 360) (January 14): Through the professional guidelines that dictate best practices in fair value measurement and reporting, Fair Value Measurement Symposium curator Mark Zyla (Acuitas Inc.) will examine the current state of fair value, where it has been, and where its evolution is heading.

Step Up Your Game: Effective Business Appraisal Reporting (January 10): BVR kicks off 2014 with a four-part look at the written and oral presentation of the business appraisal process. In the first installment, we look at the best practices on business appraisal reporting, as noted by professional standards and judicial decisions, to make the best presentation of the valuation process and conclusion. Featuring: L. Paul Hood Jr. (University of Toledo Foundation) and Timothy Lee (Mercer Capital)

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