First question to ask re: executive compensation

Adjustments to owner compensation are arguably among the most critical when valuing a closely held business under the income approach, because every dollar modified has a multiple effect on the valuation conclusion.   But too often, business appraisers resort to a formula (excess earnings) and/or a survey of what similar professionals are paid—and the reasonable compensation adjustment can become the “tail” that wags the “dog” of the business valuation, according to Brian Brinig, JD, CPA, ASA (Brinig & Co., San Diego), who spoke at the California CPA 2008 BV Conference last week in Los Angeles.  “Ten years ago, I argued that we should not call it a ‘reasonable compensation’ adjustment.”  Reasonable compensation was already a term of art in tax law, and this precedent often confuses the issue (because there the focus is on unreasonable compensation).  Instead, the more appropriate term is “a fair value of the owner’s services adjustment,” Brinig said.  “Our objective is to determine the replacement value of the owner’s services to the business,” from the perspective of a hypothetical investor.

Thus, the first question appraisers should ask is: “What is the underlying asset that we are valuing?”   After defining the asset, the second question is, “Does it generate any income, separate from the working services of the owner?”   Goodwill valuation is not readily ascertainable by formula.  In many cases, its resale may be subject to actual or practical restrictions (as in professional practice firms or the goodwill of a neurosurgeon).  Often goodwill is not saleable at all, because “there is no ‘thing,’ separate from the professional that generates the income stream,” Brinig explained.   Using a salary survey implies that there is a separation between the value of the professional services and the income flow.   “If the goodwill of the business is not saleable, that’s a big red flag,” he said, which may indicate—albeit not conclusively, that there is no definable asset.  That’s what appraisers should examine before simply going to the next step in a formula or study.  “You’ve got to have an asset to value,” Brinig said.  “Comparative studies talk about the tail—and we need to keep our eye on the dog.” 

Can CPAs qualify on compensation?   The annual California CPA conference—which focuses on a single topic (this year, an in-depth look at executive compensation), featured some telling presentations on expert testimony.  Attorney Bob Kippur (Robert Kippur P.C., Beverly Hills) offered that he’s never seen a court exclude a CPA to testify regarding compensation.  He told the story of a local judge who responds to attorneys’ objections by saying, “You’re right.  Overruled.”  This means that the judge “doesn’t want to hear any objections,” Kippur explained.  “He wants to hear the information.”  Look for more Cal CPA conference tips on deposition testimony in next week’s BVWire™.  

Holman on FLP discounts: Did the better expert win?

Last week the Tax Court issued Holman v. Commissioner (May 27, 2008), a decision jam-packed with issues relevant to gifts of family limited partnership interests, including 1) whether the transfer of assets (shares of Dell stock) constituted a direct or indirect gift; 2) whether the limited partnership should be treated (and valued) analogous to a trust; and 3) what discounts for lack of control and marketability apply to the gifts.  Of particular interest to appraisers and attorneys: Holman is a fully reviewed opinion, binding on the entire Tax Court bench.  Coming on the heels of Astleford v. Commissioner (see BVWire # 68-1), it’s another great case—“great from a guidance perspective,” says Mel Abraham in his latest e-alert.  (Go to, click on the Latest E-Alert, current issue, for his full analysis.)

In its consideration of direct/indirect gifts, Holman resurrects Chapter 14 (§§ 2703, 2704 I.R.C.), “something we haven’t seen in a long time,” Abraham says.  The valuation issues saw both experts starting with the net asset values, and both used closed-end funds to determine minority discounts.  But while the taxpayer’s expert included specialized equity funds, the IRS expert relied solely on general equity funds—which the court found the more “thoughtful” approach.  As for determining the discount for lack of marketability (DLOM), both experts began with the restricted stock studies.  But in what promises to be the most controversial aspect of the opinion, the IRS broke down the data by market access (liquidity) and holding periods, concluding that in this case, limited market access supported a 12.5% DLOM.  The IRS expert made no adjustment for a holding period, because the partnership’s redemption provisions allowed it to repurchase the shares at fair market value, thus succeeding to the benefits of any discounts.  The court agreed with this approach, finding the holding period of “little influence” in this case.

Experts weigh in.  “I am not sure I agree with that," Abraham says.  “The holding period does have an impact on the ability to liquidate [the partnership]. The uncertainty of the process gives rise to some level of discounts.”   The “metric of marketability” assumes that there is a market in place to begin with, he says—but for many of these interests (limited partnerships and minority shares in a private company), there is no ability to sell or get at cash flows.  The holding period in the restricted stock studies doesn’t change the liquidity of these interests—“it just changes the liquidity of the restricted stocks that have a publicly traded…component.”

Lance Hall (FMV Opinions) agrees that the court took a “novel interpretation of the restricted stock data.”   Its acceptance of the IRS’s proposed restructuring liquidation also “seems to depart from the fair market value ‘hypothetical willing buyer/ willing seller’ construct,” he says, in his FMV Valuation Alert™.  (Even the court noted that such a transaction “is perhaps inconsistent with the stated purpose of the partnership.”)  But primarily, Hall disagrees with the court’s determination of DLOM.  “Marketability is not an on and off switch,” he says.  The issue is one of varying degrees of liquidity.  “Rule 144A did not create a market for restricted stock…[it] merely increased the number of potential buyers, thus increasing the liquidity of restricted stock.”   Moreover, after a relatively brief holding period, restricted stock can be sold in the public marketplace at no discount—but there is no such option available for these FLP interests.  “All things being equal,” Hall says, “the restricted stock of a public company is more liquid than private stock.  It always is and always will be.  Surprisingly, the Holman Court found otherwise.”

The court’s acceptance of the liquidation premise “appears to be inappropriate,” says Owen Fiore (Kooskia, ID).  He’s also troubled by the Tax Court finding one appraiser less helpful then the other—and assigning the latter’s work greater credibility.  “Legal practitioners and their clients must work with appraisers to make certain that the valuation evidence, data used and conclusions reached are most appropriate and reasonable,” Fiore says.  “Choose your expert wisely,” Hall agrees.  “Even with its [unsupported] claims…the IRS won because it simply had the better expert.”  The abstract Holman will appear in the next (July 2008) issue of Business Valuation Update; a copy of the full-text court opinion is available to subscribers of BVLaw™.

Subsequent events vs. BV standards:
How to tell the Judge what happened post-valuation

During his lecture on Standards of Value at the recent AICPA/AAML National Conference on Divorce, Jay Fishman discussed AICPA SSVS 1’s requirement that valuation analysts disclose events that occur subsequent to the valuation date only if the event was "known, knowable or foreseeable."  At the same time, "the lawyers and the judges want to know what happened," says Fishman.  But putting in an unforeseeable subsequent event "taints the whole process," he says.  How do you explain that the “unknowable” subsequent event does not affect the valuation analysis?   Fishman's solution: If there is a significant change in circumstance after the valuation date, "instead of trying to taint [the report] by referring to a subsequent event, we'll just try to do an updated valuation."

What do the courts say?   Speaking at the NYSCCPA Business Valuation conference last month, Judge David Laro confirmed that per the U.S. Supreme Court landmark, Ithaca Trust Co. v. United States (1929), the valuation of property for Federal tax purposes is made as of the valuation date without regard to subsequent events.  However, the reality is that “judges use subsequent events to determine value,” Laro said.  How can they get away with it?  The Federal Rules of Evidence (enacted after Ithaca) added relevancy to the judge’s discretionary admission of facts related to the valuation.  If the subsequent events were foreseeable, “then they are relevant,” Laro explained, and they are also admissible—at least in the Second Circuit.

Other federal circuits abide by the “bright line” Ithaca Trust rule, while still others admit subsequent events only to support direct proof of value as of the valuation date.  If this sounds confusing—you may want to review Estate of Noble v. Commissioner, a 2005 Tax Court memorandum, authored by Laro, which discusses unforeseeable events in the admission of a sale that took place fourteen months after the valuation date:

An event occurring after a valuation date may affect the fair market value of property as of the valuation date if the event was reasonably foreseeable as of that earlier date…An event occurring after a valuation date, even if unforeseeable as of the valuation date, also may be probative of the earlier valuation to the extent that it is relevant to establishing the amount that a hypothetical willing buyer would have paid a hypothetical willing seller for the subject property as of the valuation date…Unforeseeable subsequent events which fall within this latter category include evidence, such as we have here, ‘of actual sales prices received for property after the date [in question], so long as the sale occurred within a reasonable time ... and no intervening events drastically changed the value of the property.’  [citations omitted]

“Valuation is a prophecy,” Laro told his New York audience, citing Rev. Ruling 59-60.  The rightness (or wrongness) of a valuation doesn’t turn on the outcome of the prophecy—but “on the reasonableness of the prophecy at the time it was made.”   Reminder: Estate of Noble (along with over 2,700 federal and state court BV cases) are all available at BVLaw

FASB releases conceptual framework

Last week the Financial Accounting Standards Board and the International Accounting Standards Board jointly released the Exposure Draft, Conceptual Framework for Financial Reporting: The Objective of Financial Reporting and Qualitative Characteristics and Constraints of Decision-Useful Financial Reporting Information.  Chapter One focuses on the objective of financial reporting, and the Boards are seeking input on their decision to identify/present potential capital providers—including equity investors, lenders, and other creditors—as the “primary user group” for general purpose financial reporting.  In addition, the Boards want feedback on the broadening of reporting objectives to encompass all decisions (resource allocation and investment) by these capital providers.

In Chapter Two (“Qualitative Characteristics and Constraints of Decision-Useful Financial Reporting Information”), the Boards distinguish between characteristics that are “fundamental”—relevance, faithful representation, and those that are “enhancing”—comparability, verifiability, timeliness, and understandability.  Materiality and costs also comprise the most common constraints on financial reporting.  The Boards want to know: How useful are these distinctions?  Are they appropriately identified and defined?  If not—why?  All comments are due in writing by September 29, 2008, as per the introduction to the Exposure Draft.  Also last week, the FASB released its Preliminary Views, Conceptual Framework for Financial Reporting: The Reporting Entity; comments are also due Sept. 29, 2008.


USPAP for BV Practitioners
Nov. 8–9
Instructor: Carla Glass, FASA

Cost of Capital
Nov. 12–13
Instructor: Roger Grabowski, ASA

Bellagio Hotel and Casino in Las Vegas

Presented by the American Society of Appraisers
in conjunction with the 2008 AICPA/ASA Joint BV Conference.

Appraisal Foundation wants input re: customer relationships

The Appraisal Foundation has just put out a call for literature and input related to its second working group: “Best Practices for Intangible Asset Valuations in Financial Reporting: The Valuation of Customer Relationships.”  In addition to existing literature, the working group would like to gather “examples and firm standard procedures related to the valuation of customer-related intangible assets, including contractual customer relationships, non-contractual customer relationships, customer lists and contracts,” according to its release

The working group hopes to develop best practices from the best examples of current practice that are also faithful to the purpose of performing valuations of intangible assets for use in financial reporting…Thus [it] requests from all those participating in the valuation profession, who regularly work in  the area of valuing intangible assets, to provide citations for articles, examples, write-ups of ‘firm standard procedures,’ copies of public domain documents, etc. related to the previously mentioned sub-topics. 

Submissions will be held in strictest confidence.  The working group will also consider formal citations for its bibliography.  Contributors can send materials directly to the Foundation, care of Paula Douglas, or by e-mail to   For those who have requested the soon-to-be-published Discussion Draft on Contributory Assets from TAF’s first working group (see BVWire # 68-3), due to a slight delay email copies should now go out June 10, 2008.

IASB to form valuation work group

“Invitations have been sent out to senior bankers and regulators to form a new group to tackle the problems of valuing securities in illiquid markets—an issue central to the credit crunch and banks’ complaints about the write-downs they have been forced to report,” says a new Financial Times article.  At the prompting of the Financial Stability Forum, an international banking and regulatory group, the International Accounting Standards Board is looking into the problem of write downs—which total more than $300 billion, the article says.  The IASB has come under fire for its support of fair value accounting rules, and another leading bank group—the Institute of International Finance—has proposed relaxing the rules when markets become illiquid and prices become unreliable.  But apparently Goldman Sachs is still protesting what it terms “Alice-in-Wonderland accounting,” the article says, adding impetus to the IASB’s working group, which is expected to meet in London on June 13 behind closed doors.  Apparently, the non-public nature of the discussions has already caused some backlash—and so far, the IASB homepage makes no mention of the working group.

Slee on the ‘new math’ of M&A

“An ex-partner of mine used to say that M&A is more of a sport than a business,” says I-banker Rob Slee (Robertson & Foley) in a new article posted at his Midas Managers blog.  “Sometimes you bag big game—but more often than not the target runs away unharmed.  Like real hunting, there are certain quantitative elements to M&A.  And right now the math doesn’t look good.”  According to Slee’s research, one variable correlates well to lower middle market acquisition multiples: senior lending multiples.  “In broader terms, availability of capital determines private business valuation (at least for ‘market’ purposes)—and senior lenders provide most of the capital structure.”  When times are good, senior lenders get aggressive, lending up to 5-6 times EBITDA.  But when the economy ultimately cools, creditors retreat to asset-based lending. 

“In the current market,” Slee says, “senior lenders have moved down to about ‘3x’ run rate EBITDA on total debt.”  This combination of debt and equity has caused acquisition multiples to fall below five—and “owners just hate selling for less than 5-6 acquisition multiples.”  But this is what they’re now facing.  “Obviously sellers have a big math problem.  Crafty advisors are starting to rely more on economic bridges (earn-outs, seller notes) to boost purchase prices.  Assuming that lenders continue to retrench, which is highly likely, acquisition multiples will continue to fall—as will the total number of deals completed in the lower middle market,” Slee predicts.  “It appears to me that our sport is about to become a most dangerous game.”

Correction: We incorrectly spelled the last name of Michael Rosendahl, CFA (PCE Investment Bankers) in the last issue of BVWire.  Rosendahl authored “State of the M&A Markets, First Quarter 2008 Update,” available at the PCE website.

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