CLE Presentation for attorneys discussing valuation theory and case law updates on business valuation topics.

1. BUSINESS VALUATION IN A
LITIGATION CONTEXT
PRESENTED: JANUARY 13, 2011
David R. Bogus, ASA
Zachary C. Reichenbach

2. Overview
• Standard of Value
• Valuation Approaches and Methods
• Application of Discounts
• Discount for Lack of Control
• Discount for Lack of Marketability
• S Corporation Income Adjustments
• Court Case Examples – Delaware Chancery Court
• Court Case Examples – Tax Court
• Questions

3. Standards of Value

4. Standard of Value
• U.S. Tax Court: Fair Market Value
• According to Internal Revenue Code Section
2031(a) and Regulation 20.2031-1(b), Fair
Market Value is defined as:
• “...the price at which property would change hands between a
willing seller and a willing buyer, neither being under any
compulsion to buy or to sell and both having reasonable knowledge
of relevant facts.”

5. Standard of Value (cont.)
• Delaware Chancery Court: Fair Value
• Fair Value is defined by the Model Business Corporation Act, Section 13.01 (3) (1998) as:
• “The value of the shares immediately before the effectuation of the corporate action to which the dissenter objects,
excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable.”
• Section 262 of the Delaware General Corporation Law provides that Fair Value shall be
determined:
• “exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation….”
• Further, in determining Fair Value:
• “the Court shall take into account all relevant factors.”
• Finally, Fair Value in an appraisal context measures:
• “that which has been taken from the shareholder, viz., his proportionate interest in a going concern.”

6. Differences in Standard of Value
U.S. Tax Court Delaware Chancery Court
• Fair Market Value • Fair Value
• Can be on a Controlling or • “Going Concern Basis”
Noncontrolling Basis • Typically Not Subject to
• Typically Subject to: Discounts
• Discount for Lack of Control
AND Discount for Lack of
Marketability

7. Valuation Approaches and Methods

8. Valuation Approaches and Methods

9. Cost Approach
• Cost (or Asset-Based) Approach – Determines a value
indication of a business, business ownership interest, or
security, by using one or more methods based directly on
the value of the assets of the business less liabilities
• Arrives at a value indication on a controlling interest basis
• Based on the economic principle of substitution
• Least commonly applied approach for valuing an
operating company

10. Asset Accumulation Method - Example
FMV Adjusted
As of December 31, 2011 Book Value Eliminations Adjustments Book Value
Assets
Current Assets $ 21,000 $ (4,000) $ - $ 17,000
Property, Plant & Equipment, Net 75,000 (75,000) 100,000 100,000
Total Assets $ 96,000 $ (79,000) $ 100,000 $ 117,000
Liabilities and Shareholder's Equity
Total Liabilities $ 80,000 $ - $ - $ 80,000
Total Shareholder's Equity 16,000 (79,000) 100,000 37,000
Total Liabilities and Shareholder's Equity $ 96,000 $ (79,000) $ 100,000 $ 117,000
Fair Market Value - 100% Equity Interest
on a Controlling Interest Basis $ 37,000

11. Income Approach
• Income Approach – Estimates value by converting
anticipated future benefits into a present single amount
• Value indication dependent upon income (benefits)
stream
• Can arrive at a value indication on either a controlling or
noncontrolling interest basis
• Value indication depends on adjustments and/or
assumptions made in developing cash flow stream
• Based on the economic principle of anticipation
(expectation)

12. Adjustments to Income Stream
• Types of Adjustments:
• Normalizing - removes unusual non-recurring expenses
• Controlling - make adjustments that require control of Company
• Includes adjustments to salaries, perks
• Synergistic - adjustments are specific to buyer
• Applicability of Adjustments Depends on the Nature of the
Assignment

13. Weighted Average Cost of Capital
(WACC)
• Required rate of return required to attract funds to an
investment
• Risk is the key factor in determining cost of capital
• Risk is the likelihood of achieving the expected returns
• Two Components:
• Cost of Equity
• Cost of Debt

14. Cost of Equity
• Capital Asset Pricing Model (CAPM)
• Cost of Equity = Rf + (β x ERP) + SPs + SCs
• Definitions
• Rf = Risk-free rate
• β = Beta of specific company
• ERP = Equity risk premium
• SPs = Size (or small company) risk premium
• SCs = Specific company risk premium

15. Cost of Debt
• Based on the rate at which a company can
borrow money
• If company has debt, look at rates on
existing debt
• If debt-free, estimate based on market
rates

16. WACC – Capital Structure
•A weighted average of the expected returns on all of a
company's securities
•Can be based on company’s capital structure or
industry/market indicated capital structure

17. WACC - Example
Type of Cost of Percentage of Total Weighted Cost
X =
Financing Financing of Financing
Debt 5% x 40% = 2%
Equity 25% x 60% = 15%
WACC 17%

18. Discounted Cash Flow Method -
Example
Forecasted
For the Year Ending December 31, 2012 2013 2014 2015 2016 Terminal
Value
Net Cash Flow $ 1,750 $ 2,100 $ 2,415 $ 2,657 $ 2,789 $ 2,929
Capitalized Terminal Net Cash Flow
(at 17% discount rate less 5% perpetuity growth rate) 24,408
Periods to Discount 0.50 1.50 2.50 3.50 4.50 4.50
Present Value Factor (at 17% discount rate) 0.9245 0.7902 0.6754 0.5772 0.4934 0.4934
Present Value of Net Cash Flow 1,618 1,659 1,631 1,534 1,376 12,043
Total Present Value of Net Cash Flow 19,861
Concluded Enterprise Value (rounded) $ 19,900

19. Differences Between the Courts
U.S. Tax Court Delaware Chancery Court
• Adjustments to Income • Adjustments to Income
Stream if on a Controlling Stream on a “Going
Basis Concern” Basis
• Specific Company Risk • Specific Company Risk is
more commonly used less commonly used
• Use of company’s capital • Use of industry average
structure in determining capital structure in
WACC determining WACC

20. Market Approach
• Market Approach – Estimates value by comparing the subject
to similar businesses or business ownership interests that have
been sold
• Can arrive at a value indication on either a controlling or
noncontrolling interest basis
• Value indication dependent upon level of ownership interest
that was sold
• Based upon the related economic principals of competition and
equilibrium (i.e. in a free and unrestricted market, supply and
demand factors will drive the price to a point of equilibrium)
• Methods:
• Guideline Merged & Acquired Company Method
• Guideline Publicly Traded Company Method

21. Guideline Merged & Acquired
Company Method
• Based on the premise that the value of the business
interest is estimated by comparing the subject company to
guideline companies that have been merged or acquired
during a period of time reasonably near the valuation date
• Arrives at a value conclusion on controlling basis
• Merger and acquisition prices may be representative of
fair market value, investment value, or somewhere in
between

22. Guideline Merged and Acquired
Company Method - Example
Guideline Guideline Guideline Subject
Transaction A Transaction B Transaction C Average Company
Financial Data
Purchase Price $ 300,000 $ 1,000,000 $ 550,000
Sales 500,000 1,800,000 400,000 250,000
EBIT 100,000 400,000 115,000 65,000
EBITDA 125,000 450,000 100,000 70,000
Implied Value of
Multiples Subject Interest
MVIC/Sales 0.60 0.56 1.38 0.84 210,880
MVIC/EBIT 3.00 2.50 4.78 3.43 222,790
MVIC/EBITDA 2.40 2.22 5.50 3.37 236,185

23. Guideline Publicly Traded Company
Method
• Based on the premise that the value of the business
interest is estimated based on what astute and rational
capital market investors would pay to own an equity
interest of the subject company
• Arrives at a value conclusion on a noncontrolling basis

24. Guideline Publicly Traded Company
Method - Example
XYZ COMPANY, INC.
Guideline Guideline Guideline Subject
Company A Company B Company C Average Company
Sales $ 90,000 $ 60,000 $ 40,000 $ 30,000
EBIT 12,000 8,000 5,000 4,000
EBITDA 19,000 13,000 8,000 6,500
Market Price Per Share 6.00 5.00 25.00
Shares Outstanding 10,000 6,000 1,000 1,000
Market Value of Equity 60,000 30,000 25,000
Plus: Market Value of Debt 30,000 20,000 10,000
MVIC 90,000 50,000 35,000
Implied Value
of Subject
MVIC/Sales 1.00 0.83 0.88 0.90 27,083
MVIC/EBIT 7.5 6.3 7.0 6.9 27,667
MVIC/EBITDA 4.7 3.8 4.4 4.3 28,076

25. Application of Discounts

26. Application of Discounts
• Two Discounts
• Discount for Lack of Control
• Discount for Lack of Marketability
• The application of discounts should always be taken in the
context of:
• The level of value the discount is applied to
• Legal documents that control the rights and restrictions of the
interest holder
• The ultimate rate of return produced for the investor
* Failure to consider these elements could often result in indications
of value which are overstated or understated.

27. Determining Value
$120 per share
Controlling, Marketable Interest
Control Premium (20%) Discount for Lack of Control (16.6%)
Noncontrolling, Marketable Interest $100 per share
(as if freely traded)
Discount for Lack of Marketability (35%)
Combined
Discount of
Noncontrolling, Nonmarketable $65 per share 45.8%
Interest

28. Discount for Lack of Control
• A noncontrolling interest has a lower value than a
controlling interest because the holder of a
noncontrolling interest in a closely-held entity would
have no authority or control to:
• Change management
• Appoint Board members
• Determine management compensation
• Manage business assets
• Select target markets
• Liquidate the business
• Effect IPO or M&A transactions
• Declare dividends

29. Discount for Lack of Marketability
• An investment is worth more if the security is marketable
since investors prefer liquidity
• Things to consider:
• Relative ease and promptness with which a security or commodity
may be sold when desired without significant concession in price
• Amount of time required to convert an asset into cash or pay a
liability

30. Influential Factors on Discount for Lack
of Marketability
• Put rights • Size of revenues
• Potential buyers • Size of earnings
• Size of interest (trading • Revenue growth and
block) stability
• Buyer’s ability to obtain • Earnings growth and
information stability
• Restrictive transfer • Product risk
provisions • Industry risk
• Size of distributions or
dividends

31. S Corporation Income Adjustments

32. S Corporation Economic
Adjustment
• Income tax attributes are different between C
Corporations and S Corporations.
• C Corporations
• Income taxed at the corporate level
• Dividends taxed at shareholder level
• S Corporations
• Income taxed at shareholder level

33. S Corporation Economic Adjustment
(cont.)
C Corp. S Corp.
Income before Income Taxes $100,000 $100,000
Corporate Income Taxes at 35% (35,000) N/A
Net Income 65,000 100,000
Dividends to S Corporation Shareholders N/A 100,000
Income Tax Due by S Corporate Shareholders at 35% N/A (35,000)
Net Cash Flow to S Corporation Shareholders N/A 65,000
Dividends to C Corporation Shareholders 65,000 N/A
Income Tax on Dividends at 15% (9,750) N/A
Net Cash Flow to C Corporation Shareholders 55,250 N/A
Net Cash Flow to Shareholders $ 55,250 $ 65,000

34. Court Case Examples – Delaware
Chancery Court

35. Reis v. Hazelett Strip-Casting
Corporation
Issued February 1, 2011
Judge Laster
Summary:
• The controller of Hazelett Strip-Casting Corporation
cashed out the minority shares held by the estate of his
deceased brother via a reverse stock split. The plaintiff
sued on behalf of the beneficiaries of the estate who
would have received shares, but for a reverse split.

36. Reis v. Hazelett Strip-Casting
Corporation
• Issues of the case:
• Applicability of normalizing adjustments
• Applicability of cost approach and market approach
• Determination of company specific risk premium and
perpetuity growth rate

37. Reis v. Hazelett Strip-Casting
Corporation
• Conclusions of the case:
• Relied upon the capitalization of earnings method and
made certain normalizing adjustments
• Also, considered book value of company, but discarded
guideline company analysis
• Replaced defendant’s expert’s company specific risk
premium with plaintiff’s expert
• Utilized defendant’s growth rate

38. S. Muoio & Co. LLC v. Hallmark Entertainment Investments
Co.
Issued March 9, 2011
Judge Chandler
Summary:
• The action challenges the fairness of the June 29, 2010
recapitalization of Crown Media Holdings, Inc. orchestrated by
Crown’s controlling stockholder and primary debt holder, Hallmark
Cards, Inc. and its affiliates. Plaintiff contends that the
recapitalization was consummated at an unfair price and drastically
undervalued Crown.

39. S. Muoio & Co. LLC v. Hallmark
Entertainment Investments Co.
• Issues of the case:
• Use of multiple valuation methodologies
• Consideration of third party indications of value
• Reliance on management’s projections

40. S. Muoio & Co. LLC v. Hallmark
Entertainment Investments Co.
• Conclusions of the case:
• Use of single valuation methodology made the plaintiff expert’s
analysis less credible
• Contemporaneous market indications of value are credible
• Found it unreasonable to reject management’s projections
• Found it unreasonable to project DCF out further than
management

41. Sunbelt Beverage Corp. Shareholder
Litigation
• Issued January 5, 2010
• Judge Chandler
• Summary
• This consolidated breach of fiduciary duty and appraisal
proceeding arises out of the August 22, 1997 merger of SBC
Merger Corporation with and into Sunbelt Beverage Corporation.
One consequence of the merger was the cash-out of a minority
shareholder in Sunbelt. Plaintiff contents that the cash-out was at
an unfair price.

42. Sunbelt Beverage Corp. Shareholder
Litigation
• Issues of the case:
• Reliance on previous transactions in company
stock
• Use of multiple valuation methods
• Determination of discount rate
• Benefits of S corporation status

43. Sunbelt Beverage Corp. Shareholder
Litigation
• Conclusions of the case:
• Discarded earlier transactions in company stock utilized by defendant’s
expert as the transactions were based on a formula price
• Discarded plaintiff expert’s transaction analysis due to insufficient
comparability with subject
• Examined two elements of DCF discount rate
• Small company risk premium
• Company specific risk premium
• Did not consider effects of a conversion to Subchapter S Status despite
both experts considering this benefit

44. Hanover Direct, Inc. S’holders Litig.
• Issued September 24, 2010
• Judge Chandler
• Summary
• A going-private merger consummated on April 12, 2007, in which
the public stockholders of Hanover Direct, Inc. were cashed out of
the company for $0.25 a share. Hanover was a financially
distressed company that had been heading toward insolvency.

45. Hanover Direct, Inc. S’holders Litig.
• Issue of the case:
• Use of multiple valuation approaches

46. Hanover Direct, Inc. S’holders Litig.
• Conclusion of the case:
• Found respondent expert’s use of
several methodologies to be a more
robust approach

47. Golden Telecom, Inc. v. Global GT
LP
• Issued December 29, 2010
• Judge Steele
• Summary:
• After a tender offer, Golden Telecom, Inc. merged into Lillian
Acquisition, Inc. Golden remained as the surviving entity and all
tendering Golden shareholders received $105 per share. Global
GT LP, Golden shareholders, sought appraisal.

48. Golden Telecom, Inc. v. Global GT
LP
• Issues of the case:
• Calculation of equity risk premium
• Determination of perpetuity growth rate
• Calculation of an appropriate beta
• Equity risk premium
• Terminal growth
• The calculation of an appropriate beta

49. Golden Telecom, Inc. v. Global GT
LP
• Conclusions of the case:
• Rejected use of arithmetic mean equity risk premium
calculation
• Beta calculation based on previously utilized methods

50. Berger v. Pubco Corp.
• Issued September 24, 2010
• Judge Chandler
• Summary:
• Delaware’s short-form merger statute does not impose
onerous burdens on parent corporations seeking to make
sure of its expeditious process for merging with subsidiaries.
It simply mandates that the minority shareholders of the
subsidiary be notified of their statutory right to appraisal.
Such notice must include a copy of the appraisal and
implicates the parent’s fiduciary duty to disclose all material
information with respect to shareholder’s decision whether or
not to seek appraisal.

51. Berger v. Pubco Corp.
• Issues of the case:
• Should capital gains tax effect on securities portfolio have been
considered
• Should control premium be a part of the valuation analysis; ruled it
should not have been applied to DCF and book value
methodologies
• Should a control premium be applied to the GPC method

52. Berger v. Pubco Corp.
• Conclusions of the case:
• Capital gains tax effect on securities portfolio should not have been
considered
• Control premium as part of the valuation analysis and ruled it
should not have been applied to DCF and book value
methodologies
• Appropriate to add a control premium to GPC method

53. Court Case Examples – U.S. Tax Court

54. Estate of Natale B. Giustina et al. v.
Commissioner
Issued June 22, 2011
Judge Morrison
Summary:
• The IRS valued the Estate’s ownership interest in Giustina
Land and Timber Company at $35,710,000, while the
Estate’s expert determined a value of $12,678,117. The
IRS issued both a deficiency and a Sec. 6662 accuracy
related penalty of $2,531,501.

55. Estate of Natale B. Giustina et al. v.
Commissioner
• Issues of the Case
• Use of the Income Approach and financial projections
• Pre-tax cash flow vs. After-tax cash flow
• Specific Company Risk Premium
• Discount for Lack of Marketability
• Weightings to Valuation Methods

56. Estate of Natale B. Giustina et al. v.
Commissioner
• Conclusions of the Case
• Reduction in the Specific Company Risk Premium
• Reduction in the Marketability discount to the Income Approach
method; no marketability discount to the Cost Approach method
• Financial Projections based on several historical years is better
than one year to consider the effects of volatility
• Income Approach weighted higher than Cost Approach

57. Estate of Gallagher- T.C. Memo
2011-148
Issued June 28, 2011
Judge Halpern
Summary:
• The IRS determined a deficiency of $7,000,000 in Federal
estate tax due from the estate of Louise Gallagher. The
deficiency arose out of a difference of opinion between
the IRS and the estate over the fair market value as of
July 5, 2004 of 3,970 units of Paxton Media Group, LLC
(“PMG”) included in the decedent’s gross estate. These
units represented 15% of the total units outstanding.

58. Estate of Gallagher- T.C. Memo
2011-148
• Issues of the Case:
• Financial statement adjustments
• Market based valuation approach (guideline public
company method)
• DCF valuation method
• SEAM adjustment

59. Estate of Gallagher- T.C. Memo
2011-148
• Conclusions of the Case
• Adjustments to historical financial statement must prove
validity and must be non-recurring
• Guideline public company approach must have ample
comparable public companies to be effective
• Not taxing cash flows better indication of value than the
SEAM adjustment

60. Questions?