BUSINESS VALUATION IN ALITIGATION CONTEXTPRESENTED: JANUARY 13, 2011David R. Bogus, ASAZachary C. Reichenbach
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
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.”
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.”
Differences in Standard of ValueU.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
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
Asset Accumulation Method - Example FMV AdjustedAs of December 31, 2011 Book Value Eliminations Adjustments Book Value AssetsCurrent Assets $ 21,000 $ (4,000) $ - $ 17,000Property, Plant & Equipment, Net 75,000 (75,000) 100,000 100,000Total Assets $ 96,000 $ (79,000) $ 100,000 $ 117,000Liabilities and Shareholders EquityTotal Liabilities $ 80,000 $ - $ - $ 80,000Total Shareholders Equity 16,000 (79,000) 100,000 37,000Total Liabilities and Shareholders Equity $ 96,000 $ (79,000) $ 100,000 $ 117,000Fair Market Value - 100% Equity Intereston a Controlling Interest Basis $ 37,000
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)
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
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
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
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
WACC – Capital Structure•A weighted average of the expected returns on all of acompanys securities•Can be based on company’s capital structure orindustry/market indicated capital structure
WACC - ExampleType of Cost of Percentage of Total Weighted Cost X =Financing Financing of FinancingDebt 5% x 40% = 2%Equity 25% x 60% = 15%WACC 17%
Discounted Cash Flow Method - Example ForecastedFor the Year Ending December 31, 2012 2013 2014 2015 2016 Terminal ValueNet Cash Flow $ 1,750 $ 2,100 $ 2,415 $ 2,657 $ 2,789 $ 2,929Capitalized Terminal Net Cash Flow(at 17% discount rate less 5% perpetuity growth rate) 24,408Periods to Discount 0.50 1.50 2.50 3.50 4.50 4.50Present Value Factor (at 17% discount rate) 0.9245 0.7902 0.6754 0.5772 0.4934 0.4934Present Value of Net Cash Flow 1,618 1,659 1,631 1,534 1,376 12,043Total Present Value of Net Cash Flow 19,861Concluded Enterprise Value (rounded) $ 19,900
Differences Between the CourtsU.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
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
Guideline Merged & AcquiredCompany 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
Guideline Merged and Acquired Company Method - Example Guideline Guideline Guideline Subject Transaction A Transaction B Transaction C Average CompanyFinancial 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 ofMultiples 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
Guideline Publicly Traded CompanyMethod• 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
Guideline Publicly Traded Company Method - ExampleXYZ COMPANY, INC. Guideline Guideline Guideline Subject Company A Company B Company C Average CompanySales $ 90,000 $ 60,000 $ 40,000 $ 30,000EBIT 12,000 8,000 5,000 4,000EBITDA 19,000 13,000 8,000 6,500Market Price Per Share 6.00 5.00 25.00Shares Outstanding 10,000 6,000 1,000 1,000Market Value of Equity 60,000 30,000 25,000Plus: Market Value of Debt 30,000 20,000 10,000MVIC 90,000 50,000 35,000 Implied Value of SubjectMVIC/Sales 1.00 0.83 0.88 0.90 27,083MVIC/EBIT 7.5 6.3 7.0 6.9 27,667MVIC/EBITDA 4.7 3.8 4.4 4.3 28,076
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.
Determining Value $120 per shareControlling, 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
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
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
Influential Factors on Discount for Lackof 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
S Corporation EconomicAdjustment• 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
S Corporation Economic Adjustment(cont.) C Corp. S Corp.Income before Income Taxes $100,000 $100,000Corporate Income Taxes at 35% (35,000) N/ANet Income 65,000 100,000Dividends to S Corporation Shareholders N/A 100,000Income Tax Due by S Corporate Shareholders at 35% N/A (35,000)Net Cash Flow to S Corporation Shareholders N/A 65,000Dividends to C Corporation Shareholders 65,000 N/AIncome Tax on Dividends at 15% (9,750) N/ANet Cash Flow to C Corporation Shareholders 55,250 N/ANet Cash Flow to Shareholders $ 55,250 $ 65,000
Reis v. Hazelett Strip-CastingCorporationIssued February 1, 2011Judge LasterSummary:• 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.
Reis v. Hazelett Strip-CastingCorporation• 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
Reis v. Hazelett Strip-CastingCorporation• 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
S. Muoio & Co. LLC v. Hallmark Entertainment InvestmentsCo.Issued March 9, 2011Judge ChandlerSummary: • 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.
S. Muoio & Co. LLC v. HallmarkEntertainment Investments Co.• Issues of the case: • Use of multiple valuation methodologies • Consideration of third party indications of value • Reliance on management’s projections
S. Muoio & Co. LLC v. HallmarkEntertainment 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
Sunbelt Beverage Corp. ShareholderLitigation• 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.
Sunbelt Beverage Corp. ShareholderLitigation• 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
Sunbelt Beverage Corp. ShareholderLitigation• 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
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.
Hanover Direct, Inc. S’holders Litig.• Issue of the case: • Use of multiple valuation approaches
Hanover Direct, Inc. S’holders Litig.• Conclusion of the case: • Found respondent expert’s use of several methodologies to be a more robust approach
Golden Telecom, Inc. v. Global GTLP• 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.
Golden Telecom, Inc. v. Global GTLP• 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
Golden Telecom, Inc. v. Global GTLP• Conclusions of the case: • Rejected use of arithmetic mean equity risk premium calculation • Beta calculation based on previously utilized methods
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.
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
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
Estate of Natale B. Giustina et al. v.CommissionerIssued June 22, 2011Judge MorrisonSummary:• 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.
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
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
Estate of Gallagher- T.C. Memo2011-148Issued June 28, 2011Judge HalpernSummary:• 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.
Estate of Gallagher- T.C. Memo2011-148• Issues of the Case: • Financial statement adjustments • Market based valuation approach (guideline public company method) • DCF valuation method • SEAM adjustment
Estate of Gallagher- T.C. Memo2011-148• 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