Valuing a Business - · PDF fileValuing a Business The Analysis and ... Common-Size Statements. ... Comparative Ratio Analysis. Obtaining the Guideline Companies' Market Value Data.

Valuing a BusinessThe Analysis and Appraisalof Closely Held Companies

Fifth Edition

Shannon P. Pratt, CFA, FASA, MCBA, MCBC,CM&AA

Chairman and CEO

Shannon Pratt Valuations, Inc.

Alina V Niculita, CFA, MBAPresident and COO

Shannon Pratt Valuations, Inc.

Me:GrauuHill . >

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Seoul • Singapore • Sydney • Toronto

Contents

PART I State of the Profession, the Engagement,and the Basic Theory . 1

1. Business Valuation Standards and Credentials 3Growing Consensus on Business Valuation Standards. The AppraisalFoundation. Background and Organization. Uniform Standards ofProfessional Appraisal Practice. Standards Published by Business ValuationProfessional Organizations. Other Organizations That Have OfferedGuidance on Business Valuation Issues. Internal Revenue Service.Department of Labor. Association for Investment Management andResearch. The ESOP Association. Recognition of Professional Standardsby Courts. International Acceptance of U.S. Standards and Practices.Professional Organizations Offering Accreditation in Business Valuation.American Society of Appraisers. Institute of Business Appraisers. NationalAssociation of Certified Valuation Analysts. American Institute of CertifiedPublic Accountants. The Canadian Institute of Chartered Business Valuators.Summary. Bibliography.

2. Defining the Assignment 29Basic Elements of the Valuation Assignment. Definition of Who Offered andWho Accepted the Assignment. Description of the Legal Interest or Intereststo Be Appraised. Description of the Business Entity. Description of theSpecific Business Interest. Interests Other than Direct Fee SimpleOwnership. Description of the Specific Ownership Interest Characteristics.Control versus Minority. Degree of Marketability. Valuation Date. Purposeof the Appraisal. Standards of Value. Fair Market Value. Investment Value.Intrinsic or Fundamental Value. Fair Value under State Statutes. FairValue for Financial Reporting. Going-Concern versus Liquidation Premiseof Value. Sources of Guidance as to Applicable Standards and Premises ofValue. Form of the Work Product. Scheduling. Fee Arrangements. Summary.

3. Business Valuation Theory and Principles 55Generally Accepted Theory. Reliance on Projected versus HistoricalBenefits. Basic Variables Affecting Value. Impact of Risk on Value.Accepted Business Valuation Approaches and Methods. Background andStructure. Interrelationship of the Three Broad Approaches. Impact ofControlling versus Noncontrolling Ownership Interest. Impact ofMarketability. Distinction between Discount for Lack of Control andDiscount for Lack of Marketability. Other Qualitative Factors AffectingValue. Matching the Valuation Methodology with the Standard and Premisesof Value. Sum of Parts Not Necessarily Equal to Whole. Summary ofBusiness Valuation Principles. Bibliography.

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PART II Gathering and Analyzing Data 73

4. Gathering Company Data 75Generalized Company Information Checklist. Financial Statements.Relevant Time Period. Levels of Financial Statement Preparation. Impactof Enterprise Legal Structure. Federal Tax Returns. Interim Statements.Other Financial Schedules. Current Assets and Liabilities. Plant andEquipment. Officers' and Directors' Compensation Schedule. Distributionof Ownership. Dividend or Partnership Withdrawal Schedule. Schedule ofKey Person Life Insurance. Off-Balance Sheet Assets or Liabilities. RelatedParty Transaction Information. Operating Information. Company History.Brochures, Catalogs, Web Sites, and Price Lists. Key Personnel. Customerand Supplier Base. Contractual Agreements and Obligations. Industry andTrade Association Information. List of Past Transactions in the Stock orOffers to Buy. Budgets and Forecasts. Capital Requirements. CapitalExpenditures. Deferred Maintenance. Working Capital Requirements.Company Documents Relating to the Rights of Owners. Corporate orPartnership Records. Buy-Sell and Employee Stock Ownership PlanAgreements. Employment and Noncompete Agreements. Summary.

5. Site Visits and Interviews 91History. Description of the Business. Management and ManagementCompensation. Operations. Materials and Supplies. Labor and GovernmentRelations. Plant and Equipment. Inventory. Markets and Marketing. Finance.Current Assets. Fixed Assets. Intangible Assets. Current Liabilities. CapitalStructure. Off-Balance Sheet Items. Profitability and Budgeting. Insurance.Dividends. Prior Arm's-Length Transactions or Offers. Catch-All Question.Interviews of Outsiders. Professionals Related to the Company. OtherPossible Outside Interviews. Summary.

6. Researching Economic and Industry Information 103National Economic Information. The Federal Statistical System.Banks. Business Periodicals and Statistical Services. Regional EconomicInformation. Industry Information. General Industry Information.Composite Company Data. Information on Management Compensation.Online Information. Indexes to Economic and Industry Information.Summary. Bibliography.

7. Analyzing Financial Statements 129Normalizing versus Controlling Adjustments. Adequacy of Allowance andReserve Accounts. Allowance for Doubtful Accounts—Accounts Receivable.Allowance for Doubtful Accounts—Notes Receivable. Inventory AccountingMethods. FIFO, LIFO, and Other Methods. Write-Down and Write-OffPolicies. Depreciation Methods and Schedules. Declining-Balance Method.Sum-of-the- Years '-Digits Method. ACRS and MACRS. AnalyticalImplications. Depletion. Treatment of Intangibles. Leasehold Interests.Other Intangible Assets. Capitalization versus Expensing of Various Costs.Timing of Recognition of Revenues and Expenses. Contract Work.Installment Sales. Sales Involving Actual or Contingent Liabilities.Prior-Period Adjustments. Accounting for Leases. Net Operating LossCarryforwards. Treatment of Interests in Affiliates. Extraordinary orNonrecurring Items. Ordinary versus Extraordinary Items. OtherNonrecurring Items. Discontinued Operations. Operating versus

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Nonoperating Items. Management Compensation and Perquisites.Transactions Involving Company Insiders. Contingent Assets and Liabilities.Adjustments to Asset Valuations. Marketable Securities. Other Assets.Computation of Earnings per Share. Weighted Average Basis. Basic versusDiluted Earnings. Computation of Book Value per Share. An Example of theEffect of Alternative Accounting Methods. Adjusting the Balance Sheet toCurrent Values. Summary. Bibliography.

8. Financial Statement Ratio Analysis 153Use and Interpretation of Ratio Analysis. Common-Size Statements.Short-Term Liquidity Measures. Current Ratio. Quick (Acid-Test) Ratio.Activity Ratios. Accounts Receivable Turnover. Inventory Turnover. Sales toNet Working Capital. Sales to Fixed Assets and Total Assets. Risk Analysis.Business Risk. Financial Risk. Balance Sheet Leverage Ratios. Total Debt toTotal Assets. Equity to Total Assets. Long-Term Debt to Total Capital.Equity to Total Capital. Fixed Assets to Equity. Debt to Equity. IncomeStatement Coverage Ratios. Times Interest Earned. Coverage of FixedCharges. Income Statement Profitability Ratios. Return on InvestmentRatios. Return on Equity. Return on Investment. Return on Total Assets.Asset Utilization Ratios. Summary.

PART III Business Valuation Approaches and Methods 171

9. Income Approach: Discounted Future Economic Income Method 173Introduction: Theoretical and Practical Soundness of the Approach.The Basic Discounted Economic Income Framework. The Numerator:Expected Prospective Economic Income. The Denominator: The DiscountRate. Estimating the Discount Rate. Return and Rate of Return Defined.Components of the Discount Rate. The Risk-Free Rate. The Equity RiskPremium. The Capital Asset Pricing Model. Systematic and UnsystematicRisk. Beta: The Measure of Systematic Risk. Using Beta to EstimateExpected Rate of Return. Levered and Unlevered Betas. AssumptionsUnderlying the Capital Asset Pricing Model. The Size Premium.The Build-Up Model. Formula for the Build-Up Model. Company-SpecificRisk Premium. Industry Risk Premia. The Discounted Cash Flow or theImplied Method of Estimating the Cost of Capital. Arbitrage Pricing Theory.Sources of Data to Estimate the Cost of Equity Capital. Risk-Free Rate.Equity Risk Premium. Beta. Size Premium. Industry Risk Premia.Investment-Specific Risk. Arbitrage Pricing Theory Factors. Rate of ReturnAllowed to Regulated Companies. Cost of Capital Yearbook. DiscountingEconomic Income Available to Overall Capital. Defining the CapitalStructure. Weighted-Average Cost of Capital Formula. Should an Actual ora Hypothetical Capital Structure Be Used? Specific Projection Period plus aTerminal Value. The "Midyear Discounting Convention." Example ofApplication of Discounted Economic Income Methods. Estimating an EquityDiscount Rate. Discounting Net Cash Flow to Equity. Estimating aWeighted-Average Cost of Capital. Discounting Net Cash Flow to InvestedCapital. Caveats in Using Discounted Economic Income Methods. Convertinga Discount Rate Applicable to Net Cash Flow to a Discount Rate Applicableto Net Income. Does the Discounted Economic Income Model Produce aControl or a Minority Value? What Standard of Value Does a Discounted

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Economic Income Model Produce? Common Errors. Mismatching theDiscount Rate with the Economic Income Measure. Confusing DiscountRates with Capitalization Rates. Projecting Growth Beyond What the CapitalBeing Valued Will Support. Projecting That Extrapolation of the Recent PastRepresents the Best Estimate of Future Results. Discounting a TerminalValue for an Incorrect Number of Periods. Internally Inconsistent CapitalStructure Projection. Assumptions That Produce a Standard or Premise ofValue Other Than That Called for in the Valuation Engagement. Summary.Bibliography.

10. Income Approach: Capitalized Economic Income Method 237Essential Difference between the Discounting Model and the CapitalizationModel. The Perpetual Economic Income Stream Model. Converting aDiscount Rate to a Capitalization Rate—The Constant Growth Model.The Gordon Growth Model, Sensitivity to Growth Rate Assumptions. Whento Use the Discounting versus the Capitalization Method. Equivalence of theDiscounting and Capitalization Methods. Implementing the CapitalizedEconomic Income Method. Projecting the Basic Economic Income Leveland the Growth Rate. Start with Sustainable Expected Economic Income.The Projected Long-Term Growth Rate. Defining the Components in theCapitalization Method. Valuing Equity versus Invested Capital. Selecting theAppropriate Measure of Economic Income. Modification of the CapitalizedEconomic Income Method to Reflect the Midyear Discounting Convention.Using the Capitalized Economic Income Method to Develop a TerminalValue for the Discounted Economic Income Method. Why the CapitalizedEconomic Income Method Is Preferable. Implementation of the CapitalizedEconomic Income Method to Estimate the Terminal Value. Does theCapitalized Economic Income Method Produce a Control Value or aMinority Value? What Standard of Value Does the Capitalized EconomicIncome Model Produce? Relationship between the Capitalized EconomicIncome Method and the Market Approach. Derivation of Income ApproachCapitalization Rates versus Market Approach Multiples. Economic IncomeVariables Used in the Income Approach versus the Market Approach.Summary. Bibliography.

11. Market Approach: Guideline Publicly Traded Company Method 261Overview of the Guideline Publicly Traded Company Method. When Is theGuideline Publicly Traded Company Method Most Useful? Standard ofValue. Ownership Characteristics. Going-Concern versus Liquidation Value.Quantity and Quality of Available Data. Criteria for Guideline CompanySelection. How Many Guideline Companies? Time Period to Consider.Deciding Which Valuation Multiples to Use. Influence of the OwnershipCharacteristics. Going-Concern versus Liquidation Value. Type of Company.Availability of Data. Compiling Guideline Company Tables. Developing aList of Guideline Companies. Financial Statement Adjustments to GuidelineCompanies. Adjusting for Operating Leases. Comparative Ratio Analysis.Obtaining the Guideline Companies' Market Value Data. PresentingGuideline Company Tables. Selecting and Weighting Multiples for theSubject Company Based on Guideline Companies. Impact of GuidelineCompany Data Evaluation. Measures of Central Tendency and Dispersion.Multiples of Economic Income Variables. Capitalization of Dividends or

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Dividend-Paying Capacity. Multiples of Revenue. Multiple of Stock Valueto Asset Value. Treating Nonoperating Assets, Excess Assets, and AssetDeficiencies. Nonoperating Assets. Marginal Operating Real Estate. ExcessAssets or Asset Deficiencies. Beware of Recent Acquisitions . MultilineCompanies. Procedures for Valuation. "Portfolio Effect." Typical Adjustmentsto Reach a Value Conclusion. Valuation Multiples Using Market Value ofInvested Capital. Common Errors. Failure to Conduct an Adequate Searchfor Guideline Company Data. Failure to Make Appropriate FinancialStatement Adjustments to Guideline Companies. Multiples that MismatchNumerator and Denominator. Simple Reliance on Average of GuidelineCompany Multiples without Comparative Analysis. Summary. Bibliography.

12. Market Approach: Guideline Merged and AcquiredCompany Method 309

Overview of the Merged and Acquired Company Method. When Is theGuideline Merged and Acquired Company Method Most Useful? Standardof Value. Going-Concern versus Liquidation Value. Quantity and Quality ofData Available. Control Transaction (Acquisition) Valuation Multiples.Announcement versus Closing Date Value. Caveat: Check the Deal Structure.Deal Terms. Exactly What Was Transacted? Noncompete and Employment orConsulting Agreements. Sources of Merger and Acquisition Data. Sources

for Large Company Transactions. Sources for Middle-Market and SmallerCompany Transactions. Past Subject Company Transactions. Past SubjectCompany Changes of Control. Bona Fide Offers. Past Acquisitions by theSubject Company. Formulas or Rules of Thumb. Nonoperating Assets,Excess Assets, and Asset Deficiencies. Selecting and Weighting Multiplesfor the Subject Company Based on Guideline Transactions. Impact ofGuideline Transactional Data Evaluation. Multiple of Stock Value to AssetValue. Reaching the Value Conclusion. Summary. Bibliography.

13. The Capitalized Excess Earnings Method 331The History of the Capitalized Excess Earnings Method. The CapitalizedExcess Earnings Valuation Method. Practical Application of This Method.The Seeming Simplicity of This Method. An Illustration. Analysis of theCapitalized Excess Earnings Method. Estimation of the "Net Tangible AssetValue." Estimation of the "Normalized Level of Earnings." Appropriate Rateof Return on Tangible Assets. Appropriate Direct Capitalization Rate forExcess Earnings. Comprehensive Example. The Treatment of NegativeGoodwill. Common Errors in Applying the Capitalized Excess EarningsMethod. Failure to Allow for Shareholder/Employee Salary. Failure to UseRealistic Estimate of Future Normalized Earnings. Errors in Developingthe Appropriate Direct Capitalization Rates. Summary. Bibliography.

14. Asset-Based Approach: Asset Accumulation Method 349Fundamentals of the Asset Accumulation Method. Asset-Based Approachversus Book Value. Asset Accumulation Method and Capitalized ExcessEarnings Method. Asset Accumulation Method—Individual Revaluation.Combining Elements of Asset Accumulation Method and Capitalized ExcessEarnings Method. Asset Accumulation Method Procedures. Obtain orDevelop a Cost-Basis Balance Sheet. Identify Assets and Liabilities to BeRevalued. Identify Off-Balance Sheet Assets. Identify Off-Balance Sheet andContingent Liabilities. Value the Accounts Identified Above. Construct a

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Value-Basis Balance Sheet. Individual Asset Valuation Procedures. FinancialAssets. Real Estate. Tangible Personal Property. Intangible Real Property.Intangible Personal Property. Categorization of Intangible Assets. Valuationof Intangible Assets. Remaining Useful Life Analysis of Intangible Assets.Example. Advantages of the Asset Accumulation Method. Disadvantages ofthe Asset Accumulation Method. Summary. Bibliography.

PART IV Discounts, Premiums, and the Value Conclusion 381

15. Control and Acquisition Premiums 383Levels of Value. Elements of Control. Control or Lack of Control Coversa Spectrum. How the Standard of Value Affects the Control Premium. FairMarket Value. Fair Value. Fair Value for Financial Reporting. InvestmentValue. Market Evidence Regarding Control and Acquisition Premiums.The Mergerstat Review. The Mergerstat/Shannon Pratt s Control PremiumStudy. Negative Control Premiums. Means, Medians, and Effect of NegativePremiums. Robinson, Rumsey, and White Study. Summary. Bibliography.

16. Discount for Lack of Control 397Lack of Control Covers a Spectrum. Factors That Influence the Lack ofControl Discount. Effect of State Statutes. Articles of Incorporation andBylaws. Potential Dilution. Preemptive Rights. Cumulative versusNoncumulative Voting. Contractual Restrictions. Financial Condition ofBusiness. Highly Regulated Industries. Buy-Sell and Other ShareholderAgreements. Fiduciary Duties. Private Company with Public Securities.Private Company That Operates Like a Public Company. Control HasAlready Been Dissipated. Nonoperating Assets. Empirical Evidence toQuantify Lack of Control Discounts. Discounts from Net Asset Value.Holding Companies. Limited Partnerships. Built-in Gains Discount.Trust and Estate Sales Study. Discounts for Direct Undivided OwnershipInterests in Real Estate. Procedures for the Valuation of NoncontrollingOwnership Interests. The Discount Approach. The Direct ComparisonApproach. The Bottom-Up Approach (Income Approach). Adjustments toIncome Statement. Summary. Bibliography.

17. Discounts for Illiquidity and Lack of Marketability 415Concept and Importance of Marketability. Adjustment for Lack ofMarketability for Noncontrolling Ownership Interests. Evidence for theQuantification of Discount for Lack of Marketability. MarketabilityDiscounts Extracted from Prices of Restricted Stocks. SEC InstitutionalInvestor Study. Gelman Study. Trout Study. Moroney Study. Maher Study.Standard Research Consultants Study. Willamette Management AssociatesStudy. Silber Study. FMV Opinions, Inc., Study. Management Planning, Inc.,Study. Johnson Study. Columbia Financial Advisor Study. LiquiStatDatabase. Summary of Empirical Studies on Restricted Stock Transactions.Studies of Private Transactions before Initial Public Offerings. Robert W.Baird & Company Studies. Willamette Management Associates Studies.Criticisms of Willamette Management Associates Studies. Valuation AdvisorStudies. Summary of Conclusions from Private Transaction Studies. OtherAnalysis of Discounts for Lack of Marketability for Minority OwnershipInterests. Discounts for Lack of Marketability for Controlling Ownership

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Interests. Illiquidity Factors Affecting Controlling Ownership Interests.Benchmark for the Illiquidity Discount for Controlling Ownership Interests.Differences between Private and Public Company Acquisition Price/Earnings Multiples. Factors That Affect the Discounts for Illiquidity andLack of Marketability. "Put" Rights. Dividend Payments. Potential Buyers.Size of Interest. Prospect of Public Offering or Sale of the Business.Information Access and Reliability. Restrictive Transfer Provisions.Company Characteristics: Size, Performance, and Risk. Court Decisionson Discounts for Illiquidity and Lack of Marketability. Mandelbaum v.Commissioner Reviews Lack of Marketability Factors. Estate of Barge v.Commissioner Considers Lack of Marketability Factors. Okerlund v. UnitedStates Approves Pre-IPO Studies. McCord v. Commissioner Lacks Rebuttal.Howard v. Shay Upholds 50 Percent DLOM. Summary. Bibliography.

18. Other Valuation Discounts 459Entity Level Discounts. Key Person Discounts. Discounts for Trapped-InCapital Gains Taxes. "Portfolio " (Nonhomogeneous Assets) Discount.Discount for Contingent Liabilities. Other Shareholder Level Discounts.Nonvoting versus Voting Stock. Blockage. Summary. Bibliography.

19. Valuation Synthesis and Conclusion 471The Reconciliation Process. Criteria for the Selection of ValuationApproaches and Methods. Quantity and Quality of Available Data.Type of Business, Nature of Business Assets, and Type of Industry Subjectto Valuation. Nature of the Business Interest Subject to Valuation. Statutory,Judicial, and Administrative Considerations. Informational Needs of theValuation Audience. Purpose and Objective of the Analysis. ProfessionalJudgment and Expertise of the Analyst. Reconciling Divergent Indicationsamong Valuation Methods. Weighting of Valuation Method Results. At WhatPoint Are Valuation Discounts and Premiums Applied? Concluding the ValueEstimate. Explicit Weighting. Implicit Weighting. Final Value Estimate.Summary.

PART V Writing and Reviewing Business Valuation Reports 483

20. Writing the Business Valuation Report 485Overview of the Business Valuation Report. USPAP Reporting Standards.Written Business Valuation Reporting Standards. Oral Business ValuationReporting Standards. USPAP Ethics Provisions. Retention of ValuationReports and Work Paper Files. Confidentiality Provision. Internal RevenueService Business Valuation Guidelines. Valuation Industry ReportingStandards. American Society of Appraisers. The Canadian Institute ofChartered Business Valuators. National Association of Certified ValuationAnalysts. Institute of Business Appraisers. American Institute of CertifiedPublic Accountants. Guidelines for Effective Report Writing. What CausesIneffective Report Writing? Make the Report "Incisive." Summary.Bibliography.

21. Sample Report 501Introduction. Description of the Assignment. Summary Description of theCompany. Capitalization and Ownership. Sources of Information. Analysisof the U.S. Economy. Overview. Outlook. Analysis of the Poultry Processing

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Industry. Overview. The Current Market. Exports. Identification of GuidelineCompanies. Overview. Descriptions of Selected Guideline Companies.Financial Statement Analysis. Overview. Balance Sheets. Income Statements.Cash Flow Statements. Adjustments. Financial and Operating Ratios.Valuation of Common Stock. Overview. The Guideline Publicly TradedCompany Method. The Discounted Cash Flow Method. Overall ValuationConclusion. Discount for Lack of Marketability. Summary and Conclusionof Empirical Research. Selection of the Applicable Lack of MarketabilityDiscount for a Warm Chicken Noncontrolling Ownership Interest.

22. Reviewing a Business Valuation Report 535Identification of the Subject Property. Relevant Dates. Definition of Value.Standard of Value. Reason for the Selected Standard of Value. Purpose ofthe Valuation. Actual or Assumed Ownership Characteristics. Degree ofMarketability. Degree of Ownership Control. Basic Company Information.Economic and Industry Outlook. Sources of Information. Site Visits.Management Interviews. Economic and Industry Data. Company FinancialStatements. Income Approach Data. Market Approach Data. Asset-BasedApproach Data. Financial Statement Analysis. Financial StatementAdjustments. Comparative Financial Statement Analysis. ValuationMethodology. Income Approach. Market Approach. Asset-Based Approach—Asset Accumulation Method. Asset-Based Approach—Capitalized ExcessEarnings Method. Are the Data Used Appropriate for the Valuation Date?Cost of Capital Data. Market Approach Data. Asset-Based Approach Data.Valuation Synthesis and Conclusion. Analyst's Qualifications. ProfessionalAccreditations. Education. Professional Association Memberships.Experience and Professional Involvement. Appraisal Certification.Statement of Contingent and Limiting Conditions. Overall Evaluation.

PART VI Valuing Specific Securities and Interests 545

23. Valuing Debt Securities 547Common Situations Requiring Valuation of Debt Securities. Purchase orSale for Cash. Exchange of Equity for Debt. Gift and Estate Taxes. Allocationof Total Enterprise Value among Classes of Securities. Adjusting a BalanceSheet for Debt Securities Owned or Owed. Lease Financing. Method ofValuation. Amount and Timing of Future Payments. Estimation of Yield toMaturity. Marketability Aspects of Closely Held Debt Securities. SpecialCharacteristics of Various Debt Securities. Call Provisions. Sinking FundProvisions. Collateral Provisions. Income Tax Status. Zero Coupon Debt.Convertible Debt. Summary. Bibliography.

24. Valuing Preferred Stock 563Common Situations Requiring Valuation of Preferred Stock. Purchase orSale for Cash. Exchange of Common Equity or Debt for Preferred Stock.Gift and Estate Taxes. Allocating Total Enterprise Value among Classes ofSecurities. Adjusting a Balance Sheet for Preferred Stock Owned orOutstanding. Income Taxes—Code Section 409A. Special Characteristicsof Closely Held Preferred Stocks. Dividend Rate. Liquidation Preference.Cumulative versus Noncumulative Dividends. Redeemable versus

r Nonredeemable. Put Option. Voting versus Nonvoting. Participating versus

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Nonparticipating. Convertible versus Nonconvertible. Method of Valuation.Assessing Dividend and Liquidation Payment Risk. Comparison withPublicly Traded Preferred Stocks. Capitalizing the Income Stream.Marketability Aspects of Closely Held Preferred Stock. Revenue Ruling83-120. Summary. Bibliography.

25. Introduction to Valuing Stock Options 585Common Situations Requiring Valuation of Options. Terminology.The Basic Call Option Equation. The Black-Scholes Option Model.European Options on Non-dividend-Paying Stocks. European Options onDividend-Paying Stocks—The Merton Model. American Call Options—ThePseudo-American Call Option Model. Empirical Tests of Black-ScholesOptions Models. Valuing Options on the Stock of Closely Held Companies.The Binomial Model for American Call Options. Introduction. Methodology.Employee Incentive Stock Options. Using Option Pricing to Value theBuilt-in Gains (BiG) Tax Liability. Real Options. Summary. Bibliography.

26. Valuing S Corporation Stock and Interests in OtherPass-Through Entities 613

Case Law History. Gross v. Commissioner. Wall v. Commissioner.Estate of Heck v. Commissioner. Estate of Adams v. Commissioner.Empirical Research on Sales of Controlling Interests. Erickson-WangStudy. Mattson, Shannon, and Upton Study. Summary of EmpiricalResearch. Models for Valuation of S Corporation Minority Interests.Summary. Bibliography.

PART VII Valuations for Specific Purposes 625

27. Valuations for Gift and Estate Tax Purposes 627Introduction. Current Tax Rates and Penalties. Appraiser Penalty andPotential for Blacklisting. Guidelines for Federal Gift and Estate TaxValuations. Weight to Be Accorded Various Factors. Capitalization Rates.Average of Factors. Restrictive Agreements. Summary of Guidelines.Chapter 14 Special Valuation Guidelines. Valuing Recapitalizations andSenior Equity Interests under Section 2701. Valuation Issues under Section2702. Buy-Sell Agreements and Leases (Including Operating Agreements ofLLCs) or Sale of Options under Section 2703. Valuation Rules for LapsingRights and Other Restrictions under Section 2704. Locking in theThree-Year Gift Tax Statute of Limitations. Shifting the Burden of Prooffrom the Taxpayer to the IRS. Valuation Issues in Estate and Gift TaxPlanning. Placing Family Assets in Corporate, Limited Liability Company,or Partnership Form. Minimizing Taxes through a Series of Timely MinorityOwnership Interest Transfers. Loss of Key Person. Trapped-In Capital GainsDiscounts. Other Estate Planning Situations Requiring Valuations.Other Gift and Estate Valuation Issues. Summary. Bibliography.

28. Estate and Gift Tax Court Cases 661Standard of Value. Approaches to Value. Burden of Proof. Selection ofGuideline Companies. Buy-Sell Agreements. Covenants Not to Compete.Reliance on Subsequent Sales. Subsequent Events and Data. Discount for Lackof Marketability (DLOM). Discounts for Lack of Marketability—ControllingOwnership Interests. Discount for Lack of Control (DLOC). Blockage

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Discounts. Key Person Discount. Contingent Liability Discounts.Combined Discounts. Premiums. Trapped-In Capital Gains Taxes.S Corporations. Family Limited Partnerships. FLP Valuation Issues.Validity Issues. Focus on Willing Seller as Well as on Willing Buyer.Inadequacy of the Valuation. Must Use Empirical Data to QuantifyVariables. Sufficiency of Data. Summary. References.

29. Buy-Sell Agreements 707Types of Buy-Sell Agreements. Valuation Provisions of the Buy-SellAgreement. Need for Clear Direction. Formula Approaches. NegotiationAmong the Parties. Independent Outside Appraisal. Understanding anAgreement's Pricing Philosophy. Terms and Funding. Term PaymentProvisions. Funding the Buy-Sell Agreement with Life Insurance.Restrictions on Transfer. Buy-Sell Agreement Values for Estate andGift Tax Valuation under Chapter 14. Valuation Requirements underSection 2703. Bibliography.

30. Valuation for Income Tax Purposes 723Introduction. Federal Income Tax Reasons to Conduct an Appraisal.Valuation of Property Received in a Transaction. Determining Basis in aProperty. Joint Ownership of Property. Property Acquired from a Decedent.

- Valuation Requirements for Charitable Contribution Deductions.Documentation Requirements—Contributions of Property. Noncash PropertyContributions. Appraisals for Noncash Contributions. Year^End CharitableGifting Considerations. Limitations on Charitable Contribution Deductions.Valuation of Compensation. Multifactor Tests. Independent Investor Test.Valuation of Worthless and Abandoned Property. Worthless Securities.Valuation Aspects of Section 165. Abandonment Loss for NondepreciableBusiness Assets. Worthless Stock Deduction. Summary of Worthless andAbandoned Property Valuation. Valuation Aspects of Cancellation ofIndebtedness Income. Unfavorable Tax Consequences of Debt Restructuring.Insolvency Provisions of Code Section 108. Insolvency Test IllustrativeExample. The "Costs" of Code Section 108. Valuation-Related IncomeTax Penalties. The Section 6695A Appraiser Penalties. The Section 6662Accuracy-Related Penalties. Negligence Penalty. Substantial ValuationOverstatement Penalty. Substantial Overstatement of Pension LiabilitiesPenalty. Definitions and Special Rules under Section 6664. Tax ReturnPreparer Penalties. Summary of Valuation-Related Income Tax Penalties.Valuation Aspects of Intercompany Transfer Pricing. Key Features of theFinal Section 482 Regulations. Special Circumstances. Multiple Year Data.Purposes and Roles of Valuation and Economic Analysis Experts. Types ofExperts. Summary of Transfer Pricing Valuation Issues. Valuation ofIntellectual Properties for State Income Taxation Purposes. Trademarks andTrade Names. Transfer of Intellectual Properties. Creation of the IntellectualProperty Holding Company. Valuation of the Transferred IntellectualProperties. Summary. Bibliography.

31. Income Tax Court Cases 753Introduction. General Valuation Methodology Issues. Pabst BrewingCompany v. Commissioner. Nathan and Geraldine Morton v. Commissioner.Caracci v. Commissioner. Gow v. Commissioner. BTR Dunlop Holdings, Inc.v. Commissioner. Charitable Contribution Issues. John T. and Linda L.

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Hewitt v. Commissioner. John C. Todd v. Commissioner. Gerald D. andCatherine Leibowitz v. Commissioner. Koblick v. Commissioner. ReasonableCompensation Issues. Multifactor Tests. LabelGraphics, Inc. v.Commissioner—9th Circuit. B&D Foundations, Inc. v. Commissioner—10thCircuit. Brewer Quality Homes, Inc. v. Commissioner. O.S.C. & Associates,Inc. v. Commissioner. Law Offices—Richard Ashare, PC. v. Commissioner.Alpha Medical, Inc. v. Commissioner. Beiner, Inc. v. Commissioner.E.J. Harrison and Sons, Inc. v. Commissioner. Independent Investor Test.Exacto Spring Corporation v. Commissioner—7th Circuit. Menard, Inc. v.Commissioner. Intangible Asset Valuation Issues. Nestle Holdings, Inc. v.Commissioner. Bemidji Distribution Company v. Commissioner. FrontierChevrolet Co. v. Commissioner. DHL Corporation and Subsidiaries v.Commissioner. Other Income Tax Issues. Purchase Price Allocation. IndeckEnergy Services, Inc. v. Commissioner. Present Value as Indicator of"For Profit" Status. Walford v. Commissioner. Stock Warrant Valuation.Kimberlin v. Commissioner. Valuation as Accounting Method. In re HeiligMeyers Company. Summary.

32. Valuations for Employee Stock Ownership Plans 809General ESOP Framework. Types of ESOPs. Nonleveraged ESOPs.Leveraged ESOPs. All Parties to a Leveraged ESOP Transaction Benefit.Valuation of a Company for ESOP Purposes. Adequate Consideration.Independence of the Appraiser and the Appraiser's Role. ReportingRequirements. Valuation Approaches and Methods. ESOP-SpecificAdjustments. ESOP Contributions. Normalized Employee Benefit Costs.Compensation Adjustments. ESOP Compensation Adjustment. ControlPremiums. Discount for Lack of Marketability. Put Option and RepurchaseLiability. Current Controversies. Posttransaction Value in Leveraged ESOPs.Legislative and Regulatory Issues in ESOPs. Section 1042 Rollover. 409(1)Employer Securities. Principal Deductibility and Code Section 415. CodeSection 133 Interest Exclusion. The IRS Audit Guidelines. ESOP SpecificPlan Administration Issues. Allocations to Participant Accounts. DistributionPolicy. Diversification. Finance Issues in Leveraged ESOPs. RepurchaseLiability. Repurchase or Recycling. Redemption. Managing the RepurchaseLiability. Methods of Funding. Fiduciary Issues in ESOPs. Voting Issues.Trustee's Voting Rights. Circularity of Control. Independent, Directed, orInternal Trustee. Accounting for ESOPs. Nuances of S Corporation ESOPs.Limitations on S Corporation Tax Benefits. Voting Issues. Form ofDistribution. S Corporation Distributions. Steps to Implementing an ESOP.Summary. Bibliography.

33. ESOP Court Cases 837Introduction. Sommers Drug Stores. Introduction. The Facts of the DistrictCourt Case. The Facts of the Appeal. The Plaintiff's Position. TheDefendants' Position. Commentary and Conclusion. U.S. News & WorldReport. Introduction. The Facts of the Case. The Valuation Issues. TheDistrict Court's Decision. The Appeals Court's Decision. Commentary andConclusion. Andrade v. Parsons. Introduction. The Facts of the Case. TheDistrict Court's Decision. The Appeals Court's Decision. Commentaryand Conclusion. Reich v. Valley National Bank of Arizona. Introduction.The District Court's Findings. Commentary and Conclusion. Howard v.

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Shay. Introduction. The Facts of the Case. The District Court's Decision.The District Court's Decision—Commentary and Conclusion. The AppealsCourt's Decision. The District Court Retrial. The District Court Retrial—Commentary and Conclusion. Eyler v. Commissioner. Introduction.The Issues of the Case. The Facts of the Case. The Issues before the Court.The Petitioner's Position. The Appeals Court Decision—The ValuationIssues. The Appeals Court Decision—The Fiduciary Issues. Commentaryand Conclusion. Davis v. Torvick. Introduction. The Facts of the Case.The Issues of the Case. The Plaintiffs' Position. The Defendants' Position.The District Court's Decision. Commentary and Conclusion. Henry v.Champlain Enterprises. Introduction. The Facts of the Case. The Issues ofthe Case. The District Court's Decision. Commentary and Conclusion.Eckelkamp v. Beste. Introduction. The Facts of the Case. The District Court'sDecision. The Appeals Court's Decision. Commentary and Conclusion.Horn v. McQueen. Introduction. The Facts of the Case. The District Court'sDecision. Commentary and Conclusion. Chao v. Hall Holding Co., Inc.Introduction. The Facts of the Case. The District Court's Decision. TheAppeals Court's Decision. Commentary and Conclusion. Keach v. U.S.Trust Co. Introduction. The Facts of the Case. The Issues before the DistrictCourt. The District Court's Decision. The Issues before the Appeals Court.The Appeals Court's Decision. Commentary and Conclusion. Armstrong v.LaSalle Bank National Ass 'n. Introduction. The Facts of the Case. TheDistrict Court's Decision. The Appeals Court's Decision. Commentaryand Conclusion. Kennedy v. Trustmark National Bank. Introduction.The Facts of the Case. The District Court's Decision. Commentary andConclusion. Summary.

34. Valuations for Ad Valorem Taxation 873Introduction. Definitions of Ad Valorem Taxation Terminology. MarketValue as the General Basis of Property Assessment. The Property TaxValuation Process. The Property Tax Equalization Process. Assessment RatioStudies. Use of Assessment Ratio Studies in Administrative Appeals andLitigation. The Property Tax Unitary Valuation Process. The Property TaxAppeal Process. Steps in the Ad Valorem Taxation Valuation Process: TheAssessing Authoritys Objective. The Property Owner's Objective. TheIndependent Valuation Analyst s Objective. Special Topics. Identification andQuantification of Functional Obsolescence. Identification and Quantificationof the Economic Component of External Obsolescence. Issues in UnitValuation for Ad Valorem Purposes. Jurisdictional Differences. ValueExcluded from the Taxable Unit. Identification and Valuation of IntangibleAssets in the Unit Method of Assessment. Alternatives to Use of Stock Market

"' Data. Problems with the Use of Stock Market Data in Property TaxValuations. Introduction. Income Approach Valuation Issues. ResolvingCircularity Due to Property Tax Expenses. Differences in the Risk andExpected Return Investment Characteristics between Operating Property andNegotiable Securities. Capitalization of Leased Equipment Rental Expense.Introduction. Operating Lease Rental Expense. Summary. Bibliography.

35. Dissenting Stockholder and Minority Oppression Actions 905Dissenting Stockholder Actions. Interpretation of the Fair Value Standard inDissent Cases. "That Which Has Been Taken." The Delaware Block Method.

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Should Consider All Relevant Factors. Requirement for Entire Fairness.Fair Consideration. Procedural Fairness. Consequences of Lack of EntireFairness. Minority Interest Dissolution Actions. Interpretation of the FairValue Standard in Dissolution Cases. Summary. Bibliography.

36. Dissenting Stockholder and Minority Oppression Court Cases 915Readers Must Interpret Cases Carefully. Fair Value Is Not Fair Market Value.Premise of Value. Breach of Fiduciary Duty Expands Plaintiffs' PotentialDamages. Approaches to Value. Should Consider Market Value, Asset Value,and Investment Value. Market Approach. Guideline Merged and AcquiredCompany (Transaction) Method. Discounted Cash Flow Method. Net AssetValue. Excess Earnings Method. Weighting of Methods. Discounts andPremiums. Lack of Control Discounts Rejected. Lack of Control DiscountsAccepted. Ownership Control Premium Accepted. Lack of MarketabilityDiscounts Rejected. Lack of Marketability Discounts Accepted. Lack ofCombinatorial Value Discount Rejected. Discounts for Trapped-In CapitalGains. Discounts Left to Court's Discretion. Sufficiency of ValuationEvidence. "Dr. Pangloss and Mr. Scrooge." Summary.

37. Valuations for Marital Dissolution Purposes 943The Marital Estate. Community Property. Equitable Distribution. Active orPassive Appreciation During Marriage. Active or Passive Post-ValuationDate Appreciation. Standard of Value. Investment Value. Fair Market Value.Intrinsic Value. Fair Value. Internal Contradictions in the Case Law.Valuation Date. Discovery. Goodwill. Valuation Methods. Income Approach.Market Approach. Asset-Based Approach. The Capitalized Excess EarningsMethod. Usually Employ More Than One Method. Compensation.Noncompete Covenants. Buy-Sell Agreements. Treatment of Trapped-InCapital Gains Taxes. Valuation Discounts and Premiums. The Role of theAnalyst. "Jointly Retained" Assignments. Adequacy of Evidence. Summary.Bibliography.

38. Marital Dissolution Court Cases 963Standards of Value. Fair Market Value. Fair Value. Investment Value.Premise of Value. Active versus Passive Appreciation. "Active" Appreciationas a Marital Asset. "Active" Appreciation Must Be Proven. Valuation Date.Goodwill. The "Market Value of Goodwill" Paradox. Personal Goodwill Nota Marital Asset in Many States. Personal Goodwill Is a Marital Asset inMany States. Other Goodwill Issues. The "Double Dipping" Issue. ValuationMethods in the Family Law Courts. The Size Argument. The LiquidityArgument. The Risk Argument. The Cost of Flotation Argument. NoncompeteCovenants. Buy-Sell Agreements. Cases Rejecting Buy-Sell Agreements.Cases Finding Buy-Sell Price Controlling. Buy-Sell Agreement May BeConsidered. Discounts for Lack of Control and Lack of Marketability.Discount for Lack of Control. Discount for Lack of Marketability. Adequacyof Evidence. The Need for a Solid Record. Preserving the Record.Inadequate Evidence. Greater Weight Given to Valuation Professionals.Rejection of Unqualified Experts and Unaccepted Methodolgies. Appraiser sDue Diligence Duties. Treatment of Tax Liabilities. Summary.

39. Fair Value for Financial Reporting 1005Definition of Fair Value. Differences from Fair Market Value.Disclosures.

Contents

PART VIII Litigation and Dispute Resolution 1009

40. Litigation Support Services 1011Valuation-Related Controversy Matters. Types of Litigation. ContractDisputes. Commercial Torts. Business Interruption Claims. Antitrust Claims.Shareholder Disputes and Securities Litigation. Marital Dissolution.Personal Injury or Wrongful Termination Cases. Estate, Gift, and IncomeTaxes. State and Local Property Taxes. Bankruptcy/Insolvency/Reorganization. Intellectual Property Rights Infringement. Engaging theAppraiser. Qualifications. Conflicts of Interest. Engagement Agreement.Discovery. Assessing the Case. Business Appraisal Discovery. PermanentFiles. Accountant's Files. Bank Files. Invoices. Interrogatories. Depositions.Research. Calculating the Amount of Damages. The Before-and-AfterMethod. The Yardstick (Comparable) Method. Sales Projections ("But For ")Method. Mitigation. Summary of Damages. Work Product. Affidavits.Written Reports. Critique of the Opposition. Expert Testimony. Rebuttal.Assistance in Preparing Briefs. Summary.

41. Expert Testimony 1031Background Preparation. Basic Preparation and Documentation. FederalRules of Civil Procedure. State Rules Are Often Less Stringent. Discovery.Reading Prior Cases and Articles. Federal Rules of Evidence RegardingExpert Testimony. Use of Hearsay Evidence. Challenges to Testimony perDaubert/Kumho. Daubert. General Electric v. Joiner. Kumho Tire Company.Other Cases Rely on Daubert Factors. Depositions. What to Bring to theDeposition. Deposition Testimony. After the Deposition. OutliningCourtroom Testimony. Qualifying the Witness. Description of theAssignment. Summary of Conclusion. Description of Steps Taken. Findings.Final Conclusion. Exhibits. Preparation with the Attorney. In the Courtroom.General Guidelines for Testimony. Direct Examination. Cross-Examination.Redirect Examination. Rebuttal Testimony. Exclusion of Witnesses. Courts'Expectations Regarding Expert Testimony. Summary. Bibliography.

42. Arbitration and Mediation 1053Advantages of ADR over Court Trial. Situations Suitable for Arbitration.Corporate and Partnership Dissolutions and Buyouts of Minority Interests.Dissenting Stockholder Actions. Damage Cases. Divorces. The ArbitrationAgreement. Factors Specified in the Arbitration Agreement. Factors Left tothe Arbitrators' Discretion. Other Factors to Address. Selection ofArbitrators. Criteria for Selection. Procedure for Selection. AmericanArbitration Association Procedure. Engagement and Compensation ofArbitrators. The Arbitration Process. Review of Arbitration Document. InitialCommunication among Arbitrators. Field Visit. Hearings. The ValuationMeeting. Reporting the Results of the Arbitration. Mediation. HowMediation Differs from Arbitration and Litigation. Self-Determination Is theFundamental Principle. Role of the Business Valuation Expert in Mediation.Mediation in Family Law. Mediation in Federal Tax Disputes. Summary.Bibliography. Professional Arbitration and Mediation Organizations.

Appendix A International Glossary of Business Valuation Terms 1069

Index 1077