Corporate Valuation

Executive SummaryEstate planning for business owners is rarely straightforward, and it becomes significantly more complex when a potential sale of the business in question enters the picture. Timing matters and so does understanding how valuation interacts with both estate planning goals and the expectations of the IRS.In Mercer Capital’s new 75-minute webinar, Valuing a Business Amid a Potential Sale: What Estate Planners Must Know, Nicholas J. Heinz, ASA and Thomas C. Insalaco, CFA, ASA, explain how to navigate valuation in such an uncertain environment.When Estate Planning and M&A OverlapA liquidity event can be transformative for a family, but it raises complex valuation questions. How do you determine fair market value for gift or estate tax purposes when an M&A process is underway but incomplete? This webinar offers insight into what valuation analysts must consider when a company is “in play.” Heinz and Insalaco explain how to evaluate indications of value that emerge from deal discussions, what constitutes relevant market evidence, and how to apply weights to preliminary offers that may or may not close.What the IRS ExpectsThe presenters outline IRS guidance that provides insight into how appraisers should document assumptions and support their conclusions when a sale may occur soon after the transfer date. Estate planners will gain perspective on what information should be shared with valuation professionals and what documentation supports defensibility.Practical Scenarios and TakeawaysUsing examples drawn from real-world engagements, the webinar examines several practical scenarios:A business exploring a sale but not yet under letter of intentA transaction announced but not yet closedA sale that falls through after gift transfers are madeIn each case, Heinz and Insalaco discuss the influence of timing, negotiation progress, and third-party interest. They also highlight coordination points between the estate planner, client, and valuation expert to avoid costly missteps.Watch the RecordingThis session is designed for estate planning attorneys, tax advisors, and wealth professionals who advise business-owning families. Even if no sale is imminent, understanding how valuation shifts during an M&A process prepares planners to identify risk, manage client expectations, and anticipate IRS scrutiny. The recording is available on Mercer Capital’s YouTube channel: Watch the webinar here.For additional reading, the August 2025 issue of Value Matters® explores these same issues and offers complementary analysis.Together, these resources seek to equip estate planners with practical guidance for advising clients whose estate planning and exit planning timelines may overlap—a scenario that is increasingly common in today’s dynamic M&A environment.

Critical Considerations for Estate PlannersExecutive SummaryThis article summarizes Mercer Capital’s newest whitepaper, Valuing a Business for Estate Planning Purposes During a Transaction, which addresses the complex intersection of business valuations and estate planning when M&A processes are underway.Estate planning for business owners becomes much more complicated when a merger or acquisition process is underway. IRS guidance suggests requirements that business valuations for transfer tax purposes must consider all knowable facts as of the valuation date—including pending transaction processes. This creates both opportunities and risks for estate planners working with clients who own businesses actively engaged in sale discussions.The challenge lies in determining how much weight to assign to potential deal proceeds versus traditional standalone valuations at different stages of the M&A process. While early-stage processes may warrant minimal consideration of transaction value, later stages with formal offers require greater weighting of expected proceeds. Understanding the nuances of an engagement of this type is essential for avoiding costly mistakes and ensuring credible valuations that optimize estate planning outcomes.The intersection of business transactions and estate planning presents one of the most complex challenges in wealth transfer strategies. When business owners—whose enterprises often represent the majority of their wealth—simultaneously pursue exit opportunities and engage in estate planning, the valuation considerations become particularly intricate and consequential.IRS Chief Counsel Advice 202152018In Chief Counsel Advice 202152018 (“CCA 202152018”), the IRS addressed two issues in the context of a business owner who funded a GRAT during an active sale process. First, it considered whether hypothetical willing buyers and sellers would take into account a pending merger when valuing stock for gift tax purposes. The Service answered affirmatively: under the fair market value standard, known or knowable facts—including an ongoing sale process and offers already received—must be incorporated into valuation. Second, the IRS considered whether the donor retained a “qualified annuity interest” under §2702 when the GRAT was funded using a stale §409A appraisal that ignored the pending merger. The Service held that the retained interest failed to qualify, treating the entire transfer to the GRAT as a taxable gift.The facts of the case reveal a pattern of valuation inconsistencies. The taxpayer used a seven-month-old §409A appraisal—prepared for deferred compensation purposes, not transfer tax purposes—to support the GRAT funding, even though multiple offers had already been received at higher prices. Shortly thereafter, however, the same taxpayer funded a charitable remainder trust using a contemporaneous qualified appraisal that reflected the higher offer price. This inconsistency, coupled with reliance on an outdated and contextually inappropriate appraisal, invited IRS scrutiny and resulted in the Service’s determination that the GRAT was fatally flawed.While CCAs do not carry precedential weight, they are instructive of how the IRS is likely to approach similar fact patterns. CCA 202152018 signals heightened IRS vigilance where GRATs or other transfer tax strategies are executed amidst an ongoing or foreseeable liquidity event. It highlights the necessity of contemporaneous, purpose-appropriate appraisals that consider all relevant facts at the valuation date. Failure to do so risks not only valuation adjustments but also possible disqualification of retained interests under §2702, leading to the result of treating the entire transfer as a taxable gift.Understanding the M&A Process FrameworkTo properly value businesses during transaction processes, estate planners must understand the typical stages of mergers and acquisitions. The process generally unfolds through six distinct phases, each presenting different levels of transaction certainty and information availability.During the planning phase, when owners hire M&A advisors and organize information, there may be little quantifiable expectation of proceeds. However, once confidential information memorandums are distributed to potential buyers, expectations around selling prices become clearer. As the process progresses through qualification phases with indications of interest, buyer selection with letters of intent, due diligence, and final negotiations, the probability of completion and the certainty of proceed size generally increase.The critical insight for estate planners is that valuation weight should shift toward transaction proceeds as deal certainty increases. A business in early marketing phases might warrant only modest consideration of potential proceeds, while a company with binding letters of intent is more likely to merit substantial weighting of expected transaction value.Market Reality of Deal Success and FailureUnderstanding transaction success rates provides crucial context for valuation decisions. In a McKinsey & Company analysis of over 2,500 large deals valued above €1 billion, approximately 10.5% of deals were canceled, with larger transactions facing higher failure risks. Deals exceeding €10 billion experienced cancellation rates above 20%, while those under €5 billion maintained consistent 10% annual cancellation rates.In this analysis, industry factors significantly impacted success probability. Energy and financial sector deals showed the lowest cancellation rates at around 7%, while consumer discretionary and communications services faced higher failure rates of 13% and 19% respectively. Nearly 75% of canceled deals failed due to price expectations, regulatory concerns, or political issues.However, these statistics apply primarily to publicly announced transactions, making them most relevant for closely held companies in later deal stages. Earlier-phase failures often remain private, suggesting estate planners should shift weight toward no-sale scenarios when businesses are in preliminary transaction stages.Critical Success FactorsSeveral factors influence deal completion probability and should inform valuation weightings. Expected deal timelines matter significantly—longer processes face higher failure rates. Deal structure complexity creates additional risk, as mixed cash-and-stock transactions prove less successful than simpler all-cash or all-stock arrangements.The number and quality of bidders affect completion likelihood. Multiple interested parties provide fallback options, though this dynamic can shift if secondary bidders lose interest. More sophisticated bidders, such as private equity firms or strategic acquirers with dedicated M&A teams, typically conduct more thorough early evaluation but also identify issues that might derail transactions.External factors including economic conditions, political stability, and regulatory environment all influence completion probability. Companies with clean financial records, predictable cash flows, and minimal discretionary items in recent results face higher completion probabilities due to reduced due diligence risks.The Levels of ValueBusiness owners and their professional advisors are occasionally perplexed by the fact that their shares can have more than one value. This multiplicity of values is not a conjuring trick on the part of business valuation experts, but simply reflects the economic fact that different markets, different investors, and different expectations necessarily lead to different values.Business valuation experts use the term “level of value” to refer to these differing perspectives. As shown in the figure below, there are three basic “levels” of value for a business.Estate planning transfers typically involve minority interests valued at the nonmarketable minority level, which may incorporate discounts for lack of control and marketability. In contrast, M&A transactions occur at control levels and may include strategic premiums for synergies.This creates significant value gaps. A business with $100 per share marketable minority value might be valued at $65 per share for estate planning purposes after appropriate discounts. However, strategic buyers might pay $130 per share, creating a substantial differential between transfer values and transaction proceeds.Understanding Deal ProceedsExpected transaction proceeds require careful analysis beyond headline multiples. Deal terms may include earnouts, contingent payments, or non-cash consideration that should be risk-adjusted and converted to cash equivalency. The proposed transaction could trigger corporate-level taxes that would need to be considered in valuing an equity interest. A transaction appearing to price at 12x EBITDA might only deliver 9x value on a cash-equivalent basis after considering payment timing, corporate taxes, and performance risks.Practical Application FrameworkEstate planners working with businesses in transaction processes should expect valuation frameworks that appropriately weight no-sale scenarios against expected proceeds based on process stage and specific circumstances.As transaction processes progress through marketing phases with distributed information memorandums, modest weighting of expected proceeds becomes appropriate, though determining precise allocations requires careful analysis of company-specific factors and buyer interest levels.Once formal indications of interest are received, increasing weight is likely to shift toward transaction proceeds, with the specific allocation depending on offer quality, buyer sophistication, and deal structure. By the time binding letters of intent are executed, substantial weighting of expected proceeds is typically warranted, though some consideration of failure scenarios remains appropriate until closing occurs.Compliance and Documentation RequirementsThe IRS guidance emphasizes that valuations should ideally use valuation dates matching transfer dates and consider all knowable facts. Using outdated appraisals prepared for other purposes creates significant compliance risks, particularly when those appraisals ignore ongoing transaction processes. Business appraisers should document their consideration of transaction processes and provide clear rationale for their weighting decisions.Strategic Implications for Estate PlanningUnderstanding these dynamics enables more effective estate planning strategies. Business owners contemplating both exit strategies and wealth transfer can time their planning to optimize valuations while maintaining compliance. Earlier transfers in transaction processes may capture lower valuations, though this must be balanced against deal completion risks and the potential for significant value increases.The complexity of these valuations underscores the importance of engaging qualified professionals who understand both IRS transfer tax requirements and M&A market dynamics. Estate planners need valuation specialists who can navigate the technical requirements while providing credible opinions that optimize client outcomes.ConclusionThe intersection of business transactions and estate planning presents both opportunities and pitfalls for wealth transfer strategies.Success in this complex environment requires understanding M&A process stages, deal success factors, valuation methodologies, and compliance requirements. Estate planners who understand these concepts can help business owners navigate simultaneous exit and wealth transfer strategies while avoiding the costly mistakes that have drawn IRS scrutiny.The stakes are significant—business interests often represent the majority of owner wealth, making proper valuation essential for effective estate planning. With careful planning, appropriate professional guidance, and an understanding of regulatory guidance, these complex situations can be managed successfully to achieve both transaction and estate planning objectives.With 40+ years of transfer tax valuation and M&A experience, Mercer Capital understands the complexities that arise when business transactions intersect with estate planning objectives. Our team of credentialed professionals has worked with numerous clients through these challenging scenarios, providing the expertise necessary for these engagements.For estate planners seeking experienced partners who can navigate the intricate requirements of valuing businesses during active transaction processes, Mercer Capital offers the depth of experience and technical proficiency that these engagements demand.

During the first Trump administration, the Tax Cuts and Jobs Act (“TCJA”) introduced substantial modifications to the tax code, including significant reductions to estate tax liabilities. These reductions, however, were designed to sunset at the end of 2025, and addressing the expiring provisions became a priority for the current Trump administration. These were addressed in the One Big Beautiful Bill Act (“OBBBA”), an extensive legislative package touching on a variety of tax and spending policies. After a series of late-stage amendments, the OBBBA passed both chambers of Congress and was signed into law on July 4. In this issue of Value Matters, we examine the OBBBA’s provisions from a valuation perspective, focusing on implications pertinent to tax and estate planning professionals. Valuation PerspectiveOne of the key determinants of value of an interest in a company – be it a family-owned operating company or a real estate holding company – is the cash flow generated by the company and available to the shareholders for either distribution or reinvestment. The cash flow generated by a company directly impacts its valuation and the level of distributions made to shareholders impacts the magnitude of discounts applicable to non-marketable minority interests in companies. Impact of OBBBA on ValuationThe OBBBA directly impacts cash flows in several key ways. Permanency of TCJA Provisions: The OBBBA makes permanent various TCJA provisions that were scheduled to sunset at the end of 2025. These provisions include: 37% top individual income tax rate21% corporate income tax rate The Section 199A Qualified Business Income (“QBI”) deduction allowing tax pass-through entities to deduct up to 20% of their QBI. The QBI applied to entities that fall under the IRS’s definition of a “specified service trade or business” and includes entities in health, legal, accounting, and consulting fields. Reducing the tax burden owed by owners of S Corporations or members of partnerships increases the economic dividend received. All things equal, this reduces the costs of holding the asset during a nonmarketable period, reducing applicable discounts.Bonus depreciation was also made permanent under OBBBA and expanded to include buildings. Bonus depreciation can impact the timing of fixed asset purchases and allows a company to take advantage of a large upfront expense write-off, as opposed to trickling out the depreciation over the asset’s service life.The OBBBA also changed the definition of adjusted taxable income used to calculate tax loss carryforwards. The changes will ultimately allow businesses to deduct more interest upfront, reducing carryforwards and increasing cash flow in the short term. At the end of the day, asset-heavy pass-through companies are the big winners from these provisions.Changes to Capital Gains Tax TreatmentThe exclusion permitted related to sales of Qualified Small Business Stock (“QSBS”) has also been expanded. For qualified five-year holdings, 100% of the capital gains up to $15 million is exempted from capital gains taxes. The exclusion cap is indexed to inflation beginning in 2026.The OBBBA also introduced partial exclusions for QSBS shares held for shorter holding periods – 50% of gains are exempted for three-year holdings and 75% of gains are exempted for four-year holdings.The QSBS rules apply only to C corporations in non-service industries (for example, tech or retail) but can be advantageous to those planning to transfer shares across generations.Estate Tax ProvisionsOf most immediate relevance to estate planners is the substantial revision of estate tax exemption thresholds. The lifetime exclusion amount – the amount under which estate and gift taxes are not owed – was increased to $15 million for single filers and $30 million for joint filers beginning in 2026. This amount is indexed to inflation and will increase in future years.As shown in Figure 1, the lifetime exclusion amount has varied over time. The TCJA doubled the inflation-indexed exclusion amount from a base of $5 million to $10 million (or $5.49 million in 2017 to $11.18 million in 2018, after the inflation adjustment).Absent the passage of the OBBBA, the expiration of TCJA in December 2025 would have resulted in the exclusion reverting back to the $5 million base level (which would have been just over $7 million in 2026 after the inflation adjustment).It is also important to note that the estate exclusion amount is lifetime amount – gifts, estate, and generation-skipping transfers all work off of the same $15 million “pool” of exemption value. The actual rates applicable to gift and estate taxes are unchanged and portability between spouses remains.Importantly, unlike the TCJA provisions, the OBBBA’s estate tax thresholds do not include sunset provisions, offering greater predictability. Nonetheless, future legislative changes remain a possibility, underscoring the importance of sustained, proactive planning.Additionally, the OBBBA only impacts federal estate tax obligations; individual states may have their own estate tax rates and exemption levels. Taxpayers who maintain a course of consistent and vigilant estate planning will be best positioned to achieve their planning objectives and successfully thwart future challenges once the pendulum of enforcement activity and tax policies inevitably swing in the opposite direction.ConclusionAs Ben Franklin observed over two hundred years ago, “in this world nothing can be said to be certain, except death and taxes.” In navigating these certainties, collaboration with experienced estate planners and valuation professionals is critical.Feel free to reach out to us if you have any questions about the OBBBA’s impact on gift and estate tax valuations or to discuss a valuation issue in confidence.

The Importance of Relevant Data and Reasoned AnalysisThe recent U.S. Tax Court opinion in Kaleb J. Pierce v. Commissioner of Internal Revenue (T.C. Memo 202529) offers insight on several issues that regularly feature in the valuations of privately held business interests. By presenting an issue-by-issue analysis, the Pierce decision reinforces an important message for appraisers and estate planners: relevant data and reasoned analysis carry the day in court.BackgroundThe subject company, Mothers Lounge, LLC, an S corporation for tax purposes, sold mother and baby products. The company sold cheaply manufactured goods directly to consumers. The business relied on a “free, just pay shipping” no returns model, which afforded it a high profit margin, but came with a plethora of unsavory business practices, including copying competitor products, over-charging customers for shipping, undermining wholesalers and marketing affiliates, and suppressing customer reviews. The business history and practices detailed in the Findings of Fact are sufficient to raise eyebrows in a room full of former FTX executives. The dubious business model invited frequent litigation, with most lawsuits filed for trademark infringement. Two lawsuits were specifically described, one of which was for patent infringement and illegal marketing practices that had “ballooned into an existential threat.” Adding to these murky undercurrents were an affair of one of the business principals and a blackmail demand letter that spurred an FBI investigation. As noted by the Tax Court, these developments had “caused extreme dysfunction with the company’s management and demoralized the workforce” in the timeframe before the valuation date.The company’s business practices may have raised eyebrows, but they were lucrative. The first successful product, a nursing cover, illustrates the model (see Figure 1).Despite giving the product to customers for “free,” Mothers Lounge, LLC earned a healthy 64% contribution margin on each unit sold, which was more than sufficient to cover all other operating expenses of the business. In 2013, the company had an EBITDA (earnings before interest, taxes, depreciation and amortization) margin of 29%, which many readers will recognize as above average for a consumer products business. The company was debt-free and required minimal investments in depreciating assets, making EBITDA a good proxy for pre-tax cash flow. The Pierce court had to decide the proper value for gift tax purposes of two minority interests in Mothers Lounge, LLC that were transferred in 2014 (a 29.4% interest and a 20.6% interest).Expert WitnessesThe taxpayer’s expert prepared a valuation report submitted at trial. During the administrative appeal of the case in 2017, the taxpayer’s expert had also prepared a forecast for the business (the “2017 Forecast”). The taxpayer’s expert did not rely on the 2017 Forecast in his appraisal of the subject interests before the Tax Court, but the valuation expert for the IRS did. To recap, there were two valuation experts at trial, one for the taxpayer and one for the IRS. In preparing his appraisal, the IRS’s valuation expert relied on the 2017 Forecast prepared by the taxpayer’s expert, but the taxpayer’s expert did not rely on the 2017 Forecast in preparing his appraisal.Key IssuesForecastWhile both experts agreed on the application of the income approach, they relied on different forecasts. The forecast prepared by the taxpayer’s expert for his appraisal report relied on an analysis and assessment of relevant factors and market trends “known or knowable” as of the valuation date, which the Court deemed credible. In contrast, the IRS’s valuation expert relied on the 2017 Forecast “without independent verification,” which the Court easily rejected.The fact that the taxpayer’s expert prepared the forecasts underlying both his own report and that of the IRS’s valuation expert is a unique feature of the case. While the Pierce court deemed the forecast used by the taxpayer’s expert credible, it declined to ascribe weight to the 2017 Forecast used by the IRS’s valuation expert (which was prepared by the taxpayer’s expert). According to the opinion, the taxpayer’s expert “was in a time crunch” to prepare the 2017 Forecast and he ultimately relied on post-valuation data to support its projections. The Court noted that the 2017 Forecast lacked any analysis or discussion of the events surrounding the FBI investigation and inappropriately relied on post-valuation data. The Court pointedly stated that “this reliance blurs the line between information that was known or knowable as of the valuation date and the information that was not reasonably foreseeable as of the valuation date.”Tax AffectingBoth experts agreed that tax affecting the earnings of the company (an S corporation) was appropriate and used the Delaware Chancery method to calculate substantially equivalent tax rates (26.2% and 25.8%).The Court commented that tax affecting earnings of tax pass-through entities can be rejected where “a party fails to adequately explain” its necessity or where the experts “have not accounted for the benefits of S corporation status to shareholders.” We note that the 2017 Tax Cuts and Jobs Act brought C and S corporations closer to parity in taxation, diminishing the additional economic benefits formerly realized by owners of pass-through entities. Nonetheless, the Pierce opinion affirms that the valuation of an interest in a tax pass-through entity should account for the effect, if any, of tax status on the value of the interest.Discount RateMothers Lounge, LLC had no debt and both experts developed a cost of equity capital (COEC) discount rate using the build-up method. The key differences between the experts were in the presentation of the underlying data and the application of a company-specific risk premium (CSRP).The taxpayer’s expert used the Kroll Cost of Capital Navigator platform, which includes tables with output results, but does not present the underlying data. In contrast, the IRS’s valuation expert “provided a thorough review of his process and the academic papers that supported his equations.” Citing the lack of supporting data in the taxpayer’s expert report, the Court accepted the COEC rate concluded by the IRS’s valuation expert.Of particular interest is the issue of company-specific risk premium. The taxpayer’s expert added a CSRP of 5% to the build-up analysis, while the IRS’s valuation expert applied a 0% premium. In discussing the company-specific risk premium, the Court acknowledged that the build-up method allows for the consideration of such risks, but expressed concern that such risk factors may already be accounted for in other elements of the build-up approach (such as the size premium). Ultimately, the Court did not accept the premium applied by the taxpayer’s expert, who had cited five risk factors he considered in arriving at his conclusion for the premium. The Court chided the taxpayer’s expert for failing to provide sufficient details to allow the Court to understand the derivation of the selected premium. The Court’s conclusion confirms the need to support the application of a company-specific risk premiums with reference to available market evidence and the overall reasonableness of the resulting conclusion of value.Applicable DiscountsBoth experts applied discounts for lack of control and lack of marketability in the valuation of the subject minority interests.With respect to the discount for lack of control, the experts differed in the approach used to determine the discount and its application. The Court adopted the taxpayer’s expert 5% discount which was based on analysis of the company’s operating agreement, capital market evidence, and consideration of relevant facts and circumstances. In contrast, the IRS’s valuation expert applied a 10% discount, but only to the non-operating assets of the business. In its rejection of the latter approach, the Court once again cited the lack of underlying supporting data and analysis.The experts applied similar (25% and 30%) discounts for lack of marketability supported by detailed explanations of their methodologies and conclusions. The Court found the methodology used by the taxpayer’s expert to be “slightly more persuasive.” The Court once more expressed concern that the IRS valuation expert relied on the 2017 Forecast. Of note, the Court’s finding in favor of the (lower) marketability discount proffered by taxpayer’s expert was actually adverse to the taxpayer’s overall position.ConclusionThe material valuation issues in the Pierce case include the proper data to use in preparing a forecast, tax affecting pass-through earnings, and supporting appropriate risk factors and discounts to be applied in the valuation of closely held business interests. The Court’s consideration of each issue underscores the importance of marshalling relevant data and presenting reasoned analysis in valuation reports.

As we stated in the March 2025 issue of this newsletter, we believe that prudent federal estate and gift tax planning involves a lifetime horizon with adherence to best practices that yield optimal outcomes. When economic and market conditions present an opportunity for estate planning, assets with low current values and potential for significant appreciation should be considered for efficient estate planning. One type of asset that fits this category is carried interest. This article explores the strategic incorporation of carried interests in estate planning, particularly for newly formed private equity funds. It discusses the benefits and complexities of leveraging such interests under current economic conditions and tax regulations to optimize estate outcomes. We will discuss specific valuation approaches and methods in the valuation of carried interests in a future article.Carried Interest ExplainedWhat is carried interest? It is the profits interest that a private equity, venture capital, or hedge fund principal receives if the fund exceeds certain performance benchmarks. Carried interest can also be referred to as performance allocation, incentive allocation, or promote interest in the case of real estate funds. Separately, fund principals also receive economics from management fees and direct investments in the fund. Fund Structures and Carried Interest AllocationA basic private equity fund structure is shown in Figure 1. Typically, the fund principals form a general partner entity and a management company entity. The principals then raise capital from limited partners and make investments over the term of the fund. The management company receives management fees, often around 2% per year, for investment management services provided. The general partner entity typically invests alongside the limited partners and receives its pro-rata share of returns along with the limited partners. If the fund exceeds certain benchmarks, the general partner also receives carried interest, often around 20% of fund returns beyond the benchmark. It is important to note that private equity fund structures come in many forms, from basic to complex. Even though this article is focused primarily on private equity funds, similar concepts apply to certain hedge funds and venture capital funds.Navigating Uncertainty and Valuation ChallengesUncertainty exists regarding the fund’s performance, more so earlier in the fund’s life. When the fund entities are formed, and before capital is raised, there is also uncertainty regarding how much capital will be raised. These uncertainties result in low values for the fund entities at inception. The fund entity values will appreciate significantly if the fund is able to successfully raise capital and achieve strong investment returns.Why would a newly formed fund entity have any value before capital is raised? The IRS’ Revenue Procedure 93-27 provides that if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the IRS will not treat the receipt of such an interest as a taxable event for the partner or the partnership. It has been argued that 93-27 means that a profits interest has no value at issuance. However, the IRS has made it clear that 93-27 is not applicable to valuing carried interest.Challenges in Valuing Interests in Fund EntitiesA qualified appraisal prepared by a qualified appraiser with experience valuing carried interest is paramount when making estate planning transfers with newly formed fund entity interests given the complexity involved. In addition to fund structure, other items that require appraiser familiarity with carried interest include the following:Fundraising: What is the fund’s target size? What is the minimum required investment? Will the fund offer special terms for early investors or for a large “anchor” investor?Fund investment strategy: What types of investments will the fund make in terms of asset classes, industries, size of interests, number of investments, etc.? How will the investments shape expected returns for the fund? What is the expected holding period for the investments? Will capital from the sales of investments be reinvested? Will the fund use leverage?Fund terms: How is the management fee calculated and how often will it be assessed? Who will pay for fund expenses? Is there a general partner catch-up after the hurdle is reached? Are distributions made on a deal-by-deal basis, or on a cumulative basis? Can the general partner waive management fees associated with their direct investments in the fund?ConclusionIn conclusion, carried interests in newly formed fund entities present a valuable estate planning opportunity, particularly during times of economic uncertainty and where there is potential for fund appreciation.It is essential to work with qualified appraisers familiar with the complexities of fund structures and tax regulations to ensure optimal outcomes. Engaging with experienced advisors can significantly enhance the outcomes of your estate planning efforts.The professionals at Mercer Capital have experience in the valuation of carried interests. For more information or to discuss a valuation issue in confidence, feel free to contact us.

In the practice of professional services sometimes a single issue or event garners much attention. Such is the situation with the Connelly case and the valuation of an equity interest in a small building supply company, Crown C Supply (“CCS”).The question to be resolved in the case was how $3 million in life insurance proceeds received by CCS and purposed for the redemption of an equity interest from the estate of one of the company’s two shareholders should be treated when valuing the equity interest.The Connelly case attracted much attention when the United States Supreme Court agreed to hear it, and rightfully so, as few estate tax cases are heard by the highest court in the land.Much has been written about the case since then and the implications of the Court’s decisions for life-insurance funded entity purchase buy-sell agreements and business valuation are important to understand. We have written about the case in our most recent book published by the ABA, Buy-Sell Agreements: Valuation Handbook for Attorneys.Alongside a detailed analysis of these issues, however, it is instructive to also consider the timeless lessons that can be drawn from the case.These lessons become evident when one ponders the inevitable question: Why did the estate of a shareholder in a small, family-owned business with a value of less than $7.0 million have to appeal and argue its case in front of the United States Supreme Court?Some of the answers to the question lie in the errors, often ones of omission, that can be made by taxpayers when planning for the eventual estate tax liability from their ownership of a family-owned business.Four Lessons from ConnellyBelow we review four lessons that lie in the puzzle of the Connelly case.Estate Plans Accomplished Through a Family Business Will Inevitably Have Implications for All Stakeholders That Need to Be Considered and BalancedWhen the primary source of wealth is an interest in a family-owned business, there may be an understandable inclination for family members to implement an estate plan that will be executed within the bounds of the business.However, it is important to keep in mind that estate taxes are the responsibility of the individual shareholders rather than the family business.In the Connelly case, after the redemption of the deceased brother’s 77.2% controlling interest in CCS with $3.0 million in life insurance proceeds, the surviving brother’s pre-redemption 22.8% minority interest in the business effectively converted to a 100% controlling ownership interest. Thus, the redemption of the estate’s interest increased both the ownership share and basis of value of the surviving shareholder.The increase in value to the surviving shareholder was not captured by the transfer system in the sequence of steps and reportable transactions and therefore likely attracted greater scrutiny by the IRS.1To the Extent Shareholders Do Not Respect the Formalities of a Shareholders’ Agreement, Don’t Expect the IRS or a Court to Do So EitherWhen an estate plan is put in place, its provisions may require regular follow-up by the parties.It is not surprising that the time demands of running a successful business often limit the attention business owners can devote to estate plan requirements. Thus, estate plans can sit on the proverbial back shelf for years. Such lack of attention can unravel even well laid out plans.The Connelly brothers had entered into a stock-purchase agreement (“SPA”) with buyout provisions for their respective ownership interests in the event of the death of either brother.The SPA required the shareholders to annually determine the value of CCS shares and had provisions for an appraisal process to be used in determining the fair market value of CCS shares in redemption. None of these requirements were fulfilled by the Connelly brothers.Buy-Sell or Other Restrictive Agreements Need To Be Properly Drafted in Order to Have the Desired Effects for Estate Planning PurposesBuy-sell agreements (“BSAs”) are used by private business owners for a variety of purposes, including ownership control, succession planning, and liquidity needs. BSAs and similar restrictive agreements are also important tools in estate planning and can establish the value of an equity interest for estate or gift tax purposes.In order for an agreement transfer price to be considered as a factor in determining value for estate or gift tax reporting purposes, the agreement needs to meet three exception test requirements of Section 2703 of Chapter 14, namely, the agreement needs to be 1) a bona fide business arrangement, 2) not a device to transfer property for less than full and adequate consideration and 3) have terms comparable to similar arrangements entered into by unrelated parties in an arms’ length transaction.The IRS did not put forth an argument on whether the purchase price for Michael Connelly’s interest in CCS should be disregarded for estate tax reporting purposes based on the provisions of Section 2703 of Chapter 14.While such an argument was not part of the Connelly case, many legal commentators believe that the facts of the case should be examined with regard to both the provisions of Section 2703 and related case law.Estate Plans Should Incorporate Appraisals by Qualified Professionals When Fair Market Value Cannot Be Readily Established by Other MeansFair market value, defined as the price at which an asset would change hands between a willing buyer and a willing seller when neither is under any compulsion to buy or to sell and both have reasonable knowledge of relevant facts, is the standard of value for estate and gift tax reporting purposes.When fair market value cannot be readily established by reference to market or transaction prices, the opinion of a management representative will not be a suitable substitute for the opinion of a qualified appraiser.One of the missing puzzle pieces in the Connelly case is the appraisal of the subject interest by a qualified appraiser.The SPA had specific provisions for an appraisal process for shares subject to redemption, but this process was not followed by the parties. Rather, the redemption price was agreed upon in an “amicable and expeditious manner” by the estate executor and a son of the decedent.Counsel for the estate argued that the $3.0 million redemption price “resulted from extensive analysis of CCS’s books and the proper valuation of assets and liabilities of the company. Thomas Connelly, as an experienced businessman extremely acquainted with Crown C’s finances, was able to ensure an accurate appraisal of the shares.”These decisions made by the parties in the Connelly case ultimately failed to establish a supportable fair market value conclusion for the subject interest.Defining Fair Market Value and Selecting Qualified AppraisersFair Market ValueFair market value is referenced in the Connelly SPA as part of the definition of appraised value per share. Fair market value itself, however, is not defined in the SPA.Without a specific, clear definition of fair market value, such as that from the ASA Business Valuation Standards or the Internal Revenue Code, the interpretation of fair market value is left to the appraiser(s).In the Connelly matter, upon a triggering event two appraisers were to be engaged (one by CCS and one by the selling shareholder). Should the opinions of these two appraisers diverge by more than 10% of the lower appraised value, a third appraiser could have been engaged. The SPA as drafted opened the door for three interpretations of fair market value. And with multiple interpretations comes the increased likelihood of litigation.Appraiser QualificationsAdditionally, if the qualifications of an appraiser are not specified, just about anyone can do the appraisal.The Connelly SPA mentions that an appraiser “shall have at least five years of experience in appraising businesses similar to the Company.” That’s it. The SPA makes no mention of formal education, valuation credentials such as ASA, ABV, or CVA, or continuing education and training requirements.What could happen if an unqualified appraiser is hired to perform a valuation? A recent tax court case, Estate of Scott M. Hoensheid, deceased, Anne M. Hoensheid, Personal Representative, and Anne M. Hoensheid, Petitioners, v. Commissioner of Internal Revenue Service, Respondent (T.C. Memo 2023-34), addressed this situation head-on.While the case was related to the donation of closely held stock, not using a qualified appraiser had a damaging impact on the taxpayer.The company whose shares were subject to the charitable gift had been marketed for sale by an investment banker prior to the gift. In court, the petitioners argued that the investment banker was qualified to prepare the appraisal for charitable giving purposes because he had prepared “dozens of business valuations” over the course of his 20+ year career as an investment banker.According to the Court, an individual’s “mere familiarity with the type of property being valued does not by itself make him qualified.” The Court further noted that the investment banker “does not have appraisal certifications and does not hold himself out as an appraiser.”The end result for the taxpayer in Hoensheid: the Tax Court found that the taxpayer failed to comply with the qualified appraisal requirements and denied the charitable deduction.Appraisal StandardsOccasionally, buy-sell agreements lay out the specific business appraisal standards to be followed by the appraiser.Standards most often cited in buy-sell agreements are the Uniform Standards of Professional Appraisal Practice (commonly referred to as “USPAP”), the ASA Business Valuation Standards, AICPA’s Statement on Standards for Valuation Services No. 1 (commonly referred to “SSVS”) and NACVA’s Professional Standards.The Connelly SPA did not reference any of these standards.Without any appraisal standards referenced, any appraiser elected to perform a valuation under the SPA who was not a member of one of the national appraisal organizations has no requirement to follow any set of standards or code of ethics.Final ThoughtsThis tale of a small building supply company making its way to the Supreme Court emphasizes how significant — and tricky — managing business and family interests can be.Aside from the issues surrounding how to treat life insurance proceeds, Connelly is a vivid reminder of the simple errors of omission that can spiral into monumental issues, and it highlights some timeless lessons about the necessity of dotting i’s and crossing t’s in estate planning and business agreements. It also underscores the importance of clearly defining fair market value, ensuring appraisers are properly qualified, and strictly adhering to appraisal standards.This whole saga reminds us of the importance of getting things right from the start to avoid a domino effect of complications down the road.

In the course of a business valuation practice, a business appraiser may either be involved in an examination of an opinion that they have issued or serve as a consulting expert to assist legal counsel in an opinion issued by an unaffiliated business appraiser.While an accepted-as-filed resolution of an independent and objective opinion of value for a federal tax matter is the desired outcome, an IRS examination also provides an opportunity for appraisers to critically evaluate their work, and, in so doing, strengthen future work product.As Mercer Capital is frequently requested to provide expert consulting services related to federal tax valuation matters under examination, this issue of Value Added® explores the elements of a quality valuation that increase the prospects of a favorable resolution of an examined matter, or the desired accepted-as-filed outcome at an initial reporting stage.Elements of a Quality ValuationQuality business valuations possess four common elements:Identification of the rights and benefits of the business interest being valued;Relevant and sufficient capital market evidence;Sound financial analysis; and,Effective reporting to the intended audience.Identification of the Rights & Benefits of the Business InterestFundamental to any sound valuation is a thorough understanding of the rights and benefits of the business interest being valued.Most often this involves a close review of the basic governance documents of the business such as corporate articles of incorporation and bylaws, partnership or limited liability operating agreements, buy/sell agreements, and additional legal documents that address the rights and benefits related of the subject business interest. Absent formal governance documents, relevant statutory provisions in the entity’s state of domicile provide this guidance. This guidance directs the appraiser as to the appropriate level of value for the assignment, i.e., controlling interest, minority interest or veto block interest.While it is not the role of the business appraiser to be the ultimate arbiter of the legal rights and benefits related to the interest, it is the responsibility of the appraiser to have as complete an understanding as they can of these defining attributes.  In cases of ambiguous governance documents or situations of default to statutory provisions, assistance from legal counsel is warranted to provide legal direction as to the attributes of an interest.Once a complete understanding of the legal rights and benefits of the interest is gained, it is critical for the business appraiser to keep this understanding at hand throughout the appraisal process and report on this understanding in a concise and clear manner.Relevant and Sufficient Capital Market EvidenceA cornerstone of every sound opinion of value resides in the capital market evidence that is relied upon for its support. Relevancy and sufficiency are two essential concepts for consideration in evaluating capital market evidence.RelevanceThe relevance of capital market evidence is a key component of the valuation of interests in privately held businesses, as often there is a dearth of pertinent capital market evidence related to the interest being valued.  This reality illustrates the inherent challenge associated with the valuation of privately held business interests; by definition financial and transactional information related to private businesses is most often not in the public domain. As a consequence, business appraisers frequently look to capital market evidence related to publicly traded businesses to find the capital market evidence necessary to support their opinion. Material differences between the subject business interest and the capital market evidence relied upon must be reconciled and explained.SufficiencySufficiency is the second core concept related to capital market evidence.  The time-tested adage that “one sale does not make a market” certainly applies.Often, the business appraiser is faced with a scenario of capital market evidence of limited quantity.  In such instances the appraiser should expand search parameters in order to obtain capital market evidence with similar investment risk attributes as the subject interest.A default to the opinion based on the personal experience of the appraiser without sufficient market evidence will be subject to intensive scrutiny, and quite likely, may be considered a failure of the opinion for its intended use.Sound Financial AnalysisThorough and sound financial analysis is crucial to any supportable valuation. The fundamental valuation principle is that the value of a business is a function of three components: (1) expected cash flows, (2) risk profile, and (3) growth prospects.Expected Cash FlowsIdentifying and estimating the expected cash flows of a business requires careful consideration of historical financial results, anticipated economic and industry conditions, and the capital needs of the business (a more exhaustive list of data and factors that should be considered is included in IRS Revenue Ruling 59-60).RiskAn evaluation of the risk profile of a business cannot be done without understanding the key drivers of the business.  A business is subject to and impacted by a litany of factors including market risks, operational risks, and financial risks that must be evaluated.GrowthAn appraiser's assessment of growth prospects should consider growth due to market share, growth of the market, growth from profitability, and the sustainability of each.Business appraisers should conduct robust financial analyses and due diligence to evaluate these three components, and quality appraisals will provide sound and reasonable support for the concluded estimates of each.Effective Reporting to the Intended AudienceThe most important aspect of the valuation may well be how effectively the appraiser communicates to the intended audience of the valuation report.For federal transfer tax valuation matters, the intended audience consists of estate planning and tax attorneys as well as Internal Revenue Service trust & estate examining attorneys.For federal income tax matters the intended audience consists of tax attorneys, certified public accountants, enrolled agents and Internal Revenue Service agents, typically individuals with an accounting and tax background.As the readers of a valuation report may be more verbally rather than numerically oriented, a valuation report prepared for a transfer tax matter should be written in a communication style and structure that matches this orientation.  In contrast, it may be more appropriate for reports prepared for income tax matters to have a quantitative tilt.ConclusionWhile the examination of a federal tax valuation matter can be a challenging exercise laden with complexity, past examination experience also provides opportunities to focus on the fundamentals of the valuation process that underlie a quality valuation.Adherence to the concepts presented in this article will improve the likelihood of accepted-as-filed outcomes as well as place the valuation work product in a position of strength in the event of an examination.At Mercer Capital, we diligently incorporate each of the four elements of quality valuations into our reports.  To discuss your valuation need on a confidential basis, please contact one of our professionals.

A Guide for Estate PlannersIn the course of a business valuation practice, a business appraiser may either be involved in an examination of an opinion that they have issued or serve as a consulting expert to assist legal counsel in an opinion issued by an unaffiliated business appraiser.While an accepted-as-filed resolution of an independent and objective opinion of value for a federal tax matter is the desired outcome, an IRS examination also provides an opportunity for appraisers to critically evaluate their work, and, in so doing, strengthen future work product.As Mercer Capital is frequently requested to provide expert consulting services related to federal tax valuation matters under examination, this issue of Value Added® explores the elements of a quality valuation that increase the prospects of a favorable resolution of an examined matter, or the desired accepted-as-filed outcome at an initial reporting stage.Elements of a Quality ValuationQuality business valuations possess four common elements:Identification of the rights and benefits of the business interest being valued;Relevant and sufficient capital market evidence;Sound financial analysis; and,Effective reporting to the intended audience.Identification of the Rights & Benefits of the Business InterestFundamental to any sound valuation is a thorough understanding of the rights and benefits of the business interest being valued.Most often this involves a close review of the basic governance documents of the business such as corporate articles of incorporation and bylaws, partnership or limited liability operating agreements, buy/sell agreements, and additional legal documents that address the rights and benefits related of the subject business interest. Absent formal governance documents, relevant statutory provisions in the entity’s state of domicile provide this guidance. This guidance directs the appraiser as to the appropriate level of value for the assignment, i.e., controlling interest, minority interest or veto block interest.While it is not the role of the business appraiser to be the ultimate arbiter of the legal rights and benefits related to the interest, it is the responsibility of the appraiser to have as complete an understanding as they can of these defining attributes. In cases of ambiguous governance documents or situations of default to statutory provisions, assistance from legal counsel is warranted to provide legal direction as to the attributes of an interest.Once a complete understanding of the legal rights and benefits of the interest is gained, it is critical for the business appraiser to keep this understanding at hand throughout the appraisal process and report on this understanding in a concise and clear manner.Relevant and Sufficient Capital Market EvidenceA cornerstone of every sound opinion of value resides in the capital market evidence that is relied upon for its support. Relevancy and sufficiency are two essential concepts for consideration in evaluating capital market evidence.RelevanceThe relevance of capital market evidence is a key component of the valuation of interests in privately held businesses, as often there is a dearth of pertinent capital market evidence related to the interest being valued. This reality illustrates the inherent challenge associated with the valuation of privately held business interests; by definition financial and transactional information related to private businesses is most often not in the public domain. As a consequence, business appraisers frequently look to capital market evidence related to publicly traded businesses to find the capital market evidence necessary to support their opinion. Material differences between the subject business interest and the capital market evidence relied upon must be reconciled and explained.SufficiencySufficiency is the second core concept related to capital market evidence. The time-tested adage that “one sale does not make a market” certainly applies.Often, the business appraiser is faced with a scenario of capital market evidence of limited quantity. In such instances the appraiser should expand search parameters in order to obtain capital market evidence with similar investment risk attributes as the subject interest.A default to the opinion based on the personal experience of the appraiser without sufficient market evidence will be subject to intensive scrutiny, and quite likely, may be considered a failure of the opinion for its intended use.Sound Financial AnalysisThorough and sound financial analysis is crucial to any supportable valuation. The fundamental valuation principle is that the value of a business is a function of three components: (1) expected cash flows, (2) risk profile, and (3) growth prospects.Expected Cash FlowsIdentifying and estimating the expected cash flows of a business requires careful consideration of historical financial results, anticipated economic and industry conditions, and the capital needs of the business (a more exhaustive list of data and factors that should be considered is included in IRS Revenue Ruling 59-60).RiskAn evaluation of the risk profile of a business cannot be done without understanding the key drivers of the business. A business is subject to and impacted by a litany of factors including market risks, operational risks, and financial risks that must be evaluated.GrowthAn appraiser's assessment of growth prospects should consider growth due to market share, growth of the market, growth from profitability, and the sustainability of each.Business appraisers should conduct robust financial analyses and due diligence to evaluate these three components, and quality appraisals will provide sound and reasonable support for the concluded estimates of each.Effective Reporting to the Intended AudienceThe most important aspect of the valuation may well be how effectively the appraiser communicates to the intended audience of the valuation report.For federal transfer tax valuation matters, the intended audience consists of estate planning and tax attorneys as well as Internal Revenue Service trust & estate examining attorneys.For federal income tax matters the intended audience consists of tax attorneys, certified public accountants, enrolled agents and Internal Revenue Service agents, typically individuals with an accounting and tax background.As the readers of a valuation report may be more verbally rather than numerically oriented, a valuation report prepared for a transfer tax matter should be written in a communication style and structure that matches this orientation. In contrast, it may be more appropriate for reports prepared for income tax matters to have a quantitative tilt.ConclusionWhile the examination of a federal tax valuation matter can be a challenging exercise laden with complexity, past examination experience also provides opportunities to focus on the fundamentals of the valuation process that underlie a quality valuation.Adherence to the concepts presented in this article will improve the likelihood of accepted-as-filed outcomes as well as place the valuation work product in a position of strength in the event of an examination.At Mercer Capital, we diligently incorporate each of the four elements of quality valuations into our reports. To discuss your valuation need on a confidential basis, please contact one of our professionals.

Jensen Huang, the chief executive officer of Nvidia, and his family are on track to save north of $8 billion in estate and capital gains taxes. So, how has the tenth-wealthiest person in America managed to protect his wealth from the 40% estate tax? He has a plan.Beginning in 2012, the Huangs set off on their estate tax planning journey by setting up an irrevocable trust. Without getting too far into the weeds, the Huangs and their team of advisors formulated an estate tax plan that involved the use of tax planning maneuvers involving intentionally defective grantor trusts and several grantor-retained annuity trusts (“GRATs”). These tax planning vehicles enabled the Huang family to effectively (and legally) circumvent hefty gift and estate taxes that would apply to a direct transfer of the assets to Huang’s heirs.Just like the Huangs, most family business owners aim to provide financial stability and support for future generations of their families. Putting in the work on the front end and establishing a plan, like the example above, can potentially result in significant estate tax savings for you and your family in the future.Estate TaxThe Estate Tax is a tax on your right to transfer property at your death. The tax is calculated based on the “decedent’s gross estate,” less the taxpayer’s remaining gift and estate tax deduction, which in 2025 will be $13.9 million per individual, as well as other specific deductions. Family business owners face a unique hurdle as a substantial portion of their estate typically consists of illiquid interests in private company stock. If this is the case, liquidating assets to pay the estate tax may prove more difficult as estate taxes are payable only in cash. Family businesses may have to be sold or forced to borrow money to fund the payment of a decedent’s estate tax liability.Ignoring estate taxes altogether is not an affordable option either.  While it is true that the legal burden of the estate tax falls to individual shareholders rather than the family business itself, many family shareholders have not accumulated sufficient liquidity to pay those estate taxes without some action on the part of the company.  The required actions may range from a shareholder loan to a special dividend to the sale of the business. A bit of forethought can relieve the burden on heirs, but when is the right time to get started?The Sooner, the BetterAs a family business owner, it is never too early to review your estate plan. While there are things that will certainly change over time, taking the pulse on your estate plans can have a major impact on the volume of wealth you pass to your heirs.Preparing to transfer ownership to the next generation in the most tax-efficient way is daunting, but here are some ways you can start thinking about your estate plan:Review the current shareholder list & ownership table: Based on the current shareholder list, are there any shareholders that — were the unexpected to happen — would be facing a significant estate tax liability?Identifying current estate tax exposures: Will shareholders have to look to the family business to redeem shares or make special distributions to fund estate tax obligations?Identify tax & non-tax goals of the estate planning process: If there was no estate tax, what evolution would be the most desirable for your family and business?Obtain a current opinion of the fair market value of the business at each level of value (control, marketable minority, and nonmarketable minority). The most difficult time to make decisions regarding your estate plan is the short term. Should we accelerate plans to sell so we can avoid a larger tax bill? Should we realize some gains in the family securities portfolio to avoid the possibility of an increase in long-term capital gains rates? We believe these questions can be avoided when a well-thought-out estate plan is established. Diligent planning on the part of family shareholders allows directors to focus on the long-term success and sustainability of the business without the distraction of potential estate tax exposures. Give one of our family business professionals a call today to talk about balancing tax concerns with the long view on your family business.

Hard to imagine today, but just one year ago, some of the largest prices paid for new cars relative to MSRP were for an EV. The Porsche Taycan, a six-figure ride in any configuration, was commonly selling for 20-25% above sticker. What a difference a year makes. Today, EVs are shunned by many (certainly the press), and Porsche is rushing out a new version of the Taycan for 2025 to address flagging sales. For those who paid premium prices to Zuffenhausen a year ago, the depreciation they’ll experience if they try to trade that year-old Taycan today would be breathtaking. Life’s a gas!Pricing MattersThe backbone of our business at Mercer Capital is valuation, so we have a self-interested bias against formula prices in buy-sell agreements. An independent valuation is, by far, the best way to manage the settlement of transactions between shareholders. Doing so annually has the added benefit of managing everyone’s expectations.Simple is not always betterI’ll concede that annual valuations can be excessive for smaller firms with a few shareholders and transactions that seldom occur. Formula pricing offers a degree of certainty and grounds expectations in what is usually a pretty simple equation. Simple is not always better, however.More often than not, the formula prices we encounter do more harm than good. The simplicity of formula pricing equations means they don’t consider important factors like debt, non-recurring items, loss of key staff or large customers, market conditions, or offers to purchase. Formulas can ground expectations but may set expectations unrealistically low or high, provide a false sense of security, and encourage partner behaviors that do not support the business model.The Object of Transaction PricingIn part, buy-sell agreements offer a mechanism to settle transactions between shareholders when some event forces a transaction. Often the event is many years, if not decades, after the signing of the agreement. Nobody expects to be thrown out of their firm, get divorced, or die — even though we know the former two happen often and, in the case of the latter, happens to everyone. Even retirement is hard to foresee when a firm is in its nascency and crafting a shareholder agreement to handle issues that seem so far off that even the inevitable is irrelevant.Signers to a buy-sell rarely foresee the consequencesAs such, the signers to a buy-sell rarely foresee the consequences of what they’re signing. Many of these consequences involve valuation.If you ask them, most people say they want the pricing mechanism in their shareholder agreement to treat everyone fairly. “Fair” is the first word in Fair Market Value, a standard of value established by the Treasury Department in Revenue Ruling 59-60 and reiterated and expounded upon in professional literature throughout the valuation community.Fair Market Value, generally, is a standard of pricing that considers the usual motivations of typical buyers and sellers, described as hypothetical parties, to distinguish them from the very specific and particular persons involved in a subject matter. The parties to a fair market value transaction are assumed to be funded, informed, and reasonable. Fair market value further assumes an orderly (not forced) transaction, and settlement is on a cash equivalent basis.Most people want something akin to fair market value pricing in a buy-sell agreement, but formulas usually only achieve this by coincidence. Most formulas will either price an interest too high or too low. This creates “winners” and “losers,” depending on who gets the better side of the transaction.When the Formula Price Is Too HighWe often see formula pricing in buy-sell agreements set at what could be called optimistic levels. I suppose this is because these agreements are usually written when firms are first established, too new to evaluate the stabilized economics of the business model when compensation patterns are observable, fee schedules are settled, and margins become regular.Formula pricing commonly relies on rules of thumbFormula pricing commonly relies on rules of thumb that don’t represent the particular economic characteristics of a given RIA’s business model. An example of this would be the old myth that investment management firms were worth 2% of AUM.The 2% rule dates back to the days before wealth management and asset management were well delineated, and money managers commonly earned a realized effective rate of 100 basis points on assets under management. At those fees, a billion-dollar shop could produce pre-tax margins between 25% and 35%. At those margins, 2% of AUM implied a value of 6x to 8x pre-tax net income. At the time, that pricing was reasonable. RIAs were not considered an established money management platform (broker-dealers were still the dominant force), and consolidation activity was minimal. Industry insiders recognized that RIA clients were stickier than those of most professional services firms, so 6x to 8x pre-tax net income was a premium to a more typical 4x-5x for other owner-operator professions.Today, of course, consolidation activity is rampant, and multiples are generally higher. But fees have taken a hit, and not every firm earns a “normal” margin. If realized fees are 60 basis points and margins are 15%, a formula that values the RIA at 2% of AUM looks pretty expensive.There is a very human tendency to get too comfortable with large numbers. Owners like big valuations, even when they aren’t real. And until an event occurs that requires a transaction, people rarely question a robust, if unrealistic, valuation. It’s a game of mental gamma, where everyone hopes imaginary pricing pulls on value like a large block of out-of-the-money call options. It feels good but doesn’t get tested until a triggering event invokes the buy-sell agreement. Then something happens. If a 25% partner in this “Now” RIA passes away unexpectedly, and the buy-sell agreement specifies purchase at 2% of AUM, the transaction price is $5 million. We’re going to posit, for purposes of this post, that the actual fair market value of this interest is 8x-10x pre-tax, the midpoint of which is 9x. At 9x pre-tax, the 25% stake has an implied value of about $2 million. If the RIA is required to purchase the interest pursuant to the formula, they will be paying over 60% of the value of the firm for a 25% stake. The estate “wins,” and everyone else loses. What are the implications of an internal transaction at 22x pre-tax? Let’s assume the buy-sell agreement states the RIA can finance the purchase of the decedent’s interest at SOFR plus 200 basis points (about 7.3% today) over ten years. The annual payment would be nearly $725 thousand, or 80% of pre-tax (a proxy for distributable cash flow). For a decade, 80% of distributions will be claimed by a 25% ownership interest.80% of distributions will be claimed by a 25% ownership interestWe’ve seen this happen, but there are reasons the formula pricing might not hold. Usually, a buy-sell gives the other partners and/or the firm the option to purchase at the formula price but doesn’t require it. In this case, the option is entirely out of the money. In that case, the firm might decide to punt on the option and pay the estate their pro rata portion of distributions ($225K per year, or about $500K less than financing at the formula price). The estate is left as an outside minority owner in a closely held business. If the estate isn’t satisfied with this, the executor will have to negotiate — from a very weak position — with the other partners. In effect, this nullifies the buy-sell agreement.When the Formula Price Is Too LowBuy-sell formulas that undervalue interests are no better than those that overvalue interests. There is no “conservative” or “aggressive” in valuation, only reasonable and unreasonable. If, in the scenario listed above, the formula price specified that the firm was to be valued based on book value, the outcome would be no more favorable.RIAs usually don’t have much balance sheet value. Our valuations in the space rarely employ an asset approach. We consider whether the balance sheet has a normal level of working capital to finance ongoing operations or if it has a material amount of non-operating assets. Beyond that, the balance sheet is rarely more than some cash, leasehold improvements, and short-term payables. Book value for a firm like the one discussed above might be no more than $250K.At book value, that formula would price the decedent’s interest at $62,500 — unreasonable for a stake that was earning over three times that much in annual distributions. The transaction would be highly accretive to the remaining partners, who would share in the distribution stream they got for next to nothing. But the specter of what would happen to their beneficiaries in the event of their deaths would dampen any sense of having won.If this buy-sell formula also applies in the event of retirement or withdrawal from the firm, who would ever leave? It would be very difficult to execute ownership succession for partners who are giving up their distributions in exchange for so little compensation. Of course, without succession, the firm eventually wears out — a circumstance in which book value might be a reasonable measure.What’s Your Aspiration?Ask yourself whether or not you think the pricing of a forced transaction should create “winners” and “losers.” There are legitimate reasons for wanting a somewhat below-market price for transactions because it benefits the ongoing firm and continuing partners. Above-market pricing just creates a race for the exit. But if your formula price is too high and transaction execution is optional, an informed buyer will pass, and you’ll be negotiating as if there were no agreement. Hardly a good solution.If this has prompted you to think about your formula pricing and you’d like to talk specifics to us in confidence, reach out. We work with hundreds of investment management firms like yours to defuse time bombs and create reasonable resolutions. Don’t let your ownership issues disrupt your operations.

It may be an opportune time for bank investors to consider estate planning opportunities. Rising inflation has been top of mind for business owners and bankers (and everyone for that matter) over the last few years.While inflation has decelerated from its peak, business owners, bankers, and investors are adjusting to the new higher for longer interest rate environment.Higher inflation and interest rates have affected every business with few exceptions. All else equal, higher interest rates will negatively affect business value as higher discount rates are used to bring future cash flows to the present. In some industries though, inflation-driven increases in earnings or revenue growth expectations have offset (or even outweighed) the negative impact of higher interest rates.However, not all industries have been immune to pressure from higher interest rates and inflation on the value of their shares. Banking is one of several industries that have underperformed broader market indices as investors remain skeptical of the “new normal” and impact of the rate environment on banks’ cost of funds and net interest margins.As shown in the following tables, small and mid cap public bank stocks have underperformed broad market indices, and valuation multiples (as measured by P/E and P/TBV) remain below long-term historical averages.While it remains uncertain when the interest rate easing cycle will begin, the easing cycle will likely also have divergent outcomes for different industries. At this point between cycles and with bank valuation multiples below long-term averages, it is important to consider the potential opportunity to favorably transfer business value to future generations.A second reason to consider estate planning transactions in the current environment is issues on the tax and policy front.The Tax Cuts and Jobs Act enacted in December 2017 doubled the basic exclusion amounts individuals could give away without paying estate taxes. The sunsetting of this provision on December 31, 2025 and the potential for lower exclusion amounts thereafter and higher estate taxes, makes considering transfers all the more important.The combination of lower bank stock valuations combined with sunsetting favorable estate tax provisions make 2024 a worthwhile year for bank investors to consider estate planning strategies.Many strategies will require a current valuation of your bank, and our professionals are here to help.Originally appeared in the April 2024 issue of Bank Watch.

A Matter of Life (Insurance) and DeathA buy-sell agreement among family shareholders should provide clear instructions for how the company’s stock is to be valued upon the occurrence of a triggering event, such as the departure or death of a shareholder. The United States Court of Appeals for the Eighth Circuit recently heard Thomas A. Connelly, in his Capacity as Executor of the Estate of Michael P. Connelly, Sr., Plaintiff-Appellant v. United States of America, Department of Treasury, Internal Revenue Service, Defendant-Appellee. The Eighth Circuit court affirmed a district court decision that concluded that life insurance proceeds received by a company triggered by a shareholder’s death should be included in the valuation of the company for estate tax purposes.[1]Connelly is an estate tax deficiency case dominated by two themes: (i) the treatment of life insurance in the valuation of stock of a private company when a shareholder dies and (ii) the consequences of executing a buy-sell agreement that fails to meet the requirements under the Internal Revenue Code, Treasury regulations, and applicable case law, for purposes of controlling the valuation of a closely held company.[2] Using Connelly as a backdrop, we first demonstrate how opposing applications of life insurance proceeds received upon the death of a shareholder impact a company valuation. We then offer observations from a study of the Connelly buy-sell agreement from a valuation perspective that private business owners and their advisors should mind when drafting, reviewing, and amending buy-sell agreements.The Stock Purchase AgreementCrown C Supply Company, Inc. is a roofing and siding materials company founded in 1976 and headquartered in St. Louis, Missouri.[3] Crown C (an S corporation) and brothers Michael, Thomas, and Mark Connelly originally entered into a stock purchase agreement (“SPA”) on January 1, 1983. Mark’s interest in Crown C was terminated prior to the stock purchase agreement being amended and restated on August 29, 2001.[4] Crown C had 500 shares of common stock at the date of the SPA’s execution. Michael, via a trust, owned 385.9 shares of Crown C stock representing a 77.18% ownership interest. Thomas, individually, owned the remaining 114.1 shares representing a 22.82% ownership interest.Pursuant to the terms of the SPA, Michael and Thomas executed a certificate of agreed value that set the purchase price of Crown C’s stock upon a triggering event at $10,000 per share (see graphic below). Based on this purchase price per share, which disregarded accepted valuation principles and methodologies, the implied aggregate market value of the company’s stock on August 29, 2001, was $5.0 million.Therefore, at that date, Michael’s shares would have had an agreed value of approximately $3.9 million, while Thomas’s shares would have had an agreed value of approximately $1.1 million. In July 2009, with no update to the agreed value of the company’s equity, Crown C purchased life insurance policies on both Michael’s and Thomas’s lives in the amount of $3.5 million each. The rationale for purchasing the same amount of life insurance on each brother’s life when one brother’s ownership interest was approximately 3.4x larger than the other brother’s is unclear. The SPA dictatedthat life insurance proceeds were to be used to redeem a deceased shareholder’s interest.The Sale and Purchase AgreementMichael, who served as Crown C’s president and CEO, died on October 1, 2013. Thomas was the executor of Michael’s estate. Effective November 13, 2013, Thomas, as trustee of Michael’s trust and a second trust for Molly C. Connelly, Michael’s daughter, recused himself from “all matters touching upon the sale, pricing, negotiation, and transaction of any sale of the stock of Michael P. Connelly, Sr.’s interest in Crown C Supply Company, Inc.”[5] Had Thomas not recused himself he would have been in the conflicted position of negotiating on behalf of Michael’s estate with the company, of which he was now the sole surviving shareholder. Effective the same date, Thomas and Michael’s son, Michael P. Connelly, Jr., executed a sale and purchase agreement governing the redemption of the estate’s shares in Crown C as well as in other entities.[6] Thomas (representing Crown C) and Michael Jr. (representing Michael Sr.’s estate) agreed, without relying upon a formal valuation, to a purchase price of $3.0 million for the estate’s shares (see graphic below).The estate noted, however, that the $3.0 million purchase price “resulted from extensive analysis of Crown C’s books and the proper valuation of assets and liabilities of the company. Thomas Connelly, as an experienced businessman extremely acquainted with Crown C’s finances, was able to ensure an accurate appraisal of the shares.[7] I’ll discuss the importance of engaging a qualified appraiser in matters such as these below.The Estate’s Argument: Life Insurance Proceeds Are Not a Corporate AssetCrown C received $3.5 million in life insurance proceeds upon Michael’s death. Crown C immediately recognized a corporate redemption liability and used $3.0 million of the life insurance proceeds to redeem the estate’s interest in Crown C. It is interesting to note from the graphic above that Michael’s estate’s interest originally was equal to the total cash value of the life insurance proceeds, but at some point was reduced by $500,000 because the company needed additional funding.[8] Exhibit 1 demonstrates this narrative.(click here to expand the figure above)Key takeaways from this scenario:One would expect to see a “top-down” valuation methodology in which the value of 100% of Crown C’s equity is established first, followed by the determination of value attributable to the estate’s shares. However, the aggregate value of Crown C’s equity of $3.9 million was implied based on the value of the estate’s interest of $3.0 million.Crown C immediately recognizes a redemption liability equal to $3.0 million in life insurance proceeds and pays $3.0 million to Michael’s estate in exchange for redeeming the estate’s 385.9 shares; Michael’s estate is redeemed at $7,774 per share.[9]Post-redemption, the total value of the company’s equity does not change while the share count decreases from 500 shares to 114.1 shares, all owned by Thomas.Thomas now owns 100% of the company at a value of $34,067 per share,[10] which is approximately 4.4x the value at which Michael’s estate was redeemed. The value of Thomas’s ownership interest increased by 338% with no additional investment.The IRS’ Argument: Life Insurance Proceeds Are a Corporate AssetThe IRS saw things differently, arguing that the insurance proceeds should be included in Crown C’s equity value. See Exhibit 2 below.(click here to expand the figure above)Key takeaways from this scenario:The equity value of the business for estate tax purposes was $6.9 million inclusive of the $3.0 million in life insurance proceeds. The IRS did not include the excess $500,000 of life insurance in its valuation.The resulting value per share is $13,728[11].The estate’s 385.9 shares have a total value of $5.3 million and Michael’s estate is redeemed at $13,728 per share, reducing the company’s equity value to $1,566,323.Post-redemption, the share count decreases from 500 shares to 114.1 shares, all owned by Thomas at a value of $13,728 per share, which is equal to the pre-redemption value per share.As the life insurance proceeds utilized only totaled $3.0 million, the redemption liability of $5.3 million would have been underfunded by approximately $2.3 million, leaving the company (in this case, solely Thomas) on the hook to finance the shortfall.The Funding Mechanism DilemmaIt should be obvious that the manner in which life insurance proceeds are treated can have a dramatic impact on the selling shareholder, the remaining shareholders, and the company’s ability to buyout the selling shareholder. In one scenario, the estate is redeemed relative to a windfall received by the surviving shareholder. In the second scenario, the estate is redeemed at a higher value, but to the detriment of the company most likely having to finance a portion of the buyout. So, what is the fair way to treat life insurance in this situation? Ultimately, the parties to the buy-sell agreement decide what is fair with the help of their legal and other professional advisors, but such a decision must be addressed directly and without vagueness in the buy-sell agreement.The Defining Elements of a Valuation Process AgreementWe now turn to observations of the Connelly SPA itself from a valuation perspective. Valuation process agreements such as the Connelly SPA have six defining elements:[12] (i) standard of value; (ii) level of value; (iii) the “as of” date; (iv) qualifications of the appraiser; (v) appraisal standards; and (vi) funding mechanisms. The first five elements are required to specify an appraisal that is consistent with prevailing business appraisal standards. We’ve seen how the Connelly SPA addressed element #6, funding mechanisms. So, how, then, does the Connelly SPA stack up regarding defining elements #1 through #5?Standard of ValuePer the American Society of Appraisers ASA Business Valuation Standards, the standard of value is “the identification of the type of value being used in a specific engagement; e.g. fair market value, fair value, investment value.”[13]Fair market value, the standard that applies to nearly all federal and estate tax valuation matters and which is specified in most buy-sell agreements, is referenced in the Connelly SPA as part of the definition of appraised value per share. Fair market value itself, however, is not defined in the SPA. Without a specific, clear definition of fair market value, such as that from the ASA Business Valuation Standards or the Internal Revenue Code, the interpretation of fair market value is left to the appraiser(s). In the Connelly matter, upon a triggering event two appraisers were to be engaged (one by Crown C and one by the selling shareholder). Should the opinions of these two appraisers diverge by more than 10% of the lower appraised value, a third appraiser could have been engaged. The SPA as drafted opens the door for three interpretations of fair market value. And with multiple interpretations comes the increased likelihood of litigation.Level of ValueValuation theory suggests that there are various “levels” of value applicable to a business or business ownership interest. The graphic below depicts these levels. A formal business valuation for gift and estate tax purposes will clearly state the level of value, and therefore, no interpretation is needed as to the applicability of control premiums or discounts for lack of control and lack of marketability.Per the Connelly SPA, in the scenario in which appraisers are utilized in lieu of issuing a certificate of agreed value, “the appraisers shall not take into consideration premiums or minority discounts in determining their respective appraisal values.” In the absence of minority interest discounts, Thomas’s minority interest (22.82%) would have been valued on a pro-rata basis relative to Crown C’s total value.The As-Of DateEvery appraisal has an “as-of” date, more commonly referred to as the valuation date. Why is the valuation date important? Business appraisers rely upon information that was “known or reasonably knowable” on the valuation date. For purposes of filing Form 706, the valuation date is the date of death (estates may elect the alternate date, six months from the date of death, as the valuation date). For redemption purposes, however, the Connelly SPA refers to “Appraisal Date,” which is “the date an option is exercised or a mandatory purchase is required.” As such, the Connelly SPA does allow for a redemption to occur on a specific date.Qualifications of AppraisersIf the qualifications of an appraiser are not specified, just about anyone can do the appraisal. The Connelly SPA mentions that an appraiser “shall have at least five years of experience in appraising businesses similar to the Company.” That’s it. The SPA makes no mention of formal education, valuation credentials such as ASA, ABV, or CVA, or continuing education and training requirements. Ultimately, this was a moot point for Connelly because no appraiser was ever hired to do a valuation. But what could happen if an unqualified appraiser is hired to perform a valuation? A recent tax court case, Estate of Scott M. Hoensheid, deceased, Anne M. Hoensheid, Personal Representative, and Anne M. Hoensheid, Petitioners, v. Commissioner of Internal Revenue Service, Respondent (T.C. Memo 2023-34), addressed this situation head-on. While the case was related to the donation of closely held stock, not using a qualified appraiser had a damaging impact on the taxpayer. The company whose shares were subject to the charitable gift had been marketed for sale by an investment banker prior to the gift. The taxpayer’s attorney suggested that the investment banker be considered to do the appraisal for the gifting because "since they have the numbers, it would seem to be the most efficient method."[14] In court, the petitioners argued that the investment banker was qualified because he had prepared "dozens of business valuations" over the course of his 20+ year career as an investment banker. According to the court, an individual’s “mere familiarity with the type of property being valued does not by itself make him qualified.” The court further noted that the investment banker “does not have appraisal certifications and does not hold himself out as an appraiser.” The court relied on testimony at trial about appraisal experience to be instructive, as the investment banker testified that he conducted valuations "briefly" and only "on a limited basis" before starting at the investment bank the year before the appraisal. The investment banker also testified that he performed (presumably at no charge) business valuations for prospective clients "once or twice a year" in order to solicit their business. The court found the investment banker’s “uncontroverted testimony sufficient to establish that he does not regularly perform appraisals for which [he] receives compensation." The end result for the taxpayer in Hoensheid: the Tax Court found that the taxpayer failed to comply with the qualified appraisal requirements and denied the charitable deduction.Appraisal StandardsOccasionally, buy-sell agreements lay out the specific business appraisal standards to be followed by the appraiser. Standards most often cited in buy-sell agreements are the Uniform Standards of Professional Appraisal Practice (commonly referred to as “USPAP”), the ASA Business Valuation Standards, AICPA’s Statement on Standards for Valuation Services No. 1 (commonly referred to “SSVS”) and NACVA’s Professional Standards. The Connelly SPA did not reference any of these standards. Without any appraisal standards referenced, any appraiser elected to perform a valuation under the SPA who was not a member of one of the national appraisal organizations has no requirement to follow any set of standards or code of ethics.Tax Court ConclusionsConnelly was first decided by the District Court in September 2021. Having been appealed by the estate, the Eighth Circuit affirmed the District Court’s decision in June 2023. The District Court Decision The IRS had contended that the life insurance proceeds should be included in the valuation of Crown C’s equity. The estate argued that the redemption obligation was a corporate liability that offset the life insurance proceeds dollar for dollar. The District Court sided with the IRS, noting that “Because the insurance proceeds are not offset by Crown C's obligation to redeem Michael's shares, the fair market value of Crown C at the date of date of death and of Michael's shares includes all of the insurance proceeds.”[15]The Circuit Court DecisionThe Circuit Court affirmed the District Court’s decision, noting “In sum, the brothers’ arrangement had nothing to do with corporate liabilities. The proceeds were simply an asset that increased shareholders’ equity. A fair market value of Michael’s shares must account for that reality.”[16]Current StatusShareholder buyouts often occur at inconvenient times, and poor planning can have financially devastating consequences. In Connelly, a poorly drafted buy-sell agreement resulted in a notice of deficiency from the IRS in the amount of $998,155 [17] and undisclosed legal and professional fees incurred to litigate the matter. The estate has sought a refund of $1,027,042 that it views was “erroneously, illegally, and excessively assessed against and/or collected from Plaintiff as federal estate tax…”[18] In August 2023, counsel for the estate filed with the Supreme Court of the United States a petition for a writ of certiorari to the United States Court of Appeals for the Eight Circuit. On December 13, 2023, the Supreme Court granted the petition for writ of certiorari, signifying its acceptance of the case for review. As of February 2024, the case had not yet been set for argument.[1] Courts have had differing opinions on the life insurance/valuation matter. In Estate of George C. Blount, Deceased, Fred B. Aftergut, Executor, v. Commissioner, the United States Court of Appeals, Eleventh Circuit ruled that life insurance proceeds used to redeem a stockholder’s shares do not count towards the fair market value of the company when valuing those same shares.[2] The buy-sell agreement that is the subject of Connelly was challenged by the IRS as invalid for controlling the valuation of the subject company’s stock in an estate tax scenario. The district and circuit courts both agreed and deemed the buy-sell agreement invalid.[3] Crown C was sold to SRS Distribution, Inc., a portfolio company of Leonard Green & Partners and Berkshire Partners, in 2018. Terms of the deal were not disclosed. Crown C continued to serve the St. Louis market as of the publication date of this article.[4] Amended and restated stock purchase agreement by and among Michael P. Connelly, trustee U/I/T dated 8/15/90, Michael P. Connelly, grantor, and Thomas A. Connelly, executed effective August 29, 2001.[5] Sale and purchase agreement by and among Thomas A. Connelly, trustee of The Michael Connelly Irrevocable Trust dated 15 August 1990, Crown C Supply Co., Inc., a Missouri Corporation, Thomas A. Connelly, individually, Connelly Partnership/Connelly, LLC, and 5200 Manchester, LLC, executed November 13, 2013.[6] Ibid.[7]Connelly v. United States, Memorandum and Order, page 21, September 2021.[8] Appeal from the United States District Court for the Eastern District of Missouri – St. Louis, No. 21-3683, page 3, filed June 2, 2023.[9] ($3.0 million / 385.9 shares) = $7,774 / share.[10] ($3.9 million / 114.1 shares) = $34,067 per share.[11] ($6.9 million / 500 shares)[12] Mercer, Z. Christopher, Buy-Sell Agreements for Closely Held and Family Business Owners (Peabody Publishing LP, 2010).[13] American Society of Appraisers Business Valuation Standards (approved through November 2009).[14] T.C. Memo. 2023-34; Estate of Scott M. Hoensheid, deceased, Anne M. Hoensheid, Personal Representative, and Anne M. Hoensheid, Petitioners, v. Commissioner of Internal Revenue Service, Respondent.[15] Connelly v. United States, Memorandum and Order, page 35, September 2021.[16] Appeal from the United States District Court for the Eastern District of Missouri – St. Louis, No. 21-3683, page 13, filed June 2, 2023[17] Complaint of Thomas A. Connelly, Executor of the Estate of Michael P. Connelly, Sr. dated May 23, 2019.[18] Ibid.Originally published in Mercer Capital's Value Matters Newsletter: Q1 2024

How would you spend $80 billion in new funding? Much politicking and articles have been written about the Inflation Reduction Act. One piece of that legislation that will impact every taxpayer is an increased IRS of roughly $80 billion over the next ten years. The Tax Foundation analyzed how the IRS plans to deploy additional funding, as shown in Figure 1.Figure 1 :: IRS Funding Increases per Inflation Reduction Act Noticing “money sent back to my bank account” didn’t make the list, one quickly notices “Enforcement” getting the largest dollar increase over the next ten years at nearly $46 billion. The IRS lists five objectives in its 2023 strategic operations plan. One of the objectives includes: “Focus expanded enforcement on taxpayers with complex tax filings and high-dollar noncompliance to address the tax gap.” Again, from the Tax Foundation: “Digging more into the specifics of enforcement, individual initiatives acknowledge some of the trade-offs in expanded enforcement operations. Within the third objective, dedicated to expanded enforcement, five of the seven initiatives involve expanded enforcement on certain types of taxpayers: large corporations, large partnerships, high-income and high-wealth individuals, other areas where IRS audit coverage has declined (including employment, excise, and estate and gift taxpayers), and developing areas such as digital assets.” A recent presentation by Stephanie Loomis-Price and Marissa Pepe Turrell at the ASA’s International Conference summarized 709 (gift) and 706 (estate) filings and audit rates, excerpted in Figure 2 below.Figure 2 :: Gift and Estate Tax Filings and Audit Rates Total gift tax audits have been just under 1% for the last decade, and estate tax audits have been around 10% on average, per Figure 2. And while audit rates have remained stable overall for gift and estate tax filings, one doesn’t have to connect too many dots to see that may be changing. Much has been written on declining audit rates, and policymakers have explicitly said they plan to audit wealthier Americans. So, with plenty of dry powder to beef up enforcement and looming changes to the estate tax horizon (including a reduction in the estate and gift tax exemption), family businesses and estate planners need to be cognizant of the changing tax landscape and increased audit scrutiny.3 Things Family Businesses Should Do When Selecting a Business AppraiserHow do business appraisers fit into this shifting gift and estate tax paradigm? If your gift tax return involves a business valuation, having a trusted and reputable valuation firm as part of your estate planning roster is more important than ever. Below are three criteria that can help you think about who you want in your corner.Insist on an appraiser with experience and credentials. Each business appraisal is unique, and experience counts. Most business valuation firms are generalists rather than industry specialists, but the experience gained in discussing operating results and industry constraints with a broad client base gives the appraisal firm substantial ability to understand the client’s specific situation. Credentials do not guarantee performance, but they do indicate a level of professionalism for having achieved and maintained them. Family businesses and their estate planning counsel should insist upon them.Involve the appraiser early on. One of the most common concerns such owners cite around long-term planning is the ability to transfer ownership of the family business to the next generation in the most tax-efficient way. Even in seemingly straightforward gift and estate tax planning, it is helpful to seek the advice of a business appraiser as part of the planning process. Understanding the finer points around fair market value, the levels of value, discounts for lack of marketability, and ultimately estimated tax liabilities are all questions a business appraiser should be able to provide feedback and guidance upon.Expect the best. In most cases, the fee for appraisal services is nominal compared to the dollars at risk. The marginal cost of getting the best is negligible. Family businesses can help their appraiser do the best job possible by ensuring full disclosure and expecting an independent opinion of value. The best appraisers have the experience and credentials described above but recognize the delicate balance between the inherent art and science when valuing private companies. Mercer Capital has been performing business appraisals for over 40 years and has a long track record of delivering reasonable and supportable business valuations. Our team of professionals is ready to help you and your clients navigate your valuation challenges.

One of the most exciting things in the vintage car world is when a classic model is “discovered” in a barn or a forest, or a field, covered in mud or dust or worse. Special because they’re untouched for decades, usually in original condition, and often with very little wear from use, these so-called “barn-finds” can sell for extraordinary sums at auction.Forgotten and ignored buy-sell agreements are also exciting, but usually not in a good way. Buy-sells tend to favor the business’s needs and the ownership’s thinking at a particular time. Decades later, the business has changed, the owners’ perspectives have matured, and the agreement—instead of being helpful—becomes a source of contention.Few RIA owners review their buy-sell agreements until something unexpected happensOur consistent experience is that few RIA owners review their buy-sell agreements until something unexpected happens. The partners argue over the future of the business. Someone gets divorced. Someone gets in trouble with the SEC. Someone dies suddenly. At that point, the buy-sell agreement goes from being a forgotten afterthought to the only thing on everyone’s mind. And, unfortunately, that one thing may be subject to interpretation.The biggest problem we see in shareholder agreements: pricing mechanisms.If a buy-sell is triggered and a 25% shareholder is to be redeemed, what’s the transaction price?The worst situations we’ve seen involved fixed-price agreements. Second to that, we’ve seen lots of problems with formula pricing.I probably don’t have to tell you what we think of formula pricing. Formula pricing has the benefit of simplicity, but simple isn’t always better.Is the formula a multiple of trailing, current, or forward earnings? Are appropriate multiples reflective of long-term averages, current market pricing, good times, bad times? Is the formula intended to generate a change of control value? To a financial buyer or a strategic buyer? Rational buyer looking for ROI or irrational buyer making a land grab? Pricing reflective of highly synergistic deal terms (use our vendors, sell our products, adopt our brand) or on a stand-alone basis? Sale of actual equity interests or a hybrid instrument that asymmetrically shares upside but protects the buyer against downside?In one situation, the agreement called for pricing an interest based on “prevailing market value.” What does that mean? Prevailing market conditions might work something like this:RIA with reported EBITDA of $5 million and adjusted EBITDA of $7 million when the LOI was drafted and reported EBITDA of $6 million and adjusted EBITDA of $8 million at the time of closing. Assume the firm sells for upfront consideration of $40 million plus the potential to get an additional $20 million in earnout if profits grow by 25% over three years. Based on this scenario, what’s the multiple? Is it:5x (upfront consideration as a multiple of adjusted EBITDA at closing)?6x (total possible consideration as a multiple of hurdle EBITDA at the time the earnout is paid)?7x (upfront consideration as a multiple of reported EBITDA at closing)?5x (total possible consideration as a multiple of adjusted EBITDA at closing)?8x (upfront consideration as a multiple of reported EBITDA at negotiation)?9x (total possible consideration as a multiple of adjusted EBITDA at negotiation)?10x (total possible consideration as a multiple of reported EBITDA at closing)?12x (total possible consideration relative to reported EBITDA when negotiated)?When people whisper deal multiples, they use the highest number possibleNaturally, the seller wants to believe they sold for 12x, and the buyer wants to tell his capital providers he paid 5x. It does no good to ask parties what multiple was paid. We find that when people whisper deal multiples, they use the highest number possible—in most cases, the maximum transaction proceeds possible as compared to a trailing measure of reported earnings. This serves the needs of all parties to the transaction. The seller gets to brag about what he was paid—and we all value psychological rewards. The investment banker brags about what a good job she did—and she probably did do a good job. And the buyer gets a reputation for paying up, so the potential sellers will return his call. All of this is good for the deal industry but not especially revealing as to valuation.Absent some reliance on formula pricing or headline metrics, you can hire an appraiser (like us), but even that’s complicated. Do you pick a valuation specialist or an industry expert? Valuation folks characteristically rely on projection models that might be more expressive of intrinsic value than market. That’s not me engaging in professional self-loathing—it’s just reality. Then there are industry experts—usually investment bankers—whose perspective leans heavily on the best deal they’ve heard of recently with a highly-motivated and over-capitalized buyer and a pristine target company with strategic relevance.If you hire a valuation expert with ample amounts of relevant industry experience (like us), you should get a balanced approach to the pricing of your transaction. But even the best resources out there (like us) have to deal with pricing expectations set long before we are involved. A buyer who wants something akin to intrinsic value and a seller who wants the highest bid imaginable will have a hard time coming to terms with the result of any valuation exercise. That situation is more common than not.I’ll offer two closing pieces of advice on crafting the valuation mechanism in your buy-sell agreement:Get your RIA valued on some kind of regular basis. If you have a smaller firm, a valuation every few years may suffice. If you have a larger firm, you might need it more than once per year. What this process offers, more than anything, is to manage expectations. The psychological bid/ask spread I describe above is much more narrow when the parties to an agreement are accustomed to seeing particular numbers, methodologies, and metrics used to determine the value of their interest. This is the main function of regular valuations. Buy-sell valuations are five-figure Buy-sell disputes are seven-figure catastrophes.Don’t draft your pricing mechanism to intentionally privilege either the buyer or seller at the expense of the other. We’ve seen estate situations where the company was compelled to redeem a 25% stake for about 45% of the value of the business. The resulting dilution to the remaining shareholders put a significant strain on the business model, ownership transition, and sustainability of the company. We’ve seen shareholder squeeze-outs where a group of shareholders was entitled to kick out a partner for minimal consideration. There’s no virtue in democracy when two lions and one lamb vote on what’s for dinner. Regardless of what you think your RIA is worth, if you aren’t intimately familiar with the terms of your buy-sell agreement, you don’t know what your interest in your RIA will net you in a transaction. Pull your agreement out, dust it off, and read it. If it seems at all confusing as to how it will function when the buy-sell mechanism is triggered, the reality will be worse than you expect.

Over the last few weeks, I’ve had both professional and personal conversations with family business owners who utilized a business transaction to maximize their charitable giving and minimize their tax burden. While taxes are not generally the primary driver in making large gifts to charity, a little foresight and planning can create flexibility in your giving, yield more bang for your buck, and result in fewer taxes owed to Uncle Sam. In this week’s post, we discuss the tax strategy that charitable family business owners should keep in mind when selling their business.Charitable Gifts and Business TransactionFor many family businesses, the original cost basis of their business ownership interest is extremely low, if not zero. If you have received stock via gifting, your stock’s basis is "carried over" from the original donor (or was the stock's fair market value at the time of the gift). In short, for many family businesses, any sale likely has quite a large built-in capital gains tax, especially if your family business has generated solid returns over generations.So, where’s the beef? A donation of some portion of your family’s business ownership in its business prior to a sale provides two benefits:A charitable tax deduction for the fair market value of the interest at the time the gift is made.Minimized capital gains exposure for the portion donated and sold by the charity rather than the family. Below we provide an example and some thoughts on this strategy.Utilizing a Donor Advised FundA donor-advised fund, or "DAF," is a flexible and tax-efficient way to give to charities. A DAF operates like a charitable investment account for the sole purpose of supporting charitable organizations. When taxpayers contribute assets, such as cash, stock, or other (read: private business stock) assets to a DAF, they can take an immediate tax deduction, avoid capital gains recognition, and grow the donation tax-free.A primary benefit of using a DAF to implement this gifting strategy is a practical one. Many charities are not structured to take stock of privately held companies, whereas organizations that support DAFs are able to handle the complexities around private family-owned stock gifts.Gift TimingAs the saying goes, "Pigs get fat, hogs get slaughtered." If you already have a legally-binding transaction agreement in place, this strategy is less useful, and the IRS is not likely to allow recognition of the gift. However, a non-binding letter of intent ("LOI"), where each side can leave the table, meets the bill. For the gift, a qualified appraisal would likely give significant weight to the pro rata offer on the table in measuring fair market value. The likelihood of a near-term transaction would also limit the typical discounts for lack of marketability or control. This would maximize the value of the ownership interest for gifting purposes.This works for donating stock to charity broadly, not just in a business transaction context. However, if a path to liquidity is not on the horizon, discounts for lack of control and marketability are likely to be more significant. This lowers the total fair market value of your gift, reducing tax savings at the time of the gift. On the flip side, if the gift is made to a DAF, as discussed, the ownership interest may be held and grow as the business value grows. At a business exit, your DAF reaps the benefits of the sale and avoids the capital gains tax on that portion of ownership, maximizing future charitable gifts from the DAF.Qualified AppraisalIf you’re reading this blog, you may have guessed this already; Gifts of private family ownership interests require qualified appraisals per the IRS. We talk about what amounts to a "qualified appraisal" and how to pick a qualified business appraiser here.Tax Benefits of PlanningTo illustrate the benefits of this strategy, consider two alternative scenarios: (1) the business owner contributes to charity using funds after a sale of the business (“post-sale”), or (2) the business owner contributes stock to charity prior to the deal closing ("prior-to-sale"). We’ll briefly summarize Figure 1 below.In both scenarios, the value of the gift is assumed at $3.5 million. This represents the pro rata cash proceeds in the post-sale scenario and the value of the privately held stock based on a qualified appraisal (which referenced the non-binding LOI purchase price in developing the conclusion of fair market value) in the prior-to-sale scenario.In the post-sale scenario, the business owner pays a capital gains tax on the appreciation in the stock, or $700,000 (20% of $3.5 million, assuming a $0 basis). In the prior-to-sale scenario, the business owner avoids the capital gains tax because the stock was gifted to a DAF.Under both scenarios, the business owner is entitled to a charitable deduction of $1.295 million for income tax purposes.The total tax benefit in the post-sale scenario is $595,000 ($1.295 million less the capital gains tax paid of $700,000). The prior-to-sale scenario’s total tax benefit is $1.295 million, or $700,000 higher.Final ThoughtsAs we said in the beginning, tax considerations are generally on the back burner when considering major gifts. While gifts of family business stock can be complex, the benefits of the strategy and the impact it can have are too significant to ignore. We’ve worked with business owners to provide qualified appraisals for gifting purposes in both a charitable and estate planning context. Give us a call if you want to discuss a gifting strategy you are contemplating in confidence.Note: The example here and tax ramifications are for illustration only. This article does not consider state, AMT, or other complex tax situations. The value of stock in your situation may not equal post-sale pro rata proceeds. Please consult your independent appraiser and tax advisor regarding your situation and potential tax consequences.

Many enterprising families have January 1, 2026, circled on their calendars. Why? Because the individual estate tax exemption reverts to $6 million (give or take, depending on inflation) in 2026 from its current level of $12 million. As a result, many estates that are not currently large enough to be taxable will become so, and the effective tax rate for all estates will increase.A recent Wall Street Journal article highlighted the benefits, and potential downsides, of family limited partnerships, or FLPs (and their close cousin, the family limited liability company).The “magic” of the FLP is the ability to transfer assets to heirs, and out of taxable estates, at discounted values. The WSJ article points out that the IRS is skeptical of many FLP planning strategies, noting that audit challenges may become more frequent as the IRS puts its new $80 billion enforcement budget to work.While the valuation discounts applicable to FLPs may seem like estate planning magic, there really is no sleight-of-hand involved. Instead, valuation discounts reflect economic reality.Fair Market Value Is an Arm’s-Length StandardEstate planning transfers must be accounted for using the “fair market value” of the subject interest. Revenue Ruling 59-60 offers the following definition for fair market value: “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”Fair market value describes how a transaction involving the subject interest would occur between two “willing” parties, both of whom have reasonable knowledge of relevant factsThere’s a lot there, but for this post, we will simply highlight that fair market value is not determined with respect to a specific buyer or seller and therefore does not consider any familial relationship between the transferor and transferee in an exchange. Rather, fair market value describes how a transaction involving the subject interest would occur between two “willing” parties, both of whom have reasonable knowledge of relevant facts.Under this standard of value, business appraisers typically value interests in FLPs using a three-step approach.The Market Value Balance SheetThe first step is to compile a listing of all assets owned by the FLP, reduced by any liabilities. FLPs hold all kinds of assets, some of which have more readily ascertainable values than others. So, for some FLPs, the market value balance sheet can be constructed simply by referring to a brokerage statement, while other assets, like shares in a family business, will require a separate valuation process. Once the market values of the assets and liabilities have been determined, the difference between the two, referred to as “net asset value” or “NAV,” provides the starting point of the valuation analysis.It's Nice to Be in ChargeIf the subject interest possessed sole discretion over the operations of the FLP, net asset value would be an appropriate proxy for fair market value. After all, rather than sell the interest at a discount, the holder of such an interest would instead liquidate the underlying assets and settle the liabilities of the FLP, thereby realizing the net asset value.However, the FLP interests used in estate planning transfers rarely have such authority (as would be possessed by a sole general partner). Small, limited partner interests lack the ability to direct the operations of the FLP or force the liquidation or distribution of the underlying assets. Willing buyers operating under the fair market value standard are wary of such investments. All else equal, they prefer to be the ones making the key investment and operational decisions. When submitting to someone else’s decisions, they demand a higher return on their investment by applying a discount to the pro rata share of net asset value.This reflects a simple economic reality: minority interests in asset portfolios are worth less than the corresponding share of net asset value. There is ample real-world evidence supporting this conclusion in the market for shares in closed-end funds, which regularly trade at discounts to NAV.It’s Even Better to Be LiquidThat is where the similarities between FLP interests and shares in closed-end funds end, however. Unlike investors in closed-end funds who can quickly convert their shares to cash, there is little to no liquidity for most interests in FLPs. All else equal, investors tend to prefer liquid assets to illiquid ones. As a result, our “willing buyer” from the fair market value definition requires an additional discount to be convinced to buy a minority interest in an FLP.The discount appropriate to your family limited partnership interest will be a function of four primary economic characteristicsOnce more, this discount is no mere valuation parlor trick but instead reflects economic reality. The discount appropriate to your family limited partnership interest will be a function of four primary economic characteristics:Duration of the expected holding period. Since investors prefer liquidity, the longer a willing buyer would expect to be stuck holding the FLP interest, the larger the discount.Magnitude of expected distributions. Even when not readily marketable, some FLP interests receive regular distributions (beyond those needed to pay pass-through tax liabilities), while others receive none. The greater the magnitude of the expected interim distributions, the lower the discount.Expected capital appreciation of underlying assets. For the willing buyer, returns can only come from two sources: distributions (accounted for above) and capital appreciation. All else equal, the faster the underlying FLP assets are expected to grow in value, the smaller the discount.Holding period risks. Return follows risk, and owning the subject FLP interest is riskier than owning the underlying assets outright. The more incremental risk associated with the subject FLP interest, the greater the return required by the willing buyer, resulting in a larger discount.Be Sure the FLP Structure Is Right for Your FamilyValuation discounts for FLPs are not convoluted mirror tricks on the part of appraisers but rather reflect the straightforward economic reality of FLP interests. However, for these discounts to withstand IRS scrutiny, the economic reality we’ve described in this post must match, well, reality. As noted in the WSJ article, families forming FLPs should be prepared to live with the economic reality of having an FLP, including identifying and adhering to a clear business purpose, formal meetings, and pass-through taxes.We have valued minority interests in well over 1,000 FLPs over the past forty years. We don’t know if an FLP is right for your family, but if you and your tax and legal advisors conclude that it is, give one of our valuation professionals a call to see how we can help you.

“Ohana” means family…family means nobody gets left behind or forgotten. Lilo & Stitch, the Disney film about a family and an alien, taught us this just over 20 years ago. This is especially true in a family business as family business directors need to work together to ensure they are moving forward together, as a business and more importantly, as a family. As seen on the big screen with Lilo & Stitch, in family business meetings, and maybe even at the dinner table, Ohana is easier said than done. Sometimes your family does, in fact, act alien to you. But at the end of the day, family is vital to who we are and what we do.What Should We Do About Estate Taxes?Most family business owners desire to provide financially for their family. Due to this, one of the widespread concerns of these owners is the ability to transfer ownership of the family business to the next generation in the most tax-efficient way.The Estate Tax is a tax on your right to transfer property at your death. The tax is calculated based on the "decedent’s gross estate," less the taxpayer’s remaining gift and estate tax deduction, which in 2022 is $12.06 million per individual ($24.12 million per couple), as well as other specific deductions. A unique issue for family business owners is that a substantial portion of their estate often consists of illiquid interests in private company stock. If this is the case, liquidating assets to pay the estate tax may prove more difficult as estate taxes are payable only in cash. Family businesses may have to be sold or forced to borrow money to fund the payment of a decedent’s estate tax liability.Keep in Mind Fair Market Value and the Level of ValueThe concept of fair market value is essential to understanding and evaluating any estate planning strategy. For brevity’s sake, fair market value, or “FMV,” is defined by the IRS as the price at which the property would change hands between a willing buyer and seller, not under compulsion to buy or sell, and both having reasonable knowledge regarding specific facts and circumstances regarding the transaction. The IRS is clear, per Revenue Ruling 59-60, that appropriate discounts, or reductions in value, are allowed to account for the fact that the shares in the family business are privately held rather than publicly traded.How does FMV, or the standard of value, intersect with the “level of value”? For example, if an estate owns a controlling interest in a family business (more than 50% of the stock), the FMV of those shares will reflect the estate’s ability to sell the business. In contrast, the owner of a small minority block of the outstanding shares in the family business cannot force the business to change strategy, seek a sale, or unilaterally compel any action. The level of value chart captures two common-sense notions: investors prefer control rather than not, and they prefer liquidity to illiquidity. The magnitude of a lack of control and lack of marketability adjustment depends on specific factors of the subject interest being transferred, but unsurprisingly investors prefer to have control and a ready market for their shares.It’s Not All TaxesMinimizing taxes is one possible objective of an estate planning process, along with asset protection, business continuity, and providing for loved ones. Families should be careful not to let the tax tail wag the business dog; families should consult legal, accounting, and valuation advisors who understand their business needs and family dynamics to ensure that their estate plan accomplishes the desired goals.Families should be careful not to let the tax tail wag the business dogAs an example, one objective of most estate planning techniques is to ensure that no individual owns a controlling interest in the family business at his or her death. However, is the patriarch/matriarch ready to hand the reigns to the next generation? Is the next generation ready? Management and business concerns may need to prioritize the tax/liability side of the equation based on the family and its dynamics.What Now?Some potential next steps include:Review the current shareholder list & ownership table: Based on the current shareholder list, are there any shareholders that – were the unexpected to happen – would be facing a significant estate tax liability?Identifying current estate tax exposures: Will shareholders have to look to the family business to redeem shares or make special distributions to fund estate tax obligations?Identify tax & non-tax goals of the estate planning process: If there was no estate tax, what evolution would be the most desirable for your family and business?Obtain a current opinion of the fair market value of the business at each level of value (control, marketable minority, and nonmarketable minority). We are just a phone call or an email away.

As we highlighted previously in the Family Business Director blog, companies are beginning to batten down the hatches and prepare for stormy weather. The risk of a recession continues to escalate, and inflation printed a new four-decade high in May. Former Fed Chair and current Treasury Secretary, Janet Yellen, appeared before Congress to answer questions regarding inflation, which she sees as staying elevated for an extended period. Gas prices hit a nationwide average of $5 a gallon for the first time ever in the United States, and little relief is on the horizon.The Fed expects to continue raising rates to battle inflation, and a new law was passed unanimously in the House and Senate to ban the word “transitory,” which awaits President Biden’s signature. Well, maybe the last one was just floated in committee.All to say, companies and consumers alike are feeling the squeeze, and markets are reflecting less-than-rosy expectations. At the time of this writing, the S&P 500 was down almost 16% year-to-date, while the Russell 2000 was down almost 19%. Outside the energy sector, stocks are bleeding red in 2022. Lower broad market pricing translates to lower valuations for family businesses.Click here to enlarge the imageSo what? Well, for family businesses undertaking long-term intrafamily transfers and gifting plans, a market downturn represents an opportunity to reduce estate and gift tax exposure by considerable margins. How? We explain below.Fair Market ValueIf you are reading this post, you are likely familiar with the gift and estate tax process in the valuation of private company stock. To consummate an intrafamily transfer (via gift or sale) companies generally must retain a business appraiser to determine the fair market value of shares. Appraisers use a two-step process:Appraisers estimate the value of the business as if the shares were publicly traded. In other words, they consider how public market investors would view the shares if they had the opportunity to purchase them in the stock market.Appraisers consider an appropriate discount, or reduction in value, to account for the fact that the shares in the family business are privately held, rather than publicly traded. All else equal, investors prefer to have liquidity. In order to accept the illiquidity inherent in private company shares, investors require a marketability discount. The size of the marketability discount depends on several factors, including the expected holding period, yield, capital appreciation, and incremental risks associated with illiquidity.Based on the downturn in the market, the fair market value of minority shares in family businesses is likely lower today than it was just a couple of months ago. It does not matter if your family has no intention of selling the family business at a reduced value; the fact is that – if you were to sell an illiquid minority interest now – the value would reflect current market conditions. The IRS itself makes this clear in Revenue Ruling 59-60:The fair market value of specific shares of stock will vary as general economic conditions change from ‘normal’ to ‘boom’ to ‘depression,’ that is, according to the degree of optimism or pessimism with which the investing public regards the future at the required date of appraisal. Uncertainty as to the stability or continuity of the future income from a property decreases its value by increasing the risk of loss of earnings and value in the future.The potential silver lining to the cloud of depressed market values is that it provides an opportunity for more tax-efficient transfers of family wealth for estate planning purposes.Long-Term Mindsets and Estate PlanningFactors leading stocks lower are real and are affecting public and private companies alike: continued supply chain bottlenecks, rising input prices and limited ability to pass along to consumers, distressed margins, and low consumer confidence all will cause pain in the short term. However, private family businesses have the benefit of time, and a resilient family business should return to form once issues plaguing markets subside. Exhibit 2 depicts the expected value trajectory for a family business, including a bear market downturn.The immediate impact is straightforward: the magnitude of the dollar gift for the same amount of ownership or stock is reduced relative to prior periods. Exhibit 3 shows a simple example of the current market downturn on transfers of private company stock.How does this benefit private companies engaged in estate planning?If the transfer is a gift, the debit against the lifetime estate and gift tax exemption of the gifting party is reduced, leaving more room to make future gifts (both estate and gift) tax-free. Since the ownership percentage transferred remains the same, the receiver’s resulting ownership percentage is unchanged.If the transfer is a sale, the buyer (likely a younger generation) can buy into the business at a more favorable price.Both of these strategies reduce the transferer’s total estate by a larger amount, assuming measurement of the estate (ie, death) comes later once the company’s valuation has recovered.Final Thoughts – Keep an Eye on Rates and the CalendarA couple of final thoughts you should also keep in mind related to estate planning in the current environment.Private Loan Rates: The IRS publishes monthly tables identifying what is known as the applicable federal rate or AFR. The AFR is significant for estate planning because it establishes the threshold interest rate for private loans. While rates have ticked up, rates are still well below commercially available rates. The Federal Reserve is, however, planning to aggressively continue hiking rates to battle inflation, making these “on-sale” prices unlikely to last.For family businesses and estate planners, while the transfer exemptions remain at current levels, they are still set to drop by 50% on January 1, 2026. The Treasury Department has confirmed the additional transfer tax exemption under current law is a “use it or lose it” benefit. If a taxpayer uses the “extra” exemption before it expires (by making lifetime gifts), it will not be “clawed back” to cause additional tax if the taxpayer dies after the exemption is reduced. The window to capture the current exemption is undoubtedly closing, and family businesses will likely only get so many more bites at this apple before it turns sour.The example in this post is simple and perhaps obvious, and our reminders may be old news. However, we understand it is hard to have a long-term mindset when things take a sudden downward turn. Being opportunistic in stormy weather makes for better sunny days ahead.

Following up on last week’s post (Three Considerations for Your RIA’s Buy-Sell Agreement), we offer four additional considerations that you should be addressing in your firm’s buy-sell agreement. We’ve seen each of these issues neglected before, which usually doesn’t end well for at least one of the parties involved. A well-crafted buy-sell should clearly acknowledge these considerations to avoid shareholder disputes and costly litigation down the road. We highly recommend taking another look at your buy-sell agreement to see if these issues are addressed before something comes up.1. Formula Pricing, Rules-Of-Thumb, and Internally Generated Valuation Metrics Don’t Withstand TimeSince valuation is usually the most time consuming and expensive part of administering a buy-sell agreement, there is a substantial incentive to try to shortcut that part of the process. However, non-professional valuation methods, such as formula pricing, rules-of-thumb, and internally generated valuation metrics are often key reasons for costly disputes or disruptions down the road. The investment management space is particularly fraught, and not too long ago, investment manager valuations were thought to gravitate toward about 2% of AUM.We have written extensively about the fallacy of formula pricing. No multiple of AUM, revenue, or cash flow can consistently estimate the value of an interest in an investment management firm. A multiple of AUM (typically expressed in percentage terms) does not consider relative differences in stated or realized fee schedules, client demographics, trends in operating performance, current market conditions, compensation arrangements, profit margins, growth expectations, regulatory compliance issues, and a host of other issues which have helped keep our valuation practice gainfully employed for decades.The example below demonstrates the problematic nature of this particular rule of thumb for two investment management firms of similar size, but widely divergent fee structures and profit margins.Both Firm A and Firm B have the same AUM. However, Firm A has a higher realized fee than Firm B (100 bps vs 40 bps) and also operates more efficiently (25% EBITDA margin vs 10% EBITDA margin). The result is that Firm A generates $2.5 million in EBITDA versus Firm B’s $400 thousand despite both firms having the same AUM. The “2% of AUM” rule of thumb implies an EBITDA multiple of 8.0x for Firm A—a multiple that may or may not be reasonable for Firm A given current market conditions and Firm A’s risk and growth profile – but which is nevertheless within the historical range of what might be considered reasonable. The same “2% of AUM” rule of thumb applied to Firm B implies an EBITDA multiple of 50.0x – a multiple which is unlikely to be considered reasonable in any market conditions.Flawed ownership models eventually disrupt operations which works to the disservice of owners, employees, and clients.We’ve seen rules of thumb like the one above appear in buy/sell agreements and operating agreements as methods for determining the price for future transactions among shareholders or between shareholders and the company. The issue, of course, is that rules of thumb do not have a long shelf life, even if they made perfect sense at the time the document was drafted. If value is a function of company performance and market pricing, then both of those factors have to remain static for any rule-of-thumb to remain appropriate. This circumstance, obviously, is highly unlikely.But the real problem with short cutting the valuation process is credibility. If the parties to a shareholder’s agreement think the pricing mechanism in the agreement isn’t robust, then the ownership model at the firm is flawed. Flawed ownership models eventually disrupt operations which works to the disservice of owners, employees, and clients.2. Don’t Forget to Specify the “As Of” Date for ValuationThis seems obvious, but the date appropriate for the valuation matters. If the buy-sell agreement specifies that value is established on an annual basis (something we highly recommend to manage expectations and avoid confusion), then the date might be the calendar year end. If, instead of having annual valuations performed, you opt for an event-based trigger mechanism in your buy-sell, there is a little more to think about.Consider whether you want the event precipitating the transaction to factor into the value. If so, prescribe that the valuation date is some period of time after the event giving rise to the subject transaction. This can be helpful if a key shareholder passes away or leaves the firm, and there is concern about losing clients as a result of the departure. After an adequate amount of time, the impact on firm cash flows of the triggering event becomes apparent. If, instead, there is a desire to not consider the impact of a particular event on valuation, make the as-of date the day prior to the event, as is common in statutory fair value matters.3. Appraiser Qualifications: Who Will Perform the Valuation?Once you decide to engage a professional to value your firm, you’ll need reasonable criteria to decide whom to work with. Often, partners in investment management firms feel they are equipped to value their own business as investment management firms (unlike many other closely held businesses) have ownership groups with ample training in relevant areas of finance that enable them to understand financial statement analysis, cash flow forecasting, and market pricing data.What insiders lack, however, is the arms’ length perspective to use their technical skills to determine an unbiased result. Many business owners suffer from familiarity bias and the so-called “endowment effect” of ascribing more value to their business than what it is actually worth simply because it is well-known to them or because it is already in their possession. On the opposite end of the spectrum, some owners are prone to forecast extreme mean reversion such that they discount the outperformance of their business and anticipate only the worst.Partners with a strong grounding in securities analysis and portfolio management have a bias to seeing their business from the perspective of intrinsic value, which can limit their acceptance of certain market realities necessary to price the business at a given time. In any event, just as physicians are cautioned not to self-medicate and attorneys not to represent themselves, so too should professional investment advisors avoid trying to be their own appraiser.Over time, we have reviewed a wide variety of work product from different types of service providers - but have generally observed that there are two types of experts available to the ownership of investment management firms: Valuation Experts and Industry Experts. These two types of experts are often seen as mutually exclusive, but you’re better off not hiring one to the exclusion of the other.Valuation experts can do better work for clients if they specialize in a type of valuation or a particular industry.There are plenty of valuation experts who have the appropriate training and professional designations, understand the valuation standards and concepts, and see the market in a hypothetical buyer-seller framework. The two primary credentialing bodies for business valuation are the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA). The former awards the Accredited Senior Appraiser designation, or ASA, and the latter the Accredited in Business Valuation, or ABV, designation. Both require extensive education and testing to become credentialed, along with continuing education. Also well known in the securities industry is the Chartered Financial Analyst designation issued by the CFA Institute. While it is not directly focused on valuation, it is a rigorous program in securities analysis.There are also a number of industry experts who are long-time observers and analysts of the industry, who understand industry trends, and who have experience providing advisory services to investment management firms.However, business valuation practitioners are often guilty of shoehorning RIAs into generic templates, resulting in flawed valuation conclusions that don’t square with market realities. By contrast, industry experts are frequently guilty of a lack of awareness concerning the use and verification of unreported market data, the misapplication of valuation models, and not understanding the reporting requirements of valuation practice.We think it is most beneficial to be both industry specialists and valuation specialists. The valuation profession is still, for the most part, populated with generalists. But as the profession matures, an increasing number of analysts are realizing that it isn’t possible to be good at everything. Valuation experts can do better work for clients if they specialize in a type of valuation or a particular industry. Because our firm has specialized in valuing financial institutions since the day we opened for business in 1982, it was easy to pursue this to its logical conclusion. Ultimately, you want an expert with both professional standards and practical experience.4. Manage Expectations by Testing Your AgreementNo matter how well written your agreement is or how many factors you consider, no one really knows what will happen until you have your firm valued. If you are having a regular valuation prepared by a qualified expert, then you can manage everyone’s expectations such that, when a transaction situation presents itself, parties to the transaction have a reasonably good idea in advance of what to expect. Managing expectations is the first step to avoiding arguments, strategic disputes, failed partnerships, and litigation.Annual valuations do require some commitment of time and expense, of course, but these annual commitments to test the buy-sell agreement usually pale in comparison to the time and expense required to resolve one major buy-sell disagreement. If you don’t plan to have annual valuations prepared, have your company valued anyway. Doing so when nothing is at stake will make a huge difference if you get to a situation where everything is at stake.Most of the shareholder agreement disputes we are involved in start with dramatically different expectations regarding how the valuation will be handled. Going ahead and having a valuation prepared will help to center, or reconcile, those expectations and might even lead to some productive revisions to your buy-sell agreement.

Working on your RIA’s buy-sell agreement may seem like an inconvenience, but the distraction is minor compared to the disputes that can occur if your agreement isn’t structured appropriately. Crafting an agreement that functions well is a relatively easy step to promote the long-term continuity of ownership of your firm, which ultimately provides the best economic opportunity for you and your partners, employees, and clients. If you haven’t looked at your RIA’s buy-sell agreement in a while, we recommend dusting it off and reading it in conjunction with the discussion below.Decide What’s FairA standard refrain from clients crafting a buy-sell agreement is that they “just want to be fair” to all the parties in the agreement. That’s easier said than done because fairness means different things to different people. The stakeholders in a buy-sell scenario at an investment management firm typically include the founding partners, subsequent generations of ownership, the business itself, non-owner employees of the business, and the clients of the firm. It is nearly impossible to be “fair” to that many different parties, considering their different motivations and perspectives.Clients. Client relationships are often the single most valuable asset that an asset or wealth management firm possesses, and avoiding internal disputes is crucial to maintaining these relationships. Beyond investment advice, clients pay for an enduring and trusting relationship with their investment manager. As the profession ages and ownership transitions to a new generation of management, we see a well-functioning buy-sell agreement and broader succession planning as either a competitive advantage (if done well) or a competitive disadvantage (if disregarded).Founding owners. Aside from wanting the highest possible price for their interest in the firm, founding partners usually want to have the flexibility to work as much or as little as they want to, for as many years as they so choose. These motivations may be in conflict with each other, as winding down one’s workload into a state of partial retirement and preserving the founding generation’s imprint on the company requires a healthy business, which in turn requires consideration of the other stakeholders in the firm.Subsequent generation owners. The economics of a successful investment management firm can set up a scenario where buying into the firm can be very expensive, and new partners naturally want to buy as cheaply as possible. Eventually, however, there is a symmetry of economic interests for all shareholders, and buyers will eventually become sellers. Untimely events can cause younger partners to need to sell their stock, and they don’t want to be in a position of having to give it up too cheaply.The firm itself. The company is at the hub of all the different stakeholder interests and is best served if ownership is a minimal distraction to the operation of the business. Since handwringing over ownership rarely generates revenue, having a functional shareholders’ agreement that reasonably provides for the interests of all stakeholders is the best-case scenario for the firm. If firm leadership understands how ownership is going to be handled now and in the future, they can be free to focus on maximizing the performance of the company while at the same time avoiding costly disputes over ownership.Non-owner employees. Not everyone in an investment management firm qualifies for ownership or even wants it, but all RIAs are economic eco-systems in which all employees depend on the presence of stable and predictable ownership. The point of all this is to consider whether or not you want your buy-sell agreement to create winners and losers, and if so, be deliberate about defining who wins and who loses. Ultimately, economic interests which advantage one stakeholder will disadvantage some or all of the other stakeholders. If the pricing mechanism in the agreement favors a relatively higher valuation, then whoever sells first gets the biggest benefit of that at the expense of the other partners and anyone buying into the firm. If pricing is too high, internal buyers may not be available, and the firm may need to be sold to perfect the agreement. At relatively low valuations, the internal transition is easier, and business continuity is more certain, but the founding generation of ownership may be perversely encouraged not to bring in new partners, stay past their optimal retirement age, or push more cash flow into the compensation instead of shareholder returns as the importance of ownership is diminished. Recognizing and ranking the needs of the various stakeholders in an investment management firm is always a balancing act, but one which is typically best done intentionally.Define the Standard of ValueStandard of value is an abstraction of the circumstances giving rise to a particular transaction. It imagines the type of buyer, the type of seller, their relative knowledge of the subject asset, and their motivations or compulsions. Identifying and clearly defining the standard of value in your buy-sell agreements will save time and money when triggering events occur.Portfolio managers are familiar with certain perspectives on value, such as market value (the price at which a company’s stock trades) and intrinsic value (what they think the security is worth, based on their own valuation model). None of these standards of value are particularly applicable to buy-sell agreements, even though technically they could be. Instead, valuation professionals such as our group look at the value of a given company or interest in a company according to standards of value such as fair market value or fair value, among others.Identifying and clearly defining the standard of value in your buy-sell agreements will save time and money when triggering events occur.In our world, the most common standard of value is fair market value, which applies to virtually all federal and estate tax valuation matters, including charitable gifts, estate tax issues, ad valorem taxes, and other tax-related issues. It is also commonly applied in bankruptcy matters.Fair market value has been defined in many court cases and in Internal Revenue Service Ruling 59-60. It is defined in the International Glossary of Business Valuation Terms as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.The benefit of the fair market value standard is familiarity in the appraisal community and the court system. It is arguably the most widely adopted standard of value, and for a myriad of buy-sell transaction scenarios, the perspective of disinterested parties engaging in an exchange of cash and securities for rational financial reasons fairly considers the interests of everyone involved.For most buy-sell agreements, we would recommend one of the more common definitions of fair market value.The standard of value is critical to defining the parameters of a valuation. We would suggest buy-sell agreements should name the standard and cite specifically which definition is applicable. The downsides of an ambiguous or home-brewed definition can be severe. For most buy-sell agreements, we would recommend one of the more common definitions of fair market value.The advantage of naming fair market value as the standard of value is that doing so invokes a lengthy history of court interpretation and professional discussion on the implications of the standard, which makes application to a given buy-sell scenario clearer.Define the Level of ValueValuation theory suggests that there are various “levels” of value applicable to a business or business ownership interest. From a practical perspective, the “level of value” determines whether any discounts or premiums are applied to a baseline marketable minority level of value. Given the potential for valuation disputes regarding the appropriate level of value, buy-sell agreements function best when they memorialize the parties’ understanding of what level of value will be used in advance of a triggering event occurring.Most portfolio managers and financial advisors will already be familiar with the concept of “levels of value,” but they may be unfamiliar with the terminology used in the valuation profession to describe these levels. A minority position in a public company with active trading typically transacts as a pro rata participant in the cash flows of the enterprise because the present value of those cash flows is readily accessible via an organized exchange. This is known as the “marketable minority” level of value in the appraisal world. Portfolio managers usually think of value in this context until one of their positions becomes subject to acquisition in a takeover by a strategic buyer. In a change of control transaction, there is often a cash flow enhancement to the buyer and/or seller via combination, such that the buyer can offer more value to the shareholders of the target company than the market grants on a stand-alone basis. The difference between the publicly traded price of the independent company and the value achieved in a strategic acquisition is commonly referred to as a control premium.Closely held securities, like common stock interests in RIAs, don’t have active markets trading their stocks, so a given interest might be worth less than a pro rata portion of the overall enterprise. In the appraisal world, we would express that difference as a discount for lack of marketability. Sellers will, of course, want to be bought out pursuant to a buy-sell agreement at their pro rata enterprise value. Buyers might want to purchase at a discount (until they consider the level of value at which they will ultimately be bought out). In any event, the buy-sell agreement should consider the economic implications to the investment management firm and specify what level of value is appropriate for the buy-sell agreement. Fairness is a consideration here, as is the sustainability of the firm. If a transaction occurs at a premium or a discount to pro rata enterprise value, there will be “winners” and “losers” in the transaction. This may be appropriate in some circumstances, but in most investment management firms, the owners joined together at arms’ length to create and operate the enterprise and want to be paid based on their pro rata ownership in that enterprise. That works well for the founders’ generation, but often the transition to a younger and less economically secure group of employees is difficult at a full enterprise-level valuation.In any event, the buy-sell agreement should consider the economic implications to the investment management firm and specify what level of value is appropriate for the buy-sell agreement.Further, younger employees may not be able to get comfortable with buying a minority interest in a closely held business at a valuation that approaches change of control pricing. Typically, there is often a bid/ask spread between generations of ownership that has to be bridged in the buy-sell agreement, but how best to do it is situation-specific. Whatever the case, the shareholder agreement needs to be very specific as to the level of value.Does the pricing mechanism create winners and losers? Should value be exchanged based on a control level valuation that considers buyer-seller specific synergies, or not? Should the pricing mechanism be based on a value that considers valuation discounts for lack of control or impaired marketability? Exiting shareholders want to be paid more and continuing shareholders want to pay less, obviously. What’s not obvious at the time of drafting a buy-sell agreement is who will be exiting and who will be continuing.There may be a legitimate argument to having a pricing mechanism that discounts shares redeemed from exiting shareholders, as this reduces the burden on the firm or remaining partners and thus promotes the firm's continuity. If exit pricing is depressed to the point of being punitive, the other shareholders have a perverse incentive to retain their ownership longer and force out other shareholders artificially. As for buying out shareholders at a premium value, the only argument for “paying too much” is to provide a windfall for former shareholders, which is even more difficult to defend operationally. Still, all buyers eventually become sellers, so the pricing mechanism has to be durable for the life of the firm.ConclusionKeeping the above considerations in mind when drafting or updating your buy-sell agreement will help create a document that promotes the sustainability and orderly ownership transition of the firm while balancing the interests of the firm’s various stakeholders and the firm itself. However, this is far from an exhaustive list of things to consider when constructing your buy-sell agreement. In next week’s post, we’ll discuss additional parameters that should be addressed when constructing your buy-sell agreement.

Over the next several weeks, we will be publishing a series of blog posts discussing the importance of buy-sell agreements and other adjacent topics for RIA owners. Ownership is perhaps the single greatest distraction for advisors looking to grow with their firm, but it can also be an opportunity to align interests and ensure continuity of the firm in a way that is accretive for the firm’s founders, next generation management, and clients. As highlighted in the Charles Schwab 2021 RIA Benchmarking Study, planning for a successful transition of ownership — whether through internal succession or a strategic sale – continues to be a key differentiator among top RIA performers.Most wealth management firms are closely held, so the value of the firm is not set by an active market. They are typically owned by unrelated parties, whereas closely held businesses in other industries are often owned by members of the same family. In recent years, the profitability and value of many wealth management firms have increased substantially as assets under management have risen with the markets and a proliferation of capital aimed at the wealth management sector has bid up multiples. As a result of these dynamics, there is usually more than enough cash flow to fund the animosity when disputes arise, and what might be a five-figure settlement in some industries is a seven-figure trial for an RIA.Avoiding expensive litigation is one reason to focus on your buy-sell agreement, but for most firms, the more compelling reasons revolve around transitioning ownership to perpetuate the firm and provide liquidity for retiring partners. Clients increasingly seem to ask us about business continuity planning—and for good reason. In times of succession, tensions can run high. Having a clear and effective buy-sell agreement is imperative to minimizing costly and emotional drama that may ensue in times of planned or unplanned transition.Buy-Sell Agreement BasicsSimply put, a buy-sell agreement establishes a process by which shares of a private company transact. Ideally, it defines the conditions when the buy-sell agreement is triggered, describes the mechanism by which the shares are priced, addresses the funding of the transaction, and satisfies all applicable laws and regulations.A buy-sell agreement establishes a process by which shares of a private company transact.These agreements aren’t necessarily static. In wealth management firms, buy-sell agreements may evolve over time with changes in the scale of the business and breadth of ownership. When firms are new and more “practice” than “business,” these agreements may serve more to assign who gets what if the partners decide to go separate ways.As the business becomes more institutionalized, and thus, more valuable, a buy-sell agreement – properly rendered – is a key document to protect the shareholders and the business (not to mention the firm’s clients) in the event of a dispute or other unexpected changes in ownership. Ideally, the agreement also serves to provide for more orderly ownership succession, as well as a degree of certainty for shareholders that allows them to focus on serving clients and running the business instead of worrying about who gets what benefit of ownership.The irony of buy-sell agreements is that they are usually drafted and signed when all the shareholders think similarly about their firm, the value of their interest, and how they would treat each other at the point they transact their stock. The agreement is drafted, signed, filed, and forgotten. Then an event occurs that invokes the buy-sell agreement, and the document is pulled from the drawer and read carefully. Every word is parsed, and every term scrutinized because now they are not simply co-owners with aligned interests but rather buyers and sellers with diametrically opposed interests.Triggering EventsBuy-sell agreements govern the process and terms of a transaction if certain defined events occur. These “triggering events” can stem from voluntary or involuntary circumstances. Many buy-sell agreements call for an independent appraisal upon a triggering event to establish the price at which shares will transact. In cases where ownership is more fluid, some agreements require an annual appraisal to establish the price at which all transactions will take place.Voluntary CircumstancesAt any point in time, one generation of business owners is preparing for retirement, having planned (or frequently not planned) for a successful ownership transition from one generation of business leaders to the next. A buy-sell agreement is one of the most important steps to ensure a successful, planned transition of ownership, and as such, it should complement your succession plan.A buy-sell agreement is one of the most important steps to ensure a successful, planned transition of ownership.An effective succession plan could call for the sale of the retiring partner’s stake to current management or an outside investor group or may require the sale of the entire firm to a strategic buyer.If your exit strategy includes a sale to an insider, it should specify the terms and define the process for determining the price that shares are transacted at as an owner exits to retire. This is often a point of contention as young partners and retiring partners have inherently opposed objectives. A retiring partner will want to exit at the highest share price possible while the continuing partners are ultimately financing this repurchase.Because many wealth management firms are highly valuable, successors are often financially stretched to take over the founder’s interest in the firm. By establishing the process through which price is determined and the terms at which the shares will be transacted, a buy-sell agreement mitigates any potential drama. As such, a buy-sell agreement is foundational for your firm’s succession plan.If your exit strategy is to sell your firm to an outside buyer, you should be aware of your opportunities and make it explicitly known to your firm that this is your intention. For example, you should know the different incentives of potential buyers and what options exist with financial or strategic buyers.You should make sure that your buy sell agreement makes sense in the context of your other operating agreements. A buy-sell agreement should specify the process by which a sale to an outside investor group is agreed to. We once worked with a client whose operating documents required unanimous consent to bring on a minority partner, as this required an amendment to the operating agreement, while the sale of a majority of the Company just required the consent of a super majority.Knowing your exit strategy options will help clarify what is needed from your succession plan and your buy-sell agreement going forward.Involuntary CircumstancesBuy-sell agreements guard against undesirable transitions in ownership from a potential partner to an unaffiliated party; they also define a set price per share to ensure a fair transaction. In the case of death, disability, divorce, and bankruptcy, current partners will ultimately need to redeem the shares of their colleague.For instance, in the event of the death of a shareholder, a buy-sell agreement can protect the deceased’s family, ensuring such shares are bought at a fair price and in a timely manner. It can also protect your company from the inheritors of a deceased owner, who may want to benefit from the firm’s earnings but are not able to contribute to the growth of the business. Life insurance policies for owners are advised to protect your firm in case of an untimely death or a disabling scenario. A life insurance policy will secure your firm’s ability to repurchase shares in the case of the death or disability of an owner.A buy-sell agreement will outline the process through which a price is set and the transaction is financed.Additionally, if an owner files bankruptcy, the firm will need to repurchase his or her stake to avoid the shares being acquired by the owner’s creditors. In the case of a divorce, an owner’s shares may legally transfer to his or her spouse, in which case ownership would be seeded to the ex-spouse. A buy-sell agreement will outline the process through which a price is set and the transaction is financed.Our RecommendationWe recommend revisiting your buy-sell agreement to ensure that it makes sense in the context of your firm’s vision and in partnership with its other governing documents. If you do not currently have a buy-sell agreement in place, we highly encourage you to draft one with the help of legal counsel and an independent valuation expert. Doing so will help ensure the continuity of you firm, align incentives, and may even help avoid costly litigation down the road. If you plan on reviewing your buy sell agreement and other governance matters, please give us a call.

Where Are We With Tax Policy?Entering 2021, tax worries and changes in tax policy were at the forefront of discussion in the political, business, and estate arenas. Changes including removing the step-up in basis on capital gains at death, increasing the corporate tax rate, eliminating valuation discounts, neutering GRATS, increasing the capital gains rate on high incomes, and lowering the gift and estate tax exemption were all on the table as part of the Biden Administration’s agenda upon taking office.As 2022 kicks off, tax policy largely remains unchanged from a year ago. President Biden’s Build Back Better (“BBB”) Act went through numerous iterations over the year and was politicked down from a headline program cost of $3.5 trillion to $1.7 trillion before ultimately being kiboshed by Senator Joe Manchin (D-WV) publicly pulling his “Yea” from the bill in late December.But where does that leave estate planners and family businesses? There are three things estate planners and business advisors need to keep top of mind regarding tax policy in 2022.1. Major Tax Overhaul Less Likely…A short column from Bloomberg Tax highlighted the President’s herculean task of resurrecting BBB heading into a contentious 2022 midterm election cycle, with multiple purple state Democrat Senators not named Joe or Kyrsten facing tougher reelection battles. The likelihood of major tax changes diminishes as the calendar approaches November 2022, and the polling would suggest Democrats may be less willing to pass sweeping changes in the face of a ‘red wave’ in the midterm elections. Watch closely: if nothing transpires early in the legislative calendar, the likelihood of major tax changes will likely dissipate until at least January 2025.According to a report from The Hill, Democratic aides say the BBB bill won't be ready for floor action any time soon and predict the wide-ranging legislation may have to be completely overhauled. Senate Majority Leader Chuck Schumer (D-NY) informed colleagues the Senate will begin focusing on voting rights legislation in the New Year, further signaling a shift from tax policy. After a year of tax consternation, it might be nice to ring in the new year with less tax anxiety immediately on the horizon.2. Changes Still LurkingSpeaking during a radio interview, Senator Manchin offered a path to revive a skinnier version of President Biden’s BBB bill. Senator Manchin said the legislation should go through Senate committees in order to examine any economic impacts and focus on rolling back the 2017 Tax Cuts and Job Act (“TCJA”) tax cuts.What parts of TCJA is Senator Manchin referring to? Hard to say, but the largest changes in the TCJA included a decrease in individual income tax rates, a decrease in the federal corporate income tax rate from 35% to 21%, and the qualified business income deduction to pass-through entities. The law also increased the estate tax exemption for single and married couples (discussed below) to their current schedule.Senator Manchin has also indicated he is willing to support some version of a tax targeting billionaire wealth via a wealth tax mechanism, a cause generally supported by the more progressive wing of the Democrat party. While this may not affect as many readers here, it does reflect the Senator’s willingness to entertain more aggressive tax increases (while maintaining his issue with the spending programs outlined in BBB). While less vocal moderate Democrats are likely concerned with voting on any tax increase in 2022, this may be the President’s only shot to pass broader tax policy changes if a ‘red wave’ does transpire in 2022.3. Remember the Transfer Tax Law SunsetFor family businesses and estate planners, while the transfer exemptions remain at current levels, they are still set to drop by 50% on January 1, 2026 (as well as current income tax rates). Per The National Law Review, the Treasury Department has confirmed the additional transfer tax exemption under current law is a use it or lose it benefit. If a taxpayer uses the “extra” exemption before it expires (by making lifetime gifts), it will not be “clawed back” to cause additional tax if the taxpayer dies after the exemption is reduced.As we’ve written previously the current estate and gift tax exclusion is an opportunity for privately held and family businesses to accelerate their gifting strategies. In 2022 the gift and estate tax exemption increased to $12.06 million ($24.12 million for a married couple), allowing families and estate planners to maximize lifetime gifts in a tax advantageous environment. As an added bonus, federal tax laws allow for an annual exclusion that avoids the estate/gift tax exemption entirely. This level was set at $15,000 per recipient for 2021 and will increase for inflation to $16,000 in 2022.ConclusionAs we have written previously in Family Business Director, don’t let the tax tail wag the business dog. Estate tax planning efforts should be opportunistic while remaining focused on the bigger goal, which is ensuring a successful transition of the ownership of the family business from one generation to the next in a way that promotes the long-term sustainability of the family and the business.Keeping a semi-regular eye on Washington D.C. can be beneficial to estate attorneys and family businesses looking to avoid legislative pitfalls that can torpedo an estate plan. Just remember that predicting the future is perilous: the BBB act may be mortally wounded, but like any good political drama, you have to remember the evil twin brother who has been lurking out of frame. Contact a professional at Mercer Capital with your valuation needs in support of your estate planning.

By this Thanksgiving, Congress hopes to pass two of the largest bills in American history, the $1 trillion infrastructure bill (which was signed into law by President Biden on November 15th) along with a $1.75 trillion Build Back Better bill. While the infrastructure bill made it through Congress with minimal tax hikes, the passing of the larger reconciliation bill may still create sweeping changes to American tax policy, specific to high-net-worth individuals.Over the past several months, numerous tax code changes have been proposed to fund the two bills, and concessions have whittled away some of the more drastic proposals that made headlines back in the Spring of 2021. In this article, we look to address what policies are still on the table, which are most likely to pass, and what the implications for their passing might be.The Unfolding of Biden’s Economic AgendaOn March 31, 2021, the Biden administration proposed The American Jobs Plan which outlined $1.7 trillion in infrastructure investment targeting a number of projects such as public drinking water, renewed electric grid, high-speed broadband, housing, educational facilities, veteran hospitals, and job training programs among various other projects. The Made in America Tax Plan was proposed simultaneously with the American Jobs Plan as a source of funding. The plan enumerated on several proposed increases to individual and corporate tax rates as well as various other reforms. Some of which have found their way into current legislative efforts. On April 28, 2021, President Biden proposed an additional spending plan, The American Families Plan, targeting “social infrastructural” works such as universal pre-school, universal two-year community college and postsecondary education (since dropped), childcare, paid leave (also has been dropped), nutrition, unemployment insurance, as well as various tax cuts to low-income workers. The Plan also outlined extensive tax reform directly targeting high income earners: setting capital gains and dividend taxes equal to taxes on wages and increasing tax rates on the top tax bracket from 37% to 39.6%. The sticker price of the American Families Plan was set at $1.8 trillion, with $1 trillion in direct government investment and the remainder in tax breaks. On May 28, 2021, the Biden Administration further elaborated on his economic agenda in the unveiling of the 2022 fiscal budget plan to Congress alongside the Treasury Department “Green Book.” On August 10, 2021, the Senate approved the $1.2 trillion infrastructure bill with bi-partisan support after months of debate. The bill includes many of the hard infrastructure objectives outlined in Biden’s American Jobs Plan. On the same day, a 100-member Congressional Progressive Caucus declared that it would refuse to vote for the bill before the larger reconciliation bill was passed in the Senate, despite overwhelming popularity of the infrastructure bill in Congress and in polling. In prioritizing Biden’s “soft infrastructure proposals” as specified in the reconciliation bill, Progressives effectively tied the fate of both the infrastructure and reconciliation bill in ongoing negotiations. On August 24, 2021, the House Democrats approved a $3.5 trillion budget resolution which set in motion the reconciliation process by which Democrats could potentially sign the budget into law, requiring only a majority approval while circumventing an inevitable filibuster from Republicans in the Senate. The same measures were taken by the Republican Party with the passing of the American Tax Cuts and Jobs Act in 2017. Support from all 50 Democratic Senators and all but a handful of House Democrats would be needed to pass the legislation as objections from Republicans are widely expected. The budget resolution has since been negotiated down to a $1.9 trillion dollar package. On September 12, 2021, the House and Ways Committee released a revised draft of the tax changes proposed as part of the budget reconciliation bill. Specific tax increases largely targeted trusts and estates and carried significant implications for gift and estate tax planning. On September 27, 2021, under pressure from both moderates and progressives, Speaker of the House, Nancy Pelosi originally scheduled the House vote for the infrastructure bill for September 27th. But without the passing of the budget resolution bill, and therefore the support of Progressives, Nancy Pelosi postponed the House vote to extend negotiations. In doing so, ongoing government funding was jeopardized without a fiscal 2022 budget and government debt neared the self-imposed debt ceiling. On September 30, 2021, the last day of the federal calendar, Congress narrowly avoided a government shut down by passing a temporary package funding the government through December 3, 2021 while the House suspended the debt ceiling through December 2022. The increase in the debt ceiling is widely expected to be rejected by Senate Republicans. On October 21, 2021, the New York Times reported, Arizona Senator Krysten Sinema, would refuse to vote to support any increases in corporate or individual tax rates. The opposition came as a surprise to many and left the Democratic party scrambling to secure funding for the Build Back Better Bill from other avenues. On October 28, 2021, President Biden unveiled a $1.75 trillion framework for the Build Back Better social spending bill, a draft of the legislation quickly followed. The announcement was released moments before Mr. Biden departed for Rome followed by Glasgow for the 2021 United Nations Climate Change Conference. On November 8, 2021, the $1 trillion infrastructure bill passed in the House with bipartisan support after months of debate among members of the Democratic party looking to pass the Build Back Better bill before sending the infrastructure bill to a vote. On November 15, 2021, the $ 1 trillion infrastructure bill was signed into law by President Biden.Proposals, Negotiations, Amendments, and More ProposalsBiden’s historically ambitious proposals made earlier in the year have since been trimmed by months of negotiations with more conservative members of the Democratic party. Most notably Joe Manchin of West Virginia and Krysten Sinema of Arizona have criticized the size of the bill, the tax hikes required for funding the bill, and the speed and process by which the party hopes to pass such landmark legislation. In efforts to gain the support of these two senators, and thereby achieve the unanimous support needed for the reconciliation, Democratic leaders have floated numerous tax proposals in recent months to fund the bill.While many of the tax change proposals outlined in the House and Ways Committee draft for the reconciliation bill were not included in the most recent framework published by the Biden Administration on October 29, 2021, many believe the policies outlined in mid-September may still be in play as negotiations continue amongst the conservative and progressive members of Congress. It is widely believed that the intent behind some of the initial funding proposals outlined by the Biden administration and later incorporated in the House and Ways Committee draft were beyond economics and were intended to combat “wealth inequality” and disparities in effective corporate tax rates.As reported in an article from CNBC, none of the three major holdouts, Joe Manchin, Krysten Sinema, or Bernie Sanders, have committed to supporting the framework as it stands. As many of the initial social spending policies have been cut, including most recently the federal paid family and medical leave proposal, uncertainty remains surrounding the scope of the bill and the funding it will require.Tax changes proposed in the House and Ways Committee draft were numerous, albeit less drastic than those considered earlier in the year. A comprehensive summary of the funding provisions can be found here. Key tax reforms specific to closely held businesses include the following:A reduction in the estate and gift tax exemption effectively reducing the exemption from $11.7 million to $6.0 million per individual.A change in the tax status of grantor trusts. Grantor trusts would be included in the grantor’s taxable estate, and transactions between grantor and a grantor trust would be subject to income tax.Discounts for lack of control and marketability would be disallowed for gifts of entities holding non-business assets such as asset holding entities.An increase in the individual income tax for the top tax bracket from 37% to 39.6%, essentially reversing tax reductions established in the 2017 Tax Cuts and Jobs Act, also passed via the reconciliation processAn increase in the maximum long term capital gains rate to 25% from the current rate of 20%. The effective date was set at September 13, 2021.Elimination of exemptions to the net investment income tax for active participants in the business, which applies a 3.8% tax to a taxpayer’s net investment income when adjusted gross income exceeds a certain threshold. Currently, income earned from active participants in the business is exempt.Limitations on the qualified business income deduction (QBID). The deduction would be subject to a cap once qualified business income exceeds $2.5 million for married couples filing jointly, $2.0 million for single filers, $1.3 million for married taxpayers filing separately, and $50.0 thousand for trusts and estates.Reimplementation of the graduated corporate income tax rate structure. In 2017, the Tax Cuts and Jobs Act established a flat rate of 21%. The proposal would restore the graduated rate structure: < $400 thousand : 18% $400 thousand $5 million : 21% (the current rate)$5 million : 26.5%What Made it into the Biden Framework for the Build Back Better Bill?Because of recent opposition from conservative members of Congress, many of the proposed tax reforms recommended in the House and Ways Committee draft back in September were not included in Biden’s Build Back Better framework issued October 28. Funding proposals for the Build Back Better bill issued in Biden’s most recent draft included the following:A 15% minimum tax on corporations based on 15% of adjusted financial statement (book) income rather than recognized income. The tax increase was proposed as an alternative to propositions made earlier in the year to increase the corporate tax rate to 28%.A 1% surcharge on corporate stock buybacks.A separate 15% global minimum tax on corporate profits earned abroad along with a penalty rate for foreign corporations based in non-compliant countries. The proposal comes after the U.S. led negotiations earlier in the year among G20 leaders in adopting a minimum 15% corporate tax rate along with other restrictive reforms.New surtax on multi-millionaires and billionaires.Close Medicare self-employment tax loophole.Continue limitation on excess business losses. The new surtax on multi-millionaires and billionaires is intended to replace numerous other proposals to tax high income individuals such as: a rate increase to the top tax bracket, taxing unrealized gains annually, a wealth tax, taxing unrealized capital gains at death, and ending the practice of stepped-up in basis. The surtax is set to add an additional 5% tax on income exceeding $10 million and an additional 3% tax on income exceeding $25 million. While perhaps not too different than levying additional income taxes, the surtax was agreed upon after Krysten Sinema refused to support increases to income tax rates on high earners. While the most recent draft still targets high income individuals and corporations, most of the significant tax changes have been avoided for now. Avenues for gift and estate planning and taxes related to closely held businesses were largely spared in the recent proposal. For now, it appears that there will be no changes made to the step-up in basis, reduction in estate and gift taxes, the application of marketability and control discounts, income tax rates on the top tax bracket, capital gains tax rates, or changes in the qualified business income deductions.Forward Looking ExpectationsMuch like the Infrastructure bill, which gained bipartisan support via not drastically changing the tax code, the Build Back Better bill may make it to the final yard line without incorporating the vast majority of major tax changes proposed earlier in the year or during the negotiations in recent months. The outline and proposals set forth represent the closest framework for consensus among the Democratic party, and tax proposals put forth have been forged by nearly a year of debate among party members. However, in no way is the recent draft set forth by President Biden final.Much uncertainty still remains regarding the draft’s support from the party’s more progressive and conservative members. If the recent months have taught us anything, with a bill this large, funding measures are liable to shift upon further negotiations. Regardless, many expect the bill to be put to a vote within weeks.Mercer Capital will continue to monitor any changes to the tax code and report on how they may affect our clients. In the meantime, to discuss a valuation need in confidence, please don’t hesitate to contact us.

Fall is upon us. The weather is getting cooler, the leaves are changing colors, football is in full swing, the World Series is beginning, and Halloween is right around the corner. For auto dealers this year, Fall may also be a sign of change.As we’ve written in this space, 2021 has been largely profitable for dealers, despite unique challenges. A combination of good fortunes, high blue sky multiples, consolidation in the industry, the onset of electric vehicles, proposed tax law changes, and other factors can have many dealers contemplating their future.October and November are also when many state auto associations hold their District Meetings to discuss timely topics with their dealer members. We recently attended a series of District Meetings in Tennessee and the topic at hand seemed to revolve around potential transactions.In the spirit of Halloween, we review some of the buy/sell considerations (from the perspective of the selling auto dealer) that were discussed at the district meetings. For those statements that are true, we will classify them as TREATS and provide additional commentary. For those statements that are false, we will classify them as TRICKS and provide additional commentary.TREAT - Timing Is EverythingDeciding whether to sell your dealership or continue to hold on to it should be a conscious decision. Don’t wait until you have to sell.  Dealers should consider the following areas in their decision-making process:Family – What are the ages and current health status of the operating dealer and his/her spouse? Does the dealer have any children that are either active in the business or are capable of eventually running the business?Market – What are the prevailing market conditions?  Is this a good time to sell or a bad time to sell?  As we have discussed numerous times during 2021, the M&A market has been very active for auto dealers.  Despite operating challenges with COVID and inventory supplies with the chip shortage, auto dealers have posted record or near-record profits.  Favorable operational results combined with increased blue sky multiples have yielded a frenzy in the valuations of some dealerships.OEM/Brand – What conditions is the dealer currently facing with their own OEM?  Has the brand been favorable in recent history, or does the dealership represent an OEM that has faced production issues or the inability to release attractive vehicle models?  Is the OEM demanding additional image requirements?  How is the OEM responding to the electrification of vehicles and how will they involve the traditional dealership moving forward?Monetary – What are the unique financial needs of the operating dealer and his/her family?  Is the perceived value of the dealership equal to or greater than the offers in the marketplace?  Are there sizable capital projects on the horizon needed to compete with other dealership groups or with OEM demands?TRICK - An Auto Dealer Contemplating a Sale Should Hire a Business BrokerTransactions can be very complicated and complex.  A selling dealer should hire capable professionals to assist in the process. These professionals should include a transaction attorney and a CPA at a minimum. These roles shouldn’t automatically be filled by your existing professionals if those professionals aren’t seasoned in transactions of auto dealerships.Should the selling dealer hire a business broker?It depends.Not all business brokers can be helpful to the process. Be careful and selective about whether to hire a business broker, and if so, which business broker to hire. If the buyer or target is already identified, the business broker may not be necessary. Be cautious of business brokers that want to establish a long-term exclusive relationship. The selling dealer wants to maintain privacy and confidentiality about their potential decision to market their dealership.  Some business brokers might market the dealership to everyone around town which can cause uncertainty and strain to existing employees and might cause harm to the value of the dealership if the seller loses the leverage of their decision.Business brokers can be helpful as can industry-specific valuation specialists like Mercer Capital. One obstacle to any potential transaction is the value or price of the dealership. Dealers may have an indication of what their store might be worth, but often a valuation is crucial to manage expectations or assist in the negotiation of price with the potential buyer.TREAT - A Selling Dealer Must Prepare for a Potential Sale Prior to the Transaction ClosingDealers that are contemplating a sale should begin to take steps to prepare for the eventual transaction.  Some of those steps consist of the following:Capital Projects Pending – Are there capital projects that need to be completed or are required by the OEM?  Has the dealer recently completed an image requirement or are additional requirements pending?  The status of the facilities and capital projects can greatly affect the price paid for the dealership in a transaction.Key Personnel – Identify the key employees that you want to retain during the process and/or those the buyer might want to retain. The future success of a dealership can be impacted by key employees and department heads.  Selling dealers might consider granting special bonuses to these key individuals to keep them focused during this process.  A potential buyer would not want to see a hiccup in financial performance or turnover in key personnel during the process.Customer Obligations – Selling dealers should examine their long-term customer obligations.  Are there any “warranties for life” such as free lifetime oil changes or obligations to provide loaner vehicles to prior owners or immediate/distant family members?  A potential buyer would want to know their exposure in these areas and may not wish to continue these arrangements.Existing Contracts/Contract Renewals – Selling dealers should review their existing contracts.  How long will they continue or are any set to expire?  Key contracts would include the Dealer Management System (DMS) among others.  Selling dealers must balance opposing factors with contracts:  not wanting to experience an interruption during the transaction process versus renewing a long-term contract that a perspective buyer would not view as attractive or valuable.Environmental Survey – Does the dealership have any exposure to environmental issues?  A selling dealer should complete an environmental survey at the beginning or during this process.  Environmental concerns for dealerships usually involve in-ground lifts, underground storage tanks, and oil/water separators.TRICK - A Selling Dealer Should Inform Their OEM That They Are Contemplating a Potential TransactionSimilar to the decision regarding whether to hire a business broker or not, the decision to inform the OEM should be diligently thought out.Should a dealer inform their OEM that they are contemplating a transaction?Again, it depends.A selling dealer wants to maintain privacy and confidentiality within their community and their workforce. An OEM or area manager might inform other dealerships of the news of your potential sale, or the information could make its way back to your key employees. Selling dealers will want to continue consistency in operations and performance and maintain their leverage in their possible sale to ensure the highest success and value for a transaction. Conversely, the OEM will need to be informed at some point because they will ultimately have to approve the dealer principal after a transition.TREAT - A Buyer’s Due Diligence Is Essential to the Transaction ProcessDue diligence refers to the part of the process where the potential buyer collects and analyzes certain information from the seller, including financial statements and other reports, in an effort to make a decision about conducting the transaction and to ensure that a party is not held legally liable or any loss or damages. Key elements of the due diligence process include the following:Financial Statements – Buyers will typically want to review at least three prior years to gain an understanding of the dealership’s historical performance and an expectation of anticipated future performance.  Sellers will want to make sure they have complete and accurate financial statements to aid in the transaction process.Existing Litigation – Prospective buyers will want to know of any pending litigation with any customers or employees.Environmental Assessment – As previously discussed, a buyer will want to know if there are any pending environmental liabilities.  If a selling dealer had a survey performed recently it can keep the process moving and not cause any interruption waiting for a survey to be completed.Facilities Inspection – Buyers will want to inspect the physical premises of the dealerships.  Buyers will also inquire and inspect the status of current conditions in light of OEM imaging requirements.TRICK - The Character of the Buyer Is Not Important to the TransactionOne might think that if a prospective buyer can be located at an agreeable price, then the process is over. However, the seller should be concerned with the character of the buyer. What is the buyer’s reputation with other stores that he/she operates? Has the buyer ever been involved in lawsuits with their OEM, their employees, or with other sellers in previous transactions? Has the buyer ever been turned down by an OEM for approval as a dealer principal in a previous transaction or transition?In most cases,  a dealer may only sell a dealership once in their lifetime. Chances are they have established a legacy within their local community and with their employees. Despite exiting after a transaction, dealers do not want to see their reputation and legacy diminished.ConclusionMercer Capital can assist auto dealers that are contemplating a sale by joining the team of professionals involved in a transaction. Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business and how it is impacted by economic, industry and financial performance factors. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

The most common valuation-related family business disputes we see in our practice relate to measuring value for buy-sell agreements. Far too often, buy-sell agreements include valuation provisions that appear designed to promote strife, incur needless expense, and increase the likelihood of intra-family litigation.The ubiquity of valuation provisions in buy-sell agreements that do not work is striking. While there are many variations on the theme, the exhibit below illustrates the broad outline of the valuation processes common to many buy-sell agreements.The buy-sell agreement presumably exists to avoid litigation, but the valuation processes in most agreements seem to increase, rather than decrease, the likelihood of litigation. It is almost as if failure is a built-in design feature of many plans.Top Five Causes of Valuation Process FailureAmbiguous (or absent) level of value. As we discussed at length in section 3 of the What Family Business Advisors Need to Know About Valuation whitepaper, family businesses have more than one value. There is no “right” level of value for a buy-sell agreement, so the agreement must specify very clearly which level of value is desired. Failing to specify the level of value, and just assuming that the eventual appraiser will know what the parties intended is a recipe for disaster. The difference between the pro rata value of the family business to a strategic control buyer and the value of a single illiquid minority share in the family business can be large. Yet too many buy-sell agreements simply say that the appraisers will determine the “value” or “fair market value” of the shares. That is not good enough.Information asymmetries. Most buy-sell agreements have no mechanisms for ensuring that the appraiser for the selling shareholder has access to the same information regarding historical financial performance, operating metrics, plans, and forecasted financial performance as the appraiser retained by the family business. The resulting asymmetries give both sides a ready-made excuse to cry foul when the valuation results do not meet their expectations. We recommend a thoroughly documented process of simultaneous information sharing, joint management interviews, and cross-review of valuation drafts to eliminate the likelihood of information asymmetries derailing the transaction.Lack of valuation standards / appraiser qualifications. It is not hard to find an investment banker, business broker, or other industry insider who probably has a well-informed idea of what the family business might be worth (particularly in the context of a sale to a strategic buyer). However, when executing the valuation provisions of a buy-sell agreement, it is crucial to specify the qualifications for the appraisers. While an opinion of value from a business broker might be suitable for some purposes, the scrutiny that is attached to a buy-sell transaction can best be withstood by an appraiser who is accountable to a recognized set of professional standards that set forth analytical procedures to be followed and reporting guidelines for communicating the results of their analysis. There are multiple reputable credentialing bodies for business appraisers that promulgate quality standards for their members. The buy-sell agreement should specify which professional credentials are required to serve as an appraiser for either the selling shareholder or the company.Unrealistic timetable / budget. Families often share a well-founded fear that the valuation process will prove interminable without specified deadlines. Deadlines are important but must be realistic. If there is ever a time for a “measure twice, cut once” mentality, it is in buy-sell transactions. Due diligence and analysis takes time, and the schedule set forth in the buy-sell agreement needs to take into account the inevitable “dead time” during which appraisers are being interviewed and retained, information is being collected, and diligence meetings are being scheduled. The same goes for budget: if you think a quality appraisal is expensive, see how costly it is to get a cheap one. Provisions that identify which parties will bear the cost of the appraisal can help incentivize the parties to reach a reasonable resolution, but can also be so punitive that they discourage shareholders from pursuing what is rightfully theirs. Each family should carefully evaluate what system will work best for their circumstances.Advocative valuation conclusions. Sadly, even when the level of value is clearly defined, information asymmetries are eliminated, valuation standards are specified, and the timetable and budget is reasonable, the two appraisers may still reach strikingly different valuation conclusions. Whether this is a result of genuine difference of (informed) opinion or bald advocacy is hard to say, but it is rare for the appraiser for the selling shareholder to conclude a lower value than that of the appraiser for the company. Valuation is a range concept, so it should ultimately not be too surprising when appraisers don’t agree. Yet that inevitable disagreement adds time and cost to many buy-sell valuation processes.Is There a Better Way?Given the challenges and pitfalls described above, is there any hope that a valuation process for a buy-sell agreement can reliably lead to reasonable resolutions? We think so. We have identified three steps that we recommend for clients to help make their buy-sell agreements work better.Make sure that the buy-sell agreement provides unambiguous guidance to all parties as to the level of value and qualifications of the appraiser.Retain an appraiser to value the company now, before a triggering event occurs. This is essential for two reasons. First, it transforms the “words on the page” into an actual document that shareholders can review and question. No matter how carefully one defines what an appraisal is supposed to do, the shareholders are likely to have different ideas about what the output will actually look like. This appraisal report should be widely circulated among the shareholders, so they have an opportunity to familiarize themselves with how the company is appraised. Second, performing the valuation before a triggering event occurs increases the likelihood that the family shareholders can build consensus around what a reasonable valuation looks like. People tend to take a more sane view of things when they don’t know if they will be the buyer or the seller.Update the valuation periodically. Simply put, static valuation formulas don’t work in a changing world. Periodic updates to the valuation help the valuation process become more efficient, and help all shareholders keep reasonable expectations about the outcome in the event of an actual triggering event. Discontent and strife are more likely to be the product of unmet expectations rather than the absolute valuation outcome. Periodic valuations help to set expectations and reduce the likelihood of friction. Following these three steps are essential to increasing the likelihood that the valuation process in a buy-sell agreement will actually work and will help keep the family out of the courtroom, where both sides to the dispute often walk away losers. Following these three steps are essential to increasing the likelihood that the valuation process in a buy-sell agreement will actually work and will help keep the family out of the courtroom, where both sides to the dispute often walk away losers. This week's post is an excerpt from the whitepaper, What Family Business Advisors Need to Know About Valuation. If you would like to read the full version click here.

"Have you not reserved even some type of blessing for me? Has my brother really taken everything?!" cried Esau. Isaac answered, "Behold, I made him a master over you, and I gave him all his brothers as servants, and I have sustained him with corn and wine; so for you then, what shall I do, my son?” – Genesis 27 : 36-37Jacob may have caused the first recorded major disruption to a family’s long-term estate planning goals. While there is no familial deception or lentil soup traded for birthrights, numerous changes lurk in the current reconciliation bill snaking its way through Congress and it could have major ramifications to the plans you worked up just a few years ago.We applaud family businesses and their advisors setting up estate plans with more guardrails than deathbed blessings, but would we be remiss if we failed to ask: Have you pulled out those documents recently?  Below we briefly touch on planning vehicles and structures as well as valuation tools currently being debated in the reconciliation bill and why they are important to many family business owners and advisors.Estate & Gift Tax ExemptionThe current law provides an estate and gift tax exemption of $11.7 million per individual or $23.4 million for a married couple.  This provision is currently set to sunset December 31, 2025.  Previous guidance has stated any gifts made prior to any changes to the exemption will not be clawed back.The current proposal rolls back the exemption amount to $6.02 million per individual adjusted for inflation or $12.04 million for a married couple, slashing the benefit effectively in half.  The effective date of change under the current proposed bill is January 1, 2022.Individuals who anticipate their estate may exceed the lower threshold of $12.04 million should consider executing estate planning strategies to transfer that wealth before the end of the year, including gifting to descendants or a trust (more discussed below).  In less eloquent terms: Use It or Lose It!Trust ChangesThe “Bull Moose” would likely beam with pride regarding the current reconciliation bill’s “Trust busting” features.  In general, many of the law’s provisions are meant to curtail, if not outright eliminate, tools utilized by estate tax advisors and attorneys.  Many of the changes are expected to become effective either 1) at signage of the bill or 2) January 1, 2022.The National Law Review provided a good summary regarding Grantor Trusts. In general, the current reconciliation bill largely eliminates many of the estate planning benefits of grantor trusts (trusts deemed to be owned by the creator of the trust or another person (each referred to as a “grantor”) for federal income tax purposes). The following rules would apply to trusts created on or after the date of enactment and to existing trusts to the extent transfers are made to such trusts on or after the date of enactment.Estate Tax Inclusion - Assets owned by a grantor trust would be included in the grantor's estate and subject to estate tax upon the grantor's death.Distributions as Gifts - Distributions from a grantor trust during the grantor's lifetime would generally be treated as taxable gifts.Taxation Upon Termination of Grantor Trust Status - If the trust's grantor trust status is terminated (i.e., the trust becomes a separate taxpayer from the deemed owner), the grantor would be deemed to have made a taxable gift of the trust assets.Gain Recognized Upon Transfers to Grantor Trust - Transfers between a grantor trust and its grantor would be subject to income tax regardless of when the grantor trust was created. A key piece you and your planning team need to consider is, as it reads: The Legislation would apply to all post-enactment transfers between a grantor and grantor trust, including grantor trusts created prior to the date of enactment. Therefore, a sale or swap of assets after the Legislation’s effective date between a pre-enactment grantor trust and its grantor would be an income tax realization event.  Likewise, a GRAT annuity payment made in kind with appreciated assets to the grantor, after the Legislation’s effective date, would be an income tax realization event.  With respect to these grantor trust provisions, the House Bill includes a footnote which states, “A technical correction may be necessary to reflect this intent.” Grantor trusts are a big deal, but many other trust structures could fall under some of the same new, restrictive rules, including the following:Grantor Retained Annuity Trusts (GRATs)Qualified Personal Residence Trusts (QPRTs)Grantor Charitable Lead Annuity Trusts (CLATs)Spousal Lifetime Access Trusts (SLATs)Irrevocable Life Insurance Trusts (ILITs) Gassman, Crotty, & Denicolo, P.A. had a great webinar recently to cover several possible changes to these vehicles. You can check it out here.Valuation Discounts for Passive AssetsIn a business valuation setting, valuation discounts for lack of control, lack of marketability, and lack of voting rights are allowed, but often require substantiation, quantification, and defense by a business appraiser communicated in a formal appraisal report.As discussed in Mercer Capital’s Auto Dealer blog, the current version of the reconciliation bill proposes to eliminate valuation discounts for an entity’s “non-business”, or passive, assets including certain cash balances, marketable securities, equity in another entity, or real estate.  Actively utilized working capital or real estate for business operations would not be considered “passive.”  The effective date of enactment would be January 1, 2022.We would argue discounts for lack of marketability and control represent quantifiable economic realities facing minority owners in nonmarketable passive entities. Regardless, the law’s impact would be large. Often, combined discounts for lack of control and marketability can range from 25-45%.An option business owners should consider is triggering a valuation of minority ownership positions with a valuation date prior to the effective law date.  A 25%-45% increase in reportable gifts would only be compounded by the law’s lowering gift tax exemption (discussed previously).ConclusionWe provide valuation services to families seeking to optimize their estate plans and we work with estate tax attorneys all across the country. Give one of our professionals a call to discuss how we can help you in the current environment.

Benjamin Franklin famously said that the only things certain in this life are death and taxes. While both may be certain, taxes are always subject to change.Last fall, we wrote a blog post about the estate planning environment for auto dealers and other industries. In that post, we highlighted the prevailing conditions that existed in the marketplace that would enable auto dealers to capitalize on executing any estate planning opportunities. Those conditions included opportunities for depressed valuations caused by uncertain operational results (at the time), low interest rates, and changing political forces caused by the Presidential election.Fast forward to Fall 2021 and while some of these conditions have changed, rumors of potential tax changes have finally re-surfaced nearly three-fourths of the way through the first year of the Biden Administration.Earlier this month, President Biden and Congress introduced the Build Back Better Act (“BBB Act”). After its introduction, the House Ways and Means Committee commented and circulated a draft of many of the proposed policies. A brief synopsis of the entire BBB Act from BKD CPAs and Advisors is provided here.In this post, we focus on four particular proposals that impact estate planning and business valuations for auto dealers (and other industries): 1) Estate Tax / Lifetime Exclusion; 2) Corporate Income Tax Rates; 3) Capital Gains Rates; and 4) Valuation Discounts for Passive Assets.Estate Tax/Lifetime Exclusion AmountThe Estate Tax / Lifetime Exclusion Amount is also referred to as the Generation Skipping Transfer Tax Exemption. This concept consists of the amount of an estate that is subject to be transferred free from taxes either during the lifetime of an individual/couple or at death.Current Status: $11.7 million per individual or $23.4 million for a married couple as stated in the Tax Cuts and Jobs Act (“TCJA”) for gifts made between January 1, 2018 and December 31, 2025. Based on these figures, all estates under these amounts can be transferred during the lifetime or at death without incurring any estate taxes.Current Proposal: Revert back to $5 million per individual adjusted for inflation to arrive at a figure of approximately $6.02 million per person or $12.04 million for a married couple.Effective Date of Change: January 1, 2022Valuation Impact: If enacted, the current proposal would now lower the lifetime annual exemption to $12.04 million for married couples, nearly cutting the exclusion in half. Estates with a value over $12.04 million would now be subject to tax on the amount exceeding $12.04 million.Who Should Consider: Individuals who anticipate their estate may exceed the lower threshold of $12.04 million should consider executing estate planning strategies to transfer that wealth before the BBB Act is passed. Current estates with values exceeding $23.4 million or those estates that have not utilized the full prior lifetime annual exclusion amount, should also consider executing estate planning strategies before that heightened amount is reduced. The reduced exclusion amount also increases the number of affected people. Someone owning a business worth $15 million could now benefit from tax planning strategies that previously may have been less concerned when they fell below the threshold established by the TCJA.Corporate Income Tax RatesCorporate income tax rates are the amount of taxes paid on profits earned by a corporation.Current Status: Flat rate of 21%, reduced by the TCJALatest Proposal: Graduated rates with a top rate of 26.5%Effective Date: January 1, 2022Valuation Impact: Business valuations of auto dealerships are generally impacted by three broad overall assumptions: expected annual cash flows, growth of said cash flows, and risks to achieve those cash flows. A proposed increase in the corporate income taxes would reduce the annual cash flows of an auto dealership simply by the fact that income tax rates are higher. We saw the reverse of this trend when income tax rates were lowered by the TCJA. While many auto dealerships are organized in entities that consist of S Corporations, Limited Liability Companies, and Partnerships, the corporate income tax assumption still impacts the business valuation. We won’t belabor the mechanics of a business valuation in this post, but effectively the hypothetical earnings of a business are tax affected to a C Corporation equivalent basis since the assumptions for the discount and capitalization rates (the risks associated with achieving expected cash flows) are derived from public C Corporations.Who Should Consider: As briefly discussed above, income tax rates comprise one of the assumptions in a business valuation. On its surface, the proposed increase in corporate income taxes will certainly reduce expected the after-tax earnings of an auto dealership, all other things being equal. However, other prevailing industry conditions, such as heightened profitability due to operational efficiencies, might mitigate the overall impact caused by increased tax rates. The opposite was true in 2017.Capital Gains Tax RateThe capital gains rate is the tax rate paid on the disposition of an asset. Rates can differ based on the holding period of the asset prior to disposition and are often bifurcated into short-term (one year or less) or long-term (longer than one year) rates.Current Status: Rates of 15% to 20% + 3.8% surtax on net investment incomeLatest Proposal: Top rate of 25% + 3.8% surtax on net investment income for tax year 2022Effective Date: Transactions occurring after September 13, 2021, would be subject to new rates.  Transactions occurring prior to September 13, 2021 would be subject to current rates.Valuation Impact: Most business valuations do not calculate or consider the net amount received after a sale or disposition of the company or asset because the premise of these valuations is a going concern. However, we know business owners are definitely interested in the proceeds that ultimately hit their bank account.Who Should Consider: Auto dealers that are contemplating whether to sell their dealership or continue to hold and operate should consider this potential rate increase. Dealers are currently experiencing record profits but also face challenges with the inventory shortages caused by suspended manufacturing from the pandemic and the microchip shortage. While it can be hard to let go when profits are rolling in, there are long term concerns surrounding the increasing capital costs of developing and maintaining digital platforms to compete with the public auto groups and larger private groups. Many dealers are choosing to sell, as evidenced by the current white hot auto dealer M&A market. If the BBB Act passes, auto dealers that sell in 2022 can expect fewer after-tax dollars from a sale or disposition due to higher capital gains tax rates, all other things being equal.Valuation Discounts for Passive AssetsBusiness valuations of auto dealerships, real estate holding companies, and related businesses typically consist of determining the value of the entire business, as well as the value of a particular interest in the business. Often the subject interest comprises less than 100% of the total business and exhibits elements of lack of control and marketability. As such, discounts for lack of control, lack of marketability, and lack of voting rights are often applicable and determined to reduce the fair market value of the overall pro rata value of the subject interest.Current Status: Valuation discounts for lack of control, lack of marketability, and lack of voting rights are allowed, but often require substantiation, quantification, and defense by a business appraiser communicated in a formal appraisal report.Latest Proposal: The current version of the BBB Act proposes to eliminate valuation discounts for an entity’s “non-business,” or passive, assets. The BBB Act defines “non-business” or passive assets as cash, marketable securities, equity in another entity, real estate, etc. Further, passive assets are those assets that are held for the production or collection of income and are not used in the active conduct of a trade or business. Passive assets which are held as part of the reasonably required working capital of a trade or business are also excluded. Real property is excluded from this rule if real property assets are used in the active conduct of real property trade or business in which the transferor actively and materially participates. Examples include real property used for rental, operation, and management, among others.Effective Date: January 1, 2022Valuation Impact: In a world where combined discounts for lack of control and marketability can range from 25-45%, this is a material impact. Passage of this piece of the legislation in its current form may not have a dramatic impact on the business valuation of dealership operations, which would still be subject to discounts. However, many auto dealerships carry excess cash or working capital in order to smoothly run operations or provide cushions in down periods. If the BBB Act were to interpret that all cash or working capital exceeds the “guide” figure on the dealer financial statement, this could inflate both the total value of the business as well as the portion attributable to passive assets, which would not be subject to discounts. Many auto dealers currently hold heightened levels of cash and marketable securities as a result of increased profitability and retainage of any PPP funds and loan forgiveness. Many of our auto dealer clients also own the operating real estate for the dealership in a separate asset holding company. These proposed rules could also jeopardize the applicable discounts for lack of control and marketability in those entities for any marketable securities or “non-business” or passive assets.Who Should Consider: If these discounts are eliminated for “non-business” or passive assets, auto dealers owning both types of entities, operating dealerships and real estate holding companies, should consider implementing and executing estate planning strategies. If all the discounts (not likely) or the discounts on “non-business” or passive assets are eliminated, the resulting business valuation of a subject interest in either of these types of entities will be dramatically higher. In turn, the overall values of the estates of auto dealers or the net value of transfers could be greatly increased for transfer tax purposes.ConclusionsJust as death and taxes are the only certain things in life, another relevant adage is that change is inevitable. As the BBB Act and proposals from the House Ways and Means Committee start to evolve, there are numerous tax and estate planning implications.While the final version of the Act will look almost certainly different than the current proposals for each provision, changes to existing rates and policies are anticipated. Fall 2021 is shaping up to be a busy estate planning season.Seek qualified professionals to assist you with your estate planning, from the attorneys determining and drafting the plan to the valuation professional providing the valuation. Not all valuations and valuation professionals are created equal. The role of all of the professionals in your estate planning process should be to protect the integrity of the proposed transaction. Often when these transactions are challenged, they are challenged based on the formation factors or the quality/conclusion of the valuation.Contact a professional at Mercer Capital to assist you and your attorney with your valuation needs involving your estate planning.

Estragon: Let's go! Vladimir: We can't. Estragon: Why not? Vladimir: We're waiting for Godot. Estragon: (despairingly) Ah!Waiting for Godot, Act I- Samuel BeckettYes, “Ah!”. Tax watchers seem to have been unsuspectingly cast in Samuel Beckett’s famous existential and absurdist play, leaving many waiting and waiting. We have waited alongside many tax professionals and family business advisors, writing about the prospect of tax changes here, here, and here among other places throughout the year.However, in what could only be described as excitement similar to Christmas morning, many rushed to tear open the U.S. House Ways and Means markup of the $3.5 trillion reconciliation bill. There were definitely surprises both big and small, and below we summarize some of the major pieces that you and your family board need to keep an especially close eye on as Godot finally approaches.Summary ChangesBKDprovides a good summary of the House’s Tax bill changes for both corporations and individuals. While the write-up goes into more details, the changes we are watching most closely include:Increases the top rate C Corp tax rate to 26.5% from 21% for corporations with incomes of $5 million while reducing the rate to 18% for corporations with incomes less than $400,000 (corporations with income from $400,000 to $5 million would remain at 21%).Increases the top capital gains rate to 31.8% (25% statutory rate + 3.8% NIIT + 3% percent surtax). This proposal is lower than the 43.4% top capital gains rate proposed by the president for those with adjusted gross incomes exceeding $1 million ($500,000 married filing separately). The proposed effective date for a 25% capital gain rate is September 13, 2021.Cuts the estate and gift tax lifetime exemption from the current inflation adjusted $10 million per person ($11.7 million in 2021) to an inflation adjusted $5 million. The proposed change would apply to estates of decedents dying and gifts made after December 31, 2021. Numerous other changes, including limitations on Roth IRA rollovers, creating a 3% surtax on individuals at certain income thresholds, and a host of other changes exist in the reconciliation bill and are being hashed out in Congress currently.Estate and Gift TaxesThe National Law Reviewdiscussed specifics of the reduction in the gift and estate tax exemption available to family businesses. In addition to the reduction of the exemption by 50% beginning January 1, 2022, current legislation is also targeting other estate planning tools. WealthManagement.com highlights a bevy of changes to current trust treatments as well as valuation discounts on gifts of specific entities.Some Dodged BulletsRandall Forsyth at Barron’s summarized some areas where the current iterations of the tax plan diverged from the original White House proposals. The top capital gains rate is expected to be well below the top individual rate as discussed previously. Additionally, the proposed elimination of the step-up in cost basis for estates, an area of concern for many multi-generation family businesses, did not make the House’s language. The $10,000 ceiling on state and local tax deductions was unchanged, which ruffled the feathers of Congressmen from high-tax states.Something Is Rotten in the State of DenmarkSimilar to Shakespeare’s Hamlet, something is in fact “rotten” in the Democrat’s respective Senate and House caucuses. Some obvious defections are highlighted below:Senator Joe Manchin (D-WV), the nation’s most watched Senator, penned an op-ed highlighting his concerns with the current $3.5 trillion reconciliation bill. Senator Manchin has called for a more modest proposal and highlighted hesitation to numerous new taxes.Senator Krysten Sinema (D-AZ), as well as moderate House Democrats, are sharing their own reservations as well as a desire to vote on the bi-partisan infrastructure bill first.The Hill highlighted opening issues on the more progressive side as well, with Senator Bernie Sanders (I-VT) and Rep. Pramila Jayapal (D-WA) arguing the bill must stand at $3.5 trillion, which they view as a compromise from their initial $6 trillion goal. We mention these political developments only to highlight one thing: the final bill is going to look different.ConclusionDissimilar to Godot, the budget bill will, in fact, arrive in the next few weeks. Family business directors can prepare themselves and their businesses by checking in with their estate attorneys and financial advisors regarding their estate plans.We provide valuation services to families seeking to optimize their estate plans. Give one of our professionals a call to discuss how we can help you in the current environment.

Managing Complicated Multi-Tiered Entity Valuation EngagementsWhen equity markets fell in early 2020 due to the onset of the COVID-19 global pandemic, many business owners and tax planners contemplated whether it was an opportune time to engage in significant ownership transfers.Although equity markets have recovered to all-time highs, a confluence of three factors may make 2021 an ideal time for estate planning transactions for owners of private companies:Depressed Valuations. Valuations for many privately held businesses remain somewhat depressed due to significant supply chain challenges and hiring difficulties.Low Interest Rates.Applicable federal rates (AFRs) are at historically low levels, allowing business owners to make leveraged estate planning strategies more efficient.Political Risk.The Biden administration’s proposal to lower the gift and estate tax exemption andincrease the capital gains tax rate may prompt some individuals and businesses to take advantage of currently favorable tax conditions before any adverse changes are made.Mercer Capital has been performing valuations for complicated tax engagements since its inception in 1982.For many high net worth individuals and family offices, complex ownership structures have evolved over time, typically involving multi-tiered entity organizations and businesses with complicated ownership structures and governance.In this article, we describe the processes that lead to credible and timely valuation reports.These processes contribute to smoother engagements and better outcomes for clients.Defining the EngagementDefining the valuation project is an important step in every engagement process, but when multiple or tiered entities are involved, it becomes critical.It is insufficient to define a complicated engagement by referring only to the top tier entity in a multi-tiered organizational structure.The engagement scope should clearly identify all the direct and indirect ownership interests that will need to be valued.This allows the appraiser to plan the underlying due diligence and analytical framework to design the deliverable work product.For example, will the appraiser need to perform a separate appraisal at each level of a tiered structure?Or, can certain entities or underlying assets be valued using a consolidated analytical framework?Planning well on the front end of an engagement leads to more straightforward analyses that are easier to defend.Collecting the Necessary InformationDuring the initial discussion of the engagement, the appraiser will usually request certain descriptive and financial information (such as governing documents, recent audits, compilations, and/or tax returns) to determine the scope of analysis needed to render a credible appraisal for the master, top-tier entity and the underlying entities and assets.Upon being retained, one of the first things an appraiser will do is to prepare a more comprehensive information request list designed to solicit all the documentation necessary to render a valuation opinion.Full and complete disclosure of all requested information, as well as other information believed pertinent to the appraisal, will aid the appraiser in preventing double-counting or otherwise missing assets all together.Information Needed for Complex Multi-Tiered Entity ValuationRequested information for complex multi-tiered entity valuations typically falls into three broad categories:Legal documentation. The legal structure and inter-relationships in complex assignments are essential to deriving reliable valuation conclusions.In addition to the operating agreements, it is important to have current shareholder/member lists.A graphical organization chart is often a very helpful supplement to the legal documents and helps ensure that everyone really is “on the same page” regarding the objectives of the valuation assignment.Financial statements. A careful review of the historical financial statements for each entity in the overall structure provides essential context for the cash flow projections, growth outlook, and risk assessment that are the basic building blocks for any valuation assignment. Depending on ownership characteristics and business attributes, it may be appropriate to combine financial statements for multiple entities to promote efficiency in project execution.Supplementary information.For operating businesses, supplementary information may include financial projections, detailed revenue and margin data (by customer, product, region or some other basis), personnel information, and/or information pertaining to the competitive environment.For asset-holding entities, supplementary data may include current appraisals of real estate or other illiquid underlying assets, brokerage statements, and the like.The ultimate efficiency of the project often hinges on timely receipt of all requested information. Disorganized information or data that requires a lot of handling or interpretation on the part of the appraiser adds to project cost, and more importantly, can make it harder to defend valuation conclusions that are later subject to scrutiny.In short, providing high quality information in response to the appraiser’s request list promotes a more predicable outcome with the IRS and with other stakeholders.The Importance of Reviewing the Draft AppraisalUpon completing research, due diligence interviews with appropriate parties, and the valuation analysis, the appraiser should provide a draft appraisal report for review.The steps discussed thus far – careful planning and timely information collection – are not substitutes for careful review of the draft appraisal report.The complexity of many multi-tiered structures increases the need for relevant parties to review the draft appraisal for completeness and factual accuracy.Engagements involving complicated entity and operational structures are not easily shoehorned into typical appraisal reporting formats and presentation. Unique entity and asset attributes may require complex valuation techniques and heighten the need for clear and concise reporting of appraisal results. Regardless of the complexity of the underlying structure and valuation techniques, the appraisal report should still be easy to read and understand.Click here to expand the checklist above

It’s been over six months since we last took inventory of where we stood in the face of tax changes (increases) affecting estate planning. We are happy to report that in that time we have gained a firm understanding of the changes that are set to occur. Estate planners should have clarity on how to work through the changes with their clients in a timely manner and at a leisurely pace before the end of the year. Hey look, flying pigs!As Paul wrote to the Corinthians, "For now we see through a glass, darkly." While we may have some ideas on what is coming with the current tax policy, the full picture remains murky. Here’s what we are reading and listening to regarding tax changes and other factors affecting family businesses and estate plans.What Are the Exact Changes as Proposed?Fiduciary Trust International highlighted the key tax issues currently at hand regarding estate planning. These included:The top individual federal income tax rate could increase from 37% to 39.6%.Long-term capital gains tax rate could increase from 23.8% to as high as 43.4% when including the net investment income tax of 3.8%.Cost basis ‘step-up’ could be removed for gains of over $1 million on inherited assets.The federal estate tax rate could increase on a progressively sliding scale for assets transferred over $3.5 million. A reduction in the gift and estate tax exemption has not been explicitly included in the current round of changes. Given that the current limits are set to expire in 2025, one may wonder if conserving political capital was not part of the equation in leaving the current $11.7 million exemption ($23.4 million for a married couple) in place. One piece of advice the article gives: consider using your full estate and gift tax exemption before the exemption amount is set to decrease.Tax Update: How Proposed Tax Changes Could Impact Family-Owned BusinessesFamily Business Magazine sponsored a webinar featuring two members from BMO Family Office discussing tax planning and tax changes that could affect family businesses – including tax considerations for buying and selling, the tax impact for C corporations vs. S corporations, and 1031 exchanges. The webinar is free for replay when you sign up. Overall, the speakers are 'bullish' (read: not convinced) at the likelihood of the full tax changes coming to fruition. One of the speakers highlighted that the step-up in basis at death has been repealed multiple times legislatively, all to be reversed shortly thereafter. He cited the administrative nightmare of determining basis in family businesses/assets that have been held by families for decades.Bipartisan Infrastructure Deal Still Faces a Long, Uncertain RoadMarketWatch highlighted the recent U.S. Senate movement on the stand-alone infrastructure bill coming in at a cool $1 trillion in new infrastructure spending. However, the Biden Administration’s proposed tax increases would be included in the larger $3.5 trillion budget reconciliation process and are not currently part of the bipartisan traditional infrastructure bill. Benjamin Salisbury, director of research at Height Capital Markets, relayed the following in an investment note:"We maintain our estimate of a roughly 35%-45% probability of passing a joint bipartisan infrastructure bill and slimmed down reconciliation bill, although the situation is highly fluid.""A lesser probability (20%-30%) is that either the infrastructure bill or reconciliation bill pass on their own.""Lastly there is an ever present risk (25%-45%) that the entire effort will collapse under its own weight. We continue to regard the inflation narrative as the largest risk to passage."Moderate Democrats Remain SkepticalElected moderate Democrats remain the most watched politicians in the U.S. today, with multiple congressmen giving pause to the full slate of tax increases and new spending. Senator Kyrsten Sinema (D-AZ) said to the Arizona Republic, "I have also made clear that while I will support beginning this process, I do not support a bill that costs $3.5 trillion." Senator Joe Manchin (D-WV) indicated months ago that he does not support raising the corporate tax rate to 28%. House Agriculture Committee Chairman David Scott (D-GA) has criticized Biden’s plan to get rid of the so-called step-up basis, worrying about its impact on family farms and small businesses. Senator John Tester (D-MT) shared a similar sentiment regarding the basis step-up.Further ReadingNational Law Review – President Biden's Tax Plan Impacts Estate Planning, Capital GainsNorthwestern Mutual – With Gift Taxes and Estate Taxes in Congress’ Sights, Consider Revisiting Your Estate PlanningBarnes & Thornburg LLP - Unprecedented Changes Proposed to Gift and Estate Tax LawsKiplinger – Biden Hopes to Eliminate Stepped-Up Basis for MillionairesFinal ThoughtsOne of my favorite books in 2020 was Radical Uncertainty: Decision-Making Beyond the Numbers. The authors make the distinction between risk (quantifiable: think roulette tables) and uncertainty. Most of life is uncertain, and we are naïve to place numbers and probabilities on all aspects of our lives. The authors note, "Radical uncertainty cannot be described in the probabilistic terms applicable to a game of chance. It is not just that we do not know what will happen. We often do not even know the kinds of things that might happen." Tax changes are quantifiable risks, political machinations in Washington represent uncertainty. Our actions need to represent this distinction.Thus, we leave you with the same advice we provided six months ago: take care of your family and make sure your current estate plan makes sense today. We provide valuation services to families seeking to optimize their estate plans. Give one of our professionals a call to discuss how we can help you in the current environment.

In prior pieces, we have expressed our general disdain for formula clauses. While there are many flaws and specific issues that can arise, formula clauses can also serve a valuable purpose, particularly for family members or people with an interest in an auto dealership that do not know much about the industry. In this post, we explain formula clauses, when they are used, why they are used, and why we ultimately recommend they not be used.A formula clause explains how a business will be valued, usually as part of a buy-sell agreement, employment agreement, transfer of interests under certain circumstances, or other agreement entered between owners of a company. Formula clauses are most often used for the purposes defined in their respective governance documents.  Common triggering events include death, disability, retirement, divorce, or termination of an owner.Formula clauses typically involve a combination of accounting and valuation information.  For example, formula clauses may begin with a company’s book value of equity from the most recent month’s financial statement, most recent year ended, or some average of periods.  Formula clauses may also include some component of a valuation multiple such as a multiple of revenue, EBITDA, earnings, or some other financial metric.  These valuation multiples are often kept static throughout the life of the buy-sell agreement.What Are the Benefits of a Formula Clause?Formula clauses are simple and leave little room for debate as to the value of an interest in a business.  This is particularly helpful for family members that might own an interest in a dealership but have little idea of how the business works. The learning curve for auto dealerships can be quite steep, but most people can navigate to a page and line on a financial statement and do the basic math involved with adding an indication of Blue Sky value to net assets.  No long division required.This can also lead to less contentious transfers if everything goes smoothly.  If partners are frequently coming and going, or minority investors have always been cashed out at a Blue Sky value of 4x LTM pre-tax income, a reasonable expectation can be set for the worth of the business and people can plan accordingly.  However, this tends not to be the case, and formula clauses do not always make for the smooth ownership transitions that their writers envisioned.What Are the Common Pitfalls of Formula Clauses?While simplicity can be good in certain cases, there are obvious drawbacks to having such a cut and dry conclusion. Three main issues we’ve seen include:Formulas may be drafted by those without industry knowledge which leads to less meaningful conclusions.Formulas that make sense at the writing of the agreement may become stale in time.Rigid calculations do not allow for normalization adjustments that may be obvious to parties on both sides of an actual negotiation between a willing buyer and willing seller.Formulas That Consider and Correctly Apply Valuation Methods Used Frequently in the Auto Dealer IndustryBy its nature, the value indicated by a formula clause is unlikely to be the most analytically rigorous conclusion. This means an auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.An auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.For starters, if the formula clause starts by talking about P/E multiples or EBITDA multiples, the drafter of the agreement is likely not aware of how auto dealerships are valued. It is important that the valuation methodology that the formula clause seeks to approximate reflects how industry participants discuss value.The multiples also must be appropriately applied. If a blue sky multiple is used to approximate intangible value, it’s important not to double count any franchise rights that may be on the books from an acquisition. If an EBITDA multiple is used, it is important that the calculation appropriately captures floor-plan interest as an operating expense and does include floor-plan debt in enterprise value.Formula Clauses Can Become Stale Over Time, Particularly if Not Used RegularlyValuation multiples also ebb and flow through the business cycle. If the buy-sell agreement is written to include a blue sky value of 5x LTM pre-tax income, for example, that may make sense when the document is written. Fast forward five years. Is your dealership going for the same multiple?An easy way around this would be to have the multiple be dynamic. Haig Partners and Kerrigan Advisors publish blue sky ranges quarterly, so pinning the multiple on the most recently published range could better approximate what dealerships are going for in the marketplace when the valuation is needed.Fast forward five years. Is your dealership going for the same multiple?However, as my colleague here in Nashville likes to point out, our work tends to be less on the multiple and more on estimating the ongoing earnings correctly. Multiples, whether from market transactions or built up using a discount rate, are largely based on market based indications. It is up to experienced appraisers to determine what earnings stream is applicable to these multiples.Simple Calculations Can Miss Crucial Normalization AdjustmentsFirst, we should say that we believe a multi-year approach is appropriate. In light of heightened profits in 2020 extending into this year, other industry participants are moving toward a multi-year viewpoint as dealers looking to divest are unlikely to receive high multiples on peak profits. In previous posts, we’ve discussed some common normalization adjustments for auto dealerships. Here, we’ll give a simple example that shows the pitfalls of not making adjustments or using a multi-year approach.Consider a dealership with $5 million in tangible net asset value and pre-tax income levels as shown below. Also assume the dealership received a PPP loan of $500 thousand that was forgiven. Taking a 3-year average from 2018-2020, as suggested by Haig Partners, adjusted ongoing pre-tax income would be $1.1 million. Assuming a blue sky multiple of 5.0x is applicable to this dealership, Blue Sky would be $5.5 million and the total equity would be $10.5 million. Now, assume the 3-year average is based on pre-tax income directly off the dealer financial statement with no adjustments. While reasonable people would agree that the PPP loan is clearly an example of something that is not expected to happen every year, the formula clause does not leave room to make this adjustment. Despite only giving this period 1/3 of the weight, we see total equity value would go up by over $833 thousand or about 8%. Taking this one step further, look at the implied value by taking the multiple based on only one year of performance. While $2 million in earnings is almost double historical levels, a formula clause with a static multiple will likely lead to overvaluation. In the example above, value increased by $4.5 million, or 43%. These simplified examples show the potential pitfalls of formula clauses. We’re only scratching the surface of potential adjustments that might be applicable, including market adjustments to rent, owner’s compensation, discretionary expenses, non-recurring items, and any other adjustments in order to determine what a buyer of the dealership might reasonably expect to earn. ConclusionHopefully, we’ve illustrated the potential issues with formula clauses that we find in buy-sell agreements. In our opinion, there is truly no substitute to having a qualified business appraiser with experience valuing auto dealerships analyze the company to determine the value of an interest in the dealership. We think there are still some benefits, particularly for those outside the business to have an idea of the value of the dealership. It is more important, however, to get the appropriate value of a business, particularly if the transaction has the potential to become contentious.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

In prior pieces, we have expressed our general disdain for formula clauses. While there are many flaws and specific issues that can arise, formula clauses can also serve a valuable purpose, particularly for family members or people with an interest in an auto dealership that do not know much about the industry. In this post, we explain formula clauses, when they are used, why they are used, and why we ultimately recommend they not be used.A formula clause explains how a business will be valued, usually as part of a buy-sell agreement, employment agreement, transfer of interests under certain circumstances, or other agreement entered between owners of a company. Formula clauses are most often used for the purposes defined in their respective governance documents.  Common triggering events include death, disability, retirement, divorce, or termination of an owner.Formula clauses typically involve a combination of accounting and valuation information.  For example, formula clauses may begin with a company’s book value of equity from the most recent month’s financial statement, most recent year ended, or some average of periods.  Formula clauses may also include some component of a valuation multiple such as a multiple of revenue, EBITDA, earnings, or some other financial metric.  These valuation multiples are often kept static throughout the life of the buy-sell agreement.What Are the Benefits of a Formula Clause?Formula clauses are simple and leave little room for debate as to the value of an interest in a business.  This is particularly helpful for family members that might own an interest in a dealership but have little idea of how the business works. The learning curve for auto dealerships can be quite steep, but most people can navigate to a page and line on a financial statement and do the basic math involved with adding an indication of Blue Sky value to net assets.  No long division required.This can also lead to less contentious transfers if everything goes smoothly.  If partners are frequently coming and going, or minority investors have always been cashed out at a Blue Sky value of 4x LTM pre-tax income, a reasonable expectation can be set for the worth of the business and people can plan accordingly.  However, this tends not to be the case, and formula clauses do not always make for the smooth ownership transitions that their writers envisioned.What Are the Common Pitfalls of Formula Clauses?While simplicity can be good in certain cases, there are obvious drawbacks to having such a cut and dry conclusion. Three main issues we’ve seen include:Formulas may be drafted by those without industry knowledge which leads to less meaningful conclusions.Formulas that make sense at the writing of the agreement may become stale in time.Rigid calculations do not allow for normalization adjustments that may be obvious to parties on both sides of an actual negotiation between a willing buyer and willing seller.Formulas That Consider and Correctly Apply Valuation Methods Used Frequently in the Auto Dealer IndustryBy its nature, the value indicated by a formula clause is unlikely to be the most analytically rigorous conclusion. This means an auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.An auto dealership valued using a formula clause is likely to be different from the value determined by a qualified business appraiser that has experience valuing auto dealerships.For starters, if the formula clause starts by talking about P/E multiples or EBITDA multiples, the drafter of the agreement is likely not aware of how auto dealerships are valued. It is important that the valuation methodology that the formula clause seeks to approximate reflects how industry participants discuss value.The multiples also must be appropriately applied. If a blue sky multiple is used to approximate intangible value, it’s important not to double count any franchise rights that may be on the books from an acquisition. If an EBITDA multiple is used, it is important that the calculation appropriately captures floor-plan interest as an operating expense and does include floor-plan debt in enterprise value.Formula Clauses Can Become Stale Over Time, Particularly if Not Used RegularlyValuation multiples also ebb and flow through the business cycle. If the buy-sell agreement is written to include a blue sky value of 5x LTM pre-tax income, for example, that may make sense when the document is written. Fast forward five years. Is your dealership going for the same multiple?An easy way around this would be to have the multiple be dynamic. Haig Partners and Kerrigan Advisors publish blue sky ranges quarterly, so pinning the multiple on the most recently published range could better approximate what dealerships are going for in the marketplace when the valuation is needed.Fast forward five years. Is your dealership going for the same multiple?However, as my colleague here in Nashville likes to point out, our work tends to be less on the multiple and more on estimating the ongoing earnings correctly. Multiples, whether from market transactions or built up using a discount rate, are largely based on market based indications. It is up to experienced appraisers to determine what earnings stream is applicable to these multiples.Simple Calculations Can Miss Crucial Normalization AdjustmentsFirst, we should say that we believe a multi-year approach is appropriate. In light of heightened profits in 2020 extending into this year, other industry participants are moving toward a multi-year viewpoint as dealers looking to divest are unlikely to receive high multiples on peak profits. In previous posts, we’ve discussed some common normalization adjustments for auto dealerships. Here, we’ll give a simple example that shows the pitfalls of not making adjustments or using a multi-year approach.Consider a dealership with $5 million in tangible net asset value and pre-tax income levels as shown below. Also assume the dealership received a PPP loan of $500 thousand that was forgiven. Taking a 3-year average from 2018-2020, as suggested by Haig Partners, adjusted ongoing pre-tax income would be $1.1 million. Assuming a blue sky multiple of 5.0x is applicable to this dealership, Blue Sky would be $5.5 million and the total equity would be $10.5 million. Now, assume the 3-year average is based on pre-tax income directly off the dealer financial statement with no adjustments. While reasonable people would agree that the PPP loan is clearly an example of something that is not expected to happen every year, the formula clause does not leave room to make this adjustment. Despite only giving this period 1/3 of the weight, we see total equity value would go up by over $833 thousand or about 8%. Taking this one step further, look at the implied value by taking the multiple based on only one year of performance. While $2 million in earnings is almost double historical levels, a formula clause with a static multiple will likely lead to overvaluation. In the example above, value increased by $4.5 million, or 43%. These simplified examples show the potential pitfalls of formula clauses. We’re only scratching the surface of potential adjustments that might be applicable, including market adjustments to rent, owner’s compensation, discretionary expenses, non-recurring items, and any other adjustments in order to determine what a buyer of the dealership might reasonably expect to earn. ConclusionHopefully, we’ve illustrated the potential issues with formula clauses that we find in buy-sell agreements. In our opinion, there is truly no substitute to having a qualified business appraiser with experience valuing auto dealerships analyze the company to determine the value of an interest in the dealership. We think there are still some benefits, particularly for those outside the business to have an idea of the value of the dealership. It is more important, however, to get the appropriate value of a business, particularly if the transaction has the potential to become contentious.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers, their partners, and family members understand the value of their business. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

It is imperative for estate planners to engage valuation analysts that perform the proper procedures and follow best practices when performing valuations for gift and estate planning purposes. It is necessary to have a well-supported valuation because these reports are scrutinized by the IRS and may end up going to court. The recent decision by the U.S. Tax Court in Estate of Michael J. Jackson v. Commissioner provides several lessons and reminders for valuation analysts, and those that engage valuation analysts, to keep in mind when performing valuations for gift and estate planning purposes. Michael Jackson, the “King of Pop,” passed away on June 25, 2009. His Estate (the “Estate”) filed its 2009 Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, listing the value of Jackson’s assets. After auditing the Estate’s tax return, the Commissioner of the Internal Revenue Service (the “Commissioner”) issued a notice of deficiency that concluded that the Estate had underpaid Jackson’s estate tax by a little more than $500 million. Because the valuation of some assets were considered to be so far off, the Commissioner also levied penalties totaling nearly $200 million on the Estate. The IRS and the Estate settled the values of several assets outside of court. The case involved three contested assets of Michael Jackson’s estate: Jackson’s Image and LikenessJackson’s interest in New Horizon Trust II (“NHT II”) which held Jackson’s interest in Sony/ATV Music Publishing, LLC, a music-publishing companyJackson’s interest in New Horizon Trust III (“NHT III”) which contained Majic Music, a music-publishing catalog We discuss the key topics that the Tax Court ruled on and addressed that inform valuation analysts in the preparation of quality valuation reports.Known or KnowableIt is important that valuation analysts only rely on information that was known or knowable at the valuation date.In the decision, the Tax Court rejects the analysis of experts on several occasions for using information that was “unforeseeable at the time of Jackson’s death.”The Tax Court goes on to state that “foreseeability can’t be subject to hindsight.”It can be difficult to distinguish and depend on only the information known or knowable at the valuation date especially when a significant amount of time has passed between the current date and the valuation date.Therefore, a careful examination of all sources of information is necessary to be sure that it can be relied upon in the analysis.As can be seen from the Tax Court’s opinion, valuation analysts and experts can undermine their credibility by relying on information that was not known or knowable at the valuation date.Tax Affecting S CorporationsThe Tax Court, in this specific case, did not accept the tax affecting of S Corporations: “The Estate’s own experts used inconsistent tax rates.They failed to explain persuasively the assumption that a C corporation would be the buyer of the assets at issue.They failed to persuasively explain why many of the new pass-through entities that have arisen recently wouldn’t be suitable purchasers.And they were met with expert testimony from the Commissioner’s side that was, at least on this very particular point, persuasive in light of our precedent.This all leads us to find that tax affecting is inappropriate on the specific facts of this case.”The Tax Court did, however, leave room for the possibility of tax affecting being appropriate by stating, “we do not hold that tax affecting is never called for.”At Mercer Capital, we tax affect the earnings of S corporations and other pass-through entities.Given that this issue continues to be a point of contention, it is imperative that valuation analysts provide a thorough analysis and clear explanation for why tax affecting is appropriate for S corporations and other tax pass-through entities.Developing Projected Cash FlowsIn the valuation of NHT II, the Court found it more reasonable to use the projections of Sony/ATV in the development of a forecast used in the income approach rather than relying on historical financial performance to inform the projection.The Tax Court based its decision on the fact that “the music-publishing industry was (and has remained) in a state of considerable uncertainty created by a long series of seismic technological changes. We think that projections of future cashflow, if made by businessmen with an incentive to get it right, are more likely to reflect reasonable estimates of the short-to-medium-term effects of these wild changes in the industry that even experts, much less judges, are unlikely to intuit correctly.”This decision makes it clear that valuation analysts need to fully understand the industry in which the company operates and develop a forecast that is most reasonable given the information available as of the valuation date.In cases where analysts have access to a projection developed by management, valuation analysts should have a clear, well-reasoned rationale for not relying on the forecast should they decide not to use it in the analysis.However, valuation analysts should not blindly accept management’s forecasts as truth but should perform proper due diligence to assess the reasonability of the forecast and clearly articulate any deviations from management’s forecast.Other Topics AddressedA few other topics of note are addressed throughout the decision that can help valuation analysts provide reliable valuation analyses.On more than one occasion, the Tax Court sided with the expert that provided a compelling explanation for the use of a certain assumption rather than arbitrarily using an assumption without explanation.The Tax Court also sided with one expert simply because they provided a clear citation for their source when another expert did not.The Tax Court also called out the inconsistency of an expert in their report and testimony.These topics addressed by the Tax Court demonstrate that consistently explaining and citing the sources of assumptions and key elements of the valuation analysis help to produce a supportable valuation analysis.Finally, the expert for the Commissioner seriously damaged their credibility in the eyes of the Tax Court when the expert was caught in a couple lies during the trial.The Tax Court found that the expert “did undermine his own credibility in being so parsimonious with the truth about these things he didn’t even benefit from being untruthful about, as well as not answering questions directly throughout his testimony.This affects our fact finding throughout.”Takeaways & ConclusionThe table below presents the valuation conclusions of the Estate, Commissioner, and the Tax Court at trial. This decision has shown that it is critical for valuation analysts to present quality valuation reports that are clear, supported, and follow accepted best practices.At Mercer Capital, estate planners can be confident that we follow the proper procedures, standards, and best practices when performing our valuations for gift and estate planning.Mercer Capital has substantial experience providing valuations for gift and estate planning as well as expert witness testimony in support of our reports.Please do not hesitate to contact one of our professionals to discuss how Mercer Capital may be able to help your estate planning needs.

Recently, the Biden Administration announced elements of its tax agenda in the American Families Plan. The Biden Administration aims to make some significant changes to current tax law.These changes are highlighted by the following:Increasing the top capital gains tax rate to 39.6%Increasing the top federal income tax rate to 39.6%Increasing the corporate tax rate to 28% Another substantial proposal includes the elimination of the step-up in basis. The potential elimination of the step-up in basis presents an estate planning opportunity to high-networth individuals and family business owners or should at least spur them to contemplate revisiting their estate plans.What Is the Step-Up In Basis?The step-up in basis refers to the current tax environment that allows individuals to transfer appreciated assets at death to their heirs at the current market value without heirs having to pay capital gains taxes on the unrealized capital appreciation of those assets that occurred during the individual’s life. In other words, heirs currently benefit from a “step-up” in tax basis of inherited assets to the market value on the day of death, and no taxes are paid on unrealized capital appreciation of the assets.Biden Administration ProposalThe Biden Administration is proposing to eliminate this step-up in basis. This means that the heir would be responsible for the taxes on the unrealized capital appreciation of the assets being transferred as if the assets had been sold. This would result in a large tax burden on the heir especially when considering that the Biden Administration is also aiming to increase the top capital gains tax rate to 39.6%. Specifically, the proposal would end the step-up in basis for capital gains What Does the Step-Up in Basis Tax Proposal Mean for High Net Worth Individuals and Family Businesses? in excess of $1 million (or $2.5 million for couples when combined with existing real estate exemptions). So, the first $1 million of unrealized capital gains would be exempt from taxes and only the excess would be taxed. However, the proposal does state that “the reform will be designed with protections so that family-owned businesses and farms will not have to pay taxes when given to heirs who continue to run the business.” These protections and exemptions seem to provide some relief for family businesses, but the details of the protections have yet to be specified.TakeawaysThese proposals are certainly not set in stone and may change as the proposals are debated and legislature eventually makes its way through Congress. However, the Biden Administration’s current tax proposals could have a significant impact on the estate planning environment.The potential elimination of the step-up in basis is yet another reason for high-net-worth individuals and family business owners to make estate plans or revisit their current estate planning techniques. When considered alongside other Biden Administration proposals such as an increase in the capital gains tax and the fact that the increased lifetime gift and estate tax exclusion limits are set to sunset in 2025, now is a great time to have a conversation about planning. Contact a professional at Mercer Capital to discuss your specific situation in confidence.

L. Paul Hood, Jr., JD, LL.M, CFRE, FCEP is a long time friend of the firm and an experienced and thoughtful estate planner. He has considerable experience working with family business continuity planning. A native of Louisiana (and a double LSU Tiger), after obtaining his law degrees in 1986 and 1988, Paul settled down to practice tax and estate planning law in the New Orleans area. Paul has spent over 30 years specializing in taxes and estate planning. He has taught at the University of New Orleans, Northeastern University, The University of Toledo College of Law and Ohio Northern University Pettit College of Law. The proud father of two Eagle Scouts and LSU Tigers, Paul has authored or co-authored seven books and over 500 professional articles on estate and tax planning and business valuation. We hope you enjoy this brief Q&A with Paul.Welcome, Paul. Tell us a little bit about yourself and your practice.Paul Hood: I like to describe myself in two ways. First, I’m a recovering tax lawyer. Second, I’m a purposeful estate planner. I believe in focusing much more attention on the human side of estate planning because it’s the most challenging part of estate planning, much more so than the tax planning and property disposition aspects of estate planning. But very few estate planners want to delve sufficiently deeply into the human side because it involves dealing with real human emotions, including our own.Along the course of my life, I’ve been a father, husband, lawyer, trustee, director, president, partner, trust protector, director of planned giving, expert witness, agent, professor, judge, juror and a defendant, and I use this life experience in these myriad roles to guide others. I help people pursue a "good estate planning result" in every case, whatever that looks like in each unique situation.You’ve written extensively about the "psychology of estate planning." In your experience, what is the single biggest psychological hurdle for family business shareholders to begin estate planning?Paul Hood: Perhaps the greatest hurdle to estate planning is most people lack sufficient self-awareness. By self-awareness, I mean that almost no one realizes the power that each of us has with respect to our estate planning decisions. One of my most important beliefs and philosophies about estate planning is that a person’s estate plan will have effects on the relationships of those who survive them, whether they want them to or not.One of the reasons why I preach the gospel of intergenerational communication from every pulpit that’ll have me is because the best estate plans I’ve ever witnessed all involved honest two-way communication between givers and receivers. Perhaps the biggest reason for post-death estate or trust litigation is the parties didn’t communicate about the estate plan.After the testator’s death, if an heir is unhappy about the estate plan, they too often entertain what I call the parade of horribles because what happened didn’t meet their expectations, and they immediately too often blame someone still alive and come out suing.A simple explanation of why the testator arranged their estate plan the way they did can eliminate a lot of post-death litigation and hurt feelings and ended relationships. A simple conversation could cut off heartbreak and family cutoff, yet most estate planners don’t implore their clients to have these essential conversations.Estate planning tends to focus primarily on minimizing transfer taxes. While that is a laudable goal, what other objectives should family business shareholders think about when it comes to estate planning?Paul Hood: A "good estate planning result" is one in which property is properly transmitted as desired, and family relations among the survivors aren’t harmed during the estate-planning and administration process.Notice that conspicuously absent from this definition is any mention of taxes. Taxes have always been the easiest piece of the estate-planning puzzle, yet the overwhelming majority of estate planners still focus their attention almost solely on the tax piece, probably because it’s easiest to solve and easiest to demonstrate quantifiable, tangible results. This misfocus has contributed to several problems for planners and clients alike.The sad fact is that perfectly confected and properly drafted estate plans render families asunder every single day in this country because the estate planners failed to address the human side of estate planning. Sadly, many of these problems are easily predictable. Frankly, I don’t know how some estate planners sleep at night.In one of your articles, you describe a "Path of Most Resistance" to achieving a good estate-planning results. Once a family business shareholder decides to engage in estate planning, what are the pitfalls that they need to watch out for?Paul Hood: The Path of Most Resistance is a model that I developed to illustrate graphically what has to happen in order to achieve the "good estate planning result" that I defined earlier. As the Path model illustrates, there are psychological machinations at work in every participant in the estate planning play, which includes the estate planners. As I have already discussed, intergenerational communication is essential in my opinion, particularly in a family business. Where there’s a family business involved, I view a frank and honest keep-or-sell discussion involving the entire family as perhaps the most important conversation that too few families in business ever have. Why is that? I view such a discussion as a means of gauging the family members’ individual and collective interests in continuing to be in business together. However, it’s a loaded question that can open up some family wounds, so caution is in order. Done correctly, the discussion can reinvigorate a business family’s overt commitment to the business in its current form. Unfortunately, lots can go wrong and can hasten or cause loss of the family business and family relationships because the keep or sell discussion can get very emotional and bring out hidden or suppressed feelings that have been harbored in silence and allowed to simmer past the boiling point upon their invitation to the surface. An estate plan should provide a system of checks and balances on power and authority, particularly in a family business. Estate planning necessarily involves a passing of the torch of leadership and control. As Lord Acton observed long ago, power tends to corrupt, and absolute power corrupts absolutely. Power shifts can expose people and leave them vulnerable to oppression, even to being terminated in employment or as a beneficiary through, for example, a spiteful exercise of a power of appointment (POA). The purposeful estate planner will build in a series of checks and balances that simultaneously allow exercise of authority and provide protection to those who are subject to that authority, which can be in the form of veto powers, powers to remove and replace trustees, co-sale or tag along rights, accounting rights or similar types of protections. Who are the different parties involved in the estate planning process? Do you have any tips for ensuring that all these parties work together for a successful outcome?Paul Hood: As the Path model illustrates, there are several "players" in the estate-planning play. I realize that most clients have more than two estate-planning professionals or advisors assisting them, but the larger point is that having more than one advisor itself creates potential obstacles in the path toward a good estate-planning result.In addition to the interested parties (the giver and one or more receivers), achieving a good estate planning outcome often involves one or more attorneys, an accountant, a valuation professional. Depending on the structure of the plan and the clients' needs, life insurance or other professionals may be involved in the process as well.The client should have as many advisors as he feels is necessary or appropriate. I’m a big believer in referrals and collaboration simply because it was my experience that clients get better service and a better estate plan. However, having more advisors creates a situation that must be watched and managed. I’ve seen estate-planning engagements fall apart because the advisors were incapable of cooperating and collaborating, which is a bad result for the client and can add to the negative experiences that the client will take to the next advisor, if any.Each of the estate-planning sub- specialties have their own ethical rules and conventions. These ethics rules impact subspecialties differently. The legal ethics rules insert some additional complexities in the estate-planning process, particularly in the areas of confidentiality and conflicts of interest. It’s imperative that the planner’s engagement letter permits complete and total access to all of a client’s advisors.Moreover, different advisors in the same subspecialty may have vastly different philosophies about estate planning. It’s critical that advisors check their egos and biases at the door before getting down to work with an open mind and collaboratively on a client’s situation. With collaboration comes diversity of professional backgrounds, educational and experiential pedigrees; different manners of training; and significant knowledge about a certain aspect of the client’s estate plan. This diverse strength of the group exceeds the strength of the sum of its individual members. This excess is called synergy.Estate planning is one of the most important tasks a business owner will face. Assembling the right team, and making sure they can work together, can increase the odds that you achieve a good estate planning result.

In business valuation, appraisers seek to normalize historical earnings to establish the level of earnings an investor might reasonably expect from an investment in the subject company. These adjustments may increase or decrease earnings, and they can be for a variety of reasons. Normalization adjustments include surveying various expense categories and determining whether the amount historically paid is considered “market rate.”Rent paid to a related party is frequently judged to be above or below market, which can be for a variety of reasons. Dealers’ priorities lie more with sales and operating efficiency than tracking what the market says they should pay in rent. The rent paid also may be artificially high or low for tax purposes. In this post, we examine what exactly this means, and why auto dealers may hold real estate in a separate but related entity from the one that owns the dealership operations.What Are the Options and Are Taxes in Play?To understand why paying above market rent might be advantageous for an auto dealer, we need to know the options available and the tax implications. There are a few ways for gross profits to end up in the pockets of dealers:Retain as profit and pay a distribution (corporate income tax and personal dividend tax)Pay as compensation to owner (personal income tax and payroll tax)Pay as rent to related pass-through entity that owns the real estate (personal income tax)Pay Corporate Taxes on Profits and Pay a DividendMaking the decision for “tax purposes” has frequently implied avoiding the double taxation inherent in C corporations. A dealership organized as a C corporation would owe approximately 25% in state (assuming a 5% state tax rate) and federal corporate income tax, meaning $1,00,000 in pre-tax earnings would equate to a dividend of about $750,500. Then, the owner would likely owe an additional 15-20% in dividend taxes, meaning $1,000,000 may be closer to $600,400 in after-tax(es) proceeds. An all-in tax rate of approximately 40% in 2021 is much lower than what dealers would have paid prior to the 2017 Tax Cuts and Jobs Act as shown below:The reduction in the federal corporate income tax itself was a fundamental change to how business owners think about these excess profits. While it significantly increased after-tax proceeds under this payment structure, many owners had already been using more advantageous tax strategies. That’s why most private dealerships aren’t organized as C corporations.Pay Excess Profits as Compensation to DealerIf excess profits are paid as compensation, a dealer is likely to owe the top marginal personal tax rate of 37%. While this appears better than the ~40% tax contemplated above, this fails to capture payroll taxes. Up to certain income levels, a payroll tax of 15.3% is split by employers and employees to fund Social Security (6.2% each) and Medicare (1.45% each). While companies’ exposure to the social security tax is capped at $142,800 in compensation, there is no limit for individuals; in fact, there is an additional Medicare tax of 0.9% added on to the 1.45% on income over $200,000. These calculations can become more complicated depending on the level of payment, and the analysis gets further muddied by the level of pre-bonus compensation to the dealer (below analysis assumes no base salary).As seen above, the analysis becomes more nuanced, but there does not appear to be a huge opportunity for tax savings as the implied all-in tax is near the 40% calculated above post-TCJA.Pay Excess Profits as Rent to a Pass-Through Owned by the DealerPaying higher rent is likely the cleanest way to transfer profits from the dealership to a separately held entity. If the rent paid on the property was $1,000,000 more than it otherwise would be with no commensurate increase in expenses to the entity, income would be passed through at personal rates, like compensation just without payroll taxes. While pass-through entities may also be able to benefit from the Qualified Business Income Deduction, we have not considered this in our calculations because the deduction phases out well before the contemplated $1,000,000 in excess profit/rent. While this appears most advantageous, we should caveat that the IRS may not take to kindly to egregious overpayments of rent to shelter income. Regardless, income and payroll taxes aren’t the only reason a dealer might own the dealership’s real estate operations in a separate entity. There are other strategic reasons it makes sense for auto dealers to have the real estate held in a separate entity, as is common in the industry. An example of this is legal protection from creditors by separating assets.  It also enables dealers to retain upside in valuable real estate if they choose to divest of their dealership but retain steady income.  As discussed below, there are also other tax planning benefits from this structure. Tax Planning Benefits of Using Multiple EntitiesEarnings on real estate may receive a higher multiplein the marketplace than a business, including auto dealership real estate. This is because rents are paid before equity holders and are therefore viewed as less risky. These steady earnings streams can be beneficial from a financial planning standpoint. In the case of a divorce, the “out-spouse,” or the divorcing party that doesn’t actively participate in the business, might receive alimony, or an equitable division of the marital estate. It may make sense for an auto dealer’s spouse to receive an interest in a real estate entity, receiving more steady cash flows, while the auto dealer would retain the upside of their work in the business.There may also be estate planning benefits that similarly align incentives. If an auto dealer has numerous children and one works in the business, it may similarly make sense for them to either purchase or be gifted an equity interest in the dealership as they actively contribute to its profitability. For a child not involved in the business, it may be the most equitable solution to instead allow them to receive an interest in the real estate, receiving both a steady income and also passive appreciation.ConclusionAs we’ve seen, auto dealers have numerous considerations and options when it comes to excess profits that might be paid as a bonus, dividend, or rent.  As appraisers, we are unlikely to opine a higher or lower valuation to a dealership’s operations based on these decisions. While the calculations can become more complex, it is unlikely one of these will increase the value of the enterprise for two reasons: a buyer is less likely to care about the current ownership structure, and if one structure always resulted in greater value, wouldn’t everyone simply choose that structure?As we’ve discussed previously, it appears the Federal Corporate tax rate does not materially impact valuations.  If tax rates change again, auto dealers will again have to consider what works best in their unique situation. This can be complicated when there are numerous owners and other life events can impact what makes the most sense from a strategic standpoint.Mercer Capital provides business valuation and financial advisory services, and our auto team helps dealers understand the value of their business as well as the greater implications of its value. Contact a Mercer Capital professional today to learn more about the value of your dealership.

Most of our colleagues at Mercer Capital live in Texas or Tennessee – two states with very low tax burdens. This is not by design so much as by circumstance: our firm grew up where we already lived. Until recently, the relatively low cost of living, short commutes, and moderate climate came with a tradeoff: most of our clients are on the coasts, so regular travel away from home was a necessity.Now that the pandemic has made geographic proximity for many meetings a non-issue, we’re beginning to wonder how many of our clients are ultimately going to join us. Dynasty’s move from New York to Florida and UBS’s relocation to Tennessee got plenty of attention. And we’re starting to hear of smaller RIAs contemplating similar moves. This isn’t a crowded trade yet though; most investment management firms still call high-cost, high-tax states home.Texas and Florida have been climbing the rankings of states with the most RIAs, but two states still dominate this survey – New York and California. New York’s position is even stronger if you include adjacent communities of investment management firms in Connecticut, New Jersey, and Pennsylvania.California is in an enviable position as the fifth largest economy on the globe, not to mention mostly-beautiful weather. That hasn’t been enough for Schwab, which has been migrating staff to Texas, Colorado, and Arizona for years. Now we’re starting to hear from California clients with staff members who moved out of state during the worst of the pandemic and would like to continue working remotely. When will their employers follow?Manhattan is another story altogether, with city tax burdens layered on top of state taxes. With all due respect to Manhattan’s theme song, in the post-pandemic, remote-work world, if you can make it anywhere, why make it there? We have another wealth management client who just relocated from New York to Tennessee – cost structure and concern over the quality of life in Manhattan for the foreseeable future were key factors.What the table above doesn’t show is the value of the talent pools already established in financial hubs like San Francisco and New York. But the relative cost of living may be enough to convince some of that talent to relocate. If that becomes a trend, all bets are off.The wrong corporate structure can exacerbate the state tax differential. Imagine the extreme scenario of a Manhattan based C Corporation that considers moving to Florida and converting to an LLC.After-tax dividends/distributions to the Florida LLC member are about 30% higher than for a shareholder in a New York City C Corporation with the same EBIT (earnings before interest and taxes). But this differential is far greater if you consider the cost of living in Florida versus New York – a difference that will widen further if President Biden successfully rolls back some or all of the reduction in corporate taxes enacted in 2017.As for proximity to clients, there are reasons to expect ultra-high net worth families in California and New York to relocate. Florida still has no estate tax, while New York just raised theirs. Tennessee and Texas (two states with no personal income tax) also have no estate tax, and Tennessee has strong and well-developed trust laws considered on-par with South Dakota.Anecdotal experience supports this trend. Friends on the west coast and in the northeast have told me they have a recurring conversation with their neighbors that revolves around the question: “how much longer are you going to stay here?” The implication of this question is that, as soon as they could, they would decamp for a lower-tax, lower-cost of living part of the U.S. Just as the pandemic accelerated many trends, we expect to see a migration of wealthy clients to more cost-effective jurisdictions, as well as the firms that serve them.

Auto dealers, like most business owners, are focused on many aspects of their business:  daily operations, strategic vision, competition, industry conditions, the state of the economy, etc.  It is less common for auto dealers to be concerned if/when their business might need to be valued.  Often, they are made aware of the need for these services by their trusted advisors including attorneys, financial planners, accountants, etc.What are common events that trigger the need for a valuation for an auto dealership?1. Estate Planning/Wealth TransferOver time, successful dealerships can accumulate tremendous value. Estate planning allows the first generation of a family to transfer wealth to the next generation through various mechanisms.Individuals and couples can take advantage of the lifetime exemption amounts by transferring value up to the current taxable exemption of $11.7 million for individuals or $23.4 million for couples over their lifetime.1  Gifting strategies can also utilize the annual exclusion amount of $15,000 per individual.Implementation of these strategies includes many different structures requiring the valuation of the auto dealership and the specific interest being transferred.  A proper valuation assists in protecting the integrity of these transactions.  Failure to support the concluded figures with a proper valuation can often lead to these transactions being challenged or audited, causing a later described litigation dispute.2. Death of a Dealer Principal/OwnerFor certain estates, an income tax return and Form-706 will have to be filed in a timely manner after the date of death. If the decedent is an owner of a business, or in this case an auto dealership, the value of the decedent’s interest will have to be valued.  The valuation will need to be performed by a qualified business appraiser that can support the value of the dealership and specific ownership interest through accepted methodologies.3. Buy-Sell AgreementIn a prior blog post, we discussed the seven elements of a highly effective buy-sell agreement. This document, along with other corporate governance documents, describes the process and criteria for a business valuation and often requires an initial valuation to set the stock price for triggering events that will be governed by the document.  Further, some buy-sell agreements require updated valuations at regular intervals or upon the occurrence of future triggering events.  Following the provisions in these documents and maintaining regular valuations can aid in limiting or avoiding litigation disputes.4. Strategic PlanningBusiness valuations can also assist auto dealers with strategic planning. Not only can a valuation provide an indication of value at a specified point in time, but successive or regular valuations can track value over time.  These valuations could be helpful for auto dealers contemplating incentive programs to reward ownership to key management.  Auto dealers can also discover the value drivers of the current appraisal and set goals to enhance value through the improvement of those value drivers over time.5. Potential Sale of DealershipAt some point, successful dealers may reach the point where they contemplate a possible exit event. If there isn’t a viable second generation to continue the operations, a sale of the dealership may be the next best option.The auto dealer industry proved to be resilient and adaptable posting strong profitability for 2020 and continuing into 2021.  Industry transaction activity also appears high for both public and private acquirors.  Most auto dealers that have owned a dealership for a period of time have likely been contacted at one point or another with some interest either by phone or through the mail.If you have not had a recent business valuation, how can you evaluate any offers or know what your dealership is worth?  A business valuation can inform you as to the value of the dealership and manage expectations to assess potential offers.6. Litigation DisputeThe next three events that we will describe all fall under the umbrella of litigation, but each is a unique event.Shareholder DisputesShareholder disputes can come in many forms: breach of contract, wrongful termination, damages, etc. In any of these scenarios, the value of the entire dealership and a specific ownership interest will be contested.  A valuation and possibly testimony can assist the attorneys and/or triers of fact determine the outcome of the case.  Certain components of an auto dealership’s value, such as Blue Sky Value, can also be critical to the case. Taxation DisputeIf a proper valuation was not utilized in an estate planning transfer or if the valuation is being challenged by the IRS, another form of litigation involving a taxation dispute could arise. These disputes require similar elements as in a shareholder dispute – valuation of the dealership, value of specific ownership interest, and possibly testimony.  A unique element of taxation disputes is that generally an expert’s valuation report also serves as their direct testimony should the matter end up in trial.  The valuation report must communicate the expert’s methodology and support for their conclusions for the value of the dealership and any applicable discounts such as lack of marketability, lack of voting rights, etc. Family Law DisputeWhile not a popular topic, dealers or their spouses in the midst of divorce would also be in need of a business valuation and potential expert witness services. In a divorce, all of the couple’s assets and liabilities need to be compiled and valued to assist the attorneys and trier of fact in the division of assets and other matters.Some assets, such as bank accounts and real estate, are easier to value.  Other assets, such as business assets can be more difficult to value.  In the auto dealer universe, these business assets can consist of more than one entity.  Many dealerships are organized where the dealership operations and franchise agreements are contained in one entity, while the underlying real estate may be owned by a separate asset holding entity.In this example, both entities would need to be valued and the methodologies to value each are different.  Some auto dealers may also own additional entities such as separate repair and body shops or re-insurance companies that also might require a business valuation.ConclusionBusiness valuations are triggered by numerous events.  By knowing the events that dictate the need for a valuation, auto dealers can be more educated in the use of these services.  As we have previously written, the auto dealer industry is unique to valuation in the methodologies employed, the terminology communicated, and the financial information utilized.  When a valuation need arises, auto dealers are best served by someone who is both a valuation expert or an industry expert.Contact a professional at Mercer Capital to assist with you a business valuation or consultation of your auto dealership and related businesses for any of these events or others.1 The lifetime exemption amounts, estate income tax rates, and corporate income tax rates could all be subject to change with the new administration in the White House and change of control in the Legislative Branch.  These changes could have a dramatic impact on business valuations and the need for related services.

A few of our recent auto dealership valuation engagements have involved disagreements among family members and the next generation or what might otherwise be termed a business divorce.  Inevitably, one of the first questions I always ask "Is there a buy-sell agreement or governance document that will provide a roadmap into the valuation of the business and the respective subject interests?"  Often the answer is "I’m not sure, I don’t know, or maybe but we haven’t reviewed it in some time."We’ve also encountered plenty of examples where these documents exist, but they are either poorly written, do not contain the necessary information, or have not been contemplated in many years since the drafting of the document.  In Stephen Covey’s popular management book, he discussed the seven habits of highly effective people.  In this post, we cover seven factors of a highly effective buy-sell agreement for auto dealerships and also touch on several other considerations.1) Standard of ValueThe standard of value establishes the parameters for how the auto dealership will be valued.  It should be clearly defined and give clear indications for how the participants in a hypothetical transaction should be viewed:  buyer, seller, motivations, knowledge of facts, etc.  The most common standard of value is fair market value and is generally defined as a hypothetical buyer and a hypothetical seller both having reasonable knowledge of the business and all relevant factors and neither being under any compulsion to buy or sell.The other most common standard of value in buy-sell agreements is fair value.  Simply put, fair value is fair market value without consideration of any applicable discounts for lack of control and lack of marketability for the subject interest.  Fair value is often used in legal proceedings.  The difference between these two standards of value and the lack of clarity in defining which standard is governed by a company’s buy-sell agreement is often the impetus to litigation.2) Level of Value Level of value is a valuation concept describing the differences between various “levels” of a company’s value. Levels of value can include financial control, strategic control, marketable minority interest, and non-marketable minority interest.  Each level has a distinct difference in the amount of control one can exhibit over the operations of a business and/or their ability to sell an interest in that business.  For the layperson, the levels of value ultimately dictate whether premiums or discounts would be applied to the subject interest being valued.3) Define Triggering Events If the goal of a buy-sell agreement or governance document is to provide a roadmap for the valuation, then it’s important for these documents to define the events that will be governed under their parameters. These events are often referred to as triggering events and can include the death of an owner, termination of an owner, divorce, change of control, etc.  By defining the triggering events, it will be clear when the document will be enacted and enforced and when it will not apply. For example, selling or gifting a minority interest in the business to future generations is not likely to be a triggering event in this context and almost certainly would not be valued at anything besides the nonmarketable minority level of value.These events can also have unique ramifications on auto dealerships.  For example, each franchised dealer has a dealer principal that has to be approved by the manufacturer.  The death or divorce of a dealer principal can also pose challenges as the transferability of that interest and title of dealer principal is not guaranteed and cannot occur without approval from the manufacturer.4) Avoid Formula Pricing Often these documents contain a formula or a methodology to value the business.  The formula might consist of the applicable financial information to consider and the multiple to apply to those metrics to determine the value.  At the time of the drafting of the buy-sell, these formulas might establish the shareholder's perceived value of the business.  If considerable time has passed between the drafting of the document and the triggering event, these formulas and concluded values could be stale and outdated. As we’ve previously discussed in this space, the auto dealership industry is unique from a valuation perspective.  Traditional formulas such as EBITDA multiples often utilized in other industries are not as informative in this industry.  The drafting attorney may not be as familiar with the nuances of auto dealership valuation.  Even if an industry-appropriate metric, such as a Blue Sky multiple or formula is used, it is likely be dated in a short period of time.  National auto brokers (Haig Partners and Kerrigan Advisors) publish and update these Blue Sky multiples by manufacturer quarterly. As we’ve seen during the COVID-19 pandemic, operational conditions and perceived franchise values can change both quarterly and over a longer time horizon.  Additionally, dealerships could evolve over time and acquire or divest of different franchises that could drastically change their operations and perceived value.Finally, what adjustments are to be considered? Even if a buy-sell agreement has language providing for a multiple to be updated with the current market environment, significant one-time or non-recurring income or expense items can inflate or depress value.5) Specify Valuation DateThe buy-sell agreement should explicitly define the date to be used for the valuation. Typically, the date of valuation would be at or near the triggering event depending on its proximity to the timing and availability of current and reliable financial information.  A proper valuation should consider what is reasonably known or knowable as of the date of valuation.  Any ambiguity in defining the valuation date or the financial information to be used could have a significant impact on value.  Since franchised auto dealers must submit monthly financial statements to the manufacturer, an appropriate valuation date might be set to be the month-end prior to the triggering event.6) Defining Appraiser Requirements Who should perform the valuation?  Often buy-sell agreements will utilize language such as a “qualified appraiser” and may even include certain valuation credentials such as an Accredited Senior Appraiser (ASA), someone who is Accredited in Business Valuation (ABV), or a Certified Valuation Analyst (CVA) from national valuation accrediting organizations.  Since the auto dealership industry is so unique, these credentials may not be enough.  Should your buy-sell agreement also require that the appraiser have specific industry experience?  Finally, independence is key.  We recommend selecting a third-party valuation firm with experience in valuing auto dealerships so that the appraiser will be qualified and unbiased.7) Make It a Living Document How often does a company have a buy-sell agreement or governance document drafted only to be placed in an electronic file, a desk drawer, or a file cabinet and never reviewed or contemplated again? The value of an effective buy-sell agreement is to provide a roadmap for how to value the dealership at a triggering event.  If the document was never used since drafting, can it be reliable?Effective buy-sell agreements are not only drafted, but they are utilized.  Some require ongoing valuations at annual anniversaries or other timeframes to provide the owners with a value indication that could be used for strategic planning or contemplation of an upcoming triggering event.If the document didn’t clearly contain the items in this post and was never used since drafting, it could create confusion leading to litigation or the buy-sell agreement could be ignored in an eventual litigation. Frequent use or at least consideration of the terms considered in the document are likely to be much more relevant in a litigation context.Conclusion and ConsiderationsAn effective buy-sell agreement can provide a roadmap to defining the valuation process through many challenging events during the lifetime of an auto dealership.  As we’ve discussed, the document should contain and clearly define these seven elements, among others, to accomplish that goal.Other considerations to contemplate are the premise of value, funding mechanisms for repurchase, and managing expectations.  The premise of value will establish whether to determine the value of the dealership if it continues as a going-concern business as opposed to liquidation.  Funding mechanisms and repurchase requirements can also dictate the mechanical treatment of certain assumptions in the valuation such as the impact of recognizing life insurance proceeds at the death of an owner to establishing a market for the subject interest that could possibly impact the applicable discount for lack of marketability.Does your auto dealership have a buy-sell agreement or governance document?  When was it drafted?  Who drafted it?  Does it contain and discuss these seven key items?  If it contains formula pricing, would buyers and sellers find the methodology employed reasonable today? These are all items that need to be considered.To discuss the impact of your buy-sell agreement, assist you and your attorney in drafting an effective buy-sell agreement, or determine the valuation of your auto dealership at a triggering event, contact a professional at Mercer Capital today.

Working on your RIA’s buy-sell agreement may seem like a distraction, but the distraction is minor compared to the disputes that can occur if your agreement isn’t structured appropriately.  Crafting an agreement that functions well is a relatively easy step to promote the long-term continuity of ownership of your firm, which ultimately provides the best economic opportunity for you and your partners, your employees, and your clients.If you haven’t looked at your RIA’s buy-sell agreement in a while, we recommend dusting it off and reading it in conjunction with the discussion below.1) Decide what’s fair.In our experience, buy-sell agreements tend to function well when they attempt to strike a balance between the interests of the various stakeholders in an investment management firm, including the founding partners, next-gen management, employees, clients, and the firm itself.  By balancing the interests of the various stakeholders, a well-structured buy-sell agreement can be a competitive advantage by facilitating a smooth transition between founding partners and next-gen management.  Ultimately, this enhances value for everyone.2) Define the standard of value.Standard of value is an abstraction of the circumstances giving rise to a particular transaction.  It imagines the type of buyer, the type of seller, their relative knowledge of the subject asset, and their motivations or compulsions.  We wouldn’t recommend getting creative here.  Unconventional standards of value can and do lead to different interpretations that can result in wildly different conclusions of value.  For most purposes, using one of the more common definitions of Fair Market Value is advisable.  Fair Market Value contemplates a hypothetical willing seller and willing buyer, both of whom have reasonable knowledge of the subject asset and neither of whom are under any compulsion to buy or sell.  This standard has an almost universally agreed-upon definition and is well established and understood in the valuation and legal communities, all of which helps to remove uncertainty as to its valuation implications.3) Define the level of value.Valuation theory suggests that there are various “levels” of value applicable to a business or business ownership interest.  For example, a non-marketable minority interest may be worth less than an otherwise identical controlling interest.  From a practical perspective, the “level of value” determines whether any discounts or premiums are applied to a baseline marketable minority level of value.  Naturally, sellers would prefer a premium and buyers a discount, but it helps to keep in mind that today’s buyers are tomorrow’s sellers, and today’s sellers are yesterday’s buyers.  When transactions are done on a consistent basis over time, it helps to promote a sustainable marketplace for the company’s shares.4) Avoid formula pricing.We often see buy-sell agreements that use a formula to determine value (usually a fixed multiple of a historical performance metric).  These formulas often reflect what the principals of the firm thought the business was worth at the time the buy-sell agreement was drafted.  As market conditions and the business’ economics change, formula prices can quickly diverge from market value, but the ink on the page remains.When it comes time to buy or sell, perhaps years or decades after the buy-sell agreement was drafted, the formula price will inevitably be benchmarked against the actual buyer and seller’s perceptions on the current market value of the interest.  If the formula value is greater than the perceived value, then the selling shareholder may find there are no willing buyers or no reasonable way to finance the sale.  If the formula value is less than the perceived value, then the selling shareholder may be incentivized to hold on to their ownership longer than is optimal from the perspectives of the firm, next-gen management, and clients.5) Specify the valuation date.A buy-sell agreement should be explicit about the “as of” date of the valuation.  Typically, valuations will consider only what is known or reasonably knowable as of this date.  As a result, a difference of just a few days can have a significant impact on the valuation if an unexpected event occurs at the firm.  Consider, for example, the death of a key executive.  Such an event will often trigger buy-sell agreement provisions, and whether or not the event factors into the valuation will depend in part on the valuation date specified by the agreement.  For firms with larger shareholder bases and relatively frequent transactions, it often makes sense to specify an annual valuation date that then applies to transactions throughout the year.6) Decide who will perform the valuation. We recommend selecting a reputable third-party valuation firm with experience valuing investment management firms.7) Manage expectations. Most of the shareholder agreement disputes we are involved in start with dramatically different expectations regarding how the valuation will be handled.  Testing your buy-sell agreement now by having a valuation prepared can help to center or reconcile those expectations and might even lead to some productive revisions to your buy-sell agreement.For more information on RIA practice management issues, register for our upcoming conference, RIA Practice Management Insights. More information can be found below.Early Bird Pricing for the Upcoming RIA Practice Management Insights Conference Ends in 7 DaysMercer Capital has organized a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.Join us and speakers like Jim Grant, Peter Nesvold, Matt Sonnen, and Meg Carpenter, among others, at the RIA Practice Management Insights, a conference unlike any other in the industry.Take advantage of early bird pricing to receive $100 off conference registration. Offer ends next week.Have you registered yet?

December was a busy month at Mercer Capital, and at business valuation firms across the country.  Clients sought to make gifts and perform other estate planning transactions ahead of year-end.  But the changing of the calendar does not mean that the window for gifting is over.  The factors that led to a rush of estate planning transaction activity during 2020 largely remain.  The combination of depressed E&P valuations, the potential for future tax changes, and the ability to utilize minority interest and marketability discounts are still present in 2021.Depressed E&P Valuations2020 was a difficult year for many companies, though the pain was acute for E&P companies that were faced with unprecedented demand destruction that led to negative oil prices.  Recovery appears to be taking hold, but the pace is uncertain and some changes in commuting and business travel habits might be permanent.While E&P company values (as proxied by the SPDR S&P Oil & Gas Exploration & Production ETF) have recovered from their lows in March, the index remains down year-over-year, having declined 38% during 2020.[caption id="attachment_35371" align="aligncenter" width="645"]Source: Capital IQ[/caption] The recent spate of E&P bankruptcies also is indicative of a challenging operating environment and reduced equity valuations.  There are exceptions with assets and situations of highly economic Tier 1 production, and/or acreage that can maintain or have proportionally small value decreases during this downturn, but most E&P companies have suffered alongside commodity prices. While unpleasant from a net worth perspective, this (hopefully temporary) reduction in value can be a boon for estate planning purposes, allowing taxpayers to gift larger interests, while utilizing less of their gift & estate tax exemption (or paying less in taxes on the gifted interest). Potential for Future Tax ChangesPresident-elect Biden’s tax plan calls for some major changes to the current gift & estate tax regime.  Most notably, the estate tax exemption could be reduced from today’s $11.7 million (unified) to $3.5 million (estate) and $1.0 million (gift), and the tax rate could increase from 40% to 45%.  The prospects for tax reform likely increased after Georgia’s Senate run-off elections on January 5th put the Democrats in control of both houses of Congress.While new tax legislation could potentially be made retroactive to January 1, many tax policy experts see that as unlikely.  Mercer Capital’s Atticus Frank has a great blog post with additional reading for anyone interested in estate planning for 2021.Consider taking advantage of the current gift & estate tax exemptions in 2021 before they potentially go away.Minority Interest and Marketability DiscountsBy gifting minority interests to heirs, taxpayers can potentially utilize minority interest and marketability discounts to reduce the value of the gifted interest and ease gift & estate tax burdens.  These discounts are highly dependent on facts and circumstances surrounding the subject interest.  Mercer Capital has successfully defended its minority interest and marketability discounts to the IRS and in other litigated contexts.By gifting minority interests, one does not only benefit from the application of minority interest and marketability discounts during the gifting process.  If done as a part of a thoughtfully executed estate planning strategy, gifting can result in a non-controlling ownership interest in an estate, allowing for the potential application of discounts for estate tax purposes as well.Mercer Capital’s Travis Harms has an insightful blog post about this issue.  In the post, he runs hypothetical math showing the difference in potential tax liabilities under various gifting scenarios.  A thoughtful gifting strategy as part of a broader estate plan can have a significant impact on the proceeds heirs receive from an estate.ConclusionDespite what one might think, the window for gifting transactions has not closed.  Mercer Capital provides valuation and other financial advisory services to families seeking to optimize their estate plans.  Give one of our professionals a call to discuss how we can help you in the current environment.

While we are not political prognosticators, the recent Senate runoff results appear to have given new life to the Biden Administration’s tax policy goals. Numerous publications have written about the Biden Administration’s tax plan and we do not want to duplicate them here. However, we want to take the opportunity to highlight other thought leaders we are reading and what family business owners should be thinking about given recent political developments.How Will Joe Biden’s Tax Plan Impact Estate and Gift Planning?Elliot Davis, a regional accounting firm in the Southeast, highlights two key provisions in the Biden plan: i) the elimination of basis step-ups for inherited assets, and ii) a reduction in the lifetime gift and estate tax exemption. Elliot Davis presents two case studies with the proposed changes – which result in a 10% to 25% increase in the overall tax paid by the estates presented in the case studies.  These increases can be partially reduced with proper estate planning.Joe Biden Wants to Change Tax Policy. Here’s What He Might AccomplishKaren Hube at Barron’s highlights Biden’s tax plan and expectations regarding reform. Garrett Watson, a senior policy analyst at the Tax Foundation, ranks two tax increases as being the most likely to succeed: an increase in the corporate tax rate from 21% to 28%, and a bump in the top marginal income-tax rate for folks earning $400,000 or more from 37% to 39.6%, hitting both traditional C Corps and S Corps. The next most likely change would be a reduction in the estate tax exemption to 2009 levels, moving from the current $11.58 million per person, or $23.16 million for a married couple to $3.5 million, adjusted to inflation. This would also raise the estate tax rate from 40% to 45% beyond the exemption. Watson does see certain provisions as unlikely. Watson includes an increase in tax rates on capital gains over $1 million from 20% to 39.6% and a new 12.4% payroll tax on earnings over $400,000, citing a combination of political friction and complexity to draft and administer. Watson and other analysts agree that one aspect of Biden’s plan would be dead on arrival in Congress: an elimination of the step-up in cost basis at death.Richest Americans Brace for Higher Taxes, Await Moves by Biden, Senate DemocratsA new concern for estate planners is delivering the news that it may be too late. Bloomberg suggests that Biden and the Congress could make tax hikes effective as of the beginning of 2021 or delay any changes to 2022 or 2023. The threat of a retroactive tax law means wealthy families and investors do not know which rules apply to transactions conducted right now. Bloomberg indicates most advisers see retroactive tax changes as unlikely but urge caution and recommend getting your estate plan in order.After the Georgia Runoff, What Tax Planning Should You Do NOW?Martin Shenkman, an estate planning attorney, provides a comprehensive list of possible tax changes as they relate to gift and estates, as well as income and capital gains taxes. He also lists a number of strategies used by estate planners and potential reductions in the benefits of these strategies, including the use of Grantor Retained Annuity Trusts, Grantor Trusts, and Generation Skipping Transfer Taxes. We will lay a "wet-blanket" on the more aspirational policy devotee (perhaps at our peril).  Democrats will hold both the U.S. Senate (by virtue of future Vice President Harris, a Democrat, being a deciding vote in the 50-50 chamber) and the U.S. House, (222 for Speaker Pelosi’s caucus and likely 213 for the Republicans) with relatively narrow margins by historical standards.  This narrow mandate gives Democrats room for only 5 defections in the House on any single piece of legislation, with no room in the Senate. Considering these realities, we suspect more wide-reaching policy goals promised during the campaign may be tempered to preserve needed political capital for the incoming administration’s key policy objectives. Additionally, in a January 10th piece from Barron’s,  Chris Senyek, chief investment strategist at Wolfe Research noted the average tax-reform bill takes 15 months after a new president is sworn in to become law. If history holds, this fact should give markets, and families, time to digest and plan for future tax changes.Final ThoughtsWe leave you with this advice: the best time to take care of your family and estate plan was yesterday. The next best time is today. We provide valuation and other financial advisory services to families seeking to optimize their estate plans.  Give one of our professionals a call to discuss how we can help you in the current environment.

Maybe not for the best of reasons, the stars have aligned for bank investors who have significant interests in banks to undertake robust estate planning this year. Bank stock valuations are depressed as a result of the recession that developed from the COVID-19 policy responses, including a return to a zero interest rate policy (“ZIRP”) that is now known as the effective lower bound (“ELB”). The result is severe compression in net interest margins (“NIMs”), while the extent of credit losses will not be known until 2021 or perhaps even 2022.As shown in Figure 1, bank stocks have produced a negative total return that ranges from -27% for the twelve months ended September 25, 2020 for the SNL Large Cap Bank Index to -36% for the SNL Mid Cap Bank Index. At the other extreme are tech stocks. The NASDAQ Composite has produced a one-year total return of 35%–a 70% spread between the two sectors.Valuations for banks are depressed and are comparable to lows observed on March 24, 2020 when market panic and forced selling by levered investors peaked and March 9, 2009 when investors feared a possible nationalization of the large banks. Price-to-tangible book value (“P/TBV”) multiples are presented in Figure 2, while price-to-earnings (“P/E”) ratios based upon the last 12-month (“LTM”) earnings are presented in Figure 3.(Note—while P/TBV multiples are little changed from March 24, 2020, P/E ratios have increased because reserve building and reduced NIMs have reduced LTM earnings).No one knows the future, but assuming reversion to the mean eventually occurs bank stocks could rally as earnings improve once credit costs decline even if NIMs remain depressed, resulting in higher earnings and multiple expansion. Relative to ten-year average multiples based upon daily observations, banks are 30-40% cheap to their post-Great Financial Crisis trading history. In effect, current gifting and other estate planning could lock in significant tax benefits assuming a Japan and Europe scenario does not develop in the U.S. where banks are “re-rated” and underperform for decades.A second reason to consider significant estate planning transactions this year is the potential change in Washington if 2021 sees a Biden Administration backstopped with a Democrat-controlled Senate and House.Vice President Biden’s proposed estate tax changes include the elimination of basis step-up, significant reductions to the unified credit (the amount of wealth that passes tax-free from estate to beneficiary) and gift tax exemption, and increasing current capital gains tax rates to ordinary income levels for high earning households.The cumulative effect of these changes is a substantial increase in high net worth clients’ estate tax liabilities if Biden’s current proposals become law.Basis step-up is a subtle but important feature of tax law.Unusual among industrialized nations, in the United States the assets in an estate pass to heirs at a tax value established at death (or at an alternate valuation date).Even though no tax is collected on the first $11.6 million per person, the tax basis for the heir is “stepped-up” to the new value established at death.Other countries handle this issue differently, and Biden favors eliminating the step-up in tax basis.Further, he prefers taxing the embedded capital gain at death.Canada, for example, does this – treating a bequest as any other transfer and assessing capital gains taxes to the estate of the decedent.Fortunately, there are several things bank shareholders can do now to minimize exposure to these potential tax law changes.Taking advantage of the current high-level of gift tax exemptions ($11.58 million per individual or $23.16 million per married couple) could save millions in taxes if Biden’s proposed lower exemption of $3.5 million per individual becomes law. Other options include the formation of trusts or asset holding entities to transfer wealth to the next generation in a tax-efficient manner.Proper estate planning can mitigate the adverse effects of higher taxes on wealth transfers, but the window to do so may be closing if we have a regime change later this year. Further, the demand (and associated cost) for estate planning services may go up significantly in November, so you need to apprise your clients of these potential changes before it’s too late.In the 1990s, the unified credit (the amount of wealth that passes tax-free from estate to beneficiary) was only $650 thousand, or $1.3 million for a married couple.The unified credit was not indexed for inflation, and the threshold for owing taxes was so low that many families we now consider “mass-affluent” engaged in sophisticated estate tax planning techniques to minimize their liability.Then in 2000, George W. Bush was elected President, and estate taxes were to be phased out.Over the past decade, the law has changed several times, but mostly to the benefit of wealthier estates.That $650 thousand exemption from estate taxes is now $11.6 million.A married couple would need a net worth of almost $25 million before owing any estate tax, such that now only a sliver of bank stock investors require heavy duty tax planning.That may all be about to change. Vice President Biden has more than gestured that he plans to increase estate taxes by lowering the unified credit, raising rates, and potentially eliminating the step-up in basis that has long been a feature of tax law in the United States.Talk is cheap. But investors take heed; now may be the time to execute rather than plan. Originally appeared in Mercer Capital’s Bank Watch, September 2020.

Estate and tax planning matters are an important component of the overall financial plan for many RIA clients.  The current tax policy and market environment create unique estate planning opportunities that may not last if economic conditions normalize or if Biden wins in November.  This webinar addresses the available opportunities that RIA principals and advisors should be aware of in the current environment. Original air date: October 28, 2020

Buy-sell agreements don’t matter until they do. When written well and understood by all the parties, buy-sell agreements can minimize headaches when a family business hits one of life’s inevitable potholes. But far too many are written poorly and/or misunderstood. Directors are always eager to discuss best practices for buy-sell agreements.Excerpted from our recent book, The 12 Questions That Keep Family Business Directors Awake at Night, we address this week the question, “Is there a ticking time bomb lurking in your family business?”When we talk with family business owners, most confess a vague recollection of having signed a buy-sell agreement, but only a few can give a clear and concise overview of their agreement’s key terms. Yet no other governing document has such potentially profound implications for the business and for the family. My colleague of nearly twenty years, Chris Mercer, literally wrote the book(s) when it comes to buy-sell agreements. Chris and I recently sat down to talk about buy-sell agreements in the context of family businesses.Travis: Chris, to start off, what is the purpose of a buy-sell agreement? Why should a family business have one?Chris: A buy-sell agreement ensures that the owners of a business will have as fellow-owners only those individuals who are acceptable to the group. A buy-sell agreement formalizes agreements in the present – while everyone is alive and well – regarding how future transactions will occur, with respect to both pricing and terms, when the agreement is “triggered.”Every business with two or more owners should have a buy-sell agreement, and that includes family businesses. What I can tell you, after many years of working with companies and their buy-sell agreements, is that once an agreement is triggered, e.g., by the death, disability or departure of a shareholder, the interests of the departed and remaining shareholders diverge. When interests diverge, an agreement is virtually impossible even, or especially, within families. So, a well-crafted buy-sell agreement establishes an agreement in advance, so the family can avoid problems and conflict in the future.Travis: The title of your first book on buy-sell agreements described them as either reasonable resolutions or ticking time bombs. How could a buy-sell agreement become a ticking time bomb for a family business?Chris: Sure – here’s a quick example. Some agreements specify a fixed price for shares that the shareholders have all agreed to. The price is binding until updated to a new agreed-upon price. The idea sounds good in principle, but in reality, the owners almost never agree on an updated price. Years later, after a substantial increase in a company’s value renders the agreed-upon price stale, a trigger event occurs. The ticking time bomb explodes on the departing shareholder who receives an inadequate price for their shares. A second explosion occurs with the ensuing litigation to try to “fix” the problem. Needless to say, I do not recommend the use of fixed-price valuation mechanisms in buy-sell agreements.Travis: Buy-sell agreements often define a formula for determining value when triggered. Can a “formula price” provide for a reasonable resolution?Chris: Travis, I’ve said many times that some owners and advisers search for the perfect formula like the Knights Templar sought the Holy Grail. The perfect formula does not exist. Given changes in the company over time, evolving industry conditions, emerging competition, and changes in the availability of financing, no formula will remain reasonable over time. It is simply not possible to anticipate all the factors an experienced business appraiser would consider at a future date. All this assumes that the formula is understandable. Some formulas in buy-sell agreements are written so obtusely that reasonable people reach (potentially quite) different results. As you might suspect, I do not recommend the use of formula pricing mechanisms in buy-sell agreements.Travis: Other agreements provide for an appraisal process upon a trigger event. What are benefits or pitfalls of such appraisal processes?Chris: The most common appraisal process found in buy-sell agreements calls for the use of two or three appraisers to determine the price to be paid if and when a trigger event occurs.   One of the biggest problems out of the gate is that no one knows what the price of their shares will be until the end of a lengthy and potentially disastrous appraisal process.Let me explain. Assume that the shareholders have agreed on an appraisal process to determine price upon a trigger event. The Company retains one appraiser and the selling shareholder retains a second. Far too often, the language describing the type of value for the appraisers to determine is vague and inconsistent. The selling shareholder’s appraiser interprets value as an undiscounted strategic value, say $100 per share. The company’s appraiser interprets the same language as calling for significant minority interest and marketability discounts and concludes a value of, say, $40 per share. The agreement calls for the two appraisers to agree on a third appraiser who is supposed to resolve the issue. How? The two positions are not reconcilable. Litigation, unhappiness, wasted time and expense follow as the time bomb, which has been in place for years, explodes on all the parties.Travis: So if fixed price, formula price, and appraisal process agreements all have serious drawbacks, what kind of pricing mechanism do you recommend for most family businesses?Chris: Based on my experiences over many years, I have concluded that the best pricing mechanism for most family businesses is what I call a Single Appraiser, Select Now and Value Now valuation process. The parties agree on a single appraiser (I’d recommend Mercer Capital, of course!). The selected appraiser provides a valuation now, at the time of selection, based on the language in the buy-sell agreement. This ensures that any confusion is eliminated at the time of signing or revision. The appraisal sets the price for the buy-sell agreement until the next (preferably annual) appraisal. With this kind of process, virtually all of the problems we’ve discussed are eliminated, or reduced substantially. All the shareholders know what the current value is at any time. Importantly, they all know the process that will occur with every subsequent appraisal. The certainty provided by this Single Appraiser, Select Now and Value Now process far outweighs the uncertainty inherent in other processes at a reasonable cost. At Mercer Capital, we provide annual appraisals of over 100 companies for buy-sell agreements and other purposes.Travis: Finally, what is your best piece of advice for family business owners when it comes to buy-sell agreements?Chris: The best advice I have for family business owners is to be sure that there is an agreement regarding their buy-sell agreements. Many companies have had agreements in place for many years, often decades, without any changes or revisions. No one knows what will happen if they are triggered. Agreement regarding a buy-sell agreement should be the result of review by all shareholders, corporate counsel, and, I recommend, a qualified business appraiser. The appraiser should review agreements from business and valuation perspectives to be sure that the valuation mechanism will work when it is triggered. Discussions are not always easy, since shareholders from different generations and different branches of the family tree have differing objectives and viewpoints. Yet if all parties can agree now, the family can avoid unnecessary strife and litigation in the future. So the best advice I have is to “Just Do It!”ConclusionYour family’s buy-sell agreement won’t matter until it does. As families prepare for their next business meeting, leaders should carefully consider putting a review of the buy-sell agreement on the agenda.For more information or help with your buy-sell agreement, don't hesitate to contact us.

It’s nearly impossible to discuss anything automobile-related without mentioning the name Henry Ford.  Henry Ford established the Ford Motor Company in 1903 and also became one of the founding fathers of the automated assembly line mode for the production of his Model T vehicle.  One of the famous quotes attributed to Mr. Ford is that “failure is only the opportunity to begin again.”  This adage continues to inspire the auto industry today as it attempts to recover from turbulent economic conditions caused by the COVID-19 pandemic, much like its recovery from the Great Recession just a decade ago.Three converging factors have this fall shaping up to be the busiest estate planning season since 2012.While economic recovery is still uncertain as the pandemic continues on and new relief bills are on the ropes, there currently exist potentially attractive estate planning opportunities for auto dealer owners.Three converging factors have this fall shaping up to be the busiest estate planning season since 2012:  1) potentially depressed valuation of assets and businesses; 2) historically low interest rates; and, 3) uncertainty regarding the political administration going forward. Let's delve a little deeper into these three factors.Potentially Depressed ValuationsAt its core, the valuation of a business consists of three assumptions: cash flow, risk and growth.  Cash flow can be defined as the expected earnings of a business into the future.  With no certainty of the future, historical performance and recent performance can serve as a starting point for those future expectations.  The second assumption is risk: what are the risks that the company faces to achieve those expected cash flows?  Risks can be internal such as labor and management or risks can be external such as the economy or competition.  The final assumption to valuation is growth:  how are cash flows expected to grow in the future?All three of these valuation assumptions have been threatened by the pandemic.  Recent cash flow has been threatened for most industries, not just the hospitality, retail, and restaurant industries.  Certainly, for businesses, operating and economic risks have increased during the pandemic.  As far as growth and recovery, we’ve all gotten an education into the alphabet soup of recovery:  can the recovery for the general economy be described as v-shaped, u-shaped, w-shaped, k-shaped, or some other letter?Historically Low Interest RatesThose familiar with the concepts of finance and valuation also understand the relationship between interest rates and value.  Generally, as interest rates (and risk) increase, the value of the asset decreases and vice versa.  The pandemic and summer/fall of 2020 has created a unique opportunity regarding interest rates, as the Fed has brought rates to near zero in order to combat the pandemic.How are interest rates used in estate planning?  Attorneys utilize many structures when seeking to transfer family wealth from one generation to the next:  Grantor Retained Annuity Trusts (GRATs), Charitable Remainder Unified Trusts (CRUTs), installment sales, interfamily loans, and many other structures.  Most of these structures utilize some form of a note/loan between family members.  Under current tax law, a family member could not make an interest-free loan to a child or grandchild without that portion of the loan being considered as a taxable gift.  To shield that portion of the loan from being a taxable gift, the loan must carry a stated interest rate.  The IRS establishes guidelines for these interest rates in the form of Applicable Federal Rates (AFRs), which are determined monthly by the U.S. Treasury.  The mid-term AFR rates have been historically low, and below 1% for most of 2020.The mid-term AFR rates have been historically low, and below 1% for most of 2020.How do low AFRs assist in estate planning?  In addition to satisfying the IRS’ requirement so that the interest portion of the loan will not be treated as a gift, the lower level of AFRs should motivate estate planning this fall.  Often, the structures that attorneys use in this form of planning (discussed above) depend on the cash flow from the asset being transferred (perhaps an operational business as an example) to fund the debt service in connection with the loan.  In times of lower AFRs, the debt service is reduced, and it’s easier for the cash flow from the asset to cover the debt service.  Additionally, the success of these transfer vehicles is usually dependent on the potential growth and appreciation in value of that asset after it is transferred to the next generation.  With historically low AFRs and greater expected rates of return on the transferred assets, there are potential arbitrage opportunities on the spread of those returns.Uncertain Political ClimateThe fall of 2020 brings with it the national election season, and along with it, potential political change.  Two important tax provisions that affect estate planning are at stake:  the estate tax credit and the step-up basis for tax treatment.  The current estate tax credit is $11.6 million per individual, meaning a married couple can shield and pass an estate worth $23.2 million ($11.6 million times two) to their heirs without incurring estate taxes.  This provision is set to sunset in 2026 and will return to an amount of $5 million-plus inflation adjustments, expected to settle at a figure between $6 - $7 million per individual.  At those levels, the unified estate tax credit limit for couples would lower by approximately $9.2 million, resulting in a greater pool of family estates that would be subject to estate taxes.  If a new party wins the White House this fall, this provision could be debated and potentially changed sooner than 2026.Two important tax provisions that affect estate planning are at stake.A second tax provision that aids in estate planning could also be in jeopardy this fall.  Among the pillars of Vice President Joe Biden’s proposed tax plan is the elimination of the step-up basis for taxation.  Under current U.S. tax laws, the assets of an estate pass to their heirs at a tax value established at death (or alternate date of valuation).  The value is transferred to their heirs at this established value at death or a stepped-up basis.  Biden’s proposed tax plan would eliminate this step-up basis.  Consider an estate portfolio with a value of $10 million and a tax basis of $2 million.  Under the current unified estate tax credit, the portfolio example would not be subject to estate taxes and would transfer to the heirs at a stepped-up basis of $10 million.  If the step-up basis was eliminated, the portfolio would transfer to the heirs at a basis of $2 million and would also be taxed on the imbedded capital gains of $8 million.  There are also discussions that a change in power in the White House could also lead to increases in the capital gains tax rates, which are currently set at 15-20%.  Increased capital gains tax rates and the elimination of the step-up basis could greatly diminish the value of a family’s portfolio at the death of the patriarch/matriarch.Unique Estate Planning Opportunities in Auto Dealer Industry TodayAs discussed above, this fall brings a unique opportunity for owners in the auto dealership industry to capitalize on low interest rates for planning tools and potentially lower valuations of the underlying assets being transferred.  Last week’s blog covered the market’s update on Blue Sky multiples.  Despite market optimism, valuation and blue sky multiples of auto dealerships are still very specific to the individual dealership and consider their unique conditions including financial performance, competition, and local economic conditions among other factors.In a previous Family Business Director blog post, colleague Travis Harms also discussed the impact of real estate on estate planning.  It’s very common for the operations of the dealership to be contained in one entity and the real estate where the dealership resides to be contained in a separate asset holding company.  Often when owners of auto dealerships desire to transfer their wealth/assets to the next generation, they may have children that are active in the business and they may have children that are not active in the business.  We have consulted with owners on a strategy to gift interests in the operating business to the active children and interests in the real estate holding company to the non-active children.  Owners/parents often view this strategy as equitable to their children and seek to reward/incentivize the active children with a direct interest in the operations of the dealership.ConclusionNow is a unique time, rife with estate planning opportunities with potentially lower valuation of assets, historically low interest rates, and changing political winds.  Seek qualified professionals to assist you with your estate planning, from the attorneys determining and drafting the plan to the valuation professional providing the valuation.  Not all valuations and valuation professionals are created equally.  The role of all of the professionals in your estate planning process should be to protect the integrity of the proposed transaction.  Often when these transactions are challenged, they are challenged based on the formation factors or the quality/conclusion of the valuation.  Contact a professional at Mercer Capital to assist you and your attorney with your valuation needs involving your estate planning.  Mercer Capital has extensive experience providing valuations for estate planning and valuations specific to the auto dealership industry.

Family business leaders cannot afford to ignore estate taxes.  While it is true that the legal burden of the estate tax falls to individual shareholders rather than the family business itself, many family shareholders have not accumulated sufficient liquidity to pay estate taxes without some action on the part of the company.  The required actions may range from a shareholder loan to a special dividend to sale of the business.  As we’ve noted numerous times in the past few months, there are good reasons to focus on estate planning right now.The fair market value of many family business ownership interests is depressed because of the negative impact of the pandemic.Applicable federal rates are quite low, which increases the effectiveness of many of the more sophisticated estate planning techniques.Political uncertainty is high, and the Biden campaign has indicated that estate tax reform would be a priority if elected. In this week’s post, we provide a to-do list of important tasks for family business directors seeking to help prevent, or at least minimize, unhappy surprises resulting from the estate tax.Review the Current Shareholder List / Ownership Structure for the Family BusinessIn family businesses, the lines between family membership, influence, employment, economic benefit from the business, and actual ownership can be blurry.  Based on the current shareholder list, are there any shareholders that – were the unexpected to happen – would be facing a significant estate tax liability?  Are there potential ownership transfers that would not only alleviate estate tax exposure, but also accomplish broader business continuity, shareholder engagement, and family harmony objectives?Obtain a Current Opinion of the Fair Market Value of the Business at the Relevant Levels of ValueA current valuation opinion is essential to quantifying existing exposures as well as facilitating the desired intra-family ownership transfers.  If you don’t have a satisfactory, ongoing relationship with a business appraiser, the first step is to retain a qualified independent business valuation professional (we have plenty to choose from here).  You should select an appraiser that has experience valuing family businesses for this purpose, has a good reputation, understands the dynamics of your industry, and has appropriate credentials from a reputable professional organization, such as the American Institute of Certified Public Accountants (AICPA) or the American Society of Appraisers (ASA).The valuation report should demonstrate a thorough understanding of your business and its position within your industry. It should contain a clear description of the valuation methods relied upon (and why), valuation assumptions made (with appropriate support), and market data used for support.  You should be able to recognize your family business as the one being valued, and when finished reading the report, you should know both what the valuation conclusion is and why it is reasonable.The appraisal should clearly identify the appropriate level of value.  If one of your family shareholders owns a controlling interest in the business, the fair market value per share of that controlling interest will exceed the fair market value per share of otherwise identical shares that comprise a non-controlling, or minority, interest.  Having identified the appropriate level of value, the appraisal should clearly set forth the valuation discounts or premiums used to derive the final conclusion of value and the base to which those adjustments were applied.For example, many common valuation methods yield conclusions of value at the marketable minority level of value.  In other words, the concluded value is a proxy for what the shares of the family business would trade for if the company were public.  Some refer to this as the “as-if-freely-traded” level of value.If the subject interest is a minority ownership interest in your privately-held family business, however, an adjustment is required to reflect the lack of marketability inherent in the shares. All else equal, investors desire ready liquidity, and when faced with a potentially lengthy holding period of unknown duration, investors impose a discount on what would otherwise be the value of the interest on account of the incremental risks associated with holding a nonmarketable interest.  In such a case, the appraiser should apply a marketability discount to the base marketable minority indication of value.On the other hand, if the subject interest represents a controlling interest in the family business, a valuation premium may be appropriate. The “as-if-freely-traded” value assumes that the owner of the interest cannot unilaterally make strategic or financial decisions on behalf of the family business.  If the subject interest does have the ability to do so, a hypothetical investor may perceive incremental value in the interest.  Such premiums are not automatic, however, and a discussion of the facts and circumstances that can contribute to such premiums is beyond the scope of this post. We occasionally hear family shareholders express the sentiment that, since gift and estate taxes are based on fair market value, the lower the valuation the better.  This belief is short-sighted and potentially costly.  For one, gift and estate tax returns do get audited, and the “savings” from an artificially low business valuation can evaporate quickly in the form of incremental professional fees, interest, penalties, and sleepless nights when the valuation is exposed as unsupportable.  Perhaps even more importantly, an artificially low business valuation introduces unhealthy distortion into ownership transition, shareholder realignment, shareholder liquidity, distribution, capital structure, and capital budgeting decisions.  The distorting influence of an artificially low valuation can have negative consequences for your family business long after any tax “savings” become a distant memory.  While the valuation of family businesses is always a range concept, the estimate of fair market value should reasonably reflect the financial performance and condition of the family business, market conditions, and the outlook for the future.Identify Current Estate Tax Exposures and Develop a Funding Plan for Meeting Those Obligations when They AriseWith the appraisal in hand, you can begin to quantify current estate tax exposures and, perhaps more importantly, begin to forecast where such exposures might arise in the future if expected business growth is achieved.  Are shareholders prepared to fund their estate tax liability out of liquid assets, or will shareholders be looking to the family business to redeem shares or make special distributions to fund estate tax obligations?  If so, does the family business have the financial capacity to support such activities?  The most advantageous time to secure financing commitments from lenders is before you need the money.  What is the risk that an estate tax liability could force the sale of the business as a whole?  If so, what preliminary steps can directors take to help ensure that the business is, in fact, ready for sale and that such a sale could occur on terms that are favorable to the family?Identify Tax and Non-Tax Goals of the Estate Planning ProcessAs suggested throughout this post, while prudent tax planning is important, it can be foolish to let the desire to minimize tax payments completely overwhelm the other long-term strategic objectives of the family business.  If there was no estate tax, what evolution in share ownership would be most desirable for your family and business?  The overall goal of estate planning should be to accomplish those transfers in the most tax-efficient manner possible, not to subordinate the broader business goals to saving tax dollars in the present.The professionals in our family business advisory services practice have decades of experience helping family businesses execute estate planning programs by providing independent valuation opinions.  Give one of our professionals a call to help you get started on knocking out your to-do list today.

Road racecourses were originally built with at least one very long straightaway that allowed cars to reach maximum speed before braking for the turn.  As cars became more powerful, the maximum speed attainable on the straights was dangerously fast.  Racecourses added serpentine curves, known as chicanes, to the straights that require cars to slow down and maneuver before resuming a straightaway.  2020 has been a year of one chicane after another, and at this point, I don’t think anybody expects a direct path to 2021.RIAs Outran Two Challenges in 2020…After a decade of gaining speed, the outlook for the investment management industry suddenly turned fairly grim in March.  With workforces on lockdown and equities falling, the pricing of publicly traded RIAs unsurprisingly trended downward.  But running an investment advisory practice remotely turned out to be much less impossible than many imagined, and AUM rebounded rapidly with the markets.  As such, Q2 did not turn out to be the industry bloodbath that many imagined, especially in the wealth management space.2020, however, is full of surprises, and the third quarter is bringing more.  The persistence of the pandemic and the consequent economic strain on many has shifted political winds in favor of the minority party.  If these trendlines don’t roll over between now and November 3, we’ll have a new executive and legislative regime and, with it, a redirection of tax policy.  It’s not too early to start thinking about what impact certain legislative changes will have on the RIA industry, especially with regard to estate tax law.Estate Planning Rising in ProminenceInvestment advisors are not estate planners per se, but estate planning is a necessary part of financial planning for very wealthy clients.  If political winds shift, more of your clients could be subject to estate taxes and, therefore, would benefit from estate planning.  When my career started in the 1990s, the unified credit (the amount of wealth that passes tax-free from estate to beneficiary) was only $650 thousand, or $1.3 million for a married couple.  The unified credit wasn’t indexed for inflation, and the threshold for owing taxes was so low that many families we now consider “mass-affluent” engaged in sophisticated estate tax planning techniques to minimize their liability.Then in 2000, George W. Bush was elected President, and estate taxes were more or less legislated away over the following decade.  Over the past decade, the law has changed several times but mostly to the benefit of wealthier estates.  That $650 thousand exemption from estate taxes is now $11,580,000.  A married couple would need a net worth of almost $25 million before owing any estate tax, such that now only a sliver of RIA clients (not to mention RIA owners) need heavy duty tax planning.That may all be about to change.  Joe Biden has more than gestured that he plans to increase estate taxes by lowering the unified credit, raising rates, and potentially eliminating the step-up in basis that has long been a feature of tax law in the United States.Biden’s Proposed Tax PoliciesBasis step-up is a subtle but important feature of tax law.  Unusual among industrialized nations, in the United States the assets in an estate pass to heirs at a tax value established at death (or at an alternate valuation date).  Even though no tax is collected on the first $11.6 million per person, the tax basis for the heir is “stepped-up” to the new value established at death.  Other countries handle this issue differently, and Biden favors eliminating the step-up in tax basis.  Further, he prefers taxing the embedded capital gain at death.  Canada, for example, does this – treating a bequest as any other transfer and assessing capital gains taxes to the estate of the decedent.Capital gains tax rates are generally lower than ordinary income taxes, of course, but Biden has also suggested that he would raise capital gains taxes for high earning households to equal ordinary income tax rates, which he also plans to increase.  Imagine a $10.0 million portfolio with a tax basis of $2.0 million.  If your client passed today, it might go to heirs free of estate taxes and with a new tax basis of $10.0 million.  If your client pays the maximum capital gains tax rate of 20%, the unified credit and basis step-up would save them $1.6 million (20% of the $8 million gain).  The entire $10.0 million portfolio would pass to an heir tax free.  If, instead, the unified credit is significantly reduced and capital gains rates rise to, say, 40%, the change will cost your client’s estate $3.2 million, and the bequest would be diminished to $6.8 million.  If an estate tax is levied on top of that, the impact will be much greater.For those who want to minimize exposure to changes in tax law, estate planning can leverage the very low interest rate environment in conjunction with trusts and asset holding entities to transfer wealth efficiently and outside of the reach of the U.S. Treasury.  The problem that may well present itself is the overwhelming demand for these services in late 2020 if the election is decisively in favor of the Democratic Party.  If success in investing is “anticipating the anticipations of others,” this is a good time to think seriously about estate planning before tax planners become as scarce as toilet paper was in April.What is the Next Chicane?Where were you when you first realized that the Coronavirus pandemic was a big deal?  I was in, of all places, New York with my family during the second week of March, and I’ll never forget how every day of the week it became more apparent that COVID-19 was going to change the trajectory of this year, if not beyond.  First, the NBA suspended the season, then Tom Hanks – who was in Australia – tested positive, and then – also in Australia – the Formula 1 racing season was suspended about two hours before it was scheduled to start.F1 resumed on July 5 with the Austrian Grand Prix, and the motorsport, which is essentially a giant logistical exercise anyway, has successfully pivoted schedules, business practices, and financial models to adapt to operating in an environment with plenty of at-home viewers but nobody in the stands.  Even for a business that thrives on making order out of chaos, Formula 1 is going better than expected, and the same could be said of the RIA industry.  But now that you’ve successfully protected, and maybe even enhanced, your clients’ financial well-being and the earnings of your firm, the challenges that loom from political change are coming in fast.  The chicanery of 2020 never ends.

The economic effects of the COVID-19 pandemic are dire, and family businesses are not immune to the economic fallout from the virus. Yet we are confident that family businesses are best positioned to survive and lead in the post-pandemic economic recovery.For family shareholders who are optimistic about the resilience of their family businesses and focused on the long view, this is an ideal time to execute intrafamily transfers in pursuit of estate planning objectives.Coronavirus and Fair Market ValueThe precipitous decline in public equity markets has been well documented. From its Feb. 19 peak, the S&P 500 index lost nearly 24% of its value by the end of the first quarter. Small-cap stocks in the S&P 600 index suffered even more, falling approximately 33% over the same period.What caused the significant drop in public stock prices? Stock prices reflect three factors.Cash Flow. Stock prices are based on the future, not the past. Historical earnings and cash flows can provide important perspective, but investors are much more focused on what’s visible through the windshield than what is in the rearview mirror. For most public companies, the pandemic has caused investors to reassess the amount of cash flow those companies will generate in the coming year. Lower expected cash flows result in lower stock prices.Risk. When fog or other conditions reduce visibility, smart drivers slow down. Investors do the same thing. The pandemic has caused the range of potential cash flow outcomes for the coming year to be much wider than normal. In other words, stock investors are facing more risk than normal. When risk goes up, stock prices come down.Growth. The growth component describes how fast cash flows are forecast to increase in subsequent years. Theories abound as to whether the economic recovery curve from the pandemic will look a “V” or a “U” or a “W” (or some other letter). To the extent investors expect the negative effect of the pandemic to weigh on cash flows for a prolonged period, stock prices will be cut. It is impossible to dissect the observed change in stock prices to discern how much of the decrease is attributable to expected cash flow, risk, or growth. What matters is that the three factors, in combination, have caused the reduction in public stock prices. What does all this have to do with the fair market value of illiquid minority interests in private companies? The value of such interests depends on the same three factors. Business appraisers determine the fair market value of shares for gifting or other intrafamily transfers using a two-step process.First, appraisers estimate the value of the business as if the shares were publicly traded. In other words, they consider how public market investors would view the shares if they had the opportunity to purchase them on the stock market. In doing so, they develop expectations regarding the cash flow, risks, and growth prospects of the family business. If a particular family business is better positioned to weather the COVID-19 storm than its peers, the negative impact on value may be muted. For many family businesses, however, an assessment of these three factors in the midst of the pandemic will likely result in a materially lower value than would have been the case in mid-February.Next, appraisers consider the appropriate discount, or reduction in value, to account for the fact that the shares in the family business are not publicly traded. All else equal, investors prefer to have liquidity. In order to accept the illiquidity inherent in private company shares, investors require a marketability discount. The size of the marketability discount depends on the specific attributes of the shares, including the likely holding period until a favorable opportunity for liquidity is expected, the amount of expected interim distributions from owning the shares, the expected capital appreciation over the holding period, and the incremental risk associated with illiquidity. The impact of the pandemic on the magnitude of the marketability discount is more ambiguous than the effect on the as-if-freely-traded value. Some of the factors are likely to be neutral relative to the pre-pandemic environment, while others may be negatively or positively affected. In short, the fair market value of minority shares in family businesses is likely lower today than it was just a couple months ago. It does not matter if your family has no intention of selling the family business at a reduced value; the fact is that – if you were to sell an illiquid minority interest now – the value would reflect current market conditions. The IRS itself makes this clear in Revenue Ruling 59-60:The fair market value of specific shares of stock will vary as general economic conditions change from ‘normal’ to ‘boom’ to ‘depression,’ that is, according to the degree of optimism or pessimism with which the investing public regards the future at the required date of appraisal. Uncertainty as to the stability or continuity of the future income from a property decreases its value by increasing the risk of loss of earnings and value in the future.The potential silver lining to the cloud of depressed market values is that it provides an opportunity for more tax-efficient transfers of family wealth for estate planning purposes.Case Study: Decisive vs. Hesitant PlanningWe can illustrate the significance of the current opportunity with an example.  Consider a family business having a pre-pandemic value on an as-if-freely-traded basis of $25 million. Although the long-term prospects of the business remain unchanged, the dislocations caused by coronavirus have triggered a temporary reduction in fair market value of 25%. The founder has yet to do any estate planning and continues to own 100% of the shares.Exhibit 1 depicts the expected value trajectory for the family business both before and after the pandemic.Because of the resilience of the family business, the value trajectory resumes its pre-pandemic path after three years. The founder’s tax advisers suggest that – since the long-term prospects of the business are unimpaired – the current depressed fair market value provides an excellent opportunity to begin a program of regular gifts. The current lifetime gift tax exclusion is approximately $12 million, and the founder and his advisers devise a strategy of making an initial gift of $6 million, followed by annual gifts of $1 million in each of the following six years.We’ll examine two scenarios. In the first, the founder begins the gifting program immediately (the “Decisive” scenario). In the second, the founder defers the gifting program until the uncertainty associated with the pandemic has passed (the “Hesitant” scenario). In both cases, the shares gifted represent illiquid minority interests, so a 25% marketability discount is applied to derive fair market value.Since the annual gifts are for fixed dollar amounts, lower per-share values result in more shares being transferred, which reduces the amount of shares in the future taxable estate, all else equal. Exhibit 2 summarizes the shares that are transferred under the gifting program for the Decisive and Hesitant scenarios.Because the gifts under the Decisive scenario were made while share prices were depressed because of the coronavirus, a larger portion of the shares were transferred than in the Hesitant scenario. As a result, the founder retained just 33% of the total shares after using the $12 million lifetime exclusion, compared with 58% under the Hesitant scenario. As shown in Exhibit 3, the effect on the resulting taxable estate is compounded because, under the Hesitant scenario, the 58% retained interest represents a controlling position in the shares and the value is not reduced for the marketability discount. In fact, although not shown in Exhibit 3, a control premium to the as-if-freely traded could be applicable, which would exacerbate the disparity. In our example, failing to take advantage of the estate planning opportunity presented by the depressed asset prices added $7.2 million to the eventual estate tax bill. Procrastination can be costly. Estate Planning and ControlOur preceding example was relatively simple. Estate planners often use a variety of strategies involving trusts and other vehicles to accomplish estate planning and other goals. However, our simple example illustrates what is often perceived as a “cost” to aggressive estate planning: the senior generation’s loss of voting control.In the Decisive scenario, the founder’s ownership percentage fell below 50% in 2022. So, from that point on, the founder could no longer unilaterally make significant corporate decisions. We have seen a variety of strategies used to mitigate this outcome, such as establishing voting and non-voting share classes. These techniques can delay the eventual loss of control, but every business leader will eventually relinquish voting control of their company, whether through estate planning, death, or sale of the business.In our experience, deferring estate planning to accommodate a desire to maintain voting control is rarely worthwhile. When the desire to maintain control is especially strong, that is often a clue that there are other underlying family issues that need to be addressed. If, as the controlling owner advances in age, the loss of voting control remains unpalatable, that could signal that the family dynamics are such that selling the business might be the best outcome for everyone.Strike While the Iron Is HotFamily business leaders are currently facing many pressing issues. Amid the uncertainty, however, family shareholders should know that the estate planning opportunities triggered by lower valuations may not last. Schedule a quick call with your estate planning advisers to see if there are steps you can take to help reduce the burden of future estate taxes on your family and business.This article originally appeared in Family Business Magazine (April 2020) and was republished with permission.

In the depths of the stock market pullback, we wrote about the opportunity to take advantage of depressed share values. When the Applicable Federal Rate fell to historic lows, we wrote about the “double opportunity” afforded by low values coupled with low interest rates.Which leads us to last week. During our webinar on the estate planning opportunities in the current environment, fellow panelist Brook Lester reminded us that – in addition to all the other fun stuff going on in 2020 – there’s a presidential election in November.We possess no political clairvoyance. However, if a Biden administration were to assume power in January 2021, we know that adverse changes to the current estate tax regime would be likely. As November draws near, advisors are urging family shareholders to mitigate the political risk by implementing significant transactions now.In this week’s post, we have assembled some helpful resources we have come across that provide helpful insight on the estate planning opportunities and strategies available to family business owners during 2020.Written in a pre-COVID world, the 2020 Wealth Planning Outlook from Northern Trust still offers valuable perspective for family business leaders.Published in June 2020, this whitepaper from our friends at Diversified Trust provides timely insights for family shareholders evaluating their planning needs in the wake of COVID-19.This article sheds some light on how wealthy families are pursuing estate planning goals with renewed vigor under the shadow of COVID-19.Attorney and Forbes.com columnist Matthew Erskine offers a compelling case for using one’s unified credit sooner rather than later.Finally, this article from CNBC’s website digs deeper into the Biden campaign’s tax proposals, including the elimination of the “step-up” in basis currently available to heirs. It is generally a bad idea to let the tax tail wag the dog. However, the combination of depressed asset values, low interest rates, and political risk means that family shareholders should accelerate work on the business and family issues that pave the way for effective estate planning. If your family has avoided having those conversations, it’s not too late, but the time to start really is now. A well-reasoned and supported business valuation is fundamental to any estate planning strategy. Call one of our professionals today to started on a valuation of your family business.

All fair market determinations involve assumptions regarding how buyers and sellers would behave in a transaction involving the subject asset. In a recent Tax Court case, the IRS appraiser applied a novel valuation rationale predicated on transactions that would occur involving assets other than the subject interests being valued. In its ruling, the Court concluded that this approach transgressed the boundaries of what may be assumed in a valuation.BackgroundAt issue in Grieve was the fair market value of non-voting Class B interests in two family LLCs.The first, Rabbit, owned a portfolio of marketable securities having a net asset value of approximately $9 million.The second, Angus, owned a portfolio of cash, private equity investments, and promissory notes having a net asset value of approximately $32 million. Both Rabbit and Angus were capitalized with Class A voting and Class B non-voting interests. The Class A voting interests comprised 0.2% of the total economic interest in each entity. The Class A voting interests were owned by the taxpayer’s daughter, who exercised control over the investments and operations of the entities.Valuation Conclusion – TaxpayerThe taxpayer measured the fair market value of the Class B non-voting interests using commonly accepted methods for family LLCs. The net asset value of each LLC was deemed to represent the value on a controlling interest basis.Since the subject Class B non-voting interests did not possess control over either entity, the net asset value was reduced by a minority interest discount. The taxpayer estimated the magnitude of the minority interest discount with reference to studies of minority shares in closed end funds.Unlike the minority shares in closed end funds, there was no active market for the Class B non-voting interests in Rabbit and Angus. As a result, the taxpayer applied a marketability discount to the marketable minority indication of value. The taxpayer estimated the marketability discount with reference to restricted stock studies. The combined valuation discount applied to the Class B nonvoting interests was on the order of 35% for both Rabbit and Angus, as shown in Exhibit 1. Valuation Conclusion – IRSThe IRS adopted a novel approach for determining the fair market value of the Class B non-voting interests.Noting the disparity in economic interests between the Class A voting (0.2%) and Class B non-voting interests (99.8%), the IRS concluded that a hypothetical willing seller of the Class B non-voting interest would sell the subject interest only after having first acquired the Class A voting interest. Having done so, the owner of the class B non-voting interest could then sell both the Class A voting and Class B nonvoting interests in a single transaction, presumably for net asset value.If the dollar amount paid of the premium paid for the Class A voting interest is less than the aggregate valuation discount applicable to the Class B non-voting interest, the hypothesized series of transactions would yield more net proceeds than simply selling the Class B non-voting interest by itself. The sequence of transactions assumed in the IRS determination of fair market value is summarized in Exhibit 2.Tax Court ConclusionIt is certainly true that – if the Class A voting interests could, in fact, be acquired at the proposed prices – the sequence of transactions assumed by the IRS yield greater net proceeds for the owner of the subject Class B non-voting interests than a direct sale of those interests. However, is the assumed sequence of transactions proposed by the IRS consistent with fair market value?The Tax Court concluded that the IRS valuation over-stepped the bounds of fair market value. The crux of the Court’s reasoning is summarized in a single sentence from the opinion: “We are looking at the value of the Class B Units on the date of the gifts and not the value of the class B units on the basis of subsequent events that, while within the realm of possibilities, are not reasonably probable, nor the value of the class A units.” Citing a 1934 Supreme Court decision (Olson), the Tax Court notes that “[e]lements affecting the value that depend upon events within the realm of possibility should not be considered if the events are not shown to be reasonably probable.” In view of the fact that (1) the owner of the Class A voting interests expressly denied any willingness to sell the units, (2) the speculative nature of the assumed premiums associated with purchase of those interests, and (3) the absence of any peer review or caselaw support for the IRS valuation methodology, the Tax Court concluded that the sequence of transactions proposed by the IRS were not reasonably probable. As a result, the Tax Court rejected the IRS valuations.The Grieve decision is a positive outcome for taxpayers. In addition to affirming the propriety of traditional valuation approaches for minority interests in family LLCs, the decision clarified the boundaries of fair market value, rejecting a novel valuation approach that assumes specific attributes of the subject interest of the valuation that do not, in fact, exist. As the Court concluded, fair market value is determined by considering the motivations of willing buyers and sellers of the subject asset, and not the willing buyers and sellers of other assets.Originally appeared in Value Matters™, Issue No. 3, 2020

Litigation engagements are generally very complex, consisting of many moving parts.  The analogy that comes to mind is the nostalgic game of Tetris.  While invented in 1984 by a Russian named Alexey Pajitnov, most of us remember the iconic version popularized through the Nintendo Gameboy in the 1990s.  The game featured seven game pieces cascading down at increasing speed forcing the game player to manipulate them by rotating and placing them, trying to create a flat surface.  As anyone that has played can attest, the game creates more anxiety and stress as the pieces cascade faster and begin to pile up.Like the game, many clients involved in auto dealer valuation disputes also experience anxiety and stress as problems begin to pile up.  When assisting these clients in our family law and commercial litigation practices, we strive to help alleviate the pain points, or “clear the blocks.”We hope you never find yourself a party to a legal dispute; however, we offer the following words of wisdom based upon our experience working in these valuation-related disputes.The following topics, posed as questions, have been points of contention or common issues that have arisen in recent litigation engagements. We present them here so that if you are ever party to a dispute, you will be a more informed user of valuation and expert witness services.We begin with seven questions to represent each of the original Tetris pieces, and we’ve added two questions to consider additional issues raised during the COVID-19 crisis.Should Your Expert Witness Be a Valuation or an Industry Expert?Oftentimes, the financial and business valuation portion of a litigation is referred to as a “battle of the experts” because you have at least two valuation experts – one for the plaintiff and one for the defendant.  In the auto dealer world, you are hopefully combining valuation expertise with a highly-specialized industry. It is critical to engage an expert who is both a valuation expert and an industry expert – one who holds valuation credentials and has deep valuation knowledge and also understands and employs accepted industry-specific valuation techniques.  Look with caution upon valuation experts with minimal industry experience who utilize general valuation methodologies often reserved for other industries (for example, Discounted Cash Flow (DCF)1 or multiples of Earnings Before Interest, Taxes and Depreciation (EBITDA)) with no discussion of Blue Sky multiples. Does the Appraisal Discuss Local Economic Conditions and Competition Adequately?The auto industry, like most industries, is dependent on the climate of the national economy.  Additionally, auto dealers can be dependent or affected by conditions that are unique to their local economy.  The type of franchise relative to the local demographics can also have a direct impact on the success/profitability of a particular auto dealer.  For example, a luxury or high-line franchise in a smaller or rural market would not be expected to fare as well as one in a market that has a larger and wealthier demographic. In certain markets, an understanding of the local economy/industry is more important than an understanding of the overall auto dealer industry and national economy.  Common examples are local markets that are home to a military base, oil & gas markets in Western Texas or natural gas in Pennsylvania, or fishing industries in coastal areas. There’s also a balance between understanding and acknowledging the impact of that local economy without overstating it.  Often some of the risks of the local economy are already reflected in the historical operating results of the dealership. If There Are Governing Corporate Documents, What Do They Say About Value, and Should They Be Relied Upon? Many of the corporate entities involved in litigation have sophisticated governance documents that include operating agreements, buy-sell agreements, and the like. These documents often contain provisions to value the stock or entity through the use of a formula or process.  Whether or not these agreements are to be relied upon in whole or in part in a litigated matter is not always clear. In litigation, the focus will be placed on whether the value concluded from a governance document represents fair market value, fair value, or some other standard of value.  However, the formulas contained in these agreements are not always specific to the industry and may not include accepted valuation methodology for auto dealers. Two common questions that arise concerning these agreements are 1) has an indication of value ever been concluded using the governance document in the dealership’s history (in other words, has the dealership been valued using the methodology set out in the document)?; and 2) have there been any transactions, buy-ins or redemptions utilizing the values concluded in a governance document?  These are important questions to consider when determining the appropriate weight to place on a value indication from a governance document.  If they’ve never been used, and don’t conform to accepted valuation methodologies for auto dealers, then how reliable can these be? Additionally, some litigation matters (such as divorce) state that the non-business party to the litigation is not bound by the value indicated by the governance document since they were not a signed party to that particular agreement.   It is always important to discuss this issue with your attorney. Have There Been Prior Internal Transactions of Company Stock and at What Price?Similar to governance documents, another possible data point(s) in valuing an automotive dealership are internal transactions. A good appraiser will always ask if there have been prior transactions of company stock and, if so, how many have occurred, when did they occur, and at what terms did they occur? There is no magic number, but as with most statistics, more transactions closer to the date of valuation can often be considered as better indicators of value than fewer transactions further from the date of valuation. An important consideration is the motivation of the buyer and seller in these internal transactions.  Motivations may not always be known, but it’s important for the financial expert to try to obtain that information.  If there have been multiple internal transactions, appraisers have to determine the appropriateness of which transactions to possibly include and which to possibly exclude in their determination of value. Without an understanding of the motivation of the parties and specific facts of the transactions, it becomes trickier to include some, but exclude others.  The more logical conclusion would be to include all of the transactions or exclude all of the transactions with a stated explanation. What Do the Owner’s Personal Financial Statements Say and Are They Important?Most owners of an auto dealership have to submit personal financial statements as part of the guarantee on the floor plan and other financing.  The personal financial statement includes a listing of all of the dealer’s assets and liabilities, typically including some value assigned to the value of the dealership. In litigated matters, the stated value by the dealer principal on their personal financial statement provides another data point to valuation. One view of a personal financial statement is that no formal valuation process was used; so at best, it’s a thumb in the air, blind estimate of value of the business.  The opposing view would say the individual submitting the personal financial statement is attesting to the accuracy and reliability of the financial figures contained in a document under penalty of perjury.  Further, some would say that the business owner is the most informed person regarding the business, its future growth opportunities, competition, and the impact of economic and industry factors on the business.  While they are not business appraisers, they are instrumental to a valuation expert’s understanding of risk and growth in their business. It’s never a good situation to be surprised by the existence of these documents. A good business appraiser will always ask for them.  The value indicated in a personal financial statement should be viewed in the light of value indications under other methodologies and sources of information.  At a minimum, personal financial statements may require the expert to ask more questions or use other factors, such as national and local economy to explain the difference and changes in values over time.  If an expert opines the value is X, but the personal financial statements says 3X or 1/3X, an expert must be prepared to explain the difference. Does the Appraiser Understand the Industry and How to Use Comparable Industry Profitability Data? The auto dealer industry is highly specialized and unique and should not be compared to general retail or manufacturing industries.  As such, any sole comparison to general industry profitability data should be avoided.  If your appraiser solely uses the Annual Statement Studies provided by the Risk Management Association (RMA) as a source of comparison for the balance sheet and income statement of your dealership to the industry, this could be problematic.  RMA’s studies are organized by the North American Industry Classification System (NAICS).  Typical new and used retail auto dealers would fall under NAICS #441110 or #441120. This general data may do the trick in certain industries, but most dealers sell both new and used vehicles.  Further, RMA does not distinguish between different franchises. The National Automobile Dealers Association (NADA) publishes monthly Dealership Financial Profiles broken down by Average Dealerships, which would be comparable to RMA data.  However, NADA drills down further, segmenting the industry into the four following categories: Domestic Dealerships, Import Dealerships, Luxury Dealerships, and Mass Market Dealerships. While no single comparison is perfect, an appraiser should know to consult more specific industry profitability data when available. Do You Understand Actual Profitability vs. Expected Profitability and Why It’s Important?Either through an income or Blue Sky approach, auto dealers are typically valued based upon expected profitability rather than actual profitability of the business. The difference between actual and expected profitability generally consists of normalization adjustments. Normalization adjustments are made for any unusual or non-recurring items that do not reflect normal business operations. During the due diligence interview with management, an appraiser should ask does the dealership have non-recurring or personal expenses of the owner being paid by the business? Comparing the dealership to industry profitability data as discussed earlier can help the appraiser understand the degree to which the dealership may be underperforming. If a dealership has historically reported 2% earnings before taxes (EBT) and the NADA data suggests 5%, the financial expert must analyze why there is a difference between these two data points and determine if there are normalizing adjustments to be applied. Let’s use some numbers to illustrate this point.  For a dealership with revenue of $25 million, historical profitability at 2% would suggest EBT of $500,000.  At 5%, expected EBT would be $1,250,000, or an increase of $750,000. In this case, the financial expert should analyze the financial statements and the dealership to determine if normalization adjustments are appropriate which, when made, will reflect a more realistic figure of the expected profitability of the dealership without non-recurring or personal owner expenses. This is important because, hypothetically, a new owner could optimize the business and eliminate some of these expenses; therefore, even dealerships with a history of negative or lower earnings can receive higher Blue Sky multiples because a buyer believes they can improve the performance of the dealership. However, as noted earlier, the dealership may be affected by the local economy and other issues that cannot be fixed so the lower historical EBT may be justified. For more information on normalizing adjustments, see our article Automobile Dealership Valuation 101. What Is the Date of Valuation and Why Does It Matter?  Depending on the state, family law matters might require the date of valuation to be the date of filing, the date of separation, the date of the trial (current), or some other date.  Commercial litigation can require the date of valuation to be the date of a certain event, the date of trial (current), or some other date.  Why does the date matter?  In addition to the standard of value (generally fair market value or fair value), a business valuation contemplates a premise of value – often a going-concern business.  The business appraiser must use the relevant known and knowable facts at the date of valuation to incorporate into a valuation conclusion.  These facts reflected in historical financial performance, anticipated future operations, and industry/economic conditions can differ depending on the proper date of valuation.As we are all experiencing during COVID-19, the conditions of March/April 2020 are vastly different than year-end 2019.  It would be incorrect, however, to consider the impact of COVID-19 for a valuation date prior to Spring 2020.How Have Auto Dealer Valuations Been Affected by COVID-19?    Valuations of auto dealers involve many factors.  We also try to avoid absolutes in valuation such as "always" and "never."  The true answer to the question of how auto dealer valuations have been affected by COVID-19 is “It Depends.”As a general benchmark, the overall performance of the stock market from the beginning of 2020 until now can serve as a barometer.  Depending on the day, the stock market has declined anywhere between 20-30% during that time from previous highs.  Specific indicators of each auto dealer, such as actual performance and the economic/industry conditions relative to their geographic footprint, also govern the impact of any potential change in valuation.The litigation environment is already rife with doom and gloom expectations and we’ve previously written about the phenomenon referred to as divorce recession in family law engagements.  While some auto dealers may go out of business as a result of COVID-19, the valuation of most may be deflated from prior indications of value, but generally, the conclusion is not zero.  As always, it depends on the specific facts and circumstances of each particular auto dealer under examination.Putting It All TogetherAs with all litigation engagements, the valuation of automobile dealerships can also be complex. A deep knowledge of the industry along with valuation expertise is the optimal combination for general valuation needs and certainly for valuation-related disputes.  Understanding how these components fit together is important to a successful resolution, just like the assembly and combination of pieces in a game of Tetris.  If you have a valuation issue, feel free to contact us to discuss it in confidence.1 DCF methodology might have to be considered in the early stages of a Company’s lifecycle where the presence of historical financials either does not exist or are limited.Images by DevinCook via Wikimedia Commons

Estate of Aaron U. Jones v. Commissioner, T.C. Memo 2019-101 (August 19, 2019)EXECUTIVE SUMMARYIn May 2009, Aaron U. Jones made gifts to his three daughters, as well as to trusts for their benefit, of interests (voting and non-voting) from two family owned companies, Seneca Jones Timber Co. (SJTC), an S corporation, and Seneca Sawmill Co. (SSC), a limited partnership. These gifts were reported on his gift tax return with a total value of approximately $21 million. The IRS asserted a gift tax deficiency of approximately $45 million on a valuation of approximately $120 million. The Tax Court ruled that value was approximately $24 million, agreeing with the taxpayer’s appraiser.In this case, the Tax Court again concluded that “tax-affecting” earnings of an S corporation was appropriate in determining value under the income method (see also Mercer Capital’s review of the Kress decision). However, there are several other issues of interest in this case which we discuss further in this article.BACKGROUNDSSC was established in 1954 in Oregon as a lumber manufacturer.SSC operated two saw mills – its dimension and stud mill – delivering high quality products that were technologically advanced, allowing SSC to demand a higher price for its products than its competitors.Early in its history, SSC acquired most of its lumber from Federal timberlands.As environmental regulations increased, SSC’s access to Federal timberlands became at risk.Mr. Jones began purchasing timberland in the late 1980s and early 1990s when he became convinced that SSC could no longer rely on timber from Federal lands.SJTC was formed as an Oregon limited partnership in 1992 by the contribution of those timberlands purchased by Mr. Jones.SJTC’s timberlands were intended to be SSC’s inventory.Further, both SSC and SJTC maintained similar ownership groups, with SSC serving as the 10% general partner of SJTC.As of the date of valuation, SJTC held approximately 1.45 million board feet of timber over 165,000 acres in western Oregon, most of which was acquired in those initial purchases between 1989 and 1992.In 2008, approximately 89% of SJTC’s harvested logs were sold directly or indirectly to SSC and SJTC charged SSC the highest price that SSC paid for logs on the open market.GIFT TAX VALUATION In May 2009, Mr. Jones formed seven family trusts and made gifts to those trusts of SSC voting and nonvoting stock. He also made gifts to his three daughters of SJTC limited partner interests. Mr. Jones filed a timely gift tax return reporting values based upon appraisals prepared by Columbia Financial Advisors as shown in Figure 1 on the next page (Petitioner’s Value). The IRS notice of deficiency asserted values much higher.A petition was filed in the Tax Court by Mr. Jones in November 2013. Mr. Jones died in September 2014 and was replaced in the Tax Court proceeding by his estate and personal representatives. His estate then engaged another appraiser, Robert Reilly of Willamette Management Associates. Mr. Reilly was noted by the Court to have “performed approximately 100 business valuations of sawmills and timber product companies.”The original appraiser for the IRS was not noted in the case decision. At trial, the IRS’ valuation expert was Phillip Schwab who, per the Court, has “performed several privately held business valuations.” Additionally, the IRS was noted as having “previously reviewed and completed several business valuations, including several sawmills.”Their conclusions are presented in Figure 2.SUMMARY OF THE COURT’S DECISIONUltimately, the Court sided with Mr. Reilly’s conclusions of values for SSC and SJTC, along with his reported discount for lack of marketability (DLOM).The only distinction the Court made with Mr. Reilly’s DLOM was to correct a typo wherein the Appendix in Mr. Reilly’s report referred to a 30% DLOM, when in actuality, he had applied a 35% DLOM.A summary of the Court’s conclusions are shown in Figure 3.Item 1:SJTC’s Valuation Treatment as an Asset Holding Company or an Operating CompanyThe most critical issue surrounding the large difference in the valuation conclusions of SJTC for both experts centered on the valuation approach.The Court noted that “when valuing an operating company that sells products or services to the public, the company’s income receives the most weight.”Contrarily, the Court noted “when valuing a holding or investment company, which receives most of its income from holding debt securities, or other property, the value of the company’s assets will receive the most weight.”A question in this matter: is SJTC an Asset Holding Company or is it an Operating Company? Petitioners’ experts concluded that SJTC was an operating company and relied on an income approach utilizing projections from management. Conversely, one respondent’s experts concluded that SJTC is a natural resource holding company and relied on the asset approach utilizing real estate appraisal on the underlying timberlands.One of the critical factors the Court relied upon in determining its conclusion of the nature of SJTC’s operations centered on the Company’s operating philosophy.SJTC relied on a practice called “sustained yield harvesting” which didn’t harvest trees until they were 50 to 55 years old.As such, SJTC limited the harvest to the growth of its tree farms, even if selling the land or harvesting all of the trees would be the most profitable in the short-term.As discussed earlier, Mr. Jones began purchasing the timberlands and formed SJTC to supply the lumber to SSC for its long-term operations.The other argument the Court considered when determining how to treat SJTC was the limited partner units in question.Specifically, the subject blocks of limited partner units could not force the sale or liquidation of the underlying timberlands.Recall, SSC maintained the 10% general partner or controlling interest in SJTC and its focus remained on SSC’s continued operations as a sawmill company dependent on SJTC for supplying the majority of its lumber.Based on these factors, the Court concluded that SSC and SJTC “were so closely aligned and interdependent” that SJTC had to be valued based on its ongoing relationship with SSC, and thus, an income-based approach is more appropriate to value SJTC than a net asset value method.With this distinction, SJTC was more comparable to an operating company and less comparable to a traditional Timber Investment Management Organization (TIMO), Real Estate Investment Trust (REIT), or other holding or investment company.Item 2:Reliance of Revised Management Projections in Valuation of SJTC and Impact of Economic ConditionsBoth of Petitioner’s experts relied on management projections in the underlying assumptions of their discounted cash flow (DCF) analyses to value SJTC.The original appraisal utilized management projections that were included in the prior annual report.For trial, Mr. Reilly utilized revised projections from April 2009 in his DCF analysis.Respondent challenged the use of the revised projections, despite the fact that their own second expert, Mr. Schwab, also used the revised projections in his guideline publicly traded company method.He chose to average the revised projections with those from the most recent annual report.The Court specifically noted the economic conditions at the date of valuation, highlighting the volatility during the recession years.As such, the Court determined the revised projections were the most current as of the date of valuation and included management’s opinion on the climate of their market and operations.The impact of the current economic conditions is also referenced by the Court in another key takeaway that we will discuss later.Item 3: Tax-Affecting Earnings in the Valuations of SJTCMr. Reilly computed after-tax earnings based on a 38% combined proxy for federal and state taxes. He further computed the benefit of the dividend tax avoided by the partners of SJTC, by estimating a 22% premium based on a study of S Corporation acquisitions. Respondent argued that since SJTC is a partnership, the partners would not be liable for tax at the entity level and there is no evidence that SJTC would become a C corporation. Therefore, respondent argued that the entity level tax rate should be zero.The Court concluded that Mr. Reilly’s tax-affecting “may not be exact, but is more complete and convincing than respondent’s zero tax rate.”  The Court also noted that the contention from respondent on this tax-affecting issue seems to be more of a “fight between lawyers” as the criticism appeared more in trial briefs than in expert reports. In fact, respondent’s expert, Mr. Schwab, argued that tax-affecting was improper because SJTC is a natural resources holding company and therefore its “rate of return is closer to the property rates of return” rather than challenging the lack of an actual entity level tax.Item 4:Market Approach for SJTCThe Court and respondent’s expert agreed with Mr. Reilly’s market approach for the valuation of SJTC.With little to no disagreement, the key takeaway here is on Mr. Reilly’s analysis.The Court detailed the analysis by mentioning that Mr. Reilly selected six guideline companies.The Court also cited the analysis and reasoning behind Mr. Reilly’s selection of pricing multiples slightly above the minimum indications of the guideline companies. Specifically, Mr. Reilly noted that SJTC’s revenue and profitability for the most recent twelve months before the valuation date were below those of the guideline companies.Thus, he accounted for these differences in financial fundamentals in his selection of the guideline pricing multiples. Item 5:Intercompany Debt between SJTC and SSCRespondent argued that Mr. Reilly erred by excluding the receivable held by SSC and the corresponding liability of SJTC. Further, respondent contended that Mr. Reilly’s treatment of SSC’s receivable from SJTC as an operating asset, rather than a non-operating asset, reduced the value of SSC under his income approach since a non-operating asset was not added to that value.On this issue, the Court weaved in earlier themes regarding the symbiotic relationship of the two companies and also the present economic conditions on the date of valuation to make its conclusion.The Court agreed with Mr. Reilly that the intercompany debt could be removed as a clearing account based on the idea that both companies operate as “simply two pockets of the same pair of pants.”The Court rejected respondent’s theories that this treatment of intercompany debt was only to avoid a negative asset valuation of SJTC and to reduce the value of SSC by not including the receivable as a non-operating asset.The Court referenced the relationship of the two companies and how the joint credit agreements of the two companies were secured by SJTC’s timberlands. The Court recognized that SSC could not have obtained separate third-party loans without the assistance of SJTC’s underlying timberlands as collateral. A further detail of the two companies’ relationship was revealed earlier in this decision. 2009 economic conditions also included subprime mortgage lending crises, particularly in the housing market. Around this time, SSC was anticipating a shift in the market from green lumber to dry lumber. Dry lumber production required SSC to build dry kilns and a boiler in a larger renewable energy plant project. Because of economic conditions, SSC was not able to obtain the construction loans to finance the renewable energy plant for itself or with another planned related entity. Instead, SSC was forced to borrow against the timberlands of SJTC.Ultimately, the Court viewed the two companies (SSC and SJTC) as a single business enterprise and concluded that Mr. Reilly’s treatment of the intercompany debt captured their relationship.Item 6:Valuation of SSC – Treatment of General Partner Interest in SJTCRespondent’s criticisms of Mr. Reilly consisted of three items:The treatment of Intercompany debt between the two companiesTax-affecting earningsThe treatment of SSC’s general partner interest. The Court handled the intercompany debt and tax-affecting treatment consistently with SJTC’s valuationMr. Reilly captured the value of SSC’s general partner interest in SJTC by projecting a portion of the expected partnership income in his projections. Specifically, Mr. Reilly projected $350,000 annually for SSC’s general partner interest based on an analysis of the 5-year and 10-year historical distributions from SJTC.Respondent claimed that this approach undervalued SSC’s general partner interest by not considering its control over SJTC and treating it as a non-operating asset to be valued by the net asset value method.The Court concluded that SSC’s general partner interest in SJTC is an operating asset again citing the single business enterprise relationship between the two companies.Further, the value of SSC’s general partner interest is best estimated by the expected distributions that it would expect to receive.Item 7:Buy-Sell Agreement ItemsAlthough not directly discussed and cited in any of the Court’s factors that we have discussed so far, the decision did highlight certain elements from SSC’s and SJTC’s buy-sell agreements as we noted.Both buy-sell agreements contained language that prohibited the sale of the entity or transfers within the units/shares that would jeopardize the current tax status of the Companies as an S Corporation (SSC) and Limited Partnership (SJTC), respectively.Both agreements called for discounts for lack of control, lack of marketability, and lack of voting rights of an assignee (where applicable) to be considered. Finally, both agreements stated that the valuations of the entities should consider the anticipated cash distributions allocable to the units/shares.CONCLUSIONSWhile the Court’s decision to allow the tax-affecting of earnings (like in the Kress case) in the valuations of SSC and SJTC will dominate the headlines, there are additional takeaways from the case that impact the valuations.Of note, the disparity in experience of the appraisers involved, consideration of the current economic conditions, and the purpose and nature of the business relationship of the two companies seemed to influence the Court’s conclusions.Finally, the distinction and eventual valuation treatment of SJTC as an operating company rather than a holding company was of particular interest to us.

In last week’s post, we explored how the estate tax works and how family business shareholders are uniquely burdened by the prospect of having a substantial estate tax liability despite potentially having most of their wealth tied up in illiquid stock.  This week’s to-do list includes important tasks for family business directors seeking to help prevent, or at least minimize, unhappy surprises with regard to the estate tax.  While the estate tax is an obligation of the shareholders rather than the family business itself, if the shareholders are not adequately prepared to manage their emerging estate tax liabilities, there can be adverse consequences for the sustainability of the family business.Review the Current Shareholder List / Ownership Structure for the Family BusinessIn family businesses, the lines between family membership, influence, employment, economic benefit from the business, and actual ownership can be blurry.  Based on the current shareholder list, are there any shareholders that – were the unexpected to happen – would be facing a significant estate tax liability?  Are there potential ownership transfers that would not only alleviate estate tax exposure, but also accomplish broader business continuity, shareholder engagement, and family harmony objectives?Obtain a Current Opinion of the Fair Market Value of the Business at the Relevant Levels of ValueA current valuation opinion is essential to quantifying existing exposures as well as facilitating the desired intra-family ownership transfers.  If you don’t have a satisfactory, ongoing relationship with a business appraiser, the first step is to retain a qualified independent business valuation professional (we have plenty to choose from here).  You should select an appraiser that has experience valuing family businesses for this purpose, has a good reputation, understands the dynamics of your industry, and has appropriate credentials from a reputable professional organization, such as the American Institute of Certified Public Accountants (AICPA) or the American Society of Appraisers (ASA).When you are reading the valuation report, you should be able to recognize your family business as the one being valued.The valuation report should demonstrate a thorough understanding of your business and its position within your industry. It should contain a clear description of the valuation methods relied upon (and why), valuation assumptions made (with appropriate support), and market data used for support.  You should be able to recognize your family business as the one being valued, and when finished reading the report, you should know both what the valuation conclusion is and why it is reasonable.The appraisal should clearly identify the appropriate level of value.  If one of your family shareholders owns a controlling interest in the business, the fair market value per share of that controlling interest will exceed the fair market value per share of otherwise identical shares that comprise a non-controlling, or minority, interest.  Having identified the appropriate level of value, the appraisal should clearly set forth the valuation discounts or premiums used to derive the final conclusion of value and the base to which those adjustments were applied.For example, many common valuation methods yield conclusions of value at the marketable minority level of value.  In other words, the concluded value is a proxy for what the shares of the family business would trade for if the company were public.  Some refer to this as the “as-if-freely-traded” level of value.If the subject interest is a minority ownership interest in your privately-held family business, however, an adjustment is required to reflect the lack of marketability inherent in the shares. All else equal, investors desire ready liquidity, and when faced with a potentially lengthy holding period of unknown duration, investors impose a discount on what would otherwise be the value of the interest on account of the incremental risks associated with holding a nonmarketable interest.  In such a case, the appraiser should apply a marketability discount to the base marketable minority indication of value.On the other hand, if the subject interest represents a controlling interest in the family business, a valuation premium may be appropriate. The “as-if-freely-traded” value assumes that the owner of the interest cannot unilaterally make strategic or financial decisions on behalf of the family business.  If the subject interest does have the ability to do so, a hypothetical investor may perceive incremental value in the interest.  Such premiums are not automatic, however, and a discussion of the facts and circumstances that can contribute to such premiums is beyond the scope of this post. We occasionally hear family shareholders express the sentiment that, since gift and estate taxes are based on fair market value, the lower the valuation the better.  This belief is short-sighted and potentially costly.  For one, gift and estate tax returns do get audited, and the “savings” from an artificially low business valuation can evaporate quickly in the form of incremental professional fees, interest, penalties, and sleepless nights when the valuation is exposed as unsupportable.  Perhaps even more importantly, an artificially low business valuation introduces unhealthy distortion into ownership transition, shareholder realignment, shareholder liquidity, distribution, capital structure, and capital budgeting decisions.  The distorting influence of an artificially low valuation can have negative consequences for your family business long after any tax “savings” become a distant memory.  While the valuation of family businesses is always a range concept, the estimate of fair market value should reasonably reflect the financial performance and condition of the family business, market conditions, and the outlook for the future.Identify Current Estate Tax Exposures and Develop a Funding Plan for Meeting Those Obligations when They AriseThe most advantageous time to secure financing commitments from lenders is before you need the money.With the appraisal in hand, you can begin to quantify current estate tax exposures and, perhaps more importantly, begin to forecast where such exposures might arise in the future if expected business growth is achieved.  Are shareholders prepared to fund their estate tax liability out of liquid assets, or will shareholders be looking to the family business to redeem shares or make special distributions to fund estate tax obligations?  If so, does the family business have the financial capacity to support such activities?  The most advantageous time to secure financing commitments from lenders is before you need the money.  What is the risk that an estate tax liability could force the sale of the business as a whole?  If so, what preliminary steps can directors take to help ensure that the business is, in fact, ready for sale and that such a sale could occur on terms that are favorable to the family?Identify Tax and Non-Tax Goals of the Estate Planning ProcessAs suggested throughout this post, while prudent tax planning is important, it can be foolish to let the desire to minimize tax payments completely overwhelm the other long-term strategic objectives of the family business.  If there was no estate tax, what evolution in share ownership would be most desirable for your family and business?  The overall goal of estate planning should be to accomplish those transfers in the most tax-efficient manner possible, not to subordinate the broader business goals to saving tax dollars in the present.The professionals in our family business advisory services practice have decades of experience helping family businesses execute estate planning programs by providing independent valuation opinions.  Give one of our professionals a call to help you get started on knocking out your to-do list today.

Family business owners cite different motives for investing their time, energy, and savings into building successful businesses.  Some have entrepreneurial zeal, while others are creators who see problems in the world that they can solve.  Others are natural leaders who are inspired by the job opportunities and other “positive externalities” that successful enterprises generate for employees and the communities in which they operate.  But common to nearly all family business owners is the desire to provide financially for their heirs.  As a result, one of the most common concerns such owners cite is the ability to transfer ownership of the family business to the next generation in the most tax-efficient way.The estate tax is a tax on your right to transfer property at your death.The Internal Revenue Service defines the estate tax as follows: “The estate tax is a tax on your right to transfer property at your death.”  The amount of tax is calculated with reference to the decedent’s gross estate, which is the sum of the fair market value of the decedent’s assets less certain deductions for mortgages/debts, the value of property passing to a spouse or charity, and the costs of administering the estate.As with all taxes, things are not as simple as they seem.  Before calculating the estate tax due, two adjustments are made.  First, all taxable gifts previously made by the decedent (and therefore no longer in the estate) are added to the gross estate.  Second, the sum of the gross estate and prior taxable gifts is reduced by the available unified credit.  The unified credit for 2019 is $11.4 million.  The following table illustrates the calculations for the taxable estate of an unmarried individual. To complicate things a bit further, estates have benefited from the introduction of “portability” to the estate tax regime in 2011.  Portability refers to the ability of an individual to transfer the unused portion of their available unified credit to a surviving spouse.  The ultimate effect of portability is that for married family business owners, the total available unified credit is slightly more than $22 million. Taxes are never fun, but what proves to be especially vexing about the estate tax for family business owners is that a substantial portion of their estate often consists of illiquid interests in private company stock.  Going back for a moment to our prior example, if the decedent’s assets consist primarily of a portfolio of marketable securities, it is relatively easy to liquidate a portion of the portfolio to fund payment of the tax.  If, on the other hand, the decedent’s assets are primarily in the form of shares in the family business, liquidating assets to pay the estate tax may prove more difficult (estate taxes are payable in cash and may not be paid in-kind with family business shares).  As a result, family businesses may be sold or be forced to borrow money to fund payment of a decedent’s estate tax liability. Attorneys who specialize in estate taxes have devised numerous strategies for helping families manage estate tax obligations.  Strategies range from relatively simple, such as a program of regular gifts to family members, to complex, such as the use of specialized trusts.  While the finer points of various potential strategies is beyond the scope of this post, the concept of fair market value is essential to understanding and evaluating any estate planning strategy. What is Fair Market Value?As noted above, fair market value is the standard of value for measuring the decedent’s estate, and therefore, the estate tax due.  The IRS’s estate tax regulations define fair market value as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”So far, so good.The fair market value of family business shares depends not just on the fundamentals of the business but also on the relevant level of value.But how does all this work for a family business?  To understand the underlying rationale for much estate planning, we need to explore how the standard of value intersects with what is referred to as the level of value.  In other words, the fair market value of family business shares in an estate depends not just on the fundamentals of the business (expected future revenues, profits, investment needs, risk, etc.), but also on the relevant level of value.If an estate owns a controlling interest in a family business (in most cases, more than 50% of the stock), the fair market value of those shares will reflect the estate’s ability to sell the business to a competitor, supplier, customer, or financially-motivated buyer, such as a private equity fund.  In contrast, the owner of a small minority block of the outstanding shares of a family business has no ability to force the business to change strategy, seek a sale of the business, or otherwise unilaterally compel any action.  As a result, the owner of the shares is limited to waiting until the shareholders that do have control decide to sell the business or redeem the minority investor’s shares.  In the meantime, they wait (and, potentially, collect dividends).  If there is a willing buyer for the shares, they may elect to sell, but that buyer will be subject to the same illiquidity, holding period risks, and uncertainties, so the price is unlikely to be attractive.Business appraisers often describe the levels of value with reference to a chart like the following: The levels of value chart captures two essentially common-sense notions regarding value.  First, investors prefer to have control rather than not.  The degree to which control is valuable will depend on a whole host of case-specific facts and circumstances, but in general, having control is preferred.  Second, investors prefer liquidity to illiquidity.  Again, the magnitude of the appropriate marketability discount will depend on specific factors, but not surprisingly, investors prefer to have a ready market for their shares.  Fair market value is measured with respect to both of these common-sense notions. Estate Planning ObjectivesMinimizing taxes is only one possible objective of an estate planning process.As a result, one objective of most estate planning techniques is to ensure – through whatever particular mechanism – that no individual owns a controlling interest in the family business at his or her death.  Of course, minimizing taxes is only one possible objective of an estate planning process, which might include asset protection, business continuity, and providing for loved ones.Therefore, family businesses should carefully consider whether an estate planning strategy designed to minimize estate taxes will have any unintended negative consequences for the business or the family.For example, an aggressive gifting program that causes the founder to relinquish control prematurely may increase the likelihood of intra-family strife, or jeopardize the family’s ability to make timely strategic decisions on behalf of the business.Or, adoption of an unusually restrictive redemption policy in an effort to minimize the fair market value of minority shares in the company may lead to inequitable outcomes for family members having a legitimate need to sell shares. In short, families should be careful not to let the tax tail wag the business dog.  Families should consult legal, accounting, and valuation advisors who understand their business needs, family dynamics, and objectives to ensure that their estate plan accomplishes the desired goals.

A recent federal court decision in a tax dispute represented a significant victory for family business shareholders.  The case (Kress v. U.S.) revolved around the value of a multi-generation family business, Green Bay Packaging (“GBP”).  Our colleague Chris Mercer wrote an extended review of the technical appraisal issues in the case which can be found here.The plaintiffs, family shareholders in GBP, had made a series of gifts of minority shares of GBP based on contemporaneous appraisals from 2006 to 2008.In August 2014, the IRS assessed additional tax and interest on the gifts, claiming that the fair market value of the gifted shares was approximately over twice the amount claimed by family shareholders.In response to the IRS deficiency notice, the taxpayers paid the assessed tax and interest and filed suit in federal court for a refund.In its ruling, the federal district court sided with the taxpayers, concluding that the fair market value of the gifted shares was nearly identical to the amounts originally claimed. While we generally think family business directors have more important things to think about than tax-related judicial decisions, the Kress decision is one with which family business directors should be familiar.  In this post, we identify five important takeaways for family business directors from Kress.1. Contemporaneous Appraisals Are More PersuasiveThe business valuation reports that were ultimately vindicated by the Court were those prepared in real-time in the ordinary course of business.  GBP had a legacy of regular appraisals that were apparently used for a variety of purposes.  In the Court’s eyes, the contemporaneous appraisals prepared by a qualified professional having a long history of familiarity with the company were more reliable than the valuations prepared long after the fact and rendered in the context of an already existing dispute.Does your family business have a program of regular appraisals performed by a reputable and qualified business appraiser? Do the appraisals reflect a consistent valuation methodology, adapted to the unique circumstances and economic conditions at each valuation date?  Are the conclusions of these appraisals used in contexts other than tax compliance (i.e., corporate planning, shareholder redemptions, etc.)?2. S Corporations Are Not Worth More Than C CorporationsFor decades now, the IRS has maintained that S corporations – since they do not pay corporate income tax –are inherently worth more than otherwise comparable C corporations.  Observers have long noted that this position defies common sense as S corporations have to make distributions to shareholders each year in amounts sufficient for the shareholders to pay their personal tax liabilities on S corporation earnings.  In other words, S corporations are burdened by taxes on income the same way as C corporations; the only difference is that S corporation income tax payments flow through the hands of shareholders before reaching the IRS coffers.If your family business is an S corporation or LLC, does your valuation treat the company as if it were a C corporation?The IRS’ stubbornness on this issue has been a nuisance to family shareholders more than anything.  Most experienced business appraisers, understanding the economic rationale summarized above, have ignored the preferred IRS position in measuring fair market value.  However, in so doing, all parties understood that they were inviting a potential challenge from the IRS.GBP is organized as an S corporation, but the company’s appraiser opted to follow economic logic and treat the company as if it were a C corporation for purposes of the valuation.  In accepting the resulting valuation conclusion, the Kress Court effectively acknowledged the propriety of that treatment.  While the appraiser retained by the IRS applied corporate taxes as if GBP were a C corporation, he then increased the conclusion of value by adding an S corporation.  The Kress Court rejected that premium.How is your family business structured for tax purposes?  If your family business is an S corporation or LLC, does your valuation treat the company as if it were a C corporationThe Tax Cuts and Jobs Act of 2017 has shifted the calculus on whether the S election is beneficial – have your tax advisors helped you assess whether S corporation treatment remains optimal for your family business?3. Economic Conditions MatterThe gifts that were at the heart of the tax dispute were made in the years leading up to and at the start of the Great Recession.  The Kress Court criticized the report of the appraiser retained by the IRS for failing to give adequate consideration to the impact of the Great Recession on the fair market value of family businesses.By preparing contemporaneous valuations, GBP’s appraiser was necessarily attuned to the economic dislocations of the time and how the value of the business was affected.  In particular, the contemporaneous appraisals assigned significant weight to indications of value derived under the market approach, which examined the observable pricing behavior for a representative group of comparable public companies.  Developing indications of value under the market approach for consideration in the overall conclusion helps to ensure that the valuation effect of current economic conditions is not overlooked or minimized.Does your family business operate in a cyclical or counter-cyclical industry?  How does your valuation take into account signals from the market?  Is your family business ready for the next recession?4. Know Your Appraiser, and Make Sure Your Appraiser Knows YouGBP’s appraiser, John Emory, has had a long and distinguished career in the valuation profession.  Perhaps more important, it is evident from the Court’s decision that Mr. Emory had a thorough understanding of GBP’s business based on years of interviews with management.In contrast, the Kress Court noted that the appraiser retained by the IRS had not spoken with GBP management beyond attendance at a deposition.  While much can be learned about a company from careful study of its financial statements, some aspects of the business are much easier to understand by being on-site and speaking with management.Does your family business have an ongoing relationship with an experienced and qualified business appraiser?  Has your business appraiser developed a thorough understanding of how your family business operates and the factors that make your family business valuable?5. Don’t Get GreedyToo often, family business shareholders think about valuation only from the perspective of minimizing gift and estate taxes.  While the Kress decision does not provide sufficient financial data from GBP to make relative value assessments, the Court’s adoption of the taxpayer’s appraisal suggests that the valuation was a valid determination of fair market value rather than a “low-ball” estimate intended to minimize tax payments.Does the marketability discount applied reflect economic factors like expected distributions, the duration of illiquidity, anticipated capital appreciation, and the unique risks of illiquidity?This is particularly evident in the marketability discounts applied in the taxpayer appraisals.  The taxpayer’s appraiser applied marketability discounts between 28% and 30%.  While the appropriate marketability discount depends on the specific facts and circumstances pertaining to the subject interest, the marketability discounts applied often correspond to the underlying economics of minority shares in the family business.  The marketability discount is not a tool for reducing taxes, but is instead a reflection of the economic reality of owning illiquid shares in a family business.In short, while gift and estate tax compliance may be an important application of the valuation of your family business, it is not the only application.  As noted above, valuation conclusions will generally be more persuasive if they are used in multiple contexts beyond just tax compliance.  An aggressive valuation for tax compliance may carry unintended negative consequences elsewhere in your family business.As directors, how do you use appraisals of your family business?  Does the marketability discount applied reflect economic factors like expected distributions, the duration of illiquidity, anticipated capital appreciation, and the unique risks of illiquidity?  Does your family business have a redemption policy or buy-sell agreement?  If so, does it specify the “level of value” to be used?ConclusionThe Kress decision is a welcome one for family businesses.  Our valuation professionals are eager to talk with you about how the lessons from Kress noted above affect your family business.  Call us today.

The issue of a premium for an S corporation at the enterprise level has been tried in a tax case, and the conclusion is none.In Kress v. United States (James F. Kress and Julie Ann Kress v. U.S., Case No. 16-C-795, U.S. District Court, E.D. Wisconsin, March 25, 2019), the Kresses filed suit in Federal District Court (Eastern District of Wisconsin) for a refund after paying taxes on gifts of minority positions in a family-owned company.  The original appraiser tax-affected the earnings of the S corporation in appraisals filed as of December 31, 2006, 2007, and 2008.  The court concluded that fair market value was as filed with the exception of a very modest decrease in the original appraiser’s discounts for lack of marketability (DLOMs).Background on GBPThe company was GBP (Green Bay Packaging Inc.), a family-owned S corporation with headquarters in Green Bay, Wisconsin.  The company experienced substantial growth after its founding in 1933 by George Kress.  A current description of the company, consistent with information in the Kress decision, follows.Green Bay Packaging Inc. is a privately owned, diversified paper and packaging manufacturer. Founded in 1933, this Green Bay WI based company has over 3,400 employees and 32 manufacturing locations, operating in 15 states that serve the corrugated container, folding carton, and coated label markets.Little actual financial data is provided in the decision, but GBP is a large, family-owned business.  Facts provided include:Although GBP has the size to be a public company, it has remained a family-owned business as envisioned by its founder.About 90% of the shares are held by members of the Kress family (a Kress descendant is the current CEO), with the remaining 10% owned by employees and directors.The company paid annual dividends (distributions) ranging from $15.6 million to $74.5 million per year between 1990 and 2009. While historical profitability information is not available, the distribution history suggests that the company has been profitable.Net sales increased during the period 2002 to 2008.Hoovers provides the following (current) information, along with a sales estimate of $1.3 billion:Green Bay Packaging is the other Green Bay packers’ enterprise. The diversified yet integrated paperboard packaging manufacturer operates through 30 locations. In addition to corrugated containers, the company makes pressure-sensitive label stock, folding cartons, recycled container board, white and kraft linerboards, and lumber products. Its Fiber Resources division in Arkansas manages more than 210,000 acres of company-owned timberland and produces lumber, woodchips, recycled paper, and wood fuel. Green Bay Packaging also offers fiber procurement, wastepaper brokerage, and paper-slitting services. (emphasis added)The court’s decision states that the company’s balance sheet is strong. The company apparently owns some 210 thousand acres of timberland, which would be a substantial asset. GBP also has certain considerable non-operating assets including:Hanging Valley Investments (assets ranging from $65 – $77 million in the 2006 to 2008 time frame)Group life insurance policies with cash surrender values ranging from $142 million to $158 million during this relevant period and $86 million to $111 million net of corresponding liabilitiesTwo private aircraft, which on average, were used about 50% for Kress family use and about 50% for business travel GBP was a substantial company at the time of the gifts in 2006, 2007, and 2008. We have no information regarding what portion of the company the gifts represented, or how many shares were outstanding, so we cannot extrapolate from the minority values to an implied equity value.The Gifts and the IRS ResponsePlaintiffs James F. Kress and Julie Ann Kress gifted minority shares of GBP to their children and grandchildren at year-end 2006, 2007, and 2008. They each filed gift tax returns for tax years 2007, 2008 and 2009 basing the fair market value of the gifted shares on appraisals prepared in the ordinary course of business for the company and its shareholders. Based on these appraisals, plaintiffs each paid $1.2 million in taxes on the gifted shares, for a combined total tax of $2.4 million. We will examine the appraised values below.The IRS challenged the gifting valuations in late 2010. Nearly four years later, in August 2014, the IRS sent Statutory Notices of Deficiency to the plaintiffs based on per share values about double those of the original appraisals (see below). Plaintiffs paid (in addition to taxes already paid) a total of $2.2 million in gift tax deficiencies and accrued interest in December 2014. It is nice to have liquidity.Plaintiffs then filed amended gift tax returns for the relevant years seeking a refund for the additional taxes and interest. With no response from the IRS, Plaintiffs initiated the lawsuit in Federal District Court to recover the gift tax and interest they were assessed. A trial on the matter was held on August 3-4, 2017.The AppraisersThe first appraiser was John Emory of Emory & Co. LLC (since 1999) and formerly of Robert W. Baird & Co. I first met John in 1987 at an American Society of Appraisers conference in St. Thomas. He is a very experienced appraiser, and was the originator of the first pre-IPO studies. Emory had prepared annual valuation reports for GBP since 1999, and his appraisals were used by the plaintiffs for their gifts in 2006, 2007, and 2008.The Emory appraisals had been prepared in the ordinary course of business for many years. They were relied upon both by shareholders like the plaintiffs as well as the company itself.The next “appraiser” was the Internal Revenue Service, where someone apparently provided the numbers that were used in establishing the statutory deficiency amounts. The court’s decision provides no name.The third appraiser was Francis X. Burns of Global Economics Group. He was retained by the IRS to provide its independent appraisal at trial. As will be seen, while his conclusions were a good deal higher than those of Emory (and Czaplinski below), they were substantially lower than the conclusions of the unknown IRS appraiser. The IRS went into court already giving up a substantial portion of their collected gift taxes and interest.The fourth appraiser was hired by the plaintiffs, apparently to shore up an IRS criticism of the Emory appraisals. Nancy Czaplinski from Duff & Phelps also provided an expert report and testimony at trial. Emory’s report had been criticized because he employed only the market approach and did not use an income approach method directly. Czaplinski used both methods. It is not clear from the decision, but it is likely that Czaplinski was not informed regarding the conclusions in the Emory reports prior to her providing her conclusions to counsel for plaintiffs.While the court did not agree with all aspects of the work of any of the appraisers, the appraisers were treated with respect in the opinion based on my review. That was refreshing.The Court’s ApproachThe court named all the appraisers, and began with an analysis of the Burns appraisals (for the IRS). In the end, after a thoughtful review, the court did not rely on the Burns appraisals in reaching its conclusion.After reviewing the essential elements of the Burns appraisals, the court provided a similar analysis of the Emory appraisals. The court was impressed with Emory’s appraisals, and appeared to be influenced by the fact that the appraisals were done in the ordinary course of business for GBP and its shareholders. The court surely noticed that the IRS must have accepted the appraisals in the past since Emory had been providing these appraisals for many years. Other Kress family members had undoubtedly engaged in gifting transactions in prior years.The court then reviewed the Czaplinski appraisal. While the court was light on criticisms of the Czaplinski appraisals, it preferred the methodologies and approaches in the Emory appraisals.Interestingly, the entire analysis in the decision was conducted on a per share basis, so there was virtually no information about the actual size or performance or market capitalization of GBP in the opinion. We deal with the cards that are dealt.Summary of the Court’s DiscussionAs I read the court’s decision, there were ten items that were important in all three appraisals, and an additional item that was important in the December 31, 2008 appraisal. Readers will remember the Great Recession of 2008. It was important to the court that the appraisers consider the impact of the recession on the outlook for 2009 and beyond in their appraisals for the December 31, 2008 date.In the interest of time and space, we will focus on the appraisals as of December 31, 2008 in the following discussion. The summaries of the other appraisals are provided without comment at the end of this article. The December 31, 2008 summary follows. We deal with the eleven items that were discussed or implied in the subsections below.There are six columns above. The first provides the issue summary statements. The next four columns show the court’s reporting regarding the eleven items found in the 2008 appraisal based on its review of the reports of the appraisers. Note that there is no detail whatsoever for the rationale underlying the IRS conclusion for the Statements of Deficiency. The final column provides the court’s conclusion. To the extent that items need to be discussed together, we will do so.Items 1 and 2: The Market Approach and the Income ApproachAll the appraisers employed the market approach in the appraisals as of December 31, 2008 (and at the other dates). They looked at the same basic pool of potential guideline companies but used different companies and a different number of companies in their respective appraisals.The court was concerned that the use of only two comparable companies in the Burns report was inadequate to capture the dynamics of valuation. In fact, Burns used the same two guideline companies for all three appraisals, and the court felt that this selective use did not capture the impact of the 2008 recession on valuation (Item 7). He weighed the market approach at 60% and the income approach at 40% in all three appraisals.Czaplinski used four comparable companies in her 2008 appraisal and weighted the market approach 14% (same in her other appraisals). Her income approach was weighted at 86%.Emory used six guideline companies in the 2008 appraisal. While he used the market approach only, the court was impressed that “he incorporated concepts of the income approach into his overall analysis.” This comment was apparently addressing the IRS criticism that the Emory appraisals did not employ the income approach.Items 3 and 4: The S-Corp Premium/TreatmentThe case gets interesting at this point, and many readers and commentators will talk about its implications.At the enterprise level, both Burns and Emory tax-affected GBP’s S corporation earnings as if it were a C corporation. This is notable for at least two reasons:Emory’s appraisals were prepared a decade or so ago. That was the treatment advocated by many appraisers at the time (and still), including me.  See Chapter 10 in Business Valuation: An Integrated Theory, Second Edition, (Peabody Publishing, 2007) and the first edition published in 2004. The economic effect of treatment in the Emory appraisals was that there was no differential in value for GBP because of its S corporation status.The Burns appraisals also tax-affected GBP’s earnings as if it were a C corporation. This is significant because the IRS’ position in recent years has been that pass-through entity earnings (like S corporations) should not be tax-affected because they do not pay corporate level of taxes. Never mind that they do distribute sufficient earnings to their holders so they can pay their pass-through taxes. There was, therefore, no differential in GBP’s value because of tax-affecting. The Czaplinski report avoided the S corp valuation differential issue by using pre-tax multiples (without tax-affecting, of course). Since the Czaplinski report used pre-tax multiples, there was no differential in value because of the company’s S corporation status. The Burns report, however, did apply an S corporation premium to its capitalized earnings value of GBP. The decision reports neither the model used in the Burns report nor the amount of the premium.  Let me speculate. The premium was likely based on the SEAM Model (see page 35 of linked material), published by Dan Van Vleet, who was also at Duff & Phelps at the time (like Czaplinski). I speculate this because it is the best known model of its kind. If my speculation is correct, based on tax rates at the time and my understanding of the SEAM Model, it was likely in the range of 15% – 18% of equity value (100%), or a pretty hefty premium in the valuation. Nevertheless, Burns testified to the use of a specific S corporation premium at trial. Again, if my speculation is correct, the facts that Czaplinski and Van Vleet were both from Duff & Phelps and that Czaplinki did not employ the SEAM Model likely provided for some colorful cross-examination for Czaplinki. If so, she seems to have survived well based on the court’s review. The court accepted the tax-affected treatment of earnings of both Burns and Emory, and noted that Czaplinski’s treatment had dealt with the issue satisfactorily. The court did not accept the S corporation premium in the Burns report. What do these conclusions regarding tax-affecting and no S corporation premium mean to appraisers and taxpayers?The court accepted tax-affecting of S corporation income on an as-if C corporation basis in appraising 100% of the equity of an S corporation. This is good news for those who have long believed that an S corporation, at the level of the enterprise, is worth no more than an otherwise identical C corporation. It should pour water on the IRS flame of arguing that there should be no tax-affecting “because pass-through entities do not pay corporate level taxes.”The court did not accept the specific S corporation premium advanced by Burns. This is a second recognition that there is no value differential between S and C corporations that are otherwise identical. After all, the election of S corporation status is a virtually costless event. The fact that the court considered testimony regarding an S corporation premium model and did not agree with its use is a very significant aspect of this case.Kressv. U.S. will be quoted by many attorneys and appraisers as standing for the appropriateness of tax-affecting of pass-through entities and for the elimination of a specific premium in value for S corporation status.Item 5: Non-Operating AssetsThe treatment of non-operating assets by the appraisers is less than clear from the decision. What we know is the following regarding the substantial non-operating assets in the appraisals:The Burns report treated the non-operating assets at “almost full value.”  This treatment was disregarded by the court.The Emory report did not provide for separate treatment of non-operating assets, noting that it considered them in the book value of the business.  Since book value was not provided or weighted in the Emory report (or any of the others), it would appear that the court was satisfied that the non-operating assets had little value, since minority shareholders could not gain access to their value until the company was sold. That could be a long time given the desire of the Kress family to maintain family control over the company.The Czaplinski report provided for some discounting of the non-operating assets in the marketable minority valuation, and then allowed for further discounting through the marketability discount. Details of her treatment were not provided in the opinion. Since the court sided primarily with the overall thrust of the Emory report, we see little guidance for future appraisals in the treatment of non-operating assets in this decision.Item 6: Management InterviewsThe court noted that Burns had not visited with management, but had attended a deposition of GBP’s CFO. The court was impressed that Emory had interviewed management in the course of developing his appraisals, and had done so at the time, asking them about the outlook for the future each year. It is not clear from the decision whether Czaplinski interviewed management.Item 7: Consideration of the 2008 Recession (in the December 31, 2008 Appraisal)The Burns report was criticized for employing a mechanical methodology that, over the three years in question, did not account for changes in the markets (and values) brought about by the Great Recession of 2008. Specifically, it did not consider the future impact in the year-end 2008 appraisal of the recession’s impact on expectations and value at that date.Both the Emory and Czaplinski reports were noted as having employed methods that considered this landmark event and its potential impact on GBP’s value.Item 8: Impact of Family Transfer Restrictions on ValueThe court’s opinion in Kress provided more than four pages of discussion on the question of whether the Family Transfer Restriction in GBP’s Bylaws should have been considered in the determination of the discount for lack of marketability. This is a Section 2703(a) issue. Ultimately, the court found that the plaintiffs had not met their burden of proof to show that the restrictions were not a device to diminish the value of transferred assets, failing to pass one of the three prongs of the established test on this issue.Neither the Burns report nor the Czaplinski report considered family restrictions in their determinations of marketability discounts. The Emory report considered family restrictions in a “small amount” in its overall marketability discount determination.In spite of the lengthy treatment, the court found that the issue was not a big one. In the final analysis, the court deducted three percentage points from the marketability discounts in the Emory reports as its conclusions for these discounts.Item 9: Marketable Minority Value per ShareWith this background, we can look at the various value indications before and after marketability discounts. First, we look at the actual or implied marketable minority values of the appraisers. For the December 31, 2008 appraisals, the Emory report concluded a marketable minority value of $30.00 per share. Czaplinski concluded that the marketable minority value was similar, at $31.33 per share. The Burns report’s marketable minority value was 50% higher than Emory’s conclusion, at $45.10 per share.The Court concluded that marketable minority value was $30.00 per share, as found in the Emory Report.  That was an affirmation of the work done by John Emory more than a decade ago at the time the gifts were made.Item 10: Marketability DiscountsThe Emory report concluded that the marketability discount should be 28% for the December 31, 2008 appraisal (where previously, it had been 30%). The discount in the Czaplinski report was 20%. The marketability discount in the Burns report (for the IRS) was 11.2%.There were general comments regarding the type of evidence that was relied upon by the appraisers (restricted stock studies and pre-IPO studies that were not named, consideration of the costs of an initial public offering, etc.). Apparently, none of the appraisers used quantitative methods in developing their marketability discounts. The court criticized the cost of going public analysis in the Burns report because of the low likelihood of GBP going public.Based on the issue regarding family transfer restrictions, the court adjusted the marketability discounts in each of Emory’s three appraisals by 3% – a small amount.  Emory concluded a 28% marketability discount for 2008. The court’s conclusion was 25%.Item 11: Conclusions of Fair Market Value per ShareAt this point, we can look at the entire picture from the figure above. We replicate a part of the chart to make observation a bit easier. It is now possible to see the range of values in Kress. The plaintiffs filed their original gift tax returns based on a fair market value of $21.60 per share for the appraisal rendered December 31, 2008 (Emory). The IRS argued, years later (2014), for a value of $50.85 per share – a huge differential. The plaintiffs paid the implied extra taxes and interest and filed in Federal District Court for a refund. The expert retained by the IRS, Francis Burns, was apparently not comfortable with the original figure advanced by the IRS of $50.85 per share. The Burns report concluded that the 2008 valuation should be $40.05 per share, or more than 21% lower. Plaintiffs went into court knowing that they would receive a substantial refund based on that difference. Plaintiffs retained Nancy Czaplinski of Duff & Phelps to provide a second opinion in support of the opinions of Emory. Her year-end 2008 conclusion of $25.06 per share, although higher than the Emory conclusion of $21.60 per share, was substantially lower than the Burns conclusion of $40.05 per share. The court went through the analysis as outlined, noting the treatment of the experts on the items above. In the final analysis, the court adopted the conclusions of John Emory with the sole exception that it lowered the marketability discount from 28% to 25% (and a corresponding 3% in the prior two appraisals). The court’s concluded fair market value was $22.50 per share, only 4.2% higher than Emory’s conclusion of $21.60 per share. Based on this review of Kress, it is clear that Emory's appraisals were considered as credible and timely rendered. Kress marks a virtually complete valuation victory for the taxpayer. It also marks a threshold in the exhausting controversy over tax-affecting tax pass-through entities and applying artificial S corporation premiums when appraising S corporations (or other pass-through entities). Kress will be an important reference for all gift and estate tax appraisals that are in the current pipeline where the IRS is arguing for no tax affecting of S corporation earnings and for a premium in the valuation of S corporations relative to otherwise identical C corporations. When all is said and done, a great deal more will be written about Kress than we have shared here, and it will be discussed at conferences of attorneys, accountants and business appraisers. Some will want to focus on the family attribution aspect of the case, but, as the court made clear, this is a small issue in the broad scheme of things. Summary of Other Appraisal DatesFor information, below is a summary of the appraisals as of December 31, 2006 and December 31, 2007.

Due to the historical popularity of this post, we revisit it this week. Originally published in 2016, the purpose of this post is to equip ownership to understand the consequences of their buy-sell agreements before a controversy arises, and to make informed decisions about the drafting or re-drafting of the agreement to promote the financial health and sustainability of their firm.The classic car world is full of stories of “barn finds” – valuable cars that were forgotten in storage for decades, found and restored and sold for mint. Similar to the one pictured above, a Ferrari 250 GT SWB California Spyder once owned by a French actor and found in a barn on a French farm in 2014. The car was one of 36 ever made and one of the most valuable Ferraris in existence. Once the Ferrari was exhumed, it was lightly cleaned and sold, basically as found, for $23 million at auction. As difficult it is to imagine such a valuable car being forgotten, what we see more commonly are forgotten buy-sell agreements, collecting dust in desk drawers. Unfortunately, these contracts often turn into liabilities, instead of assets, once they are exhumed, as the words on the page frequently commit the signatories to obligations long forgotten. So we encourage our clients to review their buy-sell agreements regularly, and have compiled some of our observations about how to do so in the whitepaper below. You can also download it as a PDF at the bottom of this page. We hope this will be helpful to you; call us if you have any questions.IntroductionAlmost every conversation we have with a new RIA client starts something like this: “We hired you because you do lots of work with asset managers, but as you get into this project you need to understand that our firm is very different from others.” Our experience, so far, confirms this sentiment of uniqueness that is not at all unique among investment managers. Although there are twelve thousand or so separate Registered Investment Advisors in the U.S. (not to mention several hundred independent trust companies and a couple thousand bank trust departments), there seems to be a comparable number of business models. Every client who calls us, though, has the same issue on their plate: ownership.Ownership can be the single biggest distraction for a professional services firm, and it seems like the RIA community feels this issue more than most. After all, most asset managers are closely held (so the value of the firm is not set by the market). Most asset managers are owned by unrelated parties, whereas most closely held businesses are owned by members of the same family. A greater than normal proportion of asset management firms are very valuable, such that there is more at stake in ownership than most closely held businesses. Consequently, when disputes arise over the value of ownership in an asset management firm, there is usually more than enough cash flow to fund the animosity, and what might be a five-figure settlement in some industries is a seven-figure trial for an RIA.Avoiding expensive litigation is one reason to focus on your buy-sell agreement, but for most firms the more compelling reasons revolve around transitioning ownership to perpetuate the firm. Institutional clients increasingly seem to query about business continuity planning, and the SEC has of course recently proposed transition planning guidelines. There are plenty of good business reasons to have a robust buy-sell agreement in any closely held company, but in RIAs there are client and regulatory reasons as well.SEC Proposed RuleEvery SEC-registered investment adviser must adopt and implement a written business continuity and transition plan that reasonably addressed operational risks related to a significant disruption or transition in the adviser's business.Business Continuity PlanningTransition PlanningMaintenance of critical operations/systems, as well as protection, backup and recovery of dataPolicies and procedures to safeguard, transfer, and/or distribute client assets during a transitionAlternate physical office locationsPolicies and procedures to facilitate prompt generation of client specific information necessary to transition each accountCommunication plans for clients, employees, vendors and regulatorsInformation regarding the corporate governance structure of the adviserIdentification and assessment of third-party services critical to the operationIdentification of any material financial resources available to the adviserKey Elements of the SEC’s Proposal: “Adviser Business Continuity and Transition Plans,” 206 (4)-4Buy-Sell Agreement BasicsSimply put, a buy-sell agreement establishes the manner in which shares of a private company transact under particular scenarios. Ideally, it defines the conditions under which it operates, describes the mechanism whereby the shares to be transacted are priced, addresses the funding of the transaction, and satisfies all applicable laws and/or regulations.These agreements aren’t necessarily static. In investment management firms, buy-sell agreements may evolve over time with changes in the scale of the business and breadth of ownership. When firms are new and more “practice” than “business,” these agreements may serve more to decide who gets what if the partners decide to go separate ways. As the business becomes more institutionalized, and thus more valuable, a buy-sell agreement – properly rendered – is a key document to protect the shareholders and the business (not to mention the firm’s clients) in the event of an ownership dispute or other unexpected change in ownership. Ideally, the agreement also serves to provide for more orderly ownership succession, not to mention a degree of certainty for owners that allow them to focus on serving clients and running the business instead of worrying about who gets what benefit of ownership.The irony of buy-sell agreements is that they are usually drafted and signed when all of the shareholders think similarly about their firm, the value of their interest, and how they would treat each other at the point they transact their stock. The agreement is drafted, signed, filed, and forgotten. Then, an event occurs that invokes the buy-sell, and the document is pulled from the drawer and read carefully. Every word is parsed, and every term scrutinized, because now there are not simply co-owners with aligned interests – but rather buyers and sellers with symmetrically opposed interests.Our Advice: Key Considerations for Your Buy-Sell AgreementAt Mercer Capital we have read hundreds, if not thousands, of buy-sell agreements. While we are not attorneys and do not attempt to draft such agreements, our experience has led us to a few conclusions about what works well and what doesn’t. By “working well,” we mean an enduring agreement that efficiently manages ownership transactions and transitions in a variety of circumstances. Agreements that don’t work well become the subject of major disputes – the consequence of which is a costly distraction.The primary weaknesses we see in buy-sell agreements relate to issues of valuation: what is to be valued, how, when, and by whom. The following issues and our corresponding advice are drawn from our experience of agreements that performed well and those that did not. While we haven’t seen everything, we have been more involved than most in helping craft agreements, maintaining compliance with valuation provisions, and resolving disagreements.1. Decide What You Mean By “Fair”A standard refrain from clients crafting a buy-sell agreement is that they “just want to be fair” to all of the parties in the agreement. That’s easier said than done, because fairness means different things to different people. The stakeholders in a buy-sell at an investment management firm typically include the founding partners, subsequent generations of ownership, the business itself, non-owner employees of the business, and the clients of the firm. Being “fair” to that many different parties is nearly impossible, considering the different motivations and perspectives of the parties.Founding owners. Aside from wanting the highest possible price for their shares, founding partners are usually desirous of having the flexibility to work as much or as little as they want to, for as many years as they so choose. These motivations may be in conflict with each other, as ramping down one’s workload into a state of partial retirement and preserving the founding generation’s imprint on the company requires a healthy business, which in turn necessarily requires consideration of the other stakeholders in the firm. We read one buy-sell agreement where the founder had secured his economic return by requiring the company, in the event of his death, to redeem his shares at a value that did not consider the economic impact of his death (the founder was a significant rainmaker). One can only imagine, at the founder’s death, how that would go when the other partners and employees of the firm “negotiated” with the estate – as if a piece of paper could checkmate everything else in a business where the assets of the firm get on the elevator and go home every night.Subsequent generation owners. The economics of a successful RIA can set up a scenario where buying into the firm can be very expensive, and new partners naturally want to buy as cheaply as possible. Eventually, however, there is symmetry of economic interests for all shareholders, and buyers will eventually become sellers. Untimely events can cause younger partners to need to sell their stock, and they don’t want to be in a position of having to give it up too cheaply. Younger partners also tend to underestimate the cost of building their own firm instead of buying into the existing one; other times, they don’t.The firm itself. The company is at the hub of all the different stakeholder interests, and is best served if ownership is a minimal consideration in how the business is run. Since hand-wringing over ownership rarely generates revenue, having a functional shareholder’s agreement that reasonably provides for the interests of all stakeholders is the best case scenario for the firm. If firm leadership understands how ownership is going to be handled now and in the future, they can be free to do their jobs and maximize the performance of the company. At the other end of the spectrum, buy-sell disputes are very costly to the organization, distracting the senior-most staff from matters of strategy and client service for years, and rarely ending with a resolution that compensates for lost business opportunities which may never even be identified.Non-owner employees. Not everyone in an investment management firm qualifies for ownership or even wants it, but all RIAs are economic eco-systems in which all employees depend on the presence of a stable and predictable ownership.Clients. It is no surprise that the SEC made ownership continuity planning part of its recent proposed regulations for RIAs. The SEC may not care, per se, who gets the benefits of ownership of an investment management firm, but they know that the investing public is best served by asset managers who have provided for the continuity of investment management in the event of changes in the partner base. Institutional clients are often very interested in continuity plans, so it is to the benefit of RIAs to have fully functioning ownership models with buy-sell agreements that provide for the long-term health of the business. As the profession ages, we see transition planning as either a competitive advantage (if done well) or a competitive disadvantage (if disregarded) – all the more reason to pay attention.The point of all this is to consider whether or not you want your buy-sell agreement to create winners and losers, and if so, be deliberate about defining who wins and who loses. Ultimately, economic interests which advantage one stakeholder will disadvantage some or all of the other stakeholders, dollar for dollar. If the pricing mechanism in the agreement favors a relatively higher valuation, then whoever sells first gets the biggest benefit of that, to the expense of the other partners and anyone buying into the firm. If pricing is too high, internal buyers may not be available and the firm may need to be sold (truly the valuation’s day of reckoning) to perfect the agreement. At relatively low valuations, internal transition is easier and business continuity is more certain, but the founding generation of ownership may be perversely encouraged to not bring in new partners, stay past their optimal retirement age, or push more cash flow into compensation instead of shareholder returns as the importance of ownership is diminished. Recognizing and ranking the needs of the various stakeholders in an RIA is always a balancing act, but one which is probably best done intentionally.Buy-Sell Agreements and Contract TheoryThe 2016 Nobel Prize in Economics was awarded to Professors Oliver Hart (Harvard) and Bengt Holmstrom (MIT) for their work in developing contract theory as a foundational tool of economics. The notion of contract theory organizes participants in an economy into principals (owners) and agents (employees), although the principal/agent relationship can be applied to many economic exchanges.Agents act on behalf of principals, but those actions are at least partially unobserved, so contracts must exist to incentivize and punish behavior, as appropriate, such that principals can be reasonably assured of getting the benefit of compensation paid to agents. The optimal contract to accomplish this weighs risks against incentives. The problem with contracts is that all of them are incomplete, in that they can’t specify every eventuality. As a consequence, parties have to be designated to make decisions in certain circumstances on behalf of others.Contract theory has application to the design of buy-sell agreements in the ordering of priority of stakeholders in the enterprise. If the designated principal of the enterprise is the founding generation, then the buy-sell agreement will be written to protect the rights of the founders and secure their ability to liquefy their interest on the best terms and pricing. Redemption from a founder’s estate at a premium value would be an example of this type of contract.If, on the other hand, the business is the designated principal of the enterprise, and all the shareholders are treated as agents, then the buy-sell agreement might create mechanisms to ensure the long-term profitability of the investment management firm, rewarding behaviors that grow the profits of the business (with greater ownership percentages or distributions or performance bonuses) and punish agent actions that do not enhance profitability.If the clients of the firm are the designated principals of a given RIA, then the buy-sell agreement might be fashioned to direct equity returns to agents (partners or non-owner employees) based on investment performance or client retention. An example of this would be carried interest payments in hedge funds and private equity.2. Don’t Value Your Stock Using Formula Prices, Rules of Thumb, or Internally Generated Valuation MetricsSince valuation is usually the most time consuming and expensive part of administering a buy-sell agreement, there is substantial incentive to try to shortcut that part of the process. Twenty years ago, a client told us “asset management firms are usually worth about 2% of AUM.” We’ve heard that maxim repeated many times, although not so much in recent years, as some firms have sold in noteworthy transactions for over twice that, while others haven’t been able to catch a bid for much less.We have written extensively about the fallacy of formula pricing. No multiple of AUM or revenue or cash flow can consistently estimate the value of an interest in an investment management firm. A multiple of AUM does not consider relative differences in stated or realized fee schedules, client demographics, trends in operating performance, current market conditions, compensation arrangements, profit margins, growth expectations, regulatory compliance issues, and a host of other issues which have helped keep our valuation practice gainfully employed for decades.Imagine an RIA with $1.0 billion under management. The old 2% of AUM rule would value it at $20.0 million. Why might that be? In the (good old) days, when RIAs typically garnered fees on the order of 100 basis points to manage equities, that $1.0 billion would generate $20 million in revenue. After staff costs, office space, research charges and other expenses of doing business, such a manager might generate a 25% EBITDA margin (close to distributable cash flow in a manager organized as an S-corporation), or $2.5 million per year. If firms were transacting at a multiple of 8 times EBITDA, the value of the firm would be $20.0 million, or 2% of AUM.Today, things might fall more into the extremes of firms A and B, depicted in the chart below. Assume firm A is a small cap domestic equity manager earning 65 basis points on average from a mix of high net worth and institutional clients. Because a shop like that can earn a relatively high EBITDA margin of 40% or so, a $20 million valuation is a little less than 8x, which in some circumstances might be reasonable.Firm B, on the other hand, manages a range of fixed income instruments for large pension funds who are expert at negotiating fees. Their 30 basis point realized fee average doesn’t leave much to cover the firm’s overhead, even though it’s fairly modest because of the nature of the work. The 15% EBITDA margin yields less than a half million dollars in cash flow, which against the rule of thumb valuation metric, implies a ridiculous multiple. The real problem with short cutting the valuation process is credibility. If the parties to a shareholders agreement think the pricing mechanism in the agreement isn’t robust, then the ownership model at the firm is flawed. Flawed ownership models eventually disrupt operations, which works to the disservice of owners, employees, and clients.3. Clearly Define The “Standard” of Value Effective for Your Buy-Sell AgreementThe standard of value essentially imagines and abstracts the circumstances giving rise to a particular transaction. It is intended to control for the identity of the buyer and the seller, the motivation and reasoning of the transaction, and the manner in which the transaction is executed.Portfolio managers have a particular standard of value perspective, even though they don’t always think of it that way. The trading price for a given equity represents market value, and some PMs would make buying or selling decisions based on the relationship between market value and intrinsic value, which is what they think the security is worth based on their own valuation model. Investment analysts inside an RIA think of the value of their firm in terms of intrinsic value, which depending on their unique perspective could be very high or very low. CEOs, in our experience, think of the value of their investment management firm in terms of what they could sell it for in a strategic, change of control transaction with a motivated buyer – probably because those are the kinds of multiples that investment bankers quote when they meet with them.None of these standards of value are particularly applicable to buy-sell agreements, even though technically they could be. Instead, valuation professionals such as our group look at the value of a given company or interest in a company according to standards of value such as fair market value or fair value. In our world, the most common standard of value is fair market value, which applies to virtually all federal and estate tax valuation matters, including charitable gifts, estate tax issues, ad valorem taxes, and other tax-related issues. It is also commonly applied in bankruptcy matters.Fair market value has been defined in many court cases and in Internal Revenue Service Ruling 59-60. It is defined in the International Glossary of Business Valuation Terms as:The benefit of a fair market value standard is familiarity in the appraisal community and the court system. It is arguably the most widely adopted standard of value, and for a myriad of buy-sell transaction scenarios, the perspective of disinterested parties engaging in an exchange of cash and securities for rational financial reasons fairly considers the interests of everyone involved.The standard known as “fair value” can be considerably more opaque, having two different origins and potentially very different applications. In dissenting shareholder matters, fair value is a statutory standard that varies depending on legal jurisdiction. In many states, fair value protects minority shareholders from oppressive actions by providing them with the right to payment at a value equivalent to that which would be received in the sale of the company. A few states are not so generous as to providing aggrieved parties with undiscounted value for their shares, but the trend favors not disadvantaging minority owners in certain transactions just because a majority owner wants to remove them from ownership. The difficulty of statutory fair value, in our experience, is the dispute over the meaning of state statutes and the court’s interpretations of state statutes. Sometimes the standard is as clearly defined as fair market value, but sometimes less so.If a shareholders agreement names the standard of “Fair Value,” does it mean statutory fair value, GAAP fair value, or does it really mean fair market value? It pays to be clear.The standard of value is critical to defining the parameters of a valuation, and we suggest buy-sell agreements should name the standard and cite specifically which definition is applicable. The downsides of not doing so can be reasonably severe. For most buy-sell agreements, we recommend one of the more common definitions of fair market value. The advantage of naming fair market value as the standard of value is that doing so invokes a lengthy history of court interpretation and professional discussion on the implications of the standard, which makes application to a given buy-sell scenario more clear.Which Fair Value?Making matters more complex, fair value is also a standard under Generally Accepted Accounting Principles, as defined in ASC 820. When GAAP fair value was originally established, members of the Financial Accounting Standards Board, which is responsible for issuing accounting guidance, suggested that they wanted to use a standard similar to fair market value but didn’t want their standard to be governed and maintained by non-related institutions such as the U.S. Tax Court.GAAP fair value is similar to fair market value, but not entirely the same. As GAAP fair value has evolved, it has become more of an “exit value” standard, suggesting the price that someone would pay for an asset (or accept to transfer a liability) instead of a bargain reached through consideration of the interests of both buyers and sellers.The exit value perspective is useful from an accounting perspective because it obviates financial statement preparers’ tendency to avoid write-downs in distressed markets because they “wouldn’t sell it for that.” In a shareholder dispute, however, the transaction is going to happen, so the bid/ask spread has to be bridged by valuation regardless of the particular desires of the parties.4. Avoid Costly Disagreement as to “Level of Value”Just as the interests and motivations of particular buyers and sellers can affect transaction values, the interest itself being transacted can carry more or less value, and thus the “level of value," as it has come to be known, should be specified in a buy-sell agreement.A minority position in a public company with active trading typically transacts as a pro rata participant in the cash flows of the enterprise because the present value of those cash flows is readily accessible via an organized exchange. Portfolio managers usually think of value in this context, until one of their positions becomes subject to acquisition in a takeover by a strategic buyer. In a change of control transaction, there is often a cash flow enhancement to the buyer and/or seller via combination, such that the buyer can offer more value to the shareholders of the target company than the market grants on a stand-alone basis. The difference between the publicly traded price of the independent company, and value achieved in a strategic acquisition, is commonly referred to as a control premium.Closely held securities, like common stock interests in RIAs, don’t have active markets trading their stocks, so a given interest might be worth less than a pro rata portion of the overall enterprise. In the appraisal world, we would express that difference as a discount for lack of marketability. Sellers will, of course, want to be bought out pursuant to a buy-sell agreement at their pro rata enterprise value. Buyers might want to purchase at a discount (until they consider the level of value at which they will ultimately be bought out). In any event, the buy-sell agreement should consider the economic implications to the RIA and specify what level of value is appropriate for the buy-sell agreement. Fairness is a consideration here, as is the sustainability of the firm. If a transaction occurs at a premium or a discount to pro rata enterprise value, there will be “winners” and “losers” in the transaction. This may be appropriate in some circumstances, but in most RIAs, the owners joined together at arm’s length to create and operate the enterprise and want to be paid based on their pro rata ownership in that enterprise. That works well for the founders’ generation, but often the transition to a younger and less economically secure group of employees is difficult at a full enterprise level valuation. Further, younger employees may not be able to get comfortable with buying a minority interest in a closely held business at a valuation that approaches change of control pricing. Ultimately, there is often a bid/ask spread between generations of ownership that has to be bridged in the buy-sell agreement, but how best to do it is situation specific. Whatever the case, the shareholder agreement needs to be very specific as to level of value. We even recommend inserting a level of value chart, like the one you see above, and drawing an arrow as to which is specified in the agreement.One thing to avoid in buy-sell agreements is embedded pricing mechanisms that unintentionally incentivize the behavior of some partners to try to “win” at the expense of the other partners. We were involved in one matter where a disputed buy-sell agreement could be read to enable other partners to force out a minority partner and redeem their interest at a deeply discounted value.Economically, to the extent that a minority shareholder is involuntarily redeemed at a discounted value, the amount of that discount (or decrement to pro rata enterprise value) is arithmetically redistributed among the remaining shareholders. Generally speaking, courts and applicable corporate statutes do not permit this approach in statutory fair value matters because it would provide an economic incentive for shareholder oppression.By way of example, assume a business is worth (has an enterprise value of) $100, and there are two shareholders, Sam and Dave. Dave owns 60% of the business, and Sam owns 40% of the business. As such, Dave’s pro rata interest is worth $60 and Sam’s pro rata interest would be valued at $40. If the 60% shareholder, Dave, is able to force out Sam at a discounted value (of, say, $25 – or a $15 discount to pro rata enterprise value), and finances this action with debt, what remains is an enterprise worth $75 (net of debt). Dave’s 60% interest is now 100%, and his interest in the enterprise is now worth $75 ($100 total enterprise value net of debt of $25). The $15 decrement to value suffered by Sam is a benefit to Dave. This example illustrates why fair value statutes and case law attempt to limit or prohibit shareholders and shareholder groups from enriching themselves at the expense of their fellow investors. Does the pricing mechanism create winners and losers? Should value be exchanged based on an enterprise valuation that considers buyer-seller specific synergies, or not? Should the pricing mechanism be based on a value that considers valuation discounts for lack of control or impaired marketability? Exiting shareholders want to be paid more and continuing shareholders want to pay less, obviously. What’s not obvious at the time of drafting a buy-sell agreement is who will be exiting and who will be continuing. There may be a legitimate argument to having a pricing mechanism that discounts shares redeemed from exiting shareholders, as this reduces the burden on the firm or remaining partners and thus promotes the continuity of the firm. If exit pricing is depressed to the point of being punitive, the other shareholders have a perverse incentive to artificially retain their ownership longer and force out other shareholders. As for buying out shareholders at a premium value, the only argument for “paying too much” is to provide a windfall for former shareholders, which is even more difficult to defend operationally. Still, all buyers eventually become sellers, so the pricing mechanism has to be durable for the life of the firm.5. Don’t Forget to Specify the “As Of” Date for ValuationThis seems obvious, but the particular date appropriate for the valuation matters. We had one client (not an RIA) spend a quarter million dollars on hearings debating this matter alone. The appropriate date might be the triggering event, such as the death of a shareholder, but there are many considerations that go into this.If the buy-sell agreement specifies that value be established on an annual basis (something we highly recommend to manage expectations and avoid confusion), then the date might be the calendar year end. The benefit of an annual valuation is the opportunity to manage expectations, such that everyone in the ownership group is prepared for how the valuation is performed and what the likely outcome is given various levels of company performance and market pricing. Annual valuations do require some commitment of time and expense, of course, but these annual commitments to test the buy-sell agreement usually pale in comparison to the time and expense required to resolve one major buy-sell disagreement.If, instead of having annual valuations performed, you opt for an event-based trigger mechanism in your buy-sell, there is a little more to think about. Consider whether you want the event precipitating the transaction to factor into the value. If so, prescribe that the valuation date is some period of time after the event giving rise to the subject transaction. This can be helpful if a key shareholder passes away or leaves the firm and there is concern about losing clients as a result of the departure. After an adequate amount of time, it becomes apparent as to the impact on firm cash flows of the triggering event. If, instead, there is a desire to not consider the impact of a particular event on valuation, make the as-of date the day prior to the event, as is common in statutory fair value matters.6. Appraiser Qualifications: Who’s Going to Be Doing the Valuation?Obviously, you don’t want just anybody being brought in to value your company. If you are having an annual appraisal done, then you have plenty of time to vet and think about who you want to do the work. In the appraisal community, we tend to think of “valuation experts” and “industry experts.”Valuation experts are known for:Appropriate professional training and designationsUnderstanding of valuation standards and conceptsPerspective on the market as consisting of hypothetical buyers and sellers (fair market value mindset)Experienced in valuing minority interests in closely held businessesAdvising on issues for closely held businesses like buy-sell agreementsExperienced in explaining work in litigated mattersIndustry experts, by contrast, are known for:Depth of particular industry knowledgeUnderstanding of key industry concepts and terminologyPerspective on the market as typical buyers and sellers of interests in RIAsTransactions experienceRegularly providing specialized advisory services to the industryIn all candor, there are pros and cons to each “type” of expert. We worked as the third appraiser on a disputed RIA valuation many years ago in which one party had a valuation expert and the other had an industry expert. The resulting rancor bordered on the absurd. The company had hired a reasonably well-known valuation expert who wasn’t particularly experienced in valuations of investment management firms. That appraiser prepared a valuation standards-compliant report that valued the RIA much like one would value a dental practice, and came up with a very low appraised value (his client was delighted). The departing shareholder hired an also well-known investment banker who arranges transactions in the asset management community. The investment banker looked at a lot of transactions data and valued the RIA as if it were a department at Blackrock. Needless to say, that indicated value was many, many times higher than the company’s appraiser. We were brought in to make sense of it all. Vetting a valuation expert for appropriate credentials and experience should focus on professional standards and practical experience.Professional Requirements. The two primary credentialing bodies for business valuation are the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA). The former awards the Accredited Senior Appraiser designation, or ASA, and the latter the Accredited in Business Valuation, or ABV, designation. Without getting lost in the weeds, both are substantial organizations that require extensive education and testing to be credentialed, and both require continuing education. Also well known in the securities industry is the Chartered Financial Analyst charter issued by the CFA Institute, and while it is not directly focused on valuation, it is a rigorous program in securities analysis. CFA Institute offers, but does not require, continuing education.Practical Requirements. Experience also matters, though, in an industry as idiosyncratic as investment management. Your buy-sell agreement should specify an appraiser who regularly values non-depository financial institutions such that they understand the dynamic differences between, say, an independent trust company and a venture capital manager. While there are almost 12,000 RIAs in the U.S., the variety of business models is such that you will want a valuation professional who understands and appreciates the economic nuances of your firm.In any event, your buy-sell agreement should specify minimum appraisal qualifications for the individual or firm to be preparing the analysis, but also specify that the appraiser should have experience and sufficient industry knowledge to appropriately consider the key investment characteristics of RIAs. Ultimately, you need a reasonable appraisal work product that will withstand potential judicial scrutiny, but you should not have to explain the basics of your business model in the process.7. Manage Expectations by Testing Your AgreementNo matter how well written your agreement is or how many factors you consider, no one really knows what will happen until you have your firm valued. If you are having a regular valuation prepared by a qualified expert, then you can manage everyone’s expectations such that, when a transaction situation presents itself, parties to the transaction have a reasonably good idea in advance of what to expect. Managing expectations is the first step to avoiding arguments, strategic disputes, failed partnerships, and litigation.If you don’t plan to have annual valuations prepared, have your company valued anyway. Doing so when nothing is at stake will make a huge difference if you get to a situation where everything is at stake. Most of the shareholder agreement disputes we are involved in start with dramatically different expectations regarding how the valuation will be handled. Going ahead and getting a valuation done will help to center, or reconcile, those expectations and might even lead to some productive revisions to your buy-sell agreement.Putting It All TogetherIf you have not yet crafted a buy-sell agreement for your RIA, you can see that there is much to consider. Most investment management firms have some shareholders agreement, but in many cases the agreements do not account for the many circumstances and issues briefly addressed in this whitepaper. That said, our advice is to first pull your buy-sell agreement out of the drawer and read it, carefully, and compare it to the commentary in this paper. If you don’t understand something, talk with your partners about what their expectations are and see if they line up with the agreement. Consider having a valuation firm review the agreement and tell you what they might see as issues or deficiencies in the agreement, and then have the firm appraised. If there is substantial difference of opinion in the partner base as to the value of the firm, or the function of the agreement, you know that you don’t actually have an agreement.On the positive side of the equation, a well-functioning agreement can serve the long-term continuity of ownership of your firm, which provides the best economic opportunity for you and your partners, your employees, and your clients. Strategically, it may well be the lowest hanging fruit available to enhance the value of your company, and your own career satisfaction.WHITEPAPERBuy-Sell Agreements for Investment Management FirmsView Whitepaper

Karolina Calhoun, CPA/ABV/CFF, Vice President, presented "How to Value a Business & Situations That Give Rise to a Valuation" at the Tennessee Society of CPAs West Tennessee Chapter monthly meeting in Jackson, TN.The valuation of a business can be a complex process, requiring accredited business valuation and forensic accounting professionals. This session will take a deep dive into the process and methodologies used in a valuation. Also covered will be the situations that give rise to valuation services such as estate/tax planning, ESOP annual valuation, M&A transactions, GAAP/ financial reporting, family law marital dissolution, buy-sell disputes, and corporate litigation.

When we talk with family business owners, most confess a vague recollection of having signed a buy-sell agreement, but only a few can give a clear and concise overview of their agreement’s key terms. Yet no other governing document has such potentially profound implications for the business and for the family. My colleague of nearly twenty years, Chris Mercer, literally wrote the book(s) when it comes to buy-sell agreements. Chris and I recently sat down to talk about buy-sell agreements in the context of family businesses. Travis: Chris, to start off, what is the purpose of a buy-sell agreement? Why should a family business have one? Chris: A buy-sell agreement ensures that the owners of a business will have as fellow-owners only those individuals who are acceptable to the group. A buy-sell agreement formalizes agreements in the present – while everyone is alive and well – regarding how future transactions will occur, with respect to both pricing and terms, when the agreement is “triggered.” Every business with two or more owners should have a buy-sell agreement, and that includes family businesses. What I can tell you, after many years of working with companies and their buy-sell agreements, is that once an agreement is triggered, e.g., by the death, disability or departure of a shareholder, the interests of the departed and remaining shareholders diverge. When interests diverge, an agreement is virtually impossible even, or especially, within families. So, a well-crafted buy-sell agreement establishes an agreement in advance, so the family can avoid problems and conflict in the future. Travis: The title of your first book on buy-sell agreements described them as either reasonable resolutions or ticking time bombs. How could a buy-sell agreement become a ticking time bomb for a family business? Chris: Sure – here’s a quick example. Some agreements specify a fixed price for shares that the shareholders have all agreed to. The price is binding until updated to a new agreed-upon price. The idea sounds good in principle, but in reality, the owners almost never agree on an updated price. Years later, after a substantial increase in a company’s value renders the agreed-upon price stale, a trigger event occurs. The ticking time bomb explodes on the departing shareholder who receives an inadequate price for their shares. A second explosion occurs with the ensuing litigation to try to “fix” the problem. Needless to say, I do not recommend the use of fixed-price valuation mechanisms in buy-sell agreements. Travis: Buy-sell agreements often define a formula for determining value when triggered. Can a “formula price” provide for a reasonable resolution? Chris: Travis, I’ve said many times that some owners and advisers search for the perfect formula like the Knights Templar sought the Holy Grail. The perfect formula does not exist. Given changes in the company over time, evolving industry conditions, emerging competition, and changes in the availability of financing, no formula will remain reasonable over time. It is simply not possible to anticipate all the factors an experienced business appraiser would consider at a future date. All this assumes that the formula is understandable. Some formulas in buy-sell agreements are written so obtusely that reasonable people reach (potentially quite) different results. As you might suspect, I do not recommend the use of formula pricing mechanisms in buy-sell agreements. Travis: Other agreements provide for an appraisal process upon a trigger event. What are benefits or pitfalls of such appraisal processes? Chris: The most common appraisal process found in buy-sell agreements calls for the use of two or three appraisers to determine the price to be paid if and when a trigger event occurs.   One of the biggest problems out of the gate is that no one knows what the price of their shares will be until the end of a lengthy and potentially disastrous appraisal process. Let me explain. Assume that the shareholders have agreed on an appraisal process to determine price upon a trigger event. The Company retains one appraiser and the selling shareholder retains a second. Far too often, the language describing the type of value for the appraisers to determine is vague and inconsistent. The selling shareholder’s appraiser interprets value as an undiscounted strategic value, say $100 per share. The company’s appraiser interprets the same language as calling for significant minority interest and marketability discounts and concludes a value of, say, $40 per share. The agreement calls for the two appraisers to agree on a third appraiser who is supposed to resolve the issue. How? The two positions are not reconcilable. Litigation, unhappiness, wasted time and expense follow as the time bomb, which has been in place for years, explodes on all the parties. Travis: So if fixed price, formula price, and appraisal process agreements all have serious drawbacks, what kind of pricing mechanism do you recommend for most family businesses? Chris: Based on my experiences over many years, I have concluded that the best pricing mechanism for most family businesses is what I call a Single Appraiser, Select Now and Value Now valuation process. The parties agree on a single appraiser (I’d recommend Mercer Capital, of course!). The selected appraiser provides a valuation now, at the time of selection, based on the language in the buy-sell agreement. This ensures that any confusion is eliminated at the time of signing or revision. The appraisal sets the price for the buy-sell agreement until the next (preferably annual) appraisal. With this kind of process, virtually all of the problems we’ve discussed are eliminated, or reduced substantially. All the shareholders know what the current value is at any time. Importantly, they all know the process that will occur with every subsequent appraisal. The certainty provided by this Single Appraiser, Select Now and Value Now process far outweighs the uncertainty inherent in other processes at a reasonable cost. At Mercer Capital, we provide annual appraisals of over 100 companies for buy-sell agreements and other purposes. Travis: Finally, what is your best piece of advice for family business owners when it comes to buy-sell agreements? Chris: The best advice I have for family business owners is to be sure that there is an agreement regarding their buy-sell agreements. Many companies have had agreements in place for many years, often decades, without any changes or revisions. No one knows what will happen if they are triggered. Agreement regarding a buy-sell agreement should be the result of review by all shareholders, corporate counsel, and, I recommend, a qualified business appraiser. The appraiser should review agreements from business and valuation perspectives to be sure that the valuation mechanism will work when it is triggered. Discussions are not always easy, since shareholders from different generations and different branches of the family tree have differing objectives and viewpoints. Yet if all parties can agree now, the family can avoid unnecessary strife and litigation in the future. So the best advice I have is to “Just Do It!” ConclusionYour family’s buy-sell agreement won’t matter until it does. As families prepare for their next business meeting, leaders should carefully consider putting a review of the buy-sell agreement on the agenda.

For this week’s post, we’re offering the slides and recording from our recent webinar on the tax bill’s impact on the investment management community.  On balance, we believe most RIAs are better off as a consequence of the legislation, but there are nuances to the “win.”  Specifically, the webinar covers the following observations on the recent bill:U.S. equities have, overall, benefited from the tax billHigher valuations have driven ongoing revenues higher at investment management firmsMany RIA margins will expand as a consequence of improved economicsInvestment management firm valuations will grow in many cases because of stronger cash flowRIAs structured as tax pass-through entities (S corps, LLCs, Partnerships) may want to consider reorganizing as C corporations So feel free to tune in or scroll through if any of these topics are pertinent to you or your firm. Download Slides???

In 1973 Ford Motor Company committed brand espionage by replacing its reigning muscle car, the Mustang, with a slow and cramped economy box as an alleged successor: the Mustang II. Whereas earlier versions of the Mustang were fitted with a reasonably powerful V-6 and much more powerful V-8 motors, the best the “II” could boast was a smallish V-6 from the Capri. With all of 105 horsepower, the V-6 enabled Mustang II could meander to 60 miles per hour in about 13 seconds (given level pavement and favorable winds).We covered much of what we think the new tax bill will mean to RIA valuations in last week’s blogpost – and it’s mostly good news. The “rest of the story” involves the bill’s impact on shareholder returns for RIAs structured as tax pass-thru entities (S corporations, LLCs, Partnerships), for which the news is not so buoyant.As with the Mustang II, the Tax Cuts and Jobs Act took a good thing and made it not so good. The S corporation was a fairly brilliant innovation from the 1950s, allowing certain small businesses to benefit from the limited liability of a being a corporation yet file their taxes as partnerships. S corporations (and LLCs) “pass-through” the tax liability on profits to their shareholders rather than pay one layer of tax at the corporate level on company profits and another at the shareholder level on dividends.Why Many RIAs are Structured as Tax Pass-Through EntitiesBefore the Trump Tax Bill, it often made sense to structure investment management firms as tax pass through entities – usually S corporations or LLCs. As shown in the table below, given taxable income of, say, $1 million, a C corporation would only have $650 thousand to distribute after paying federal corporate taxes at a rate of 35%. Even though the same $1 million of taxable income would be taxed at a higher personal rate for S corporation shareholders, the after-tax distribution of $604 thousand would have a higher economic value when you consider S corp shareholders skip the dividend tax (paid at 23.8%) that would accrue to the C corporation shareholder. After grossing up the after-tax dividend to the S corp shareholder at the C corporation dividend tax rate, the S corporation shareholder earns a C corporation equivalent dividend of nearly $800 thousand. Assuming the RIA in this example is valued at 8x pre-tax income, the S corp shareholder experiences a distribution yield that is 180 basis points higher than if his or her RIA were structured as a C (all else equal). The example above assumes a fully distributing RIA, since many if not most RIA clients we’ve encountered over the years dividend out something close to 100% of their net income. But the S corporation yield advantage also exists if, say, an RIA only distributes half of the C corp equivalent after-tax income (or, conversely, retains half of net income). Tax Cuts and Jobs Act Mutes S Corp AdvantageThe new tax legislation has a big impact on C corporation taxes, a more modest impact on personal income taxes, and no effect on capital gains taxes. As a consequence, the economic advantage of organizing as an S corporation or LLC has been whittled away to almost nothing in some cases, and is arguably disadvantageous in other cases.The table below depicts the comparative consequences of the new tax bill on RIAs organized as C corporations and S corporations. For C corporations, the fourteen percentage point drop in corporate tax rates improves the after tax income available for distribution considerably. In our example, a fully distributing C corporation with $1 million in pre-tax income would have $790 thousand in after-tax income to distribute to shareholders – a substantial improvement over the $650 thousand available under the old tax rates. For S corporations and LLCs, however, the taxes on pass-through income are still substantial, as the after-tax distribution only improves from $604 thousand to $630 thousand (yes, it still improves). If you gross this up for taxes that would be owed on the C corporation dividend, you arrive at a C corporation equivalent dividend of $827 thousand, or not much more than the $790 thousand dividend available for the C corporation. The dividend yield advantage narrows from 180 basis points before the tax legislation to 40 basis points after the tax legislation (assuming some improvement in the valuation multiple – as discussed in last week’s blogpost). The comparison is even worse for investment management firms structured as tax pass-through entities but don’t distribute all of their net income. Going back to the example of the firms that distribute half of their after tax earnings (on a C corp equivalent basis), the dividend yield for the C corporation improves under the new legislation from 4.1% to 4.5%, even with a higher valuation. The S corp yield drops, however, assuming the same earnings retention as the C, from 4.6% to 3.5%, notably lower than the dollar amount and percentage distribution yield for the C corporation. (Probably) No QBI Deduction for YouKnowing that they were trimming back the S corporation advantage, the tax bill introduced a new concept, the Qualified Business Income deduction, that allows certain S shareholders to deduct 20% of their pass-through income and, therefore, maintain more of the S corporation differential in tax rates. However, in a very interesting and possibly more revealing move, the QBI deduction is NOT available for investment management firms.Congress decided to exclude certain “specified service trade or business” income from qualifying for the deduction. One excluded business is investment management: “The term ‘specified trade or business’ means any trade or business – (B) which involves the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).” Of note, Congress had never, to our knowledge, previously singled out investment management for specific treatment as a “specified service trade or business.” Like the limitation on the deductibility of financial planning fees mentioned last week, it appears this administration is taking aim at the RIA community (while inexplicably allowing QBI deductions for architects and engineers).Despite the exclusion, the QBI deduction remains available to RIA shareholders for whom total income is less than $315 thousand; the deduction phases out until it is completely unavailable at incomes greater than $415 thousand. As a result, many RIA shareholders will not get the benefit of the Qualified Business Income deduction.Final Thoughts and Parting ShotsSo, like the Mustang II, the tax bill is new but not necessarily improved for owners of RIAs structured as S corporations or LLCs (excluding the impact of generally higher AUM balances discussed in last week’s post). The Trump administration didn’t aim its product at the investment management community any more than Ford was looking after driving enthusiasts in the early 1970s. It could be worse, though. In the mid-1980s Ford tried to ruin the Mustang’s reputation again with a version that was also underpowered and, this time, front wheel drive. Mustang fans balked, and Ford released the car as an entirely separate product: the Probe, a name that may suggest how some RIA partners feel about the new tax law after they file their 2018 return.1988 Ford Probe: You know the marketing folks in Dearborn loved working with that name (photo: favcars.com)

A Memphis establishment long has used the slogan, “It’s Tax Time (… Baby),” in their low budget television advertising. After listening to early fourth quarter earnings calls, banks – and especially their investors – appear to be embracing this slogan as well. Four investment theses undergirded the revaluation of bank stocks after the 2016 presidential election: regulatory reform, higher interest rates, faster economic growth, and tax reform. One year later, regulatory reform is stymied in Congress, and legislative efforts appear likely to yield limited benefits. Short-term rates have risen, but the benefit for many banks has been squashed by a flatter yield curve and competition for deposits. Economic growth has not yet translated into rising loan demand.Fortunately for bank stock valuations, the tax reform plank materialized in the Tax Cuts and Jobs Act of 2017 (the “Act”).1 The Act has sweeping implications for banks, influencing more than their effective tax rates. This article explores these lesser known ramifications of the Act.2C Corporations & The ActIn 2017, the total effective tax rate on C corporation earnings – at the corporate level and, assuming a 100% dividend payout ratio, at the shareholder level – was 50.5%. Under the Act, this rate will decline to 39.8%, reflecting the new 21% corporate rate and no change in individual taxes on dividends. For a hypothetical bank currently facing the highest corporate tax rate, the Act will cause a 40% reduction in tax expense, a 22% increase in after-tax earnings, and a 269bp enhancement to return on equity (Table 1). The benefit reduces, however, for banks with lower effective tax rates resulting from, among other items, tax-exempt interest income. Continuing the example in Table 1, which assumed a 35% effective tax rate, Table 2 illustrates the effect on banks with 30%, 25%, and 20% effective tax rates. Since investors in bank stocks value after-tax earnings, not surprisingly banks with the highest effective 2016 tax rates experienced the greatest share price appreciation in 2017. Table 3 analyzes share price changes for publicly-traded banks with assets between $1 and $10 billion. ImplicationsThe preceding tax examples distill a nuanced subject into one number, namely an effective tax rate. The implications of the Act for banks, though, spread far beyond mathematical tax calculations. We classify the broader implications of the Act into the following categories:“Allocation” of Tax SavingsLendingMiscellaneousImplication #1: “Allocation” of Tax SavingsWe know for certain that the tax savings resulting from the Act will be allocated among three stakeholder groups – customers, employees, and shareholders.3 The allocation between these groups remains unknown, though.CustomersJamie Dimon had a succinct explication of the effect of the Act on customers:And just on the tax side, so these people understand, generally, yes, if you reduce the tax rates, all things being equal, to 20% or something, eventually, that increased return will be competed away.4The logic is straightforward. The after-tax return on lending and deposit-taking now has increased; higher after-tax returns attract competition; the new competitors then eliminate the higher after-tax returns. Rinse and repeat. One assumption underlying Mr. Dimon’s statement, though, is that prospective after-tax returns will exceed banks’ theoretical cost of capital. If not, loan and deposit pricing may not budge, relative to the former tax rate regime. Supporting the expectation that customers will benefit from the Act is the level of capital in the banking industry searching for lending opportunities.Renasant Corporation has noted already potential pressure on its net interest margin.Not sure [net interest margin expansion is] going to hold. We’ll need a quarter or 2 to see what competitive reaction is to say that we’ll have margin expansion. But we do think that margin at a minimum will be flat and would be variable upon competitive pressures around what’s down with the tax increase.5EmployeesAn early winner of tax reform was employees of numerous banks, who received one-time bonuses, higher compensation, and upgraded benefits packages. With falling unemployment rates, economists will debate whether employers would have made such compensation adjustments absent the Act. Nevertheless, the public nature of these announcements, with local newspapers often covering such promises, will create pressure on other banks to follow suit.Generally, bank compensation adjustments have emphasized entry level positions. An open question is whether such benefits will spread to more highly compensated positions, thereby placing more pressure on bank earnings. For example, consider a relationship manager who in 2017 netted the bank $100 thousand after considering the employee’s compensation and the cost of funding, servicing, and provisioning her portfolio. Assuming that customers do not capture the benefit, the officer’s portfolio suddenly generates after-tax net income of $122 thousand. The loan officer could well expect to capture a share of this benefit, or take her services to a competitor more amenable to splitting the benefit of tax reform.ShareholdersMr. Market clearly views shareholders as the biggest winner of tax reform, and we have no reason to doubt this – at least in the short-run. Worth watching is the form this capital return to shareholders takes. With bank stocks trading at healthy P/Es, even adjusted for tax reform, banks may hesitate to be significant buyers of their own stock. Instead, some public banks have suggested higher dividends are in the offing. Meanwhile, Signature Bank (New York), which has not paid dividends historically, indicated it may initiate a dividend in 2018. In the two days after the CEO’s announcement, Signature’s stock price climbed 8%.Table 4 compiles announced expenditures by certain banks on employees, philanthropy, and capital investments. Click to view Table 4.Some public market analysts have “allocated” 60% to 80% of the tax savings to shareholders, with the remainder flowing to other stakeholders. Time will tell, but banks will face pressure from numerous constituencies to share the benefits.Implication #2: LendingThe Act potentially affects loan volume with future possible effects on credit quality.VolumeLooked at most favorably, higher economic growth resulting from the Act, as well as accelerated capital expenditures due to the Act’s depreciation provisions, may provide a tailwind to loan growth. However, some headwinds exist too. Businesses may use their tax savings to pay down debt or fund investments with internal resources. The Act eliminates the deductibility of interest on home equity loans and lines of credit, potentially impairing their attractiveness to consumers. Last, the Act disqualifies non-real estate assets from obtaining favorable like-kind exchange treatment, potentially affecting some types of equipment finance.QualityWhile we do not expect the Act to cause any immediate negative effects on credit quality, certain provisions “reallocate” a business’ cash flow between the Treasury and other stakeholders (e.g., creditors) in certain circumstances:Net Operating Loss (“NOL”) Limitations. Tax policy existing prior to the Act allowed businesses to carry back net operating losses two years, which provided an element of countercyclicality in periods of economic stress. The Act eliminates the carryback provision. Further, businesses can apply only 80% of future NOLs to reduce future taxable earnings, down from 100% in 2017, thereby potentially pressuring a business’ cash flow as it recovers from losses. As a result, less cash flow may be available to service debt.Interest Deductibility Limitations. The Act caps the interest a business may deduct to 30% of EBITDA (through 2021) and EBIT (thereafter) for entities with revenue exceeding $25 million.6 Assuming a 5% interest rate, a business’ debt must exceed 6x EBITDA before triggering this provision. Several issues arise from this new limitation. First, community banks may have clients that manage their expenses to achieve a specified tax result, which could face disallowed interest payments. Second, in a stressed economic scenario, cash flow may be diverted to cover taxes on nondeductible interest payments, rather than to service bank debt.Real Estate Entities. The Act appears to provide relatively favorable treatment of real estate managers and investors. However, banks should be aware that the intersection of (a) the interest deductibility limitations and (b) the Act’s depreciation provisions may affect borrower cash flow. Entities engaged in a “real property trade or business” may opt out of the 30% interest deductibility limitation. However, such entities (a) must depreciate their assets over a longer period and (b) cannot claim 100% bonus depreciation for improvements to the interior of a commercial property. Banks should also prepare for reorganizations among business borrowers currently taxed as pass-through entities, especially in certain service businesses not qualifying for the 20% deduction described subsequently. From a tax planning standpoint, it may be advisable for some business clients to reorganize with certain activities conducted under a C corporation and others under a pass-through structure.Implication #3: Miscellaneous ConsiderationsAdditional considerations include:Effect on Tangible Book ValueTable 5 presents, for publicly traded banks with assets between $1 billion and $5 billion, their net deferred tax asset or liability positions as a percentage of tangible common equity. Table 5 also presents the number of banks reporting net DTAs or DTLs. From a valuation standpoint, we do not expect DTA write-downs to cause significant consternation among investors. If Citigroup’s $22 billion DTA revaluation did not scare investors, we doubt other banks will experience a significant negative reaction. In Citigroup’s case, the impairment has the salutary effect of boosting its future ROE, as Citigroup’s regulatory capital excluded a large portion of the DTAs anyway. Regulatory Capital7The Basel III capital regulations limit the inclusion of DTAs related to temporary differences in regulatory capital, but DTAs that could be realized through using NOL carrybacks are not subject to exclusion from regulatory capital. As noted previously, though, the Act eliminates NOL carrybacks. Therefore, certain banks may face disallowances (or greater disallowances) of portions of their DTAs when computing common equity Tier 1 regulatory capital.8Business InvestmentsAn emerging issue facing community banks is their relevance among technology savvy consumers and businesses. Via its “bonus” depreciation provisions, the Act provides tax-advantaged options for banks to address technological weaknesses. For qualifying assets – generally, assets other than real estate and, under the Act, even used assets – are eligible for 100% bonus depreciation through 2022. The bonus depreciation phases out to 0% for assets placed in service after 2026.9Mergers & AcquisitionsOur understanding is that the Act will not materially change the existing motivations for structuring a transaction as non-taxable or taxable. With banks accumulating capital at a faster pace given a reduced tax rate, it will be interesting to observe whether cash increases as a proportion of the overall consideration mix offered to sellers.Permanence of Tax ReformOne parting thought concerns the longevity of the recent tax reforms. The Act passed via reconciliation with no bipartisan support, unlike the Tax Reform Act of 1986. As exhibited recently by the CFPB, the regulatory winds can shift suddenly. Like the CFPB, is tax reform built on a foundation of sand?S Corporations & The ActAt the risk of exhausting our readership, we will detour briefly through the Act’s provisions affecting S corporations (§199A). While the Act’s authors purportedly intended to simplify the Code, the smattering of “lesser of the greater of” tests throughout §199A suggests that this goal went unfulfilled.Briefly, the Act provides that shareholders of S corporations can deduct 20% of their pro rata share of the entity’s Qualified Business Income (“QBI”), assuming that the entity is a Qualified Trade or Business (“QTB”) but not a Specified Service Trade or Business (“SSTB”).10 That is, shareholders of QTBs that are not SSTBs can deduct 20% of their pro rata share of the entity’s QBI.11 Simple.The 20% QBI deduction causes an S corporation’s prospective tax rate to fall to 33.4%, versus the 44.6% total rate applicable in 2017, thereby remaining below the comparable total C corporation tax rate (Table 6). S corporations should review closely the impact of the Act on their tax structure. The 2013 increase in the top marginal personal rate to 39.6% and the imposition of the Net Investment Income Tax on passive shareholders previously diminished the benefit of S corporation status. The Act implements a $10 thousand limit on the deductibility of state and local taxes, which may further diminish the remaining benefit of S corporation status. While we understand this limitation will not affect the deductibility of taxes paid by the S corporation itself (such as real estate taxes on its properties), it may reduce shareholders’ ability to deduct state-level taxes paid by a shareholder on his or her pro rata share of the S corporation’s earnings. S corporations also should evaluate their projected shareholder distributions, as S corporations distributing only sufficient amounts to cover shareholders’ tax liability may see fewer benefits from maintaining an S corporation election.12ConclusionFor banks, the provisions of the Act intertwine throughout their activities. Calculating the effect of a lower tax rate on a bank’s corporate tax liability represents a math exercise; predicting its effect on other constituencies is fraught with uncertainty.13 We look forward to discussing with clients how the far reaching provisions of the Act will affect their banks, clients, and the economy at large. It will be Tax Time for quite some time. As always, Mercer Capital is available to discuss the valuation implications of the Act.This article originally appeared in Mercer Capital's Bank Watch, January 2018.End NotesLest we be accused of imprecision, the Act’s formal name is “An act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018.”Before proceeding, we include the de rigueur disclaimer for articles describing the Act that Mercer Capital does not provide tax advice and banks should consult with appropriate tax experts.We recognize that some of the tax savings may be invested in capital expenditures or community relations, but these expenditures ultimately are intended to benefit one of the three stakeholder groups identified previously.Transcript of J.P. Morgan Chase & Co.’s Fourth Quarter 2016 earnings call.Transcript of Renasant Corporation’s Fourth Quarter 2017 earnings call.Floor plan financing is exempt from this provision.See also Federal Reserve, Supervisory & Regulatory Letter 18-2, January 18, 2018.Generally, DTAs are includible in regulatory capital up to a fixed percentage of common equity Tier 1 capital.In addition, §179 allows entities to expense the cost of certain assets.The §179 limit increases from $500 thousand in 2017 to $1 million in 2018.The Act also expands the definition of assets subject to §179 to include all leasehold improvements and certain building improvements.We recognize that the risk of exploding heads is acute with reference to §199A.Therefore, we avoided discussion of the limits on the 20% deduction relating to W-2 and other compensation, “qualified” property, and overall taxable income, as well as the various income thresholds that exist.Suffice to say, §199A is considerably more complex than we have described.It does not appear that banks are SSTBs (and, thus, banks are eligible for the 20% deduction), although the explanation is mind numbing.An SSTB is defined in §199A by reference to §1202(e)(3)(A) but not §1202(e)(3)(B).Existing §1202 provides an exclusion from gain on sale to holders of “qualified small business stock.”However, §1202(e)(3)(A) and §1202(e)(3)(B) disqualify certain businesses from using the QSB stock exclusion.Banks are specifically disqualified from the QSB stock sale exclusion under §1202(e)(3)(B).Since §199A’s definition of an SSTB does not specifically cite the businesses listed in §1202(e)(3)(B), such as banks, §199A has been interpreted to provide that banks are not SSTBs.Interested in more SSTB arcana?Architects and engineers are excluded specifically from the list of businesses ineligible for the 20% deduction, apparently speaking to the lobbying prowess of their trade groups (or their ability to build tangible things).We are not aware that the Act limits the increase in an S corporation shareholder’s tax basis arising from earnings not distributed to shareholders.However, the tax basis advantage of S corporation status typically is secondary to the immediate effect of an S corporation election on a shareholder’s current tax liability.To be fair, we should limit the “math exercise” comment to C corporations; the S corporation provisions in §199A undeniably are abstruse.

My seventeen year old daughter is getting pretty deep into her college search; she’s narrowed it down to a handful of schools that are between 1,000 miles from home and 4,000 miles from home, if that tells you anything.  A few weeks ago she told an admissions officer from a really fine school in California that she is “interested in politics,” but that she doesn’t want to be a politician; instead she’s interested in “economics as they relate to public policy, especially tax policy.”  I learned this over dinner one night.I know I should have teared up with pride, but instead I lost my appetite.Having my creative, funny, yet also quantitatively astute daughter sell her soul not just to the dismal science of economics but in particular Washington’s never ending quest to pervert the dismal science...feels a little like an act of betrayal - like her telling me that her dream car is a Saturn.  At least it hasn’t come to that.For Once, Taxes Are Not BoringBecause we like our readers, the RIA team at Mercer assiduously avoids talking about tax policy in this blog.  The Trump tax bill, however, can’t go without mention.  We won’t mince words – this tax bill is a blockbuster for the investment management industry.  Whatever your politics, you can’t ignore the magnitude of the change that is afoot.Among the issues presented by the tax bill is that advisor fees are no longer a line-item deduction for clients, an interesting shot at investors by this administration that doesn’t line up very well with the tax treatment of other professional services.  While this is peculiar, David Canter recently published an interview with industry leaders Brent Brodeski and Michael Nathanson that cautions against making too much of this.We’re staying focused on the implications of the tax bill for investment management firm valuations, and there’s much to consider.The Tax Bill Has Driven Up AUM (for Most)Investment management revenue is a function of AUM, and the impact of the tax bill on valuations across a spectrum of asset classes is significant.  While the impact of this on anyone who derives fee income from managing equities (fixed income shops are a different story) is clear, we don’t think it’s sufficient to just take the increase in market valuations at face; it’s more useful to unpack the issue and consider why.One of our colleagues here at Mercer, Travis Harms, did some research on the impact of the tax bill on valuation multiples to consider not just the what but also the why.  Notably, Travis looked at the impact on pre-tax multiples, such as EBITDA, to interrogate whether or not a dollar of pre-tax cash flow is indeed worth more if it is less burdened with tax liabilities.  Travis is interested in the change in multiples because he works heavily in the portfolio valuation space.  We saw broad implications to his modeling exercise for the investment management community.Travis pulled monthly forward EBITDA multiples for the S&P 1000 (ex financials).  The S&P 1000 is a combined mid and small cap index, consisting of company #501 through #1500.  As shown in the following chart, the median multiple for such firms was approximately 9.0x to 9.5x during the fall of 2016, when a Clinton administration, and tax status quo, seemed inevitable.  By late 2017, the median multiple had expanded by almost a full turn, to about 10.3x.Forward EBITDA multiples for sample equity index (S&P 1000 ex financials) shows movement in multiples that appear to correlate with changes in the outlook for corporate tax reductions. Valuation multiples are, of course, a function of three factors: 1) cash flow, 2) risk, and 3) growth.  To determine whether or not the change in multiples is indeed attributable to a change in tax rates, Travis investigated whether or not there had been an effective change in the cost of capital (risk) or an expectation of increased growth in earnings.  Travis’s analysis inferred an aggregate cost of capital (supply side weighted average cost of capital, or WACC) for his equity basket in September of 2016 as an anchor point, and then looked at the change in the cost of capital over the same period that resulted from a change in interest rates (holding the assumed equity risk premium constant). The risk-free rate (the interest rate on long dated treasuries) gapped up from close to 2.0% in September of 2016 to something on the order of 2.8% in December of that year, pushing the implied supply side cost of capital up to about 9.2%.  Doing some fancy footwork, Travis ran a DCF model on his equity basket, letting the tax rate float.  His DCF model suggests that the market priced in effective tax rates of approximately 20% by the end of 2017.  Significantly, the early expectations for rate reduction seem to have waned a bit over the summer months as the Trump administration experienced a series of legislative failures.  Also significant is that the model assumes there are no changes in the expected growth outlook for the companies in the sample basket, consistent with statements from the Federal Reserve suggesting no material uptick in GDP growth consequent from the tax bill.  Travis didn’t modify expected growth because there is no robust way to review earnings estimates for a broad array of companies on a month by month basis.  Of note, Aswath Damodaran, a finance professor at NYU, thinks the tax bill may in fact increase the sustainable growth rate for U.S. companies. Using a DCF model framework to evaluate the impact of a change in tax expectations on valuation multiples, we can let the cost of capital float with interest rates and hold growth expectations constant, such that the change in valuation multiples can be attributed to the change in tax rates. The implication of Travis’s analysis is that the market repriced as a consequence of lower tax rates, and not because of changes in the cost of capital (which, with higher interest rates, would have caused multiples to fall), nor expectations of higher earnings growth (of which there is little evidence). Put another way, the tax bill appears to have, indeed, inflated equity valuation multiples by reducing the tax burden on corporate profits.  On one level, this is obvious, but the implications of this are interesting if it also suggests that current equity valuations are more sustainable than some believe.  Perhaps valuation multiples gapped higher, as they should have, and will remain higher than they would otherwise be, so long as corporate tax rates persist at these levels.  That would certainly be good news for the asset management community. The Tax Bill Has Improved RIA Economics (for Many)Taking this one step further, the tax bill would seem to have improved returns for many subsectors of the investment management industry.  If public market valuations gapped up 10% or so, would we expect to see nearly a 10% increase in assets under management across the equity space in the industry?  More AUM means more revenue and more profitability?  In short, yes, as we can show in the example below. This table is fairly self-explanatory.  Assuming an RIA with $5 billion under management, of which 80% is managed equities and 20% is fixed income, a 10% increase in equity valuations would have a corresponding 8% increase in overall AUM, ceteris paribus. If the same investment management firm realized fees of 65 basis points on equities and 20 basis points on fixed income, the leverage on the higher AUM attributable to equities would increase revenue a bit more than total AUM, or 9.3%.  One potential problem with this aspect of the model is the assumption that clients with higher AUM balances won’t pass through breakpoints that will lower overall realized fees.  For purposes of this example, however, we have assumed that the fee schedule isn’t progressive with the increase in AUM. When we consider the leverage on operating expenses, however, things really get interesting.  Higher AUM balances can lead to a correspondingly higher expense base if the increase comes from more accounts or assets that are more expensive to manage.  In this instance, however, AUM is simply inflated because of market activity.  We might not assume G&A costs would rise at all, nor would, necessarily, salaries.  Incentive compensation, however, would probably increase.  Assuming bonus compensation to be 30% of pre-bonus EBITDA, we see an almost 20% increase in incentive compensation resulting from higher assets under management.  Even with higher bonuses, however, total expenses only increase about 4%.  The consequence of this is an increase in earnings before interest, taxes, depreciation, and amortization of almost 20%, and a cash flow margin increase of three percentage points. If you’re an asset manager, your reality may (will) be different than our example.  If interest rates continue to rise, our sample RIA might experience some diminution in income from managing fixed income portfolios.  Clients may rebalance to maintain the same allocation between stocks and bonds.  Clients are, on the whole, more fee sensitive than they once were, and may want some betterment of their fee schedule as a consequence of this moment of good fortune.  And your staff will probably notice that there is more cash flow available for compensation.  The market may bid up the cost of talent, or at least salaries and bonuses will increase more than we show here in an effort to “keep a good thing going.”  In any event, if your AUM increases nearly 10% and margins don’t widen, it would be worth looking through your numbers some to assess why.  The opportunity for a significant increase in profitability at many RIAs appears to be on offer. The Tax Bill Has Improved RIA valuations (for Some)Taking this one step further, RIAs may not only benefit from a repricing of market multiples of their clients’ assets, but also of the value of their own returns.  In our example firm, EBITDA increases 18.6% as a direct consequence of the tax bill.  Valuations of RIAs would be expected to increase similarly, if there were no change in the valuation multiples for the RIAs themselves. If, however, appropriate multiples for RIAs gap-up 10% like Travis Harms observed happened in the public equity market, then the combination of that plus improved profitability produces a 30% increase in enterprise values for RIAs, and a corresponding 20% expansion in the implied AUM multiple.  The reason for the increase in RIA multiples is the same as the increase in the market basket of equities Travis studied: a dollar of pre-tax cash flow is worth more when the tax burden on that dollar is less (assuming no change in the cost of capital or earnings growth). Your Results May (Will) DifferWhatever you do, don’t run out of your office and tell your partners that I’ve just proven your firm is worth 30% more than it was two months ago.  There are many variables that affect firm valuation – some discussed in this post, some I’ve left out, and some I probably haven’t thought of yet.  One issue in comparing movement in the public market multiples and private RIAs is that public companies are C-corporations whereas many, if not most, private RIAs are some kind of tax pass-through entity like an S corporation or an LLC.  I’ll be back next week to talk about how the tax bill treats tax pass through enterprises, and it’s not nearly as generous as conferred upon C corps.In any event, the tax bill is bullish for the RIA community.  There may not be a Saturn in my driveway, but a friend of mine who, like me, was born under the astrological sign of Capricorn says that Saturn is in our house this year (cosmologically, a favorable thing).  I don’t know what the “Saturn” effect is for the markets, but for now it appears that the stars are aligned for the RIA community, an augur of good things to come.If you have questions as you wrestle with the valuation implications of the new tax bill on your RIA, give us a call to discuss your situation in confidence and/or register for our upcoming webinar addressing the matter.

Unless your client has had their buy-sell agreement reviewed from a valuation perspective, they don’t know what it says. This comes as a surprise to many – an often unpleasant surprise as too many find themselves caught up in unexpected and costly legal wrangles or personal turmoil.Originally presented by Z. Christopher Mercer, FASA, CFA, ABAR at the 2017 Southern Federal Tax Institute, this session provides you with information from a valuation perspective that will help ensure that your clients’ buy-sell, shareholder, or joint venture agreement results in a reasonable resolution and is not a ticking time bomb set to explode upon a triggering event. In other words, you will leave this session understanding how your clients’ buy-sell agreement will work - before a trigger event occurs.

Clients writing new buy-sell agreements or re-writing existing ones frequently ask us how often they should have their RIA valued.  Like most things in life, it depends.  We usually recommend having a firm valued annually, and most of our clients usually do just that.  “Usually,” though, is subject to many specific considerations.How many shareholders are there in the RIA?  The more owners you have, the more transactions will occur and the more useful a semi-annual or quarterly valuation might be.  Small firms with only a couple of owners typically don’t need to know their value on an annual basis, but checking in on some scheduled basis – such as every two or three years – is helpful to keep track of firm performance, update any life insurance coverage, and to plan for succession issues or sale of the firm.Is your firm growing rapidly?  If so, an annual valuation might become stale very quickly.  Mature firms probably only need to look at their valuation metrics once per year to see how their performance and outlook compares with the greater market for investment management firms.Even annual valuations can be inadequate, however, when an RIA experiences big increases or decreases in assets under management.  Since we have been operating in a low volatility market (at least for U.S. equities) for some time, it’s easy to forget that normal, but nonetheless major, market swings can have a material impact on profitability and valuation.  In the case of a market swoon, even a mature RIA with healthy margins can lose ground rapidly, and a valuation that looked reasonable six months earlier may no longer be practical.  Consider an equity manager with $2 billion of AUM, realized fees of 60 basis points, and a 40% EBITDA margin.  If the regular annual valuation is prepared at an effective EBITDA multiple of 9x, then enterprise value would come in at around $43 million.One might expect that a valuation such as that would satisfy the needs of an investment management firm over the course of a year, until the time came for the next update.  Markets are fickle, though.  Imagine the same RIA endures a significant market downturn late in the summer, and then an event happens which triggers the buy-sell.  AUM drops 20% versus the start of the year, nothing changes in the expense base, and the valuation multiple is steady.  Because of the inherent operating leverage in the asset management business, the profit margin drops from 40% to 25% on 20% lower revenue, and because of that compounding effect value declines by half. This example has more simplifying assumptions than not, and most firm valuations would not move so dramatically just because of a 20% downturn in AUM.  That said, market events and client whims can have an outsized impact on RIA profits and, consequently, valuation, such that an annual valuation may not hold up over the course of a year. So what’s a firm to do?  One option, of course, is to accept the vagaries of the market – any unusual events during the course of the year may be just as temporary as conditions at the annual valuation date.  One of the functions of the buy-sell agreement is to get the parties to agree to what they are willing to live with, and what they are willing to live without.  Many firms do just that. This brings me to the subject of the photo above.  European rally car races have always fascinated me, although I’ve never been brave enough to actually attend one.  During the 1980s Audi ruled the rally scene with the Ur-quattro.  The Ur-quattro was a hatchback that Audi developed after the racing rules were changed in the late 1970s to allow four-wheel drive.  The Audi could handle anything, and to underscore that point the manufacturer used both Italian (“quattro” for four wheel drive) and German (“Ur” for primordial or original) to name it.  Regardless of snow, mud, gravel, flat curves or deep hills, the Ur-quattro couldn’t be beat.  Audi’s rally reputation was such that they started to offer the quattro system in all of their passenger cars, and all-wheel drive has become commonplace today – from Subaru to Lamborghini. A client of ours that is drafting a new buy-sell agreement recently brought us an idea which we think offers a similar level of preparation for any circumstance.  In their agreement, they’ve added a provision which would call for an interim update to their otherwise annual valuation if 1) the prospect of a transaction arises and 2) AUM is more than 10% higher or lower than at the time of the previous valuation.  The annual valuation is important to set a pattern of expectations for parties to the buy-sell of how they’ll be treated in a transaction, and most of the time will suffice when a transaction occurs.  Adding the update provision is a simple way to prepare for the possibility of substantial changes in the financial performance of the RIA.  Even if they never use the provision, having it offers peace of mind for parties to the agreement that they’ll be treated fairly if the company’s performance changes radically over the course of the year. In the decades since the Ur-quattro was introduced, Audi has sold cars with quattro to millions of people whose morning commute is nothing like a rally race.  Most people buy all-wheel drive cars for that “just-in-case” moment that will make the added expense worth it.  Like all-wheel drive, you may never need an event-based update provision in your buy-sell agreement.  It’s nice to know, though, that your buy-sell is all-terrain ready, no matter how rough the ride gets.

Master Limited Partnerships (MLPs) are publicly traded partnerships, which reap the tax benefits of a partnership and the liquidity benefits of a public company. There are many tax benefits to an MLP.  Unlike public companies, MLPs are taxed only at the unitholder level.  Distributions to unitholders are tax deferred, if the Partnership distribution is greater than Partnership income.  And, units can be passed down to successors at a basis of fair market value, which means that the capital gains tax is not passed down along with the unit.  There are also some serious tax implications of the MLP structure.  For example, when an MLP’s debt is forgiven, the amount cancelled is treated as income and is taxed at the unitholder level.  However, there is generally not a cash distribution which accompanies this tax payment.History of MLPsApache Oil established the first MLP in 1981 and had such great success with the structure that real estate investors, restaurants, hotels, and NBA teams restructured to become MLPs.  In 1987, Congress revamped the tax code specifying that in order to be an MLP at least 90% of a company’s income must be generated from “qualified sources”.  Qualified sources include, “the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil, or products thereof), or the marketing of any mineral or natural resource (including fertilizer, geothermal energy, and timber).”  In 2008, Congress expanded this to include carbon dioxide, biofuels, and other alternative fuels.E&P companies are sensitive to swings in commodity prices and do not have stable enough cash flows to sustain the distribution requirement of MLPs.  Often times E&P companies spun off their midstream assets into MLPs because midstream operations provide stable cash flows and have the ability to reliably make distributions. Thus the majority of MLPs are involved in the midstream oil and gas sector.  Recently, however, the stability of midstream cash flows has been called into question.Midstream companies have long term contracts called take-or-pay contracts which require producers to pay midstream companies even if they are not currently using their gathering assets.  It was always assumed that these contracts were inviolate; however, the recent turmoil in the oil and gas market, which led to a multitude of bankruptcies in the E&P sector, caused these contracts to be called into question in bankruptcy court proceedings.   During the bankruptcy process, producers can request that certain contracts be rejected.  If the midstream contracts are thought to be vastly different from market value then the producer can request the judge consider the rejection of midstream contracts.  We saw this in March of 2015 when a New York judge ruled that Sabine Oil and Gas Corp., which was going through bankruptcy proceedings, could reject contracts it was in with midstream companies. This uncertainty caused the price of MLPs to fall as investors began to question the immunity of their cash flows.  From December 2014 to December 2015 the price of MLPs on average fell by 25%.MLPs have two classes of Partners: General Partners, who are responsible for managing day to day operations and receive compensation for doing so, and Limited Partners (called unitholders) who are investors in the Partnership and receive periodic distributions.  Unlike a public company which is governed by a board, a MLP is generally managed by a general partner.  Legally, the general partner has no fiduciary duty to the unitholders, but mostly their interests align.MLPs payout a large portion of cash flows (generally 80% to 100%) to their unitholders. Distributions are based on each MLP’s partnership agreement and usually minimum quarterly distributions are written into the MLP’s partnership agreements. The General Partner typically owns a 2% equity interest along with incentive distribution rights (IDRs).  Incentive distribution rights give a general partner an increasing share in the incremental distributable cash flow of the Partnership.  IDRs are meant to incentivize the GP to increase distributions for the limited partners.Valuing an MLPThere are approximately 140 MLPs and in 2013 over 50% of MLPs operated in the midstream and downstream oil and gas sector.  While each Company is unique the guideline approach can commonly be used to value MLPs in the oil and gas sector.   A price to earnings multiple however is uninformative when valuing an MLP.  MLPs generally have a lot of fixed assets on the balance sheet that result in high depreciation expenses charged to earnings. Thus earnings are not a good indicator of value. Instead we turn to companies’ distribution history.Several MLPs and their key financials are summarized in the chart below.   MLPs generally pique the interest of investors looking for income generating investments, demonstrated by the dividend yield.  But there are three other measures that should be used to understand the value and inherent risk of an MLP: (1) Distribution Coverage Ratio (DCR), (2) Price / Distributable Cash Flow (P / DCF), and (3) Debt / EBITDA.A MLP’s distribution coverage ratio (DCR) measures the sustainability of current distributions.  A DCR of 1.0 indicates that an MLP is distributing all available cash flow and a DCR of greater than 1.0 indicates that a Partnership is retaining some cash.  A DCR of less than 1.0 is not sustainable.  All of the MLPs above have sustainable levels of distributions but Magellan Midstream’s (MMP) DCR of 1.0 does beg for further analysis as they are paying out all available cash flow.Instead of evaluating Price / Earnings multiples, we analyze Price / Distributable Cash Flow for MLPs.   Generally a P / DCR of more than 15x or 16x is considered high.  However, if the MLP has consistently grown distributions then the partnership may be worth the premium. Magellan Midstream was trading at 17.4x distributable cash flow, which is on the higher end of the range shown above. However, MMP has increased its quarterly distribution 59 times since it IPO-ed in 2001.  This trend of an increasing yield merits a higher P / DCF multiple.The Debt to EBITDA multiple can give us further insight into the company’s risk position.  Since MLPs must pay out the majority of their cash flows as distributions to unitholders, in order to fund capital expenditures and acquisitions an MLP must take on debt.  Magellan has a debt to EBITDA ration of 3.9x.  Generally a debt to EBIDTA multiple above 5x would be cause for concern, but Debt / EBITDA multiples for MLPs have trended upwards over the last four years.  In 2013 the median Debt / EBITDA multiple was 3.8x but increased to 5.4x by 2015.  Over the past three years the median EBITDA of our group increased by a compound annual rate of 8% while debt increased at a rate of 16% showing that the industry as a whole has become more leveraged.Mercer Capital’s oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

[Fall 2016] This article begins with a discussion of EBITDA, or earnings before interest, taxes, depreciation, and amortization. The focus on the EBITDA of private companies is almost ubiquitous among business appraisers, business owners, and other market participants. The article then addresses the relationship between depreciation (and amortization) and EBIT, or earnings before interest and taxes, as one measure of relative capital intensity. This relationship, which is termed the EBITDA Depreciation Factor, is then used to convert debt-free pretax (i.e., EBIT) multiples into corresponding multiples of EBITDA. The article presents analysis that illustrates why, in valuation terms (i.e., expected risk, growth, and capital intensity), the so-called pervasive rules of thumb suggesting that many companies are worth 4.03to 6.03EBITDA, plus or minus, exhibit such stickiness. The article suggests a technique based on the adjusted capital asset pricing model whereby business appraisers and market participants can independently develop EBITDA multiples under the income approach to valuation. Finally, the article presents private and public company market evidence regarding the EBITDA Depreciation Factor, which should facilitate further investigation and analysis.[Reprinted from the American Society of AppraisersBusiness Valuation Review, Volume 35, Issue 3, Fall 2016]Download the article in pdf format here.

The classic car world is full of stories of “barn finds” – valuable cars that were forgotten in storage for decades, found and restored and sold for mint. One of the most famous is pictured above, a Ferrari 250 GT SWB California Spyder once owned by a French actor and found in a barn on a French farm in 2014. The car was one of 36 ever made and one of the most valuable Ferraris in existence. Once the Ferrari was exhumed, it was lightly cleaned and sold, basically as found, for $23 million at auction. As difficult it is to imagine such a valuable car being forgotten, what we see more commonly are forgotten buy-sell agreements, collecting dust in desk drawers. Unfortunately, these contracts often turn into liabilities, instead of assets, once they are exhumed, as the words on the page frequently commit the signatories to obligations long forgotten. So we encourage our clients to review their buy-sell agreements regularly, and have compiled some of our observations about how to do so in the whitepaper below. You can also download it as a PDF at the bottom of this page. We hope this will be helpful to you; call us if you have any questions.IntroductionAlmost every conversation we have with a new RIA client starts something like this: “We hired you because you do lots of work with asset managers, but as you get into this project you need to understand that our firm is very different from others.” Our experience, so far, confirms this sentiment of uniqueness that is not at all unique among investment managers. Although there are twelve thousand or so separate Registered Investment Advisors in the U.S. (not to mention several hundred independent trust companies and a couple thousand bank trust departments), there seems to be a comparable number of business models. Every client who calls us, though, has the same issue on their plate: ownership.Ownership can be the single biggest distraction for a professional services firm, and it seems like the RIA community feels this issue more than most. After all, most asset managers are closely held (so the value of the firm is not set by the market). Most asset managers are owned by unrelated parties, whereas most closely-held businesses are owned by members of the same family. A greater than normal proportion of asset management firms are very valuable, such that there is more at stake in ownership than most closely held businesses. Consequently, when disputes arise over the value of ownership in an asset management firm, there is usually more than enough cash flow to fund the animosity, and what might be a five figure settlement in some industries is a seven figure trial for an RIA.Avoiding expensive litigation is one reason to focus on your buy-sell agreement, but for most firms the more compelling reasons revolve around transitioning ownership to perpetuate the firm. Institutional clients increasingly seem to query about business continuity planning, and the SEC has of course recently proposed transition planning guidelines. There are plenty of good business reasons to have a robust buy-sell agreement in any closely held company, but in RIAs there are client and regulatory reasons as well.SEC Proposed RuleEvery SEC-registered investment adviser must adopt and implement a written business continuity and transition plan that reasonably addressed operational risks related to a significant disruption or transition in the adviser's business.Business Continuity PlanningTransition PlanningMaintenance of critical operations/systems, as well as protection, backup and recovery of dataPolicies and procedures to safeguard, transfer, and/or distribute client assets during a transitionAlternate physical office locationsPolicies and procedures to facilitate prompt generation of client specific information necessary to transition each accountCommunication plans for clients, employees, vendors and regulatorsInformation regarding the corporate governance structure of the adviserIdentification and assessment of third-party services critical to the operationIdentification of any material financial resources available to the adviserKey Elements of the SEC’s Proposal: “Adviser Business Continuity and Transition Plans,” 206 (4)-4Buy-Sell Agreement BasicsSimply put, a buy-sell agreement establishes the manner in which shares of a private company transact under particular scenarios. Ideally, it defines the conditions under which it operates, describes the mechanism whereby the shares to be transacted are priced, addresses the funding of the transaction, and satisfies all applicable laws and/or regulations.These agreements aren’t necessarily static. In investment management firms, buy-sell agreements may evolve over time with changes in the scale of the business and breadth of ownership. When firms are new and more “practice” than “business,” these agreements may serve more to decide who gets what if the partners decide to go separate ways. As the business becomes more institutionalized, and thus more valuable, a buy-sell agreement – properly rendered – is a key document to protect the shareholders and the business (not to mention the firm’s clients) in the event of an ownership dispute or other unexpected change in ownership. Ideally, the agreement also serves to provide for more orderly ownership succession, not to mention a degree of certainty for owners that allow them to focus on serving clients and running the business instead of worrying about who gets what benefit of ownership.The irony of buy-sell agreements is that they are usually drafted and signed when all of the shareholders think similarly about their firm, the value of their interest, and how they would treat each other at the point they transact their stock. The agreement is drafted, signed, filed, and forgotten. Then an event occurs that invokes the buy-sell, and the document is pulled from the drawer and read carefully. Every word is parsed, and every term scrutinized, because now there are not simply co-owners with aligned interests – but rather buyers and sellers with symmetrically opposed interests.Our Advice: Key Considerations for Your Buy-Sell AgreementAt Mercer Capital we have read hundreds, if not thousands, of buy-sell agreements. While we are not attorneys and do not attempt to draft such agreements, our experience has led us to a few conclusions about what works well and what doesn’t. By “working well”, we mean an enduring agreement that efficiently manages ownership transactions and transitions in a variety of circumstances. Agreements that don’t work well become the subject of major disputes – the consequence of which is a costly distraction.The primary weaknesses we see in buy-sell agreements relate to issues of valuation: what is to be valued, how, when, and by whom. The following issues and our corresponding advice are drawn from our experience of agreements that performed well and those that did not. While we haven’t seen everything, we have been more involved than most in helping craft agreements, maintaining compliance with valuation provisions, and resolving disagreements.1. Decide What You Mean By “Fair”A standard refrain from clients crafting a buy-sell agreement is that they “just want to be fair” to all of the parties in the agreement. That’s easier said than done, because fairness means different things to different people. The stakeholders in a buy-sell at an investment management firm typically include the founding partners, subsequent generations of ownership, the business itself, non-owner employees of the business, and the clients of the firm. Being “fair” to that many different parties is nearly impossible, considering the different motivations and perspectives of the parties:Founding owners. Aside from wanting the highest possible price for their shares, founding partners are usually desirous of having the flexibility to work as much or as little as they want to, for as many years as they so choose. These motivations may be in conflict with each other, as ramping down one’s workload into a state of partial retirement and preserving the founding generation’s imprint on the company requires a healthy business, which in turn necessarily requires consideration of the other stakeholders in the firm. We read one buy-sell agreement where the founder had secured his economic return by requiring the company, in the event of his death, to redeem his shares at a value that did not consider the economic impact of his death (the founder was a significant rainmaker). One can only imagine, at the founder’s death, how that would go when the other partners and employees of the firm “negotiated” with the estate – as if a piece of paper could checkmate everything else in a business where the assets of the firm get on the elevator and go home every night.Subsequent generation owners. The economics of a successful RIA can set up a scenario where buying into the firm can be very expensive, and new partners naturally want to buy as cheaply as possible. Eventually, however, there is symmetry of economic interests for all shareholders, and buyers will eventually become sellers. Untimely events can cause younger partners to need to sell their stock, and they don’t want to be in a position of having to give it up too cheaply. Younger partners also tend to underestimate the cost of building their own firm instead of buying into the existing one; other times, they don’t.The firm itself. The company is at the hub of all the different stakeholder interests, and is best served if ownership is a minimal consideration in how the business is run. Since hand-wringing over ownership rarely generates revenue, having a functional shareholder’s agreement that reasonably provides for the interests of all stakeholders is the best case scenario for the firm. If firm leadership understands how ownership is going to be handled now and in the future, they can be free to do their jobs and maximize the performance of the company. At the other end of the spectrum, buy-sell disputes are very costly to the organization, distracting the senior-most staff from matters of strategy and client service for years, and rarely ending with a resolution that compensates for lost business opportunities which may never even be identified.Non-owner employees. Not everyone in an investment management firm qualifies for ownership or even wants it, but all RIAs are economic eco-systems in which all employees depend on the presence of a stable and predictable ownership.Clients. It is no surprise that the SEC made ownership continuity planning part of its recent proposed regulations for RIAs. The SEC may not care, per se, who gets the benefits of ownership of an investment management firm, but they know that the investing public is best served by asset managers who have provided for the continuity of investment management in the event of changes in the partner base. Institutional clients are often very interested in continuity plans, so it is to the benefit of RIAs to have fully functioning ownership models with buy-sell agreements that provide for the long term health of the business. As the profession ages, we see transition planning as either a competitive advantage (if done well) or a competitive disadvantage (if disregarded) – all the more reason to pay attention.The point of all this is to consider whether or not you want your buy-sell agreement to create winners and losers, and if so, be deliberate about defining who wins and who loses. Ultimately, economic interests which advantage one stakeholder will disadvantage some or all of the other stakeholders, dollar for dollar. If the pricing mechanism in the agreement favors a relatively higher valuation, then whoever sells first gets the biggest benefit of that, to the expense of the other partners and anyone buying into the firm. If pricing is too high, internal buyers may not be available and the firm may need to be sold (truly the valuation’s day of reckoning) to perfect the agreement. At relatively low valuations, internal transition is easier and business continuity is more certain, but the founding generation of ownership may be perversely encouraged to not bring in new partners, stay past their optimal retirement age, or push more cash flow into compensation instead of shareholder returns as the importance of ownership is diminished. Recognizing and ranking the needs of the various stakeholders in an RIA is always a balancing act, but one which is probably best done intentionally.Buy-Sell Agreements and Contract TheoryThe 2016 Nobel Prize in Economics was awarded to Professors Oliver Hart (Harvard) and Bengt Holmstrom (MIT) for their work in developing contract theory as a foundational tool of economics. The notion of contract theory organizes participants in an economy into principals (owners) and agents (employees), although the principal/agent relationship can be applied to many economic exchanges.Agents act on behalf of principals, but those actions are at least partially unobserved, so contracts must exist to incentivize and punish behavior, as appropriate, such that principals can be reasonably assured of getting the benefit of compensation paid to agents. The optimal contract to accomplish this weighs risks against incentives. The problem with contracts is that all of them are incomplete, in that they can’t specify every eventuality. As a consequence, parties have to be designated to make decisions in certain circumstances on behalf of others.Contract theory has application to the design of buy-sell agreements in the ordering of priority of stakeholders in the enterprise. If the designated principal of the enterprise is the founding generation, then the buy-sell agreement will be written to protect the rights of the founders and secure their ability to liquefy their interest on the best terms and pricing. Redemption from a founder’s estate at a premium value would be an example of this type of contract.If, on the other hand, the business is the designated principal of the enterprise, and all the shareholders are treated as agents, then the buy-sell agreement might create mechanisms to ensure the long term profitability of the investment management firm, rewarding behaviors that grow the profits of the business (with greater ownership percentages or distributions or performance bonuses) and punish agent actions that do not enhance profitability.If the clients of the firm are the designated principals of a given RIA, then the buy-sell agreement might be fashioned to direct equity returns to agents (partners or non-owner employees) based on investment performance or client retention. An example of this would be carried interest payments in hedge funds and private equity.2. Don’t Value Your Stock Using Formula Prices, Rules-Of-Thumb, or Internally Generated Valuation MetricsSince valuation is usually the most time consuming and expensive part of administering a buy-sell agreement, there is substantial incentive to try to shortcut that part of the process. Twenty years ago, a client told us “asset management firms are usually worth about 2% of AUM.” We’ve heard that maxim repeated many times, although not so much in recent years, as some firms have sold in noteworthy transactions for over twice that, while others haven’t been able to catch a bid for much less.We have written extensively about the fallacy of formula pricing. No multiple of AUM or revenue or cash flow can consistently estimate the value of an interest in an investment management firm. A multiple of AUM does not consider relative differences in stated or realized fee schedules, client demographics, trends in operating performance, current market conditions, compensation arrangements, profit margins, growth expectations, regulatory compliance issues, and a host of other issues which have helped keep our valuation practice gainfully employed for decades.Imagine an RIA with $1.0 billion under management. The old 2% of AUM rule would value it at $20.0 million. Why might that be? In the (good old) days, when RIAs typically garnered fees on the order of 100 basis points to manage equities, that $1.0 billion would generate $20 million in revenue. After staff costs, office space, research charges and other expenses of doing business, such a manager might generate a 25% EBITDA margin (close to distributable cash flow in a manager organized as an S-corporation), or $2.5 million per year. If firms were transacting at a multiple of 8 times EBITDA, the value of the firm would be $20.0 million, or 2% of AUM.Today, things might fall more into the extremes of firms A and B, depicted in the chart below. Assume firm A is a small cap domestic equity manager earning 65 basis points on average from a mix of high net worth and institutional clients. Because a shop like that can earn a relatively high EBITDA margin of 40% or so, a $20 million valuation is a little less than 8x, which in some circumstances might be reasonable.Firm B, on the other hand, manages a range of fixed income instruments for large pension funds who are expert at negotiating fees. Their 30 basis point realized fee average doesn’t leave much to cover the firm’s overhead, even though it’s fairly modest because of the nature of the work. The 15% EBITDA margin yields less than a half million dollars in cash flow, which against the rule-of-thumb valuation metric, implies a ridiculous multiple. The real problem with short cutting the valuation process is credibility. If the parties to a shareholders agreement think the pricing mechanism in the agreement isn’t robust, then the ownership model at the firm is flawed. Flawed ownership models eventually disrupt operations, which works to the disservice of owners, employees, and clients.3. Clearly Define The “Standard” of Value Effective for Your Buy-Sell AgreementThe standard of value essentially imagines and abstracts the circumstances giving rise to a particular transaction. It is intended to control for the identity of the buyer and the seller, the motivation and reasoning of the transaction, and the manner in which the transaction is executed.Portfolio managers have a particular standard of value perspective, even though they don’t always think of it that way. The trading price for a given equity represents market value, and some PMs would make buying or selling decisions based on the relationship between market value and intrinsic value, which is what they think the security is worth based on their own valuation model. Investment analysts inside an RIA think of the value of their firm in terms of intrinsic value, which depending on their unique perspective could be very high or very low. CEOs, in our experience, think of the value of their investment management firm in terms of what they could sell it for in a strategic, change of control transaction with a motivated buyer – probably because those are the kinds of multiples that investment bankers quote when they meet with them.None of these standards of value are particularly applicable to buy-sell agreements, even though technically they could be. Instead, valuation professionals such as our group look at the value of a given company or interest in a company according to standards of value such as fair market value or fair value. In our world, the most common standard of value is fair market value, which applies to virtually all federal and estate tax valuation matters, including charitable gifts, estate tax issues, ad valorem taxes, and other tax-related issues. It is also commonly applied in bankruptcy matters.Fair market value has been defined in many court cases and in Internal Revenue Service Ruling 59-60. It is defined in the International Glossary of Business Valuation Terms as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.The benefit of a fair market value standard is familiarity in the appraisal community and the court system. It is arguably the most widely adopted standard of value, and for a myriad of buy-sell transaction scenarios, the perspective of disinterested parties engaging in an exchange of cash and securities for rational financial reasons fairly considers the interests of everyone involved.The standard known as “fair value” can be considerably more opaque, having two different origins and potentially very different applications. In dissenting shareholder matters, fair value is a statutory standard that varies depending on legal jurisdiction. In many states, fair value protects minority shareholders from oppressive actions by providing them with the right to payment at a value equivalent to that which would be received in the sale of the company. A few states are not so generous as to providing aggrieved parties with undiscounted value for their shares, but the trend favors not disadvantaging minority owners in certain transactions just because a majority owner wants to remove them from ownership. The difficulty of statutory fair value, in our experience, is the dispute over the meaning of state statutes and the court’s interpretations of state statutes. Sometimes the standard is as clearly defined as fair market value, but sometimes less so.If a shareholders agreement names the standard of “Fair Value”, does it mean statutory fair value, GAAP fair value, or does it really mean fair market value? It pays to be clear.The standard of value is critical to defining the parameters of a valuation, and we would suggest buy-sell agreements should name the standard and cite specifically which definition is applicable. The downsides of not doing so can be reasonably severe. For most buy-sell agreements, we would recommend one of the more common definitions of fair market value. The advantage of naming fair market value as the standard of value is that doing so invokes a lengthy history of court interpretation and professional discussion on the implications of the standard, which makes application to a given buy-sell scenario more clear.Which Fair Value?Making matters more complex, fair value is also a standard under Generally Accepted Accounting Principles, as defined in ASC 820. When GAAP fair value was originally established, members of the Financial Accounting Standards Board, which is responsible for issuing accounting guidance, suggested that they wanted to use a standard similar to fair market value but didn’t want their standard to be governed and maintained by non-related institutions such as the U.S. Tax Court.GAAP fair value is similar to fair market value, but not entirely the same. As GAAP fair value has evolved, it has become more of an “exit value” standard, suggesting the price that someone would pay for an asset (or accept to transfer a liability) instead of a bargain reached through consideration of the interests of both buyers and sellers.The exit value perspective is useful from an accounting perspective because it obviates financial statement preparers’ tendency to avoid write-downs in distressed markets because they “wouldn’t sell it for that.” In a shareholder dispute, however, the transaction is going to happen, so the bid/ask spread has to be bridged by valuation regardless of the particular desires of the parties.4. Avoid Costly Disagreement as to “Level of Value”Just as the interests and motivations of particular buyers and sellers can affect transaction values, the interest itself being transacted can carry more or less value, and thus the “level” of value, as it has come to be known, should be specified in a buy-sell agreement.A minority position in a public company with active trading typically transacts as a pro rata participant in the cash flows of the enterprise because the present value of those cash flows is readily accessible via an organized exchange. Portfolio managers usually think of value in this context, until one of their positions becomes subject to acquisition in a takeover by a strategic buyer. In a change of control transaction, there is often a cash flow enhancement to the buyer and/or seller via combination, such that the buyer can offer more value to the shareholders of the target company than the market grants on a stand-alone basis. The difference between the publicly traded price of the independent company, and value achieved in a strategic acquisition, is commonly referred to as a control premium.Closely-held securities, like common stock interests in RIAs, don’t have active markets trading their stocks, so a given interest might be worth less than a pro rata portion of the overall enterprise. In the appraisal world, we would express that difference as a discount for lack of marketability. Sellers will, of course, want to be bought out pursuant to a buy-sell agreement at their pro rata enterprise value. Buyers might want to purchase at a discount (until they consider the level of value at which they will ultimately be bought out). In any event, the buy-sell agreement should consider the economic implications to the RIA and specify what level of value is appropriate for the buy-sell agreement. Fairness is a consideration here, as is the sustainability of the firm. If a transaction occurs at a premium or a discount to pro rata enterprise value, there will be “winners” and “losers” in the transaction. This may be appropriate in some circumstances, but in most RIAs, the owners joined together at arm’s length to create and operate the enterprise and want to be paid based on their pro rata ownership in that enterprise. That works well for the founders’ generation, but often the transition to a younger and less economically secure group of employees is difficult at a full enterprise level valuation. Further, younger employees may not be able to get comfortable with buying a minority interest in a closely held business at a valuation that approaches change of control pricing. Ultimately, there is often a bid/ask spread between generations of ownership that has to be bridged in the buy-sell agreement, but how best to do it is situation specific. Whatever the case, the shareholder agreement needs to be very specific as to level of value. We even recommend inserting a level of value chart, like the one you see above, and drawing an arrow as to which is specified in the agreement. One thing to avoid in buy-sell agreements is embedded pricing mechanisms that unintentionally incentivize the behavior of some partners to try to “win” at the expense of other partners. We were involved in one matter where a disputed buy-sell agreement could be read to enable other partners to force out a minority partner and redeem their interest at a deeply discounted value. Economically, to the extent that a minority shareholder is involuntarily redeemed at a discounted value, the amount of that discount (or decrement to pro rata enterprise value) is arithmetically redistributed among the remaining shareholders. Generally speaking, courts and applicable corporate statutes do not permit this approach in statutory fair value matters because it would provide an economic incentive for shareholder oppression. By way of example, assume a business is worth (has an enterprise value of) $100, and there are two shareholders, Sam and Dave. Dave owns 60% of the business, and Sam owns 40% of the business. As such, Dave’s pro rata interest is worth $60 and Sam’s pro rata interest would be valued at $40. If the 60% shareholder, Dave, is able to force out Sam at a discounted value (of, say, $25 – or a $15 discount to pro rata enterprise value), and finances this action with debt, what remains is an enterprise worth $75 (net of debt). Dave’s 60% interest is now 100%, and his interest in the enterprise is now worth $75 ($100 total enterprise value net of debt of $25). The $15 decrement to value suffered by Sam is a benefit to Dave. This example illustrates why fair value statutes and case law attempt to limit or prohibit shareholders and shareholder groups from enriching themselves at the expense of their fellow investors. Does the pricing mechanism create winners and losers? Should value be exchanged based on an enterprise valuation that considers buyer-seller specific synergies, or not? Should the pricing mechanism be based on a value that considers valuation discounts for lack of control or impaired marketability? Exiting shareholders want to be paid more and continuing shareholders want to pay less, obviously. What’s not obvious at the time of drafting a buy-sell agreement is who will be exiting and who will be continuing. There may be a legitimate argument to having a pricing mechanism that discounts shares redeemed from exiting shareholders, as this reduces the burden on the firm or remaining partners and thus promotes the continuity of the firm. If exit pricing is depressed to the point of being punitive, the other shareholders have a perverse incentive to artificially retain their ownership longer and force out other shareholders. As for buying out shareholders at a premium value, the only argument for “paying too much” is to provide a windfall for former shareholders, which is even more difficult to defend operationally. Still, all buyers eventually become sellers, so the pricing mechanism has to be durable for the life of the firm.5. Don’t Forget to Specify the “As Of” Date for ValuationThis seems obvious, but the particular date appropriate for the valuation matters. We had one client (not an RIA) spend a quarter million dollars on hearings debating this matter alone. The appropriate date might be the triggering event, such as the death of a shareholder, but there are many considerations that go into this.If the buy-sell agreement specifies that value be established on an annual basis (something we highly recommend to manage expectations and avoid confusion), then the date might be the calendar year end. The benefit of an annual valuation is the opportunity to manage expectations, such that everyone in the ownership group is prepared for how the valuation is performed and what the likely outcome is given various levels of company performance and market pricing. Annual valuations do require some commitment of time and expense, of course, but these annual commitments to test the buy-sell agreement usually pale in comparison to the time and expense required to resolve one major buy-sell disagreement.If, instead of having annual valuations performed, you opt for an event-based trigger mechanism in your buy-sell, there is a little more to think about. Consider whether you want the event precipitating the transaction to factor into the value. If so, prescribe that the valuation date is some period of time after the event giving rise to the subject transaction. This can be helpful if a key shareholder passes away or leaves the firm and there is concern about losing clients as a result of the departure. After an adequate amount of time, it becomes apparent as to the impact on firm cash flows of the triggering event. If, instead, there is a desire to not consider the impact of a particular event on valuation, make the as-of date the day prior to the event, as is common in statutory fair value matters.6. Appraiser Qualifications: Who’s Going to Be Doing the Valuation?Obviously, you don’t want just anybody being brought in to value your company. If you are having an annual appraisal done, then you have plenty of time to vet and think about who you want to do the work. In the appraisal community, we tend to think of “valuation experts” and “industry experts”.Valuation experts are known for:Appropriate professional training and designationsUnderstanding of valuation standards and conceptsPerspective on the market as consisting of hypothetical buyers and sellers (fair market value mindset)Experienced in valuing minority interests in closely held businessesAdvising on issues for closely held businesses like buy-sell agreementsExperienced in explaining work in litigated mattersIndustry experts, by contrast, are known for:Depth of particular industry knowledgeUnderstanding of key industry concepts and terminologyPerspective on the market as typical buyers and sellers of interests in RIAsTransactions experienceRegularly providing specialized advisory services to the industryIn all candor, there are pros and cons to each “type” of expert. We worked as the third appraiser on a disputed RIA valuation many years ago in which one party had a valuation expert and the other had an industry expert. The resulting rancor bordered on the absurd. The company had hired a reasonably well known valuation expert who wasn’t particularly experienced in valuations of investment management firms. That appraiser prepared a valuation standards-compliant report that valued the RIA much like one would value a dental practice, and came up with a very low appraised value (his client was delighted). The departing shareholder hired an also well-known investment banker who arranges transactions in the asset management community. The investment banker looked at a lot of transactions data and valued the RIA as if it were a department at Blackrock. Needless to say, that indicated value was many, many times higher than the company’s appraiser. We were brought in to make sense of it all. Vetting a valuation expert for appropriate credentials and experience should focus on professional standards and practical experience:Professional Requirements. The two primary credentialing bodies for business valuation are the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA). The former awards the Accredited Senior Appraiser designation, or ASA, and the latter the Accredited in Business Valuation, or ABV, designation. Without getting lost in the weeds, both are substantial organizations that require extensive education and testing to be credentialed, and both require continuing education. Also well known in the securities industry is the Chartered Financial Analyst charter issued by the CFA Institute, and while it is not directly focused on valuation, it is a rigorous program in securities analysis. CFA Institute offers, but does not require, continuing education.Practical Requirements. Experience also matters, though, in an industry as idiosyncratic as investment management. Your buy-sell agreement should specify an appraiser who regularly values non-depository financial institutions such that they understand the dynamic differences between, say, an independent trust company and a venture capital manager. While there are almost 12,000 RIAs in the U.S., the variety of business models is such that you will want a valuation professional who understands and appreciates the economic nuances of your firm.In any event, your buy-sell agreement should specify minimum appraisal qualifications for the individual or firm to be preparing the analysis, but also specify that the appraiser should have experience and sufficient industry knowledge to appropriately consider the key investment characteristics of RIAs. Ultimately, you need a reasonable appraisal work product that will withstand potential judicial scrutiny, but you should not have to explain the basics of your business model in the process.7. Manage Expectations by Testing Your AgreementNo matter how well written your agreement is or how many factors you consider, no one really knows what will happen until you have your firm valued. If you are having a regular valuation prepared by a qualified expert, then you can manage everyone’s expectations such that, when a transaction situation presents itself, parties to the transaction have a reasonably good idea in advance of what to expect. Managing expectations is the first step to avoiding arguments, strategic disputes, failed partnerships, and litigation.If you don’t plan to have annual valuations prepared, have your company valued anyway. Doing so when nothing is at stake will make a huge difference if you get to a situation where everything is at stake. Most of the shareholder agreement disputes we are involved in start with dramatically different expectations regarding how the valuation will be handled. Going ahead and getting a valuation done will help to center, or reconcile, those expectations and might even lead to some productive revisions to your buy-sell agreement.Putting It All TogetherIf you have not yet crafted a buy-sell agreement for your RIA, you can see that there is much to consider. Most investment management firms have some shareholders agreement, but in many cases the agreements do not account for the many circumstances and issues briefly addressed in this whitepaper. That said, our advice is to first pull your buy-sell agreement out of the drawer and read it, carefully, and compare it to the commentary in this paper. If you don’t understand something, talk with your partners about what their expectations are and see if they line up with the agreement. Consider having a valuation firm review the agreement and tell you what they might see as issues or deficiencies in the agreement, and then have the firm appraised. If there is substantial difference of opinion in the partner base as to the value of the firm, or the function of the agreement, you know that you don’t actually have an agreement.On the positive side of the equation, a well-functioning agreement can serve the long term continuity of ownership of your firm, which provides the best economic opportunity for you and your partners, your employees, and your clients. Strategically, it may well be the lowest hanging fruit available to enhance the value of your company, and your own career satisfaction.WHITEPAPERBuy-Sell Agreements for Investment Management FirmsView Whitepaper

There are roughly 13,000 Registered Investment Advisors (“RIAs”) in the U.S., and each tailors its services to a unique set of clients and maintains an individualized business model. Be that as it may, most who call us face one common issue: ownership succession.Ownership can be the single biggest distraction for a professional services firm, and it seems like the investment management community feels this issue more than most. In Schwab’s 2019 Benchmarking Study, which surveyed 1,300 RIAs, a full 92% of respondents indicated that they were considering internal succession, but only 38% of firms have a documented path to partnership.Most investment management firms are closely held, so the value of the firm is not set by an active market.They are typically owned by unrelated parties, whereas most closely held businesses are owned by members of the same family.Compared to other industries, a greater-than-normal proportion of investment management firms have significant value, such that there is more at stake in ownership than most closely held businesses.Consequently, when disputes arise over the value of an interest in an investment management firm, there is usually more than enough cash flow to fund the animosity, and what might be a five-figure settlement in some industries is a seven-figure trial for these businesses.Avoiding expensive litigation is one reason to focus on your buy-sell agreement, but for most firms, the more compelling reasons revolve around transitioning ownership to perpetuate the firm and provide liquidity for retiring partners.Clients increasingly seem to ask us about business continuity planning—and for good reason.In times of succession, tensions can run high.Having a clear and effective buy-sell agreement is truly imperative to minimizing costly and emotional drama that may ensue in times of planned or unplanned transition.

The creation of buy-sell agreements involves a certain amount of future-thinking. The parties must think about what could, might, or will happen and write an agreement that will work for all sides in the event an agreement is triggered at some unknown time in the future. This article addresses the important characteristics of buy-sell agreements that are important for business owners and for attorneys advising them.What Do Buy-Sell Agreements Do?Buy-sell agreements are entered into between corporations and their shareholders to protect companies against disruptive, harmful, or nonproductive owners (including divorced spouses, competitors, disgruntled former employees and the like). They also provide protections for shareholders who may, for any number of reasons, depart the company. The estates of deceased owners need protection, as do shareholders who have been terminated, with or without cause.It is important that buy-sell agreements be entered into while the interests of the parties (the corporation and the shareholders) are aligned, or at least not sufficiently misaligned, that they cannot discuss the business and valuation aspects of their buy-sell agreements. To the extent possible, attorneys should encourage parties to enter into buy-sell agreements or to review their agreements and update them if they are out of date or circumstances have changed.What is known for certain is that once a trigger event has occurred, the interests of the parties (i.e., the buyer(s) and the seller(s)) diverge and agreement over the pricing and terms of necessary transactions can become difficult or impossible to achieve.Characteristics of a Good Buy-Sell AgreementFrom valuation and other business perspectives, buy-sell agreements generally incorporate several important aspects defining their operation. The list of characteristics of successful buy-sell agreements below is taken from my book, Buy-Sell Agreements for Closely Held and Family Business Owners.Require agreement at a point in time (before trigger events or other dissension) among shareholders of a company and/or between shareholders and the company. It may seem obvious, but if there is no agreement between the shareholders and the company, then there is no buy-sell agreement. Such agreements must be evidenced by a writing of the agreement and by the signatures of all parties who will be subject to the agreement. Agreement is not always easy to obtain. Shareholders have different backgrounds, financial positions, personal outlooks, and involvement with a business, so agreement is not automatic. However, it is important that attorneys continue to work with clients to encourage agreement and that business owners remain committed to reaching agreement and signing their buy-sell agreements.The point in time at which agreement is reached is the date of the signing of each particular buy-sell agreement.Relate to transactions that may or will occur at future points in time between the shareholders, or between the shareholders and the corporation.When the shareholders of a new venture come together to discuss a buy-sell agreement, it is foreseeable that many things can happen that will trigger the operation of a buy-sell agreement. Owners may quit, one may be fired, another may retire, one could die, still another could become divorced, and another could become bankrupt — to name a few.The owners can discuss these future potential trigger events and which ones they want to include specifically in their buy-sell agreements. It is important that all owners think seriously about these issues because, at the time a buy-sell agreement is being drafted, no one knows what might happen to him or to her or to any of the other owners. In other words, no one knows who will be a buyer and who will be a seller.When the owners of an existing enterprise come together to review their buy-sell agreement, they may know that some of the above-mentioned events have already happened in the lives of their fellow owners. They will know if the buy-sell agreement operated satisfactorily, or was triggered at all.For all owners of all enterprises, discussions about buy-sell agreements reflect a form of future thinking, which is sometimes (perhaps always) difficult. As Yogi Berra famously said: “The future’s hard to predict. It hasn’t happened yet.”Choices have to be made regarding buy-sell agreements. Ignoring the importance of these documents because it is difficult to future think about them is one choice. Based on over thirty years of working with businesses and business owners, ignoring the issue is not a good choice.Define the conditions that will cause the buy-sell provisions to be triggered. Most often, business owners think of death as the most likely trigger event for buy-sell agreements. It is actually the least frequent trigger event for most companies.Trigger events have to be defined specifically. Death is fairly obvious. However, firings can be with or without cause, and agreements may need to specify what happens in each circumstance. The parties to an agreement must future think a bit to anticipate what could happen and document the agreement appropriately. If this sounds like work, it is.Determine the price at which the identified future transactions will occur (as in price per share, per unit, or per member interest). Because of the diverging interests of parties following trigger events, this is one of the hardest parts of establishing effective buy-sell agreements. This is why many appraisers and other advisers to closely held businesses recommend appraisal with a pre-determined appraiser as a generally preferable pricing mechanism for substantial business enterprises.There are buy-sell agreements with fixed prices. Unfortunately, these agreements are seldom updated and are ticking time bombs. For a poster child example of what can happen with fixed price agreements, read here.Other buy-sell agreements contain formula pricing provisions. Unfortunately, we haven’t seen a formula yet that can reasonably value any company over time with changing conditions at the company, within its industry and markets, in the local, regional or national economies, and in all market conditions and interest rate environments.Then, there are what we call valuation process agreements, which provide for a valuation process to determine the price. Many agreements have an embedded multiple appraiser process which will not be exercised until the occurrence of a trigger event. These agreements, too, are fraught with potential pitfalls.We assert that the best pricing mechanism for most buy-sell agreements of successful closely held and family businesses is a single appraiser process where the appraiser is selected by the parties at the outset and provides an appraisal to determine an agreement’s initial pricing. The appraiser is then asked to provide reappraisals each year (or every other year at most) to reset the price for the buy-sell agreement.Determine the terms under which the price will be paid.Many buy-sell agreements call for the price determined under their terms to be paid by the issuance of a promissory note by the company. Quite often, the price determined by appraisal will be the fair market value of the interest. However, many notes defined in buy-sell agreements are not worth par, or their face amounts, so recipients end up getting less than fair market value for their interests.A promissory note might be worth less than par if it has a below market interest rate for notes of comparable risk. Often, there is no security for promissory notes issued in connection with buy-sell agreements, and no protection against future financings that are subordinated, leaving the promissory note less protected.Provide for funding so the contemplated transactions can occur on terms and conditions satisfactory to selling owners and the corporation (or other purchasing owners). This element is important and often overlooked.Life insurance is often considered as a funding mechanism for buy-sell agreements. One big problem is that the only time that life insurance is received is when an insured owner dies. However, death is the least likely trigger event for most companies. Firings, retirings, divorcings, disabilities, and other things happen with far greater frequency.Funding may come from a promissory note as discussed above. It can also come from outside financing if the company is able to obtain such financing. Sinking funds have their own issues, because a selling shareholder was present while any sinking fund was accumulated, and would likely desire to share in its value.Satisfy the business requirements of the parties. While buy-sell agreements have much in common, each business situation is different, and unique parties are involved. In the end, legal counsel must draft buy-sell agreements to address the business issues that are important to the parties. Clearly, establishing and agreeing on the key business issues and having them reflected in the agreement can be difficult. If the owners do not reach agreement on key business issues, no attorney can draft a reasonable document for the parties.All of the potential trigger events discussed above are business issues (and personal issues) for business owners. Other business issues could include the maintenance of relative ownership between groups of shareholders, the admission of additional shareholders, and other issues that may or not relate directly to potential future trigger events. Some family businesses add clauses in the event of a shareholder’s divorce to preclude the shares from being granted to a divorcing spouse who is not of direct lineal descent of the family.Provide support for estate tax planning for the shareholders, whether in family companies or in non-family situations.One client of many years has a buy-sell agreement and the family has engaged in significant gift and estate tax planning. Several years ago, the gift tax returns of the owners of a client company were audited. Agreement could not be reached with the Internal Revenue Service, and the matter proceeded on a path towards Tax Court. One of the key issues in dispute was whether the buy-sell agreement met the requirements of IRS Code Section 2703 (b). After much discussion and preparation for trial, agreement was reached that the buy-sell agreement withstood the exceptions (subparagraph (b)) to the general rule of Code Section 2703:(b) Exceptions Subsection (a) shall not apply to any option, agreement, right, or restriction which meets each of the following requirements: (1) It is a bona fide business arrangement. (2) It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth. (3) Its terms are comparable to similar arrangements entered into by persons in an arms’ length transaction.As part of the preparations for trial, I was asked to render a supplemental report on behalf of Mercer Capital to assist the court in analyzing the relevant shareholder agreements from business and valuation perspectives. Fortunately, the case settled on the eve of trial with agreement that the relevant agreement satisfied the requirements, and with settlement at the conclusions of fair market value issued by Mercer Capital for the relevant years. The issues raised by the relationship of buy-sell agreements and estate planning are important.Satisfy legal requirements relating to the operation of the agreements. Buy-sell agreements must be drafted such that they are legally binding on the parties to them. In addition, agreements must be drafted to comply with laws and/or regulations that may be applicable to their operation. Business owners must rely on legal counsel regarding such matters.Business owners must agree on the business and valuation issues relevant to their buy-sell agreements. However, those agreements must be memorialized by competent legal counsel, who should be involved in the discussions to begin with, together with estate planning counsel, other financial advisers and a qualified business appraiser.ConclusionBuy-sell agreements are business and legal documents that are created in the context of business, valuation and legal requirements. We need to engage in future thinking in order that our agreements will withstand not only the tests of time, but also potential challenges from the Internal Revenue Service.

[August 2016] The IRS released its long expected proposed regulations in regards to Section 2704 on August 2. The substance of this proposal, according to the IRS, is to regulate treatment of entities for estate and gift tax purposes. According to the summary the proposal is:“…concerning the valuation of interests in corporations and partnerships for estate, gift, and generation-skipping transfer (GST) tax purposes. Specifically, these proposed regulations concern the treatment of certain lapsing rights and restrictions on liquidation in determining the value of the transferred interests. These proposed regulations affect certain transferors of interests in corporations and partnerships and are necessary to prevent the undervaluation of such transferred interests.”Before we delve any deeper on this article, let’s clarify a few things up front:We are appraisers, not lawyers and we are neither qualified nor particularly interested in dissecting the proposal from a legal perspective. Our friends in the legal community can address that.This is a proposal that, as of the writing of this article, is not in effect, could change, or might never go into effect. (Nonetheless we aim to comment from a valuation perspective as if it does). With that said – what we hope to do in this post is to (i) give readers some context about the impetus of these proposed Section 2704 changes, (ii) share what these proposed changes are, and (iii) share what this might mean from a valuation standpoint.Background of the ProposalAccording to the IRS, treatment by taxpayers in regards to certain rights and transfers, as well as rulings of the Tax Court in regards to these rights and transfers have allowed taxpayers to avoid application of Section 2704. Representative of this sentiment, Page 6 of the proposal puts it this way when referencing Section 2704(b):“The Treasury Department and the IRS have determined that the current regulations have been rendered substantially ineffective in implementing the purpose and intent of the statute by changes in state laws and by other subsequent developments.”The areas that the IRS cites as no longer ineffective fall into three primary areas:2704(a). Specifically the area covering so-called “Deathbed Transfers” – whereby liquidation rights lapse upon death. The IRS cites Estate of Harrison v. Commissioner as an example of this. The IRS claims that such transfers generally have minimal economic effects, but result in a transfer tax value that is based on less than the value of the interest.2704(b). Inter-family transfers and specifically restrictions on liquidation for family interest transfers. Reasons for this include that courts have concluded that Section 2704 applies to restrictions on the ability to liquidate an entire entity, and not on the ability to liquidate a transferred interest in that entity. Also the IRS says state laws and utilization of “assignees” have allowed taxpayers avoid 2704.2704(b). Granting of insubstantial interests to non-family members (such as a charity or employee) to avoid application of the statute. The IRS says this needs to be changed, because, in reality, such non-family interests generally do not constrain a family’s ability to remove a restriction on an individual interest.Proposed Changes and AmendmentsIn light of this perceived avoidance and ineffectiveness of certain provisions in 2704, the IRS has proposed a number of new regulations including:Change the definition of a “controlled entity” to be viewed through the lens of an entire family including lineal descendants as opposed to individual(s).Amend the regulations to address what constitutes control of an LLC or other entity that is not a corporation, partnership, or limited partnership.Amend the regulations to limit the use of eliminating or lapsing rights (voting or liquidation rights) and limit the exception to transfers occurring three (3) years or more before death.Ignore transfer restrictions for minority interests and thus assume that they would be marketable, regardless of governing documents and/or state laws.Ignore the presence of non-family members with less than 10% of the overall equity value.Valuation ImpactThe IRS is not proposing changing the definition of fair market value. However, when applying fair market value under the constructs as contemplated in the proposed 2704 changes, there would be a smaller (or perhaps no) value delineation for minority interests as compared to enterprise value of an entity. According to the IRS’s position, this would prevent taxpayers from “undervaluing” transferred interests among family members. This, of course, runs in stark contrast to the marketplace, of which fair market value is supposed to be a reflection. The marketplace’s long track record on this is abundantly clear - it differentiates for minority interests as compared to the value of entire enterprises. Thus the proposed regulations essentially circumvent the levels of value for family members as defined in a “controlled entity.”If the proposal is adopted as contemplated, there will be a powerful incentive for families with businesses and investment holding entities to initiate or complete transfers before these regulations take effect (which is thought to be December 2016). If Mercer Capital can be of any assistance in light of this development, please contact us.

This article first appeared as a whitepaper in a series of reports titled Appraisal Review Practice Aid for ESOP Trustees. To view or download the original report as a PDF, click here. This publication provides general insight about emerging issues and topics discussed in recent forums and events sponsored by the ESOP Association (“EA”), The National Center for Employee Ownership (“NCEO”) and elsewhere. Much of the current discussion is related to general valuation discipline, but none are new to a longstanding agenda within the ESOP community. Heightened Department of Labor (“DOL”) attention and the recent settlement agreement concerning the Sierra Aluminum case are driving renewed discussion of numerous critical topics within the ESOP fiduciary domain. All guidance, perspective and other information contained in this publication is provided for information purposes only. The issues and treatments highlighted in this publication do not produce the same response from all ESOP professionals and valuation practitioners. Certain treatments and perspectives contained herein lack consensus in the valuation profession and may be addressed or treated using alternative rationales. This publication is not held out as being the position of or recommended treatment endorsed by the EA or the NCEO. The purpose of this publication is to alert and inform ESOP stakeholders and fiduciaries regarding the rising standards of practice and prudence in the valuation of ESOP owned entities.IntroductionIn recent years there has been increasing concern among ESOP sponsors and professional advisors (trustees, TPAs, business appraisers, legal counsel) regarding the scrutiny of the DOL, the Employee Benefits Security Administration (“EBSA”), and the Internal Revenue Service (“IRS”). These entities (and agencies thereof) are tasked with ensuring that ESOPs comply with the Employee Retirement Income Security Act (“ERISA”) as well as with various provisions of the federal income tax code concerning qualified retirement plans (including ESOPs). Citing concerns for poor quality and inconsistency in business appraisals, the DOL has sought in recent years to expand the meaning of “fiduciary” under ERISA to include business appraisers. In the most recent forums of exchange and deriving from various court actions, there are numerous areas of concern that DOL/EBSA appear to have regarding ESOP valuations. These areas of focus include but are not limited to:Valuation Issues Receiving Recent Attention and ScrutinyThe use of financial projections in ESOP valuationThe prevalence and manifestation of conflicts of interest concerning pre- and post-transaction advisory servicesThe use and application of control premiums in ESOP valuationThe valuation of and implications stemming from seller financing used in a great many transactions now coming under reviewThe poor quality of ESOP valuation reports and the attending inconsistencies between narrative explanations and methodological execution; and, The lack of or inconsistent consideration of ESOP repurchase obligation and how it interacts with ESOP valuationThese topics have received heightened attention from numerous committees of the ESOP Association including the Advisory Committees on Valuation, Administration, Fiduciary Issues, Finance, and Legislative & Regulatory. This paper will focus on the use of financial projections in ESOP valuations. While all of the cited issues are of importance, the use (or misuse) of financial projections is often the most direct cause of over- or under-valuation in ESOPs. Other Mercer Capital publications provide insight regarding control premiums, the market approach, and other important ESOP valuation topics.Projections Used In ESOP Valuations: Assessing Growth Rate Assumptions In ValuationBusiness appraisers who practice valuation using one or more credentials in the field are required to adhere to their respective practice standards (ASA, AICPA, NACVA, CFAI). Additionally, there are overarching standards and guidance that generally dictate to and govern the valuation profession and the general considerations and content of a business valuation. The Appraisal Standards Board of The Appraisal Foundation promulgates the Uniform Standards of Professional Appraisal Practice (“USPAP”) and the IRS issued Revenue Ruling 59-60 (“RR59-60”) more than 50 years ago.Collectively, these standards and protocols provide a basic outline for procedural disciplines, analytical methodologies, and reporting conventions. Specificity on the disciplines and procedures for vetting a financial projection (and growth rates in general) are generally lacking in the body of valuation standards, but that does not exempt appraisers and trustees from the core principle that a valuation must collectively (and in its constituent parts) constitute informed judgment, reasonableness and common sense.Traditional financial and economic comparative analysis suggest vetting a projection by way of studying it from numerous perspectives:How do the projections compare to the historical and prevailing financial performance of the subject enterprise being valued (“relative to itself over time”)?How do the forecasted results compare to the past and expected performance of peers, competitors, the industry, and the marketplace in general (“relative to others over time”)?How do the projections reflect the specific outlook and capacity of the subject enterprise (“relative to its specific opportunity”)?The answers to these questions provide the appraiser a foundation upon which to construct the other required modeling elements in the valuation. An appraiser may elect to disregard projections in the valuation process in situations where forecasted outcomes are deemed beyond the organic and/or funded capacities, competence, and/or opportunity of the subject enterprise. An appraiser may elect to consider justifiable risk and/or probability assessments, among other adjustments, that serve to hedge the projections and their respective influence on the conclusions of the valuation report. Regarding valuation and the general concern for rendering valuations that heighten an ESOP trustee’s anxiety for a sustainable ESOP benefit over time, many appraisers elect to capture only proven performance capacity, avoiding the counting of eggs with questionable fertility. If today’s projection proves excessive in the light of future days (when the DOL/EBSA comes calling), the concern for a prohibited transaction rises and poses significant risk and potentially fatal consequences for the plan and the parties involved.Discrete Projections versus Implied ProjectionsA complete, formal appraisal opinion requires the consideration of three core valuation approaches. These approaches are the Cost, Income, and Market Approaches. Generally speaking, valuations of business enterprises using the Income or Market Approaches contain either an explicit projection in the methodology or capture an underlying implicit projection embedded in (or implied by) a singular perpetual growth rate assumption or in a singular capitalization metric. Appraisers and reviewers that fail to recognize this are simply blind to the basic financial mechanics of income capitalization. Accordingly, the concern for projections, in the view of this practitioner, extends beyond the discrete modeling of cash flow to the broader domain of growth in general. For the sake of further discussion, assume the following comments relate specifically and only to the Income Approach and its underlying methods.Discounted Cash Flow Method versus Single-Period CapitalizationThe size and sophistication of the subject enterprise often dictates whether or not an appraiser will enjoy the benefit of management-prepared projections. Projections are often crafted for purposes of promoting operational and marketing outcomes, or for satisfying the reporting requirements that many companies have with their lenders, shareholders, suppliers and other stakeholders. In cases where the subject enterprise is small and its performance subject to unpredictable patterns, appraisers commonly employ a single period capitalization of cash flow or earnings. In lieu of a series of discrete cash flows projected over the typical five-year future time horizon, the appraiser simply employs a measure of current or average performance and applies a single-period capitalization rate (or capitalization multiple as the case may be) in order to convert a base measure of cash flow directly into an indication of value. Seeking not to speculate on a finite sequence of future growth rates, many appraisers employ a rule-of-thumb mentality by correlating cash flow growth to a macroeconomic, inflationary, or industry-motivated rate, often ranging from 3% to 5%. In many instances this could be appropriate; in others it could reflect surprisingly little attention regarding the most basic long-term market externalities and/or internal opportunities of the subject company.The veil of a single-period capitalization approach does not relieve the appraiser from examining the various combinations of growth that could reasonably apply to the base measure of cash flow assumed in an appraisal. Many appraisers are of the mind that in the absence of management-prepared projections, no discrete projection can be developed and thus no Discounted Cash Flow Method can be employed. In lieu of fleshing out the dynamics of operational cash flow, the required capital investments, working capital needs, or the cash flow benefits deriving therefrom, the appraiser simply defaults to the time-honored single period capitalization of cash flow and calls it a day. The binary position that an appraiser cannot prepare cash flow projections lacks credibility and in some cases is simply flawed thinking. Furthermore, any appraiser that applies a perpetual growth rate assumption to develop a capitalization rate is, in fact, asserting a projection over some projection horizon. This is the simple and inescapable mathematical construct that is the Gordon Growth Rate Model. With all due respect and concern about projections - appraisers, trustees and regulators must recognize the inherent projection represented by a perpetual growth rate assumption in a single-period capitalization method. In essence, there is no income approach without either an explicit or implicit projection of future cash flows.Performing Due Diligence On Company Issued ProjectionsImagine you are a trustee tasked with reviewing an ESOP valuation prepared by the plan’s “financial advisor.” Business appraisers in their role as the trustee’s financial advisor issue opinions of value they believe to be supported by the facts and circumstances, but ultimately the appraisal of the plan assets is the trustee’s responsibility. How can the stakeholders and fiduciaries of an ESOP gain understanding and comfort in projections prepared by the Company and employed by the appraiser?The foundation begins with the general process of examining historic and prospective growth. Company projections must make sense to gain inclusion in the valuation of an ESOPowned company. A disconnect or sudden shift (whether in magnitude, trend or directionality) in expected performance is a red flag that requires specific explanation. Absent a sound rationale for a significant change in the pattern of future performance, projections that seem too good (or too bad) to be true must be reconciled with management and potentially disregarded in the appraisal process.Not all projections are created equally. Some are prepared for budgetary purposes and are constrained to a single year of outlook. Projections may be prepared for many reasons including the study of operational capacity, financial feasibility concerning capital investments, debt servicing and lender requirements, sales force management, incentive compensation, and many other reasons. Projections may be the product of a bottom-up process (originating in the operational ranks of the business) or may originate as a top-down exercise (descending from the C suite).Business appraisers cannot be indiscriminate in their employment of forward-looking financial information. Understanding the goals, intentions, motivations, and possible shortcomings of a budget or projection is vital to assessing the viability of a direct or supporting role for the projections in the valuation modeling. The nature and maturity of the business are also significant to understanding and troubleshooting a projection. For the sake of further commentary we will assume that most ESOP companies are relatively mature and not subject to the intricacies and uncertainties of valuing a start-up business (albeit, even mature business can experience significant swings in business activity).Projection Due Diligence InquiriesWho prepared the projections?What is the functional use or purpose of the projection?How experienced is the Company in preparing projections?When were the projections prepared?Do the projections incorporate increased (new) business, and if so, in what manner is the new business being generated?Do the projections reflect the discontinuation of specific segments of the revenue stream?Are the financial projections reconciled to or generated from a meaningful expression of unit volume and pricing?Does the company operate as the exclusive or concentrated agent for certain suppliers and/or customers?How does the company’s current projection reconcile to past projections?How closely does the company’s most recent actual performance compare to the prior year’s projection?Does the projection depict a transition in industry or economic cycles that may justify near-term abrupt shifts in expected outcomes?How comprehensive are the projections and the supporting documentation?What are some typical warning signs that a projection may be too aggressive or pessimistic?Who prepared the projections?A bottom-up process whereby front-line managers project their respective business results, which are then combined to create a consolidated projection, is often the most informative projection. Motivation mindset can be important as many projections are designed to “under-promise” results. Conversely, some projections are deliberately overstated to impart a mission of growth or goal-oriented outcomes. Projections that emanate and evolve through multiple levels of an organization are typically subject to more checks and balances than projections that originate in the vacuum of a single executive’s office. Conversely, such a process can also depict an organizational mob mentality that could distort reasonable expectations.A CFO’s budget may vary significantly from the sales projection of a sales manager or the projections of a senior executive. In some cases, an appraiser may review projections prepared for a lender that vary from a strategic plan projection. Often the differences can be reconciled. Projections prepared for external stakeholders such as lenders and as communicated to shareholders and possibly endorsed by a board of directors are likely to be the most relevant and appropriate for the valuation.If numerous projections exist, the trustee and appraiser are best advised to inquire about the outlook that best reflects a consensus of the most likely outcome as opposed to aspirational projections that are tied to new and/or speculative changes in the business model. In a recent engagement, a client was deploying significant capital to extend core competencies into adjacent markets. Rather than the hockey stick of growth most typical of such projections, this client’s net cash flows were relatively neutral in the foreseeable future because they included significant capital and working capital investment, which effectively paid for increased business volume. The premise behind their strategy was simply one of being larger and more diverse under the assumption that size and diversity facilitated a less risky business proposition and a broader range of potential long-term outcomes for the business.What is the functional use or purpose of the projection?Functional use is often linked to who prepares the projection. Be wary of projections that may intentionally (or as a byproduct of purpose) under or over shoot actual expected forecast results. In many cases a bottom-up projection process receives the review of senior management before becoming a functional element of business planning and accountability.How experienced is the Company in preparing projections?Are past projections reconciled to actual results with adequate explanation for variances? Firms with consistent and organized processes often produce more informative projections. Granted, a company may consistently under or over perform their projection. The quality of a projection may be better measured by its consistency over time than by its ultimate accuracy in a given year. One clue to the experience and care taken in the projection process is the model underlying the projection itself. For example, was the forecast model developed using numerous discrete modeling assumptions (such as year-to-year growth, and year-to-year margin) or from more global assumptions that are carried across all years in the projections? While modeling complexity can serve to obscure and is not automatically a sign of a well-developed projection, the inability of a projection model to be adapted quickly to alternative scenarios and assumptions may be a sign that the model was not studied for its sensitivity and reasonableness. A projection that appears to be “living” and easily modified could be a sign that the company actually uses the projection and modifies it in real time to assess variance and to modify assumptions as business conditions evolve and change. Appraisers and trustees should empower themselves with the ability to study the sensitivity and outcomes of a projection. Projections that lack detailed growth and margin details (year-to-year and CAG) should be replicated and/or reverse engineered in some fashion to facilitate basic stress testing and/or sensitivity analysis before the appraiser simply accepts the projections.When were the projections prepared?In general, valuation standards call for the consideration of all known or reasonably knowable information (financial, operational, strategically or otherwise) as of the effective date of the appraisal, which for most ESOPs is the end of the plan year. As a matter of practicality, financial statements (audits and tax returns) are not prepared for many months subsequent to the plan year end. Likewise, projections are often compiled in the first few months of the following year and may be influenced by the momentum of activity after the valuation date.Appraisers typically cite financial information delivered after the valuation date to be known or knowable and projections, while potentially exposed to a hint of subsequent influence, are often integrated without much question regarding their timeliness to the valuation date. In many cases, clients struggle to get information to us in order for their 5500s to be filed in a timely fashion (typically July 31st). In most cases we find that projections prepared after the end of the plan year are perfectly fine to employ. We inquire with management if there are aspects of the projection that were influenced by subsequent events and if so, with what degree of certainty could the subsequent event or activity have been expected at the valuation date. In some situations it may be advisable or reasonable to alter a projection’s initial year due to subsequent influences; typically the more distant years of a projection follow a pattern of knowable expectation unless there has been a material subsequent event that alters the global posture of the business. If a material subsequent event occurs that is not factored into the projections, then as a matter of common sense, the appraiser may elect not to perform a DCF, or better yet, may request that the projections be modified to take the event into financial consideration so that a DCF can be more accurately informed regarding changes in business posture.Do the projections incorporate increased (new) business, and if so, in what manner is the new business being generated?If a projection reflects a pattern of significant change in business activity, it is vital to consider whether new business represents an extension or replication of past expansions. If the company has proven the ability to expand and absorb new business (territory, staffing, productive capacity, etc.) then a projection depicting such an increase is likely reasonable, but should be gauged by past similar experiences whenever possible. And, any business expansion must be reflected in the investment and working capital charges applied to develop net cash flows. We refer to this as “buying the growth” – remember there is no free lunch.Projections with significant topline and profit growth must reflect adequate investment. This investment may take the form of the organic investment in the existing business lines or strategically by way of acquisition. If the projections include a speculative expansion into new revenue areas, the appraiser should properly assess the likelihood of successfully achieving the projection. Business extensions into logical adjacencies which leverage pre-existing supply and customer relationships may be more believable than the widget company whose projections include entry into the healthcare industry.In cases where projections include speculative ventures, the appraiser has numerous potential treatments that can temper speculative (high-risk) contributions, essentially replicating the framework applied in the valuation and capital raising processes for start-ups or early-stage companies. In some cases the appraiser may request the projection be revised to eliminate contributions from new growth projects that lack adequate investment or are simply too speculative to consider until they become observable in the reported financial results of the business. In some rare cases, not only is the projection hard to believe, but concerns are compounded by the risky and foolish deployment of capital. Betting the farm on the next reinvention of the wheel is not the making of a sustainable ESOP company.Perhaps it’s a dirty little secret in the hard-to-value world of closely held equity, but valuations using the standard of fair market value (as called for under DOL guidance) are inherently lagging in nature and typically less volatile than is the stock market or the public peers to which a company may be benchmarked. This is generally a function of regression to the mean captured in virtually every conservatively constructed projection and DCF model. The terminal value of a DCF is effectively a deferred single period capitalization using the Gordon Growth Model and often comprises 50% or more of the total value indicated under the method. Near-term performance swings (whether favorable or not) get smoothed out in the math of the terminal value calculation. As depicted in the appended growth scenarios and projection modifications, the regression of future performance to a targeted benchmark can have a similar influence on valuation as the old-guard habit of using historical averages in a single period capitalization method. The primary valuation differences between such a DCF and single period capitalization stem from the specific cash flows during the discrete projection period (years one through five).Do the projections reflect the discontinuation of specific segments of the revenue stream?A sound reason for employing a DCF model is to capture the pro forma performance of a business based on its going-forward revenue base. Most mid to large sized businesses, particularly mature ESOP companies, experience contraction and rationalization of business lines and markets over time. In many cases, the valuation might reasonably improve based on the discontinuation of unprofitable operations and the recapturing of poorly deployed capital. However, care must be taken to understand how all P&L accounts from revenue down to profit are affected by changes in facilities, products, services, staffing, etc. Projections that pretend unsupportable improvement by way of the deletion of a relatively small portion of the business lines are inclined to excessive optimism and may suggest the belief in bigger issues that management deems too daunting to fix. Regarding profitability, so-called “addition through subtraction” is similar to the concern public market investors have with public companies that cut expense merely to manufacture earnings in the near term.As the maxim goes, you can’t cut your way to success in the business world.Are the financial projections reconciled to or generated from a meaningful expression of unit volume and pricing?Financial projections that lack an operational perspective can be difficult to assess. Not all business are margin based, many are spread based – meaning that profits are more of a function of a nominal spread over cost as opposed to some percentage of sales. This is particularly true of service businesses, financial services entities, and commodity driven operations. Accordingly, neither past nor future performance can be properly understood without some idea of how much stuff is getting sold and at what price. In many cases, the required comfort level of a projection simply cannot be reached without it. Breaking revenue into primary volume and price components, as well as further into its departmental or categorical groupings, allows appraisers and trustees a better understanding of the projection and its relation to past performance and market expectations. Revenue per full-time equivalent employee, units produced per labor hour and many other performance metrics are helpful in teasing out reality from a potentially fictional projection.Does the company operate as the exclusive or concentrated agent for certain suppliers and/or customers?Our comments here exclude the consideration of risk associated with high levels of concentration on the rain-making parts of a business – such considerations are often tackled in the appraiser’s assessment of the cost of capital by way of firm-specific risk.Many dealerships, distributors, parts manufacturers, fabricators and service companies owe their existence to market demand created by their suppliers and customers. Many companies service the needs of customers and suppliers by effectively outsourcing some aspect of their respective industry model to an external provider. For example, a producer of value-added materials may use an external company to provide sales and logistical support to get product to its end users (i.e. classic bulk breaking, repacking and transportation). Regardless of which leg of the multi-leg industry the subject business may represent, the assessment of projected growth should include a consideration of what is happening to suppliers and customers (the other legs of a common stool). This same path of inquiry serves the dual purpose of understanding the risk side of the valuation equation. If these multiple legs of consideration don’t reconcile, the projection could prove too unstable for use in the valuation.How does the company’s current projection reconcile to past projections? How closely does the company’s most recent actual performance compare to the prior year’s projection?Studying projection variance can be a highly useful tool in communicating about value and in assessing the correlation between expectations and actual results. Let’s face it - we all like it when people do what they say they are going to do. But the first thing we know about any projection today is that it will be wrong tomorrow. Variances need to be explained and reconciled against the continuing willingness of the appraiser (and the trustee) to employ projections moving forward. Providing financial feedback to management and the trustee during the process of due diligence and in the form of a valuation can help refine the projection process over time. Just as we reserve the right to improve how we do things in the valuation world, so too must our clients have the leeway to refine and improve their processes.Valuation is a forward looking (ex-ante) discipline. History can be highly instructive regarding how projections are scrutinized in real time. Projections that under-promise and over-deliver tend to undervalue companies in real time. Conversely, projections that over-promise and under-deliver can lead to an over-statement of value. In the case of the later occurrence, most appraisers operate under the axiom of “fool me once shame on you, fool me twice shame on me.” Ultimately, attempts at value engineering via optimistic projections need to be balanced with an equal measure of devil’s advocacy from both appraiser and trustee. Ultimately, a DCF model views the impact of any projection through a risk-adjusted lens. The process of hedging a projection generally begins with an observation of historical variances in projected performance and actual results over time, with the primary emphasis place on most recent periods. Projections that appear to overshoot are often hedged either through risk assessment, probability factoring, or a more exotic multi-outcome analysis.Does the projection depict a transition in industry or economic cycles that may justify near-term abrupt shifts in expected outcomes?In recent decades the concept of the traditional five-year business cycle lost favor in some circles. Thought evolution evolved to encompass a lengthier cycle of ten years, mitigated volatility (not so high and not so low as in the past), higher fundamental causation (such as globalization) versus the classical cyclical drivers (such as swings in productivity), continuing evolution of the information sector, disruptive technologies, and since the early 2000s, the persistence of and sensitivity to geopolitical and terrorist events. Then along came the debt crisis followed by the great recession. Lessons of business cycles past have now garnered renewed attention and distant economic history seemed more relevant despite the modernization, globalization and regulation of the economy.Presently, we are witness to a reasonably stable economy that is slowly being weaned from years of fiscal and monetary life support and subsidization. For us business appraisers, we are beginning to lock in on the new norms of our clients’ businesses. For the last many years, our clients were reticent to speculate on a projection (“no visibility”). Many clients recall with anger and humility the great glory projected from atop the last peak cycle in 2006. Almost a decade later, many have finally re-achieved their former glory. Many others can only look up from the corporate grave. From this point forward we can only assume that some version of the business cycle is still with us. Many are now disposed to the concept of a prolonged period of relatively modest and unevenly distributed economic performance, similar to the patterns demonstrated by Japan and characterized as “secular stagnation.” The academicians can argue about how to brand it; valuations professionals and ESOP Trustees are faced with how to consider it in our valuations.Speaking from personal experience, there is a greater appreciation for industry cycles as opposed to macroeconomic cycles. Given such, we see companies vacillate between boom and bust based on numerous underlying elements and drivers that are not purely correlated to the overall economy. Recall the classic business cycle (peak / contraction / trough / expansion / peak). Appraisers and trustees must be attentive and weary of projections that cannot be supported by reasonable facts and circumstances. Some may wonder - when are projections unrealistic? The truthful answer often includes the echo: “not sure, but I know it when I see it.”Companies emerging from the trough of a business/industry cycle may have unusually robust projections. High growth during a period of recovery does not constitute grounds for the dismissal of the projection. Likewise, declining growth from a peak level of performance is not necessarily overly pessimistic. As discussed in the growth scenarios studied in the appended examples, regression to a mean level of future expectation can be achieved in varying ways. The concern for appraisers and trustees alike is the comfort and common sense of near-term expectations relative to recent performance and the level of steady-state performance assumed in the terminal value modeling of the DCF. Ex-post and ex-ante trend analysis, as well as benchmarking to relevant indices from both public and private sectors is vital to establishing the context of a specific projection.On the weight of evidence and common sense, if a projection is highly contrary to external expectations and lacks symmetry with the proven capabilities of the company, appraisers and trustees are cautioned from directly using the projection. An alternative approach for employing the projection is iterating the discount rate and terminal value modeling assumptions required to equate the DCF value indication to value indications developed from other methods (past and present). There are many instances when data lacks reliability during a given period or cycle. In such cases we tend to study the information and reconcile it to the alternative valuation results deemed more reliable. In this fashion we alert the report reviewer that projections exist that may appear contrary to the weight of history and/or external expectations.How Comprehensive are the Projections and the Supporting Documentation?Are the projections lacking detail and limited in supporting documentation? Projections that are not integrated into a full set of forward looking financial statements and that lack explanation for critical inputs may be unreliable or require significant augmentation before being integrated into a DCF valuation model. As a matter of practicality, many companies do not project more than a simple income statement. Does the lack of a balance sheet and a cash flow statement automatically exclude the projection from consideration? Not in my view, however, under many circumstances there could be a need for augmentation to consider numerous significant aspects required to develop the typical DCF model. These considerations include:Capital expenditures, which initially decrease cash flow before generating the returns that constitute future growth. Not only is the dollar amount a significant consideration, but the capacity/volume effect of physical additions relates to future growth modeling.Incremental working capital requirements, which typically absorb a portion of growth dollars in perpetuation of higher operating activity, or which may accumulate on the balance sheet in a downturn when demand for financial resources can temporarily decline.In cases where a DCF is used to directly value the equity of an enterprise, changes in net debt must be captured. Are the cash flows sufficient to cover the company’s term debt and line of credit obligations? Are new sources of debt capital required to support capital and working capital grow?Collectively, these cash flow attributes can have a significant effect on the discrete cash flows of an entity during the projection. Absent a balance sheet and/or cash flow statement, the impact of these considerations may be difficult to properly assess. In cases where the business is not deploying significant new capital and the projection is following a more or less mature pattern, capital expenditures and incremental working capital may be easily determined based on historical norms and comparative analysis with peer data. Accordingly, a full detailed projection of the balance sheet may not be required to develop reasonable modeling and outcomes. As always, a vetted and complete projection of the financial statements is desirable. Supporting documentation can take numerous forms. Reconciliation of modeling assumptions to external drivers, operating activities, market pricing, throughput capacity, supplier expectations and trends, bellwether industry peers and market participants, downstream and upstream expectations and many other supporting considerations is always helpful but generally lacking for many projections. Often, a review of the projections using such benchmarks leads to a modification or adjustment of the projections by management. In this fashion, the appraiser’s and/or trustee’s review serves to effectively adjust the projections before and/ or during their use in a DCF model – thus the need for a flexible and adaptive modeling platform built from the projection.What are some typical warning signs that a projection may be too aggressive or pessimistic?A baseline for assessing reasonableness or believability is always a good first step. A graphic representation of revenue, EBITDA and key volume measures can assist a reviewer in studying the reasonableness of a projection. Supernormal and/or counter-trend activity requires a compelling justification. Let’s use the information in the following graphic as a baseline for demonstrating some fundamental curiosity and addressing some basic questions regarding reasonableness. The five-year trend for adjusted EBITDA at the valuation date reflects a pattern of strong growth (illustrated by the dotted blue line in Figure 1), but at a decelerating rate (illustrated by the columns in Figure 1). The projected annual growth rate for each of the next five years is 10%. In this case, management represents that the 10% annual growth projection is based on the compound annual growth rate for the five years leading up to the valuation date. This is an all too familiar “technical” rationale for growth forecasting. However, it begs the question of why the decelerating trend would suddenly flip favorable as opposed to continuing its decline or perhaps stabilizing at the most recent level of modest growth. Of course, the current trend could mature as a contraction in performance before an upturn that repeats the prior cycle. Figure 1 depicts a wide variety of plausible alternative projections based on a technical review of the trend and a healthy dose of analyst scrutiny of management’s optimistic projection. The projection provided by management could easily be an order of magnitude overstated relative to other plausible outcomes. If EBITDA growth remains at the most recent rate (5% annually) then management’s projection is overstated 25% by year five (the orange dotted line). If EBITDA flatlines at current levels management’s year five projection is overstated by 60% (the black dotted line). If the deceleration of growth actually turns to a steady contraction (5% annually) then management’s projection is almost 100% overstated. If a modest near-term contraction is followed by a renewal of the previous growth cycle (the green dotted line), then management’s base 10% annual growth projection is overstated by 35% in year five. We could iterate infinite variations in future outcomes, but I submit that the variations shown above stem from a reasonable risk averse, conservative framework. The real concern is how well the projection reconciles to external and internal drivers that have proven to influence past business outcomes and/or drivers that are virtually assured to influence future outcomes. In the present case example, the platform of management’s projection is built on the prevailing economy (generally favorable but inconsistent growth) and involves a market-beta industry (highly correlated to the overall economy). More specifically, the subject company is a construction contracting concern whose early growth began from a deep trough in the cycle, then was temporarily juiced with shovel-ready government funded activity which eventually dried up as the general economy stabilized. New norms are uncertain but project budgets and financings are expected to be more difficult as real interest rates become more than zero and underwriting hurdles remain quite high. In this light, a simple extension of the five-year CAG into the future for five more years appears to ignore the decelerating trend. Absent specific contracts and backlog, industry-based drivers, and perhaps geographic hotbeds of significant in-migration, management’s projection outcome appears over optimistic if not outright aggressive. Projections that appear contrary to external trends and opportunities and which are not reconciled to the company’s capacity (whether existing or planned with the associated capital required) may need to be disregarded in the valuation process. Alternatively, the appraiser and trustee could view the projections with heighten concern for their realization and elect to effectively hedge the projections using appropriate discount rates, probability assessments, or other treatments that mimic the behavior of hypothetical investors. Ultimately, the reliance or weight placed on a projection based valuation method demonstrates the comfort of the appraiser/trustee with the method. If the final weights or reliance are placed on alternative valuation methods with materially different value indications than the DCF, the appraiser/trustee is effectively disregarding or modifying the projection. Surely, every valuation conclusion, under any valuation approach or method, has an underlying implied projection through which the same value outcome is produced.Rules Of Thumb For Growth RatesRecent Macro-Economic HistoryAssuming a company’s growth and/or projected financial performance is highly correlated to general macroeconomic growth is often an underpinning of long-term sustainable growth rates. Care must be taken when observing data reported from government agencies as such data can be “real” or “nominal” in quantification. Real rates are generally representative of movements net of the influence of inflation and nominal growth is generally total growth including inflation. Accordingly, growth rates in valuations that mirror inflation are effectively zero real growth rates. Gross domestic product is almost always reported and discussed in real terms, meaning the addition of a long-term inflation rate is typically called for in cases where the appraiser/trustee considers a company’s performance to be similar to that of the overall economy. For perspective, Figure 2 presents the history of economic cycles and the more recent performance of real GDP over the last several years (Figure 3). On the basis of inflation of approximately 2.5% in recent years, nominal overall economic growth has approximated 4.5% to 5% subsequent to the great recession. Ah, the rule of 5% +/- for growth. There is a wide variety of alternative economic measures and subsets of GDP that could serve as a proxy for long-term sustainable growth in most valuations. Of course, such growth rates may fail to capture all the underpinnings of a given industry or market and may also fail to recognize the specific financial and operational details of a given company. Most companies tend to grow in phases as capital investment, hiring, product offerings and other business attributes evolve over time. This discussion could extend to an infinite spectrum of data and benchmarks.Equity Market PerspectiveAppraisers employ various tools and data resources to determine the appropriate cost of capital for use in a valuation. Employing a bit of analytical deduction using the disciplines of the Capital Asset Pricing Model and the Gordon Growth Model, one can observe some tendencies regarding the markets’ implied earnings growth expectations. One of the most frequently employed resources is the annual Morningstar/Ibbotson SBBI publication. Given this data, and an assumed range of price-to-earnings ratios, one can deduce the implied perpetual earnings growth rates embedded in the market’s pricing over time. This framework can be applied to a specific company, a group of companies, or an industry. The example in Figures 4 and 5 demonstrates market-based influences regarding analyst predispositions about earnings growth over time. As with other tools and sensitivity analyses in this publication, changes to the inputs can result in significantly different outputs. Relative to the growth dynamics of the different sized public companies depicted in the preceding table, it’s no wonder that the closely held, mostly mature, mid-market companies typically seen in the ESOP world (with enterprise values ranging from $10-$500 million) are imbued with net cash flow growth rates on the order 3% to 5% in the appraisal process (the “comfort zone” ). However, the timing of growth during the projection can be significant to a DCF value indication and can also influence growth rates in single-period capitalizations to measures outside of the comfort zone.Framework for Studying Projections and Growth Rate AssumptionsBy convention, virtually all business valuations include a presentation composed of five years of historical financial performance. Depending on the nature of the underlying financial reporting of the sponsor company, the presentation will include balance sheets, income statements and cash flow statements. The notes to the reported financials may also contain a myriad of underlying detail and disclosures supporting the chart of accounts displayed on the core financial exhibits. Commonly, these financial exhibits are augmented with derivative analysis to study the common size (percentage of assets) balance sheets, common size income statements (historical margins expressed as a percentage of revenue), financial ratios, peer/ industry data sets, and year-to-year and compound annual growth rate measurements.The foundation for studying the reasonableness (or believability) of a forecast derives from a firm grasp of the relevant history of the subject enterprise. The reported financial statements are often recast to reflect the proper historical base from which most projections are cast. Ultimately, the valuation methodology captures the adjusted, pro forma financial performance and position of the company that serve as the appropriate base from which forecast results are projected to emerge.Financial history is not the only context for vetting projections. To the extent possible, the financial exhibits should be annotated and/or augmented with operational data (and graphics) that allow the appraiser to demonstrate and consider how the company’s activities relate to its financial performance. In addition to common size financial data, revenue and profit segmentation can be critical to understanding what aspects of a business are performing well and what parts are hindering results. In addition to perspectives on revenue mix, the report should also reflect a functional unit volume analysis that promotes an understanding of how pricing and activity volumes drive revenue and profitability. In turn, these observations help inform the appraiser about the physical capacities, break even levels, labor resources, and other aspects of the business model and operational flows that should dove-tail with the projections.For example, if a projection implies that a business will exhaust its current operating capacities or markets, then an adequate and properly timed charge to cash flow for capital expenditures should be included in the forecast to promote continued growth. Otherwise, little or no growth (beyond the price component of revenue) should be reflected in the model. Additionally, the duration of the discrete forecast should span the number of periods required for the company’s operating and financial performance to reach a reasonable normative state from which a steady level of continuing performance can be expected. Thus, a five-year projection may require augmentation of a few periods to regress a high-growth model to a mature state, or a negative growth model to a new state of sustainable performance. Ultimately, the timing of when growth occurs can be an important value determinant in a DCF model as well as a vital consideration to developing a perpetual growth rate for cash flow.When assessing a perpetual growth rate assumption, which is required in a single-period capitalization of earnings or net cash flow, one key to estimating a reasonably correct growth rate is an understanding of the internal and external factors that drive the assumption. While some appraisers are of the mind that projections cannot or should not be developed by an appraiser; surprisingly there is no debate as to the requirement of postulating a perpetual growth rate. These seemingly different disciplines are in fact one in the same. Arguably, an appraiser seeking to quantify or justify a perpetual growth rate must employ elements of the DCF mentality to define what that growth rate should be. Of course, the base amount of the cash flow is a vital starting point. For those appraisers who gravitate to the 3%-5% perpetual growth rate range, the use of a multi-period cycle-weighted historical average of cash flow can create a significant error in the valuation.Let’s construct a simple example to demonstrate the valuation issues that could result from two different historical conditions that have the same average of performance. As crazy as it may be in practice, it is not uncommon for appraisers using multi-period averages to effectively ignore prevailing conditions and use a nominal long-term average growth rate that is correlated to GDP or some other prominent macroeconomic or industry performance measure. This mentality renders real time trends and real time expected directionality in performance as irrelevant. The following example is engineered to demonstrate how far astray the mentality for averaging and the failure to model growth can lead the valuation.Example ConditionsThe average after-tax net cash flow is $10,000,000Depreciation and capital expenditures are substantially offsettingIncremental working capital needs are minimalThe cost of equity is 15%The “assumed” perpetual annual growth rate in net cash flow is 5% As can be seen in Figure 6, relative to the common valuation of $105,000, Scenario 1 represents undervaluation by approximately 30% (10 x $15,000 = $150,000) relative to recent annual performance, while Scenario 2 reflects an overvaluation by over 100% (10 x $5,000 = $50,000). More disturbing than two quite different trends giving rise to a common valuation of $105,000 is the spread of the value range from $50,000 to $150,000 derived from the “Current CF” measures of each scenario. Which valuation is more reasonable? Are there alternatives to modeling growth that represent more plausible projections or growth rates? As can be seen in Figure 8, a valuation of $105,000 is derived from the two distinctly different historical scenarios. How might alternative projections be modeled that provide an enhanced perspective from which to study a reasonable perpetual growth rate for each scenario? Frankly, most seasoned valuation professionals would admonish the appraiser in each of the example scenarios for failing to study a projection that “engineers” the prevailing cash flows from their current respective conditions to an assumed cycle-neutral point five years hence. Simultaneously, how could a discrete projection be modeled that develops the value associated with a series of future cash flows that reconciles to a reasonable steady-state measure of cash flows and forward growth? Taking Scenario 1 first, the five-year average cash flow ($10,000) results in a measure of cash flow well below the current performance ($15,000). What might a superior path of analysis be to capture the concern that current performance is unsustainable in the near-term? Substituting the implied growth rate of cash flow resulting from the assumed perpetual growth rate of 5% and a base average of $10,000, one might postulate a more believable pattern of performance and valuation as in Figure 9. Note that the year five CF is determined as the same amount ($12,763) ultimately reached in both implied forward cash flow scenarios using the 5% perpetual growth from the base average cash flow of $10,000. An alternative modification to the original implied projection would be to regress the current cash flow performance ($15,000) to the forward year five adjusted base ($10,000 x 1.055 = $12,763). The valuation resulting from the modified projection is 7.4% higher due to a less abrupt decline than the default first year drop from $15,000 to $10,500. While this is not a radical percentage difference in the valuation, the alternative smoothed projection is a more intuitively appealing and believable model. Such a construct allows for analysis to support the development of a growth rate applicable to the cyclical high Current CF of $15,000. Using the following proof we can devise a perpetual growth rate that will reconcile the Current CF to a similar adjusted valuation of approximately $113,000. Based on Figure 9, a growth rate of approximately 2% could have been reasonably applied to the Current CF ($15,000), lending enhanced credibility to a single-period capitalization than using 5% against the multi-year average performance of $10,000. The original, default approach used by many appraisers represents a 50% immediate first year disconnect from prevailing performance that lacks a reasonable basis. This is not to say that some circumstances don’t call for an abrupt shift in assumed cash flow versus prevailing cash flow, but that is typically a fundamental issue such as the loss or gain of a significant product, territory or customer. Too often this type of flaw is the result of the default five-finger rule to averaging five years of cash flows and using a 5% growth rate. Repeating the previous exercise for Scenario 2 results in Figure 10. Based on the example in Figure 10, a growth rate of approximately 8.7% could have been reasonably applied to the Current CF ($5,000), lending enhanced credibility to a single-period capitalization than using 5% against the multi-year average performance of $10,000. Again, this is not to say that some circumstances don’t call for an abrupt shift in assumed cash flow versus prevailing cash flow, but such a scenario is typically a fundamental issue such as the loss or gain of a significant product, territory or customer. Now that both of the implied projections have been modified to reflect more gradual regression to a mean level of assumed stable performance and sustainable future growth, the valuations reveal differentials from approximately 7.2% higher to 8.9% lower relative to the $105,000 derived from the default valuation mentality often employed. More significantly, the respective valuations are better suited to the prevailing cash flows and the expected directionality of performance. Each model now reflects a more thoughtful consideration of the time value of money. Figure 11 shows how the respective projections for each scenario converge on an estimated cyclically neutral level of future performance. The respective valuations, either in the form of a DCF or in the form of a single-period capitalization, are refined to capture the time value of money corresponding to a more believable performance regression/progression forecast. It should seem logical that the refined projection showing a gradual decline (Scenario 1) that starts with an above historical average level of performance, results in a higher value than the original $105,000. Likewise, the increasing projection (Scenario 2) that starts with below historical average performance results in a lower valuation than the original treatment. The chart in Figure 11 implies that performance has a gravitational attraction to the five-year outcome as a notional level of future performance ($12,763). An alternative and perhaps more realistic projection would craft a regression of the growth rate rather than a regression of performance to a notional future amount. Decelerating growth from either its peak performance (Scenario 1) or applying rapid growth during a mode of recovery (Scenario 2) seems more logical in most real world situations than the default trend. These competing projections are depicted in Figure 12. The valuations resulting from the smoothed growth patterns are developed in Figures 13 and 14 respectively. Of course, the pattern of future deceleration or acceleration requires specific study and support. The assumed patterns are presented for example purposes. A study of these alternative modeling inputs suggests that the original valuation of $105,000 is potentially flawed. Let’s summarize the various valuation outcomes from the two different scenarios. Remember, common averaging techniques coupled with seemingly benign growth assumptions result initially in the same valuation under both scenarios. However, scrutiny of the growth and/or projection modeling reveals some dramatic differences. Admittedly, in most valuations there would be underlying facts and circumstances supporting one of three modeling conditions applied to each scenario. One can easily see how valuations can be viewed quiet differently by differing parties under differing circumstances. The primary valuation differential for each stems from the implied projection and growth modeling. The common appraiser mentality of using historical average performance (rule of thumb mindset) combined with the typical “normal/benign” assumptions concerning growth and the cost of capital, can serve to understate or overstate value. Growth analysis and reasonable forecasting (birds of the same feather) allow for a more believable and optically pleasing analyses and conclusions. Comparing alternative projections from otherwise implied projections can provide better insight into growth modeling and promote more rational forecasting.Appendix A | Case Analysis: Understanding Growth RatesOne of the most debated and poorly supported assumptions in business valuation is that of the growth rate in performance, be it earnings, net cash flow, or debt-free cash flow. The default reliance on macroeconomic or industry based data is a good beginning but often falls short of the full growth profile for a specific business in a specific industry in a specific geography at a specific point in time. The real world is often lumpy and most companies experience shifts in top-line activity, cost efficiencies, and operating leverage throughout the business cycle or in conjunction with changes in the business model. Skill and experience are powerful influencers for what feels “right,” but too often the five finger-growth mentality rules the day. What tools can an appraiser use to develop and defend growth rate assumptions and how can such a tool be used as a critical review tool?Let’s study an example featuring a combination of typical facts and circumstances.Example Conditions:The economy is stable, with nominal GDP on the order of 4% and real GDP on the order of 2%The subject Company is stable, and operating with consistent resultsThe Company is twenty years old and has experienced 10% growth in annual sales over the last five yearsThe subject Company has moderate pricing power and operates in an industry with commodity players as well as value-added players (implying a range of profit margins and revenue sizes)Historical pricing for the Company’s goods and services follows a more or less inflationary pattern (say 2.0%), and the markets resist price increases such that Company profits can be squeezed without constant attention to expensesThe goal for the Company is to expand its market from the current 25 states to all 50 states in the next five years (all states represent equal market opportunity)With margins constant, sales growth represents a reasonable proxy for growth in earnings and net cash flow (EBITDA margin +/-10%)Public companies, larger and already national in market exposure, are expecting 5% annual sales volume growth over the next five years (consistent with industry expectations) and 10% annual earnings growth (implying margin expansion)Capital structure is expected to remain unchanged for the foreseeable future (debt free) » The Company has no excessive or abnormal risk exposures or concentrationsThe Company’s goods and services do not represent new or disruptive/paradigm technologyIt is not uncommon for an appraiser to uncover the above information in the course of due diligence. Yet, the same management team that can relate such feedback to the appraiser will not “speculate” on a projection. A competent appraiser should be able to cobble together the framework of a projection for purposes of quantifying a growth rate for a single-period capitalization as well as performing a summary DCF analysis (perhaps as a test of reason or as additional direct valuation evidence). Figure 16 depicts how the facts and circumstances are expected to play out in sales and EBITDA. Most often the typical approach would be to grab a recent average level of performance and use a growth rate likened to nominal GDP (4%), perhaps influenced up a bit to reflect the recent growth performance. However, the 6.3% perpetual growth rate developed does not tie directly to the underlying data and general information. For an appraiser to get the single-period perpetual growth rate correct, he/she would simply have to get that “just right” feeling. Clearly, a bit of extra effort and the constructive extension of logic would allow for an anecdotal or direct DCF-type study that could offer support for the generally favorable growth rate required in the analysis. Figures 16-18 serve notice that macroeconomic growth rates, sprinkled with a little current and near term company performance are often misleading and can fail to capture the influence of timing on the value of future cash flows.Reconciling Multi-Stage Growth Rates to a Single, Perpetual Growth RateReport reviewers are frequently confined to terse, misguided, or unjustified positions concerning growth rates. Typically, report users are bludgeoned with anecdotal growth evidence or with historical observations that fail to translate directly into reasonable future expectations. The time value of money is frequently obscured by a failure to reconcile multi-stage growth expectations into a meaningful single-period growth rate. Figure 19 displays a matrix of single, perpetual growth rates derived from the blended short term and long term growth rate expectations based on a 15% equity discount rate. Given a beginning measure of net cash flow or earnings, the table provides the single-period growth rate necessary to derive the same value result as a DCF using a five years of annual growth from the vertical axis (displayed left) and a terminal value developed using the growth rate from the horizontal axis (displayed top). For example, a company expecting to achieve 10% annual growth for years one through five and a terminal value growth rate of 5% would require a perpetual growth rate of 6.4% to equate a Gordon-style capitalization to a DCF valuation. The 6.4% perpetual rate may lack direct or specific support anywhere in the industry or economic data, but it may functionally capture the short-term and long-term expectations that are reasonable. Some appraisers may find this simple concept too burdensome to develop and communicate and thus a trustee often ends up with the five-finger approach to growth analysis. Figure 19 provides a quick and powerful tool for assessing growth rates in valuation reports (at the specific 15% equity discount rate). Even if future growth lacks “visibility,” the fact is that years one through five are more predictable than beyond five or more years. That being a matter of common sense, a given company’s prevailing and near term trends might reasonably serve as the annual growth rate for years one through five while an industry/GDP/inflationary assumption might reasonably serve as the perpetual growth rate after the initial five-year implied projection (e.g. the terminal value growth rate). Figures 19-21 are based on alternative equity discount rates. The use of the subject’s company’s equity discount rate is vital to developing a proper growth rate perspective. We note that growth rates applicable to alternative cash flows, such a cash flow to total invested capital, can also be studied using a similar approach as described in these examples. Replicating the math of these growth tables is relatively easy for any experienced analyst or reviewer.Appendix B | Case Analysis: Testing Projection Outcomes Using DCF AnalysisFor purposes of the following case study analysis, let’s refer to the various projection scenarios depicted in Figure 22. Additionally, let’s frame the effect on the valuation from the projection scenarios using a valuation of the unadjusted management projections. Figure 22 highlights the various projection scenarios one might reasonably develop as alternatives to the base management projection. Figure 23 depicts both a DCF and single-period capitalization developed from a base projection. As can be observed in Figure 24, the valuation using a modified growth rate reduced the total equity valuation by 20%. If the appraiser and/or the trustee concur that this lower growth scenario is a more plausible outcome than management’s original projection, particularly in light of the trustee’s core concern for a long-term sustainable and serviceable ESOP benefit, then all things held constant in the base projection model, the use of an equity risk premium on the order of 2.0% applied to the equity discount rate of the original model (making it 17% versus the original 15%) would converge the value of the original projection with that of the alternative 5% growth scenario. Using this technique, the appraiser/trustee has not directly modified the projection, but the valuation is hedged for the horizon risk believed to be associated with management’s base numbers. This is a simplified but powerful example of how the appraisal process can serve to effectively adjust the valuation outcome for the uncertainty of achieving a projection. Numerous other DCF treatments including discounting timing conventions, terminal growth rates, terminal value methods, capital structure for determining the WACC, working capital assumptions, and other tweaks can individually or collectively result in significantly different valuation outcomes using the same projection. These adjustments and modeling exercises can aid appraisers and trustees in determining reasonable and credible valuation outcomes. It goes without saying that these adjustments cannot simply be arbitrary. Rather, they must be reasonable and supportable in the context of the company’s capabilities and the marketplace for ESOP ownership interests in the company. With regard to valuations over time, changes in assumptions and modeling techniques should not be buried or obscured and should be clearly reconciled for the benefit of both the appraiser and the trustee. As can be observed in Figure 25, the valuation using the 0% growth scenario reduced the total equity valuation by 37% from the original growth projection. If the appraiser and/or the trustee concur that this alternative growth scenario is a more plausible outcome than management’s original projection, particularly in light of the trustee’s core concern for a long-term sustainable and serviceable ESOP benefit, then all things held constant in the base projection model, the use of an equity risk premium on the order of 4.0% applied to the equity rate (making it 19% versus the original 15%) would converge the value of the original projection with that of the alternative 0% (no) growth scenario. Using this technique, the appraiser/trustee has not directly modified the projection, but the valuation is hedged for the horizon risk believed to be associated with management’s base numbers. As can be observed in Figure 26, the valuation using a declining growth scenario reduced the total equity valuation by 48%. If the appraiser and/or the trustee concur that this alternative growth scenario is a more plausible outcome than management’s original projection, particularly in light of the trustee’s core concern for a long-term sustainable and serviceable ESOP benefit, then all things held constant in the base projection model, the use of an equity risk premium on the order of 6.0% applied to the equity rate (making it 21% versus the original 15%) would converge the value of the original projection with that of the alternative -5% annual growth scenario. Using this technique, the appraiser/trustee has not directly modified the projection, but the valuation is hedged for the horizon risk believed to be associated with management’s base numbers. As can be observed in Figure 28, the valuation using a modified growth rate reduced the total equity valuation by 32%. If the appraiser and/or the trustee concur that this alternative growth scenario is a more plausible outcome than management’s original projection, particularly in light of the trustee’s core concern for a long-term sustainable and serviceable ESOP benefit, then all things held constant in the base projection model, the use of an equity risk premium on the order of 3.3% applied to the equity rate (making it 18.3% versus the original 15%) would converge the value of the original projection with that of the alternative cyclical growth scenario. Using this technique, the appraiser/trustee has not directly modified the projection, but the valuation is hedged for the horizon risk believed to be associated with management’s base numbers.Synthesis of Outcomes Using Alternative Projections/ Equity Discount RatesFigure 28 depicts the various growth rates scenarios studied for this example. This serves as an example of the type of sensitivity and stress testing the trustee/appraiser can employ to support the due diligence process and the documentation of the projections employed (and/or not employed) as called for under the DOL settlement protocols. As previously stated, alteration of numerous other modeling inputs could be studied in the same fashion as this example using growth rates and reconciling equity (horizon/projection) premiums. The various scenarios can be used to support concerns for downside risk concerning the valuation, the ability to service debt, and the ability to support ESOP repurchase obligation (all procedures and considerations called for under the settlement protocols). These same sensitivity processes can be used to assess the quality and relative value of the subject ESOP company to transaction data and/or guideline public company data employed and/or adjusted in the valuation.As can be seen in Figure 28, modeling alternative growth scenarios can be a powerful tool in assessing the risk profile and alternative outcomes associated with a given set of projections. While this lengthy working example has examined downside scenarios associated with projection shortfalls, the same framework can be used to assess upside potential in cases where management projections appear conservative in light of past performance and/or external business drivers. It could be argued that the assessment of repurchase obligation should include the potential impact from positive budget variances, as undervaluation today could result in an underestimation of future repurchase liability, which could lead to under-informed and potentially adverse business decisions by the sponsor company.Appendix C | SETTLEMENT AGREEMENT (DOL V. GREATBANC)UNITED STATES DISTRICT COURT | CENTRAL DISTRICT OF CALIFORNIA | Case No. ED-CV12-1648-R(DTBx)THOMAS E. PEREZ Secretary of the United States Department of Labor (Plaintiff) V. GREATBANC TRUST COMPANY, et al. (Defendants)This SETTLEMENT AGREEMENT (“Settlement Agreement”) is entered into by and between Thomas E. Perez, Secretary of the United States Department of Labor (“Secretary”), acting in his official capacity, by and through his duly authorized representatives, and GreatBanc Trust Company (“GreatBanc”), by and through its duly authorized representative (individually, a “party” and collectively, the “parties”), to settle all civil claims and issues between them.WHEREAS, the Secretary’s predecessor, Hilda L. Solis, acting in her official capacity, pursuant to her authority under Title I of the Employee Retirement Income Security Act of 1974 (“ERISA”), 29 U.S.C. § 1001, et seq., as amended, filed this action in connection with the June 20, 2006 purchase of Sierra Aluminum Company (“Sierra”) stock by the Employee Stock Ownership Plan sponsored by Sierra (the “Sierra ESOP”), and Thomas E. Perez, current Secretary of the United States Department of Labor, in his official capacity, substituted for Hilda Solis and is now the plaintiff in this action;WHEREAS, the Secretary and GreatBanc have negotiated this Settlement Agreement through their respective attorneys in a mediation process;WHEREAS, the Secretary and GreatBanc have engaged in a constructive and collaborative effort to establish binding policies and procedures relating to GreatBanc’s fiduciary engagements and to its process of analyzing transactions involving purchases or sales by ERISA-covered employee stock ownership plans (“ESOPs”) of employer securities that are not publicly traded. Those policies and procedures, to which the parties have agreed, are set forth in Attachment A hereto, which is incorporated herein as an integral part of this Settlement Agreement (hereinafter collectively, “Settlement Agreement”);WHEREAS, each party acknowledges that its representations are material factors in the other party’s decision to enter into this Settlement Agreement;WHEREAS, the parties agree to settle on the terms and conditions hereafter set forth as a full and complete resolution of all of the civil claims and issues arising between them in this action without trial or adjudication of any issue of fact or law raised in the Secretary’s Complaint in this action and other claims and issues as set forth in this Settlement Agreement;[.][Terms and conditions delineated as items A through U omitted]Attachment A Of The Settlement Agreement AgreementConcerning Fiduciary Engagements And Process Requirements For Employer Stock TransactionsThe Secretary of the United States Department of Labor (the “Secretary”) and GreatBanc Trust Company (“the Trustee”), by and through their attorneys, have agreed that the policies and procedures described below apply whenever the Trustee serves as a trustee or other fiduciary of any employee stock ownership plan subject to Title I of ERISA (“ESOP”) in connection with transactions in which the ESOP is purchasing or selling, is contemplating purchasing or selling, or receives an offer to purchase or sell, employer securities that are not publicly traded.A. Selection and Use of Valuation Advisor – General. In all transactions involving the purchase or sale of employer securities that are not publicly traded, the Trustee will hire a qualified valuation advisor, and will do the following:prudently investigate the valuation advisor’s qualifications;take reasonable steps to determine that the valuation advisor receives complete, accurate and current information necessary to value the employer securities; andprudently determine that its reliance on the valuation advisor’s advice is reasonable before entering into any transaction in reliance on the advice.B. Selection of Valuation Advisor – Conflicts of Interest. The Trustee will not use a valuation advisor for a transaction that has previously performed work – including but not limited to a “preliminary valuation” – for or on behalf of the ESOP sponsor (as distinguished from the ESOP), any counter-party to the ESOP involved in the transaction, or any other entity that is structuring the transaction (such as an investment bank) for any party other than the ESOP or its trustee. The Trustee will not use a valuation advisor for a transaction that has a familial or corporate relationship (such as a parent-subsidiary relationship) to any of the aforementioned persons or entities. The Trustee will obtain written confirmation from the valuation advisor selected that none of the above-referenced relations exist. C. Selection of Valuation Advisor – Process. In selecting a valuation advisor for a transaction involving the purchase or sale of employer securities, the Trustee will prepare a written analysis addressing the following topics:The reason for selecting the particular valuation advisor;A list of all the valuation advisors that the Trustee considered;A discussion of the qualifications of the valuation advisors that the Trustee considered;A list of references checked and discussion of the references’ views on the valuation advisors;Whether the valuation advisor was the subject of prior criminal or civil proceedings; andA full explanation of the bases for concluding that the Trustee’s selection of the valuation advisor was prudent.If the Trustee selects a valuation advisor from a roster of valuation advisors that it has previously used, the Trustee need not undertake anew the analysis outlined above if the following conditions are satisfied: (a) the Trustee previously performed the analysis in connection with a prior engagement of the valuation advisor; (b) the previous analysis was completed within the 15 month period immediately preceding the valuation advisor’s selection for a specific transaction; (c) the Trustee documents in writing that it previously performed the analysis, the date(s) on which the Trustee performed the analysis, and the results of the analysis; and (d) the valuation advisor certifies that the information it previously provided pursuant to item (5) above is still accurate. D. Oversight of Valuation Advisor – Required Analysis. In connection with any purchase or sale of employer securities that are not publicly traded, the Trustee will request that the valuation advisor document the following items in its valuation report,1 and if the valuation advisor does not so document properly, the Trustee will prepare supplemental documentation of the following items to the extent they were not documented by the valuation advisor:Identify in writing the individuals responsible for providing any projections reflected in the valuation report, and as to those individuals, conduct reasonable inquiry as to: (a) whether those individuals have or reasonably may be determined to have any conflicts of interest in regard to the ESOP (including but not limited to any interest in the purchase or sale of the employer securities being considered); (b) whether those individuals serve as agents or employees of persons with such conflicts, and the precise nature of any such conflicts: and (c) record in writing how the Trustee and the valuation advisor considered such conflicts in determining the value of employer securities;Document in writing an opinion as to the reasonableness of any projections considered in connection with the proposed transaction and explain in writing why and to what extent the projections are or are not reasonable. At a minimum, the analysis shall consider how the projections compare to, and whether they are reasonable in light of, the company’s five-year historical averages and/or medians and the five-year historical averages and/or medians of a group of comparable public companies (if any exist) for the following metrics, unless five-year data are unavailable (in which case, the analyses shall use averages extending as far back as possible). a. Return on assets b. Return on equity c. EBIT margins d. EBITDA margins e. Ratio of capital expenditures to sales f. Revenue growth rate g. Ratio of free cash flows (of the enterprise) to salesIf it is determined that any of these metrics should be disregarded in assessing the reasonableness of the projections, document in writing both the calculations of the metric (unless calculation is impossible) and the basis for the conclusion that the metric should be disregarded. The use of additional metrics to evaluate the reasonableness of projections other than those listed in section D(2)(a)-(g) above is not precluded as long as the appropriateness of those metrics is documented in writing. If comparable companies are used for any part of a valuation – whether as part of a Guideline Public Company method, to gauge the reasonableness of projections, or for any other purpose – explain in writing the bases for concluding that the comparable companies are actually comparable to the company being valued, including on the basis of size, customer concentration (if such information is publicly available), and volatility of earnings. If a Guideline Public Company analysis is performed, explain in writing any discounts applied to the multiples selected, and if no discount is applied to any given multiple, explain in significant detail the reasons.If the company is projected to meet or exceed its historical performance or the historical performance of the group of comparable public companies on any of the metrics described in paragraph D(2) above, document in writing all material assumptions supporting such projections and why those assumptions are reasonable.To the extent that the Trustee or its valuation advisor considers any of the projections provided by the ESOP sponsor to be unreasonable, document in writing any adjustments made to the projections.If adjustments are applied to the company’s historical or projected financial metrics in a valuation analysis, determine and explain in writing why such adjustments are reasonable.If greater weight is assigned to some valuation methods than to others, explain in writing the weighting assigned to each valuation method and the basis for the weightings assigned.Consider, as appropriate, how the plan document provisions regarding stock distributions, the duration of the ESOP loan, and the age and tenure of the ESOP participants, may affect the ESOP sponsor’s prospective repurchase obligation, the prudence of the stock purchase, or the fair market value of the stock.Analyze and document in writing (a) whether the ESOP sponsor will be able to service the debt taken on in connection with the transaction (including the ability to service the debt in the event that the ESOP sponsor fails to meet the projections relied upon in valuing the stock); (b) whether the transaction is fair to the ESOP from a financial point of view; (c) whether the transaction is fair to the ESOP relative to all the other parties to the proposed transaction; (d) whether the terms of the financing of the proposed transaction are market-based, commercially reasonable, and in the best interests of the ESOP; and (e) the financial impact of the proposed transaction on the ESOP sponsor, and document in writing the factors considered in such analysis and conclusions drawn therefrom.E. Financial Statements.The Trustee will request that the company provide the Trustee and its valuation advisor with audited unqualified financial statements prepared by a CPA for the preceding five fiscal years, unless financial statements extending back five years are unavailable (in which case, the Trustee will request audited unqualified financial statement extending as far back as possible).If the ESOP Sponsor provides to the Trustee or its valuation advisor unaudited or qualified financial statements prepared by a CPA for any of the preceding five fiscal years (including interim financial statements that update or supplement the last available audited statements), the Trustee will determine whether it is prudent to rely on the unaudited or qualified financial statements notwithstanding the risk posed by using unaudited or qualified financial statements.If the Trustee proceeds with the transaction notwithstanding the lack of audited unqualified financial statements prepared by a CPA (including interim financial statements that update or supplement the last available audited statements), the Trustee will document the bases for the Trustee’s reasonable belief that it is prudent to rely on the financial statements, and explain in writing how it accounted for any risk posed by using qualified or unaudited statements. If the Trustee does not believe that it can reasonably conclude that it would be prudent to rely on the financial statements used in the valuation report, the Trustee will not proceed with the transaction. While the Trustee need not audit the financial statements itself, it must carefully consider the reliability of those statements in the manner set forth herein.F. Fiduciary Review Process – General. In connection with any transaction involving the purchase or sale of employer securities that are not publicly traded, the Trustee agrees to do the following:Take reasonable steps necessary to determine the prudence of relying on the ESOP sponsor’s financial statements provided to the valuation advisor, as set out more fully in paragraph E above;Critically assess the reasonableness of any projections (particularly management projections), and if the valuation report does not document in writing the reasonableness of such projections to the Trustee’s satisfaction, the Trustee will prepare supplemental documentation explaining why and to what extent the projections are or are not reasonable;Document in writing its bases for concluding that the information supplied to the valuation advisor, whether directly from the ESOP sponsor or otherwise, was current, complete, and accurate.G. Fiduciary Review Process – Documentation of Valuation Analysis. The Trustee will document in writing its analysis of any final valuation report relating to a transaction involving the purchase or sale of employer securities. The Trustee’s documentation will specifically address each of the following topics and will include the Trustee’s conclusions regarding the final valuation report’s treatment of each topic and explain in writing the bases for its conclusions:Marketability discounts;Minority interests and control premiums;Projections of the company’s future economic performance and the reasonableness or unreasonableness of such projections, including, if applicable, the bases for assuming that the company’s future financial performance will meet or exceed historical performance or the expected performance of the relevant industry generally;Analysis of the company’s strengths and weaknesses, which may include, as appropriate, personnel, plant and equipment, capacity, research and development, marketing strategy, business planning, financial condition, and any other factors that reasonably could be expected to affect future performance;Specific discount rates chosen, including whether any Weighted Average Cost of Capital used by the valuation advisor was based on the company’s actual capital structure or that of the relevant industry and why the chosen capital structure weighting was reasonable;All adjustments to the company’s historical financial statements;Consistency of the general economic and industry-specific narrative in the valuation report with the quantitative aspects of the valuation report;Reliability and timeliness of the historical financial data considered, including a discussion of whether the financial statements used by the valuation advisor were the subject of unqualified audit opinions, and if not, why it would nevertheless be prudent to rely on them;The comparability of the companies chosen as part of any analysis based on comparable companies;Material assumptions underlying the valuation report and any testing and analyses of these assumptions;Where the valuation report made choices between averages, medians, and outliers (e.g., in determining the multiple(s) used under the “guideline company method” of valuation), the reasons for the choices;Treatment of corporate debt;Whether the methodologies employed were standard and accepted methodologies and the bases for any departures from standard and accepted methodologies;The ESOP sponsor’s ability to service any debt or liabilities to be taken on in connection with the proposed transaction;The proposed transaction’s reasonably foreseeable risks as of the date of the transaction;Any other material considerations or variables that could have a significant effect on the price of the employer securities.H. Fiduciary Review Process – Reliance on Valuation Report.The Trustee, through its personnel who are responsible for the proposed transaction, will do the following, and document in writing its work with respect to each: a. Read and understand the valuation report; b. Identify and question the valuation report’s underlying assumptions; c. Make reasonable inquiry as to whether the information in the valuation report is materially consistent with information in the Trustee’s possession; d. Analyze whether the valuation report’s conclusions are consistent with the data and analyses; and e. Analyze whether the valuation report is internally consistent in material aspects.The Trustee will document in writing the following: (a) the identities of its personnel who were primarily responsible for the proposed transaction, including any person who participated in decisions on whether to proceed with the transaction or the price of the transaction; (b) any material points as to which such personnel disagreed and why; and (c) whether any such personnel concluded or expressed the belief prior to the Trustee’s approval of the transaction that the valuation report’s conclusions were inconsistent with the data and analysis therein or that the valuation report was internally inconsistent in material aspects.If the individuals responsible for performing the analysis believe that the valuation report’s conclusions are not consistent with the data and analysis or that the valuation report is internally inconsistent in material respects, the Trustee will not proceed with the transaction.I. Preservation of Documents. In connection with any transaction completed by the Trustee through its committee or otherwise, the Trustee will create and preserve, for at least six (6) years, notes and records that document in writing the following:The full name, business address, telephone number and email address at the time of the Trustee’s consideration of the proposed transaction of each member of the Trustee’s Fiduciary Committee (whether or not he or she voted on the transaction) and any other Trustee personnel who made any material decision(s) on behalf of the Trustee in connection with the proposed transaction, including any of the persons identified pursuant to H(2) above;The vote (yes or no) of each member of the Trustee’s Fiduciary Committee who voted on the proposed transaction and a signed certification by each of the voting committee members and any other Trustee personnel who made any material decision(s) on behalf of the Trustee in connection with the proposed transaction that they have read the valuation report, identified its underlying assumptions, and considered the reasonableness of the valuation report’s assumptions and conclusions;All notes and records created by the Trustee in connection with its consideration of the proposed transaction, including all documentation required by this Agreement;All documents the Trustee and the persons identified in 1 above relied on in making their decisions;All electronic or other written communications the Trustee and the persons identified in 1 above had with service providers (including any valuation advisor), the ESOP sponsor, any non-ESOP counterparties, and any advisors retained by the ESOP sponsor or non-ESOP counterparties.J. Fair Market Value. The Trustee will not cause an ESOP to purchase employer securities for more than their fair market value or sell employer securities for less than their fair market value. The DOL states that the principal amount of the debt financing the transaction, irrespective of the interest rate, cannot exceed the securities’ fair market value. Accordingly, the Trustee will not cause an ESOP to engage in a leveraged stock purchase transaction in which the principal amount of the debt financing the transaction exceeds the fair market value of the stock acquired with that debt, irrespective of the interest rate or other terms of the debt used to finance the transaction. K. Consideration of Claw-Back. In evaluating proposed stock transactions, the Trustee will consider whether it is appropriate to request a claw-back arrangement or other purchase price adjustment(s) to protect the ESOP against the possibility of adverse consequences in the event of significant corporate events or changed circumstances. The Trustee will document in writing its consideration of the appropriateness of a claw-back or other purchase price adjustment(s). L. Other Professionals. The Trustee may, consistent with its fiduciary responsibilities under ERISA, employ, or delegate fiduciary authority to, qualified professionals to aid the Trustee in the exercise of its powers, duties, and responsibilities as long as it is prudent to do so. M. This Agreement is not intended to specify all of the Trustee’s obligations as an ERISA fiduciary with respect to the purchase or sale of employer stock under ERISA, and in no way supersedes any of the Trustee’s obligations under ERISA or its implementing regulations.

This article first appeared as a whitepaper in a series of reports titled Appraisal Review Practice Aid for ESOP Trustees. The market approach is a general way of determining the value of a business, business ownership interest, security, or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold. Functionally, market methodologies are similar to direct capitalization income methods in that a benefit (or performance) measure of the subject business is converted to value by a capitalization factor. It is the specificity of the data supporting the capitalization factor that differentiates market methodology from income methodology.In general, income methodologies rely on indirect, broad market rates of return on capital (Ibbotson, et al.) and on various data sets and trends to establish growth rates. For cases in which there is more direct information from a comparable market, such information is used in a market approach to develop a value for the subject entity. These comparable markets offer evidence of either direct- or relative-value metrics based on transaction activity among investors. Such markets can be described as direct—in that a similar ownership interest or security in the same subject entity has transacted—or as indirect—in that a group of publicly traded securities of similar companies can be observed and/or that transactions of entire entities can be observed. The market approach includes numerous methods, which are generally named according to the nature of the direct or relative-value market data. Naming conventions for certain market methods differ among valuation practitioners but most fall into three categories: (1) the transaction method, (2) the guideline public company method, and (3) the guideline transactions method. As with market data sets used in income methodology, the appropriateness of the data (i.e., its comparability and overall strength of relevance) is the primary concern. Market evidence may require adjustment to address a variety of issues before it can be used to value the subject interest. These adjustments differ based on which of the various market methods is employed as well as on the nature of the transactions observed. The following provides an overview of the primary elements of comparability and adjustments under the three primary categories of market methodology.Valuation Methods Under The Market ApproachThe market approach includes a variety of valuation methods under which pricing metrics are drawn from transactions of interests in companies that are comparable to the subject company. The three primary valuation methods under the market approach are summarized below.Transactions Method — derives value using pricing metrics of historical or contemporaneous transactions of interests in the subject company.Guideline Public Company Method — derives value using transaction information drawn from publicly traded securities of companies in the same or similar lines of business as the subject company.Guideline Transactions Method — derives value using pricing metrics of mergers and acquisitions involving controlling interests of companies (public and private) in the same or similar lines of business as the subject company.The comparability and reliability of observed transactions is the central concern. The three core market methodologies yield differing types of valuation information for a given ownership interest or entity. Based on the market in which the observed transaction(s) occurred, there can be differing relative valuations. The transaction method may yield valuation information at various levels of value (control or minority). The guideline public company method generally yields valuation information at the marketable minority interest level of value. The guideline transactions method generally yields valuation information based on the controlling interest level of value. Accordingly, the value definition used for an appraisal may suggest which single method or combination of methods might directly apply in the appraisal process. Rarely is a guideline transactions method employed in a valuation calling for the minority interest level of value. Conversely, observed transactions in minority ownership interests of the subject entity may not provide appropriate valuation information for valuations in which the engagement calls for use of the controlling interest level of value. Although market methods can result in valuations at varying levels of value, each of which may differ from the level of value defined for a given appraisal, there can be useful information in transaction activity even if such activity implies a valuation that is not directly equivalent to the value definition specified in the appraisal engagement. Frequently, there are circumstances in which the appraiser may observe activity that provides indirect support for the valuation or that can be reconciled to the value definition called for in the appraisal report. As with income methods, the valuations developed using market methodology can result in a value indication for the equity of the subject or for the assets (invested capital) of the subject. In the latter case, the market value of debt is subtracted to derive the equity value of the subject. Appraisers may elect to use market methods that result in direct value indications that differ from the value definition called for in the appraisal engagement. In such cases, valuation discounts and premiums are usually applied to adjust the value indication to the specified level of value defined for the engagement.Rules of ThumbA valuation rule of thumb relates an operational or financial measure of a company to a measure of value. Most metrics are operational in nature (based on some unit of business activity or volume) or are financial (representing a multiplier to capitalize revenue, cash flow or some other financial benefit stream). There is rule-of-thumb valuation innuendo in almost every industry. In some cases, such information provides useful insight into the mentality and predisposition of what an owner of a business or business interest believes their holding is worth. This is particularly true of industries whose participants adhere to a relatively narrow range of norms in operating, financial, and/or physical composition.A rule of thumb value indication is typically a controlling interest level of value. In some cases, rules of thumb reflect a strategic value as opposed to a financial controlling interest value. Appraisers using or referring to rules of thumb must be aware, to the degree possible, of the origin of the rule of thumb in order to assess whether it captures synergies or other premium benefits (or expected profitability) available only to specific strategic investors. Because most rules of thumb have their genesis within a given industry or trade group, strategic elements are often included. Accordingly, ESOP valuations using the fair market value standard may result in conclusions lower than the common industry rules of thumb. However, industry rules of thumb may also coincide with fair market value if the hypothetical investor is closely aligned with likely market participants in the industry or market.Most rules of thumb relate to the total enterprise value of assets as opposed to the total equity value of a business. Hence, the determination of equity value requires the subtraction of debt from the total enterprise value. As with the private transaction databases, rules of thumb generally require adjustment for certain types of assets and liabilities that are not typically part of transactions. Cash balances, certain liabilities, working capital, real estate, and other balance sheet amounts may be treated separately from core business assets.Rules of thumb can be highly misleading as most subject companies differ from the stereotypical company in the stereotypical market with a steady-state cycle of performance. Even when such normalcy appears evident, there are marketplace and economic factors that result in valuations that deviate from the central point of a suggested range. Some valuation texts refer to the use of a rule of thumb as a valuation method. Likewise, there are proprietary transaction databases that, when viewed across multiple industries over extended periods of time, are promulgated to represent meaningful information in the valuation of small business enterprises. Appraisers have the task of determining whether or not such data rise to an acceptable level of reliability and/or relevance. In most cases, we see such data as constituting a rule of thumb, and, therefore, subject to healthy scrutiny and devil’s advocacy.Many small- to middle-market companies (enterprise valuations of $5 to $500 million) have enjoyed increased access to capital funding alternatives and exit strategies in recent years. The rise of private equity buyout firms and the general increase in knowledge among business owners has influenced evolution in rules of thumb. Historically simplistic references to unit revenue measures have evolved and been reconciled to financial measures.For example, an old-guard rule of thumb in the beverage distribution industry was based on annual volume of cases sold. A distributor of a given type or brand of product might generally assume or expect a certain business value based on annual case-volume activity. However, changes in product mix caused by evolving consumer preferences over time rendered these rules less reliable in explaining the value of a given distributor whose margin was below or in excess of norms. Eventually, the industry vernacular became more focused on gross profit, which better characterizes profit by taking into account the mix and pricing of product offerings. However, operating expense structures of distributors vary to the extent that gross profit is often inadequate in explaining value differentials in transactions. In the current environment, rules of thumb have taken the next step by reconciling to financial measures (such as a multiple of cash flow). Any rule of thumb based on an industry metric (i.e., tons, cases, etc.), can be reconciled to a financial equivalency. Doing so facilitates easier value comparisons and provides a financial basis for reconciling the concluded value in an appraisal to a broad industry rule of thumb.Consistent with the business valuation standards issued by the professional organizations, we do not suggest using a rule of thumb as a stand-alone valuation method under the market approach. However, when valuing a subject entity or interest using a controlling interest level of value, we do encourage appraisers and reviewers to be aware of any rule of thumb that may characterize value in the subject’s industry. In most cases, an indirect reference to a rule of thumb can provide support for a value conclusion developed under more conventional and financially sound methods. If a conclusion deviates from a rule of thumb, it can be useful for the appraiser to explain why.Transactions MethodThe transactions method is a market approach that develops an indication of value based upon consideration of observed transactions in the ownership interests of the subject entity. Transactions should be scrutinized to determine if they have occurred at arm’s length, with a reasonable degree of frequency, and within a reasonable period of time relative to the valuation date. Inferences about current value can sometimes be drawn, even if there is only a limited market for the ownership interests and relatively few transactions occur.The timeliness of a transaction is important. However, time itself is not the only parameter that determines whether a transaction is reliable for use in a given appraisal. If internal and/or external business conditions or other factors have changed or evolved in a significant way from the time of the observed transaction to the date of the valuation, then use of the transaction may be unreliable. This could also be true for a transaction occurring in close proximity to the valuation date. While a dated transaction may be unreliable in absolute value terms, the implied relative value of the transaction may be useful to examine (such as price to book or enterprise value to cash flow). Arguably, any transaction that has occurred in reasonable proximity to the valuation date should be disclosed and distilled even if it is not directly considered toward the valuation. In such a case, the appraiser may need to explicitly qualify why a transaction is not being given direct weight in the valuation. In select cases where entity and market performance have remained stable over time, transactions that are somewhat dated may provide meaningful direct or indirect support to the appraisal. Transactions occurring subsequent to the valuation date should not be considered unless the facts and circumstances of such activity were known or reasonably knowable as of the valuation date and there is (was) a high likelihood of the transaction closing.There are many corporate and shareholder events in the ordinary course of business that may produce meaningful transaction data. Shareholder redemptions, capital raising, transactions among the ownership group, recapitalizations, buy-sell trigger events, equity compensation grants, business acquisitions, dispositions, and other events are not unusual, particularly in larger entities or in entities with large and/or active ownership groups. It is important that any transaction used to develop an indication of value for the entity, or more directly for the subject interest, be considered in the proper context (in terms of value definition) of other valuation methods developed in the appraisal. Frequently, transactions must be adjusted using estimated (and reasonable) discounts or premiums to derive a meaningful base of comparison to the subject interest.Guideline Public Company MethodThe Guideline Public Company Method (GPCM) involves the use of valuation metrics from publicly traded companies that are deemed suitably comparable to the subject entity. Direct comparability is difficult to achieve in many situations, as most public companies are larger and more diverse than the subject, closely held entities in most business appraisals. However, the threshold for direct comparability need not be so inflexible that public companies with similar business characteristics are disqualified from providing guidance in the valuation of the subject company. In some cases, public companies may not be reliable for direct valuation purposes but may yield information helpful in ascertaining norms for capital structure assumptions and growth rate analysis.There are relatively few industries in which direct comparability is readily achieved, and most of those present challenges by the sheer scalar differences between the public operators and most private enterprises. The selection of, adjustment of, and application of public company valuation data can be a complicated process involving significant appraiser skill and experience. Absent proper execution, the GPCM can render valuation indications that differ significantly from other methods and thus lead to confusing and/or flawed appraisal results.Guideline companies are most often publicly traded companies in the same or similar industry as the valuation subject and/or that provide a reasonable basis for comparison to the subject company due to similarities in operational processes, supply and demand factors, and/or financial composition.Investors in the public stock markets often study the P/E ratio of a security for purposes of assessing the merits of the investment. The P/E ratio of a stock is utilized in a common variation of the GPCM whereby a guideline public P/E ratio is used to capitalize the subject company’s net income. Other variations include the use of valuation metrics to capitalize pre-tax income, numerous versions of cash flow, book value, revenues, or other performance measures of the valuation subject.Investors in the public securities markets are said to be transacting minority investments (non-controlling) in the issuer’s security, and such investors enjoy the benefit of regulated exchanges and mandatory information disclosures by the issuer. Regular filings by publicly traded companies allow investors to assess the valuation of the security in relation to an almost endless array of operational and financial performance measures for the public company. Guideline company valuation metrics produce marketable minority interest valuation indications. The term “as- if- freely- traded” is often used to describe value indications under the GPCM. Guideline companies are used to develop valuation indications under the presumption that a similar market exists for the subject company and the guideline companies.Ideal guideline companies are in the same business as the company being valued. However, if there is insufficient transaction evidence in the same business, it may be necessary to consider companies with an underlying similarity of relevant investment characteristics such as markets, products, growth, cyclical variability, and other salient factors.Although a guideline group may provide some indication of how the public markets value the subject company’s shares, there are limitations to the method. For example, it is virtually impossible to find identical guideline companies. In addition, analysts must assume that all relevant information about a company is embedded in its market price. A guideline group can sometimes provide useful valuation benchmarks, but it is ultimately left to the analyst to derive an appropriate capitalization factor for a subject company based upon a thorough comparison of the selected group of guideline companies to the subject company.Variations of the Guideline Public Company MethodThe GPCM can be used to develop value indications for both invested (or enterprise) capital and equity capital. There are numerous sub-methods for performing both types of valuations. The nature of the denominator in a guideline valuation metric or ratio determines the nature of the value indication. Consistent with the rules governing proper income method execution (namely, matching the discount rate to the proper measure of the subject’s earnings or cash flows), the benefit stream of the valuation subject should be capitalized by the appropriate guideline valuation metric. Performance measures and benefits streams have one primary differentiating feature – they are either before debt-service costs or after. The performance or benefit measures that capture cash flows before the payment of debt costs (i.e., interest expense) are used to develop value indications for the invested capital (i.e., total assets) of the guideline companies and, therefore, result in the same valuation for the appraisal subject. The performance measures that capture cash flow after debt service are used to develop value indications for equity capital. As with any approach or method that results in a direct valuation of invested capital, debt is subtracted to arrive at the value of equity. Although it is true that a valuation metric can relate a pre-debt cash flow to equity value (and vice versa an after-debt cash flow to invested capital), we view this as a likely source of valuation error and would discourage such methodology unless there is a convincing reason to do so. We would likely disregard the use of the GPCM if such mixing of benefit streams and capitalization factors were the only calculations developed (e.g., price-to-sales or priceto-EBITDA, etc.).Appraisers have the task of developing guideline company cash-flow measures and value metrics in a fashion consistent with the cash flows and valuation math used for the valuation subject. Mismatching the guideline valuation metric with the wrong benefit measure of the subject is a common mistake. Appraisers are encouraged not to take valuation multiples for a given public company or group of companies from a published or electronic data source unless the underlying definition and/or development of the metric is adequately detailed. There can be subtle but meaningful variations in how an appraiser tabulates a benefit measure, such as EBITDA, versus how it was tabulated in the cited source material.Appraisers must also be mindful of understanding the implications of developing guideline company valuation metrics using financial information and pricing data from periods that are reasonably consistent with the benefit measures of the valuation subject. Public market stock pricing conventions follow a rolling four-quarter or 12-month norm. Often, the acronym LTM (last twelve months) or TTM (trailing twelve month) is used to denote that a given cash flow or earnings measure was tabulated using the most recent annualized performance measure of the public company. That is, a given P/E ratio or MVIC/EBITDA ratio is based on the market capitalization as of a defined date and the most up-to-date, 12 month earnings or cash flow measure of the public company.Although it is not absolute that timing of the data used in developing a guideline valuation metric must be applied to the subject’s benefit measure from the same period, it is recommended that this be the base convention in most business valuations. Due to performance fluctuations and the timing of the business cycle (among other things) from the valuation subject to a given peer guideline company group, some appraisers may use average pricing metrics spanning several years for the guideline companies against a similar average of cash flows or earnings for the valuation subject. This type of execution seemingly parallels common disciplines used in various income methods in which an ongoing, average expression of earnings and cash flow is capitalized by a factor whose underlying discount rate and growth rate were derived from data observed over some historical time frame.We urge caution when not following consistency of timing regarding pricing measures and/or benefit streams from subject to peer. For example, when a multi-year average of subject earnings is capitalized using the median LTM P/E ratio from a guideline group, the valuation of the subject can be characterized as being adjusted for fundamentals resulting in a valuation that is higher or lower than would be the case had the LTM P/E ratio been applied to the LTM earnings of the subject. This type of fundamental adjustment is but one of many implicit or indirect adjustments that an appraiser can capture under the GPCM. These adjustments need not be construed as flawed as long as there is adequate purpose and explanation for why such a discipline was employed and perhaps even a calculation of the impact on the valuation indication versus a valuation using the typical timing conventions (i.e., guideline LTM to subject LTM).For valuations in which the GPCM is employed, the guideline data may serve an additional purpose. A properly developed appraisal opinion may have numerous value indications under the cost, income, and market approaches. Value indications from various methods are typically correlated with, or weighted toward an overall valuation conclusion that attempts to reflect the entirety of process and consideration captured in the valuation. Some appraisers have long practiced providing a relative value analysis at the end of their valuation reports that educates the reader on numerous observations of relative value. In such a fashion, the appraiser can present the valuation conclusions from perspectives that extend beyond the direct methodology employed. Accordingly, the appraiser may effectively assert that the conclusions directly developed are consistent with alternative or additional valuation methods that had would support the conclusions reached had such alternative or additional valuation methods been employed.The relative value analysis is often used to articulate the sanity and appropriateness of the conclusions based on comparing various valuation ratios to broad-market norms, market transactions, or public market pricing for similar (guideline) companies. Relating the valuation conclusion to the reported book value of equity, to the adjusted value of tangible equity, to various measures of cash flow, etc. is an often used technique to support the valuation and to provide a basis for explaining why the conclusion reflects or differs from various peer measurements. In some cases, a guideline company group may have been identified but not used directly. Regardless, when such market evidence is reasonably observable, comparing the data and reconciling it against the valuation conclusions can be a useful and informational exercise.For example, consider a valuation in which equal weights were applied to the cost approach (e.g., net asset value method) and the income approach (e.g., direct capitalization of earnings), resulting in a correlated equity value of $8,000,000 (marketable minority interest level of value). The subject has $2,000,000 of debt, implying a market value of invested capital (MVIC or TEV) of $10,000,000. Assume the subject entity has a debt-free net cash flow of $1,000,000, EBIT of $1,667,000, and EBITDA of $2,000,000. The resulting MVIC ratios to EBIT and to EBITDA are approximately 6.0x and 5.0x, respectively. If market data were identified but not directly employed, it may be that the valuation conclusion can be compared and reconciled to the market data. All such comparisons must be assessed using the same level of value for both the guideline peer data and the subject company. The table in Figure 1 presents an example of a multi-method execution of the GPCM. Some of the valuation metrics result in a valuation for equity and some for invested capital. In the example, it is by design that each indication of value is the same. Valuation indications from varying methods within the GPCM will vary, and, in some cases, the variations can be significant. We note that capitalized revenue and capitalized book value will often yield different valuation indications than capitalized earnings or cash flow. In such cases, the appraiser must develop and/or select from those methods and indications believed to be reliable for the appraisal assignment and the definition of value called for therein. Several caveats and considerations are required to properly execute a GPCM.There is a fundamental adjustment of 20% applied to each equity value indication developed under each method. A following section of this publication will provide an overview of how fundamental adjustments for guideline data can be developed.There is a line item for the market values of non-operating assets (and liabilities). Appraisers should apply adjustments to the earnings and other performance measures to eliminate the effects of non-operating assets because the values of such assets are typically captured on the back end of the analysis in order to develop the final indications of value. Failure to adjust the performance measures can result in double counting errors.There is a line item providing for the potential application of a control premium. Such a premium applies only when the engagement definition calls for the controlling interest level of value. The consideration of a control premium at this stage serves as a proxy for other adjustments not otherwise captured in previous adjustments or reflected in the guideline multiples or applied as a subsequent treatment after a correlation of the GPCM with other methods employed in the appraisal. We caution that blind application of published control premiums is a frequent source of flawed, over-stated valuation. Published control premiums are consequential measures of investor expectations for efficiencies and other value pick-ups from the reported transactions. They reflect expectations of post-deal operating and strategic economies. In the context of appropriately adjusted performance measures and other valuation inputs, most financial control premiums for small private companies are quite modest to nil. This can be particularly true in ESOP situations where the entity is remaining an independent going concern and will not benefit from postmerger efficiencies and synergies embedded in most market-based transactions.A memo section in the example displays what each value indication implies on a relative basis by way of comparison of each value method to the subject’s book value, net income, and EBITDA. In this fashion, appraisers and users of valuations can assess how a valuation indication using one valuation metric relates to another.When multiple indications of value are developed using the GPCM, the appraiser may elect to average the indications into a singular expression of value or may elect to carry individual value indications from the GPCM into a broader exercise to correlate the overall conclusion of value from all methods developed using the three core approaches to value. We believe both of these presentations to be appropriate, but we caution that appraisers and report users should be aware of the total consideration applied to each methods and approach.Identifying Guideline CompaniesThe initial stage generally includes the identification of relevant subject company characteristics to serve as a basis for a public company or transaction search. These characteristics include (among other things):The subject entity’s portfolio of products and/or servicesThe subject entity’s vertical and/or horizontal integration in its respective industryThe subject entity’s market share in the industry or in subsets of geography or by customer type, and so forth (to whom and where are the subject’s products and services sold?)The subject entity’s operational and organizational structureThe characteristics outlined in this list can be used to identify codes under the Standard Industrial Classification (SIC) and North American Industrial Classification Systems (NAICS - used in the United States, Mexico, and Canada). These codes can be used to identify transacting companies and public companies with common economic activities to the valuation subject. Appraisers may need to augment such global screenings with key word searches or perform parallel searches of other SIC or NAICS codes that represent businesses with substantially similar business attributes. Screening of electronic and web-based resources is a virtual standard in valuation practice today. Such resources often include industry data and noteworthy public and private participants. Additional criterion used for selecting and narrowing selections include consideration of the subject’s and the guideline companies’ financial performance and composition, the nature of the assets, the supporting capital structure, trends in absolute and relative performance via size and margin considerations, and consideration of internal and external factors that drive or influence business activity. Choice of Valuation MetricThe valuation metrics applied in a given appraisal should be commonly accepted and recognized as relevant to the subject’s industry (earnings, EBITDA, book, etc.) and should be reflective of business cycle or other relevant issues affecting the subject, its industry, and its guideline peer group. For example, guideline capitalized net income is a common valuation norm for many financial institutions and service companies, while capitalized EBITDA is a more recognized valuation norm for asset-intensive business such as manufacturers. In many valuation engagements, the value of an entity in relation to its book value can be important.The reliance of securities markets on various types of valuation information can shift during economic and industry cycles. Businesses that typically have higher valuations during economic expansions may be valued with higher reliance on capitalized cash flow or earnings, while valuations in recessionary periods or down cycles may place greater reliance on asset-based valuation methods. The point is that valuations performed from one time to another or for one purpose to another may require differing degrees of reliance on and consideration of the GPCM as a whole, as well as differing degrees of reliance on and consideration of varied indications of value underlying the GPCM. A rigid average of underlying methods in the GPCM as well on other methods and approaches in an appraisal may constitute little more than a rule-of-thumb or formulaic approach to value and can lead to flawed valuation results.The Fundamental AdjustmentUnder both the guideline public company method and the guideline transactions method, it is necessary to adjust the market evidence observed in transactions of comparable companies for fundamental differences between the subject company and the guideline companies.Adjusting Guideline Valuation Metrics for Use in Business ValuationWhat is a fundamental adjustment? The term “fundamental adjustment” is not a universal term, but it is a universal treatment applied explicitly or implicitly in virtually every GPCM and guideline transaction method (GTM). Where market-value evidence is observed, screened, and modified for use in the GPCM or GTM, one can be virtually assured that some adjustment has been applied to the data. The adjustment of market-value evidence, whether it is through selection criterion, central tendency observations, or otherwise is what we refer to as a fundamental adjustment. Labels and terms aside, we acknowledge the need for an explanation of how an appraiser adjusts market-value evidence used in the appraisal process. The obfuscation of or failure to consider such adjustment is a common feature of and/or source of error in many appraisals.Figures 2 and 3 provide perspective concerning the conceptual framework of market-value evidence and its adjustment for use in business valuations. Figure 2 relates to the marketable minority level of value that by default is the typical level of value arising from the GPCM. We note that the financial and strategic control levels of value may differ from guideline to subject using the same concepts discussed here.The necessity for fundamental adjustments is frequently overlooked. These adjustments are required to reconcile differences between the subject company and the selected group of guideline companies (or transactions as the case may be). Fundamental adjustments are generally applied as discounts to the observed market-value evidence (reflecting a typically smaller and riskier valuation subject versus larger public companies that populate a guideline company group), but they can also represent premiums in relationship to the base market-value evidence.Core comparative considerations between the valuation subject and the guideline companies include the following:Size. Publicly traded guideline companies are often larger and more diversified than the valuation subject. Diversification and scale regarding geographic footprint, customer concentration, supply inputs, and other common risk factors typically favor guideline public companies and acquirers in transactions. All things being equal, this would imply a lower valuation multiple for a relatively smaller subject entity.Growth. The growth expectations of guideline companies may be materially different than the growth expectations for the subject company. All things being equal and using the basic representative equation of valuation and the underlying elements of a valuation multiple, higher growth translates to higher valuation multiples and vice versa.Access to and Composition of Financing. The ability to obtain financing and negotiate favorable terms can facilitate future growth and provide superior returns on investment. The capital structures and financing power of large public companies can reduce the cost of capital and provide greater operational and strategic flexibility. Such factors translate to higher valuation multiples than may be reasonable for smaller companies lacking such resources.Financial/Operating Strength. Guideline companies may be better capitalized and have greater depth in their respective management teams.The underlying need for fundamental adjustments arises because of differences in the risk profile and growth prospects of the valuation subject in relation to the companies whose trading and transaction data are used in a valuation. By process, the adjustments are developed (through explicit analyses or otherwise) by substituting the risk and growth attributes captured in the guideline data with the risk and growth attributes of the valuation subject. In this fashion, the appraiser attempts to answer the question – how would the market-value evidence differ if the guideline companies and/or the transaction participants had the same risk profile and growth prospects as the valuation subject? This question provides the genesis for understanding a quantitative method for assessing the magnitude of a fundamental adjustment. There are numerous variations of quantitative adjustment and most are predicated on the principle of substitution. Quantitative Process for Assessing a Fundamental AdjustmentAs a preface to the following example, readers are reminded of the build-up and ACAPM methods for developing the required rate of return on equity capital. These CAPM-based disciplines provide the basis for disaggregating the P/E ratios of public companies in a fashion that facilitates the process for substituting the subject risk profile and growth of the subject and determining the effect on the P/E ratio. Such quantification may suggest the magnitude of an appropriate fundamental adjustment. The following assumptions and conditions are used in the example. The figures and assumptions in this example are purely for demonstration purposes.Ten public companies were identified as guideline public companies. The median P/E ratio of the group was 10x. The reciprocal of this P/E ratio equals a capitalization rate of 10%.The median equity market capitalization of the 10 guideline companies would place the hypothetical guideline company near the bottom of 9th decile of public companies according to the Morningstar/ Ibbotson SBBI Yearbook. The 9th decile companies reflected an implied size premium on the order of 4.0% in excess of returns on the S&P500 index (large cap stocks). The median beta was 1.0, implying equal volatility to the S&P500.Financial composition and performance of the subject company were reasonably consistent with the guideline company. The elements of risk were primarily related to differences in firm size.Stock analysts following the guideline companies were projecting annual earnings growth of approximately 10% for the next five years. Long-term industry prospects suggested annual earnings growth on the order of 4%. The guideline growth rate expectations equate to a perpetual earning growth rate of approximately 6%. The implied required rate of return for the hypothetical median guideline company is 16%. This measure of return minus the perpetual growth rate of 6% equals the observed capitalization rate of 10%. The subject company was mature and displayed recent earnings growth of 10%, near-term growth expectations were expected to decline by 1% each year and level out at a long-term growth rate similar to the overall industry (4%). The subject growth rate expectations equate to a perpetual earning growth rate of approximately 5%.At the valuation date, the risk-free rate of return on long-term U.S. Treasury bonds was 5%. The assumed large stock equity premium was assumed to be 7%. The size premium deemed appropriate for the subject company was 6%, and firm-specific risk was assumed to be 1%.The table in Figure 4 depicts the changes in the median guideline P/E ratio via the sequential and combined substitution of subject growth and risk into the build-up process. The differences between the resulting adjusted capitalization factors and the median guideline P/E ratio represents the fundamental adjustment.The risk differential (combined size- and firm-specific) suggests the median guideline P/E ratio be reduced by 23% solely based on the valuation subject’s risk. The growth differential suggests the median guideline P/E ratio be reduced by 9% based solely on the valuation subject’s risk. Considering risk and growth differentials, the median guideline P/E ratio would be reduced by 29%. In operation, this adjustment would be applicable to pricing metrics that result directly in value indications for total equity or could be applied to the resulting equity value derived after subtracting debt from value indications for invested capital. Using the foregoing example, we might see an appraiser use a fundamental adjustment of 15% to 25%. Every situation is unique, and the exact quantified result of this technique is not the absolute adjustment that need apply.Fundamental Adjustments in DisguiseThe following bullet points highlight some of the possible implicit adjustments we see applied to market-value evidence. These points are random in fashion and are designed to spark the necessary analytical curiosity required to scrutinize valuation methods under the market approach.Most appraisers, even those who have never employed the term “fundamental adjustment,” have employed the same concept in appraisals. In fact, any appraiser who has selected guideline company multiples other than the median (or perhaps, the average), whether above or below, has implicitly applied the concept of the fundamental adjustment. Based on comparisons between private companies and guideline groups of companies, appraisers often select multiples above or below the measures of central tendency for the public groups.Analysts routinely add a small stock premium to the base, CAPM-determined market premium based on historical rate of return data. In addition, analysts routinely estimate a specific company risk premium for private enterprises, which is added to the other components of the ACAPM or build-up discount rate. Implicitly, analysts adjust public market return data (from Ibbotson or other sources) used to develop public company return expectations to account for risks related to size and other factors. In other words, they are making fundamental adjustments in the development of discount rates.What are the differences between the subject company and the guideline companies, and how does one incorporate them into the analysis? If all of the guideline companies were identical to one another and the subject company was identical to the guideline companies, then subject value would be equal to the values of the guideline companies. Because this is never the case, the analyst has to identify the important differences and determine what adjustments are required to arrive at a reasonable estimate of value for the subject.The actual value measure applied to the subject may be anywhere within (or sometimes even outside) the range of value measures developed from the market data. Where each measure should fall will depend on the quantitative and qualitative analysis of the subject company relative to analysis of the companies that comprise the market transaction data. Valuation pricing multiples are influenced by the same forces that influence capitalization rates, the two most important of which are: (1) risk and (2) expected growth in the operating variable being capitalized.Therefore, in order for the analyst to make an intelligent estimate of what multiple is appropriate for the subject company relative to the multiples observed for the guideline companies, the analyst must make some judgments about the relative risk and growth prospects of the subject compared with the guideline companies.The analyst should be aware that a search criterion could represent the beginning of a fundamental adjustment in the eyes of potential users of a report. The analyst can unwittingly (or overtly) apply a fundamental adjustment before the mathematical process even begins.As with any discount or premium, a fundamental adjustment has limited meaning unless the base against which the adjustment is applied is clearly defined. Define such base in error, through either commission or omission, and the selection and adjustment of public company valuation metrics may be faulty.Use of generic methodology in lieu of an emphasis on relevant metrics can be construed as a fundamental adjustment.Ultimately, as a result of weighing alternative valuation methods to the ultimate valuation conclusion, the valuation may reflect a significant discount to public company multiples and potentially a higher (or lower as the case may be) fundamental adjustment than explicitly articulated (or implicitly captured) under the guideline method.ConclusionAs with many tools in the valuation, there are variations of this process. Some appraisers may elect to quantify adjustments for application to differing valuation metrics so as to take into consideration specific differences in profit margins or capital structure. Fundamental adjustments can be small or large and can be positive or negative. Appropriate quantification techniques can be useful tools in augmenting qualitative-based adjustments. Fundamental adjustments can be explicit in nature or implicit and disguised in numerous ways. Ultimately, it is the appraiser’s responsibility to select and reasonably adjust market-value evidence for use in the GPCM or the GTM.Guideline Transactions MethodThe transactions method and the GPCM follow a generally recognized (more or less) set of procedures and practices. The guideline transaction method (GTM) is inherently different in its requirements due to potential idiosyncrasies in the underlying data.The largely private purveyors of market-value evidence used in the GTM provide varying degrees of data from varying markets. Transaction events are generally classified by industry, facilitating SIC- and NAICS-enabled screening. However, transaction consideration and various valuation ratios may follow differing definitions. Certain adjustments are required to add or subtract values associated with excluded assets or to compensate for the effect of specialized transaction consideration and other deal terms in order for an appraiser to develop an appropriate valuation of the subject.The required adjustments and considerations vary from one data source to the next. Such adjustment items may include employment contracts, non-compete agreements, contingency payments, seller financing terms, working capital, real estate, specialized expressions of cash flow and other transaction attributes. Care must be taken to ensure that the methodology results in value indications that are consistent with the value definition required in the appraisal description. Appraisers and report users are cautioned that data sources should be reviewed to understand what kind of valuation is captured in the transaction data (typically it is the market value of invested capital) and how that data needs to be adjusted to derive the intended subject valuation (equity value in most valuation engagements). Confusion in the proper use of transaction data bases has fueled a veritable professional niche of publications intended to instruct appraisers on the proper use of market-value evidence from the various databases. This suggests that transaction observations be supported by sufficient (perhaps significant) underlying financial detail.In operation, the GTM is similar to direct capitalization income methods and to the GPCM in that a specified subject performance measure is capitalized by a capitalization factor that is derived from observable market-value evidence (transactions). As with other guideline data processes, capitalization factors are typically drawn from numerous transactions implying some average valuation metric or ratio. Adjustments to reconcile fundamental differences between subject and guideline follow similar considerations as discussed in the GPCM. Differing valuation metrics may be used to describe transaction values based on the nature and industry of buyers and sellers in the cited transactions. As with income methods and other market methods, consistency between performance measures and capitalization multiples is required.Valuations using transaction data result in a controlling interest valuation indication. As such, the GTM may not be employed (or useful) in a valuation intended to develop a minority interest level of value. Alternatively, a controlling interest value can be adjusted by valuation discounts to derive alternative levels of value. Market transactions are used to develop valuation indications under the presumption that a similar market exists for the subject company.As with the guideline public company method, ideal guideline transactions involve companies which that are in the same business as the company being valued. However, if there is insufficient transaction evidence in the same business, it may be necessary to consider companies with an underlying similarity of relevant investment characteristics such as markets, products, growth, cyclical variability, and other salient factors.One or a combination of data sources are typically employed in the GTM. Additionally, there are countless other potential sources of information that are reported by specialized industry trade groups, investments banking concerns, industry consultants, and other market participants. Information may also be gleaned from the corporate development activities of publicly traded buyers and sellers because such data may be reported in SEC filings. There is a wealth of potential information from diverse providers of financial and market market-based information including (among others) SNL Securities, Thomson Reuters, and Bloomberg.Virtually every caveat and caution discussed for the GPCM and the transaction method extend to the GTM (and then some). Appraisers are challenged with adequate documentation of transactions, proper application of the data, and proper adjustment of the results. Many appraisers include citation of transaction data in their reports but may elect to use such data as a supporting element to an appraisal conclusion derived from alternative methodologies. Direct use of transaction data is often reserved for situations in which adequate transaction volume can be observed, the transactions occurred within a reasonable timeframe of the valuation data, and the transaction participants’ data and deals can be reasonably adjusted and reconciled to the valuation subject.

This article first appeared as a whitepaper in a series of reports titled Appraisal Review Practice Aid for ESOP Trustees. The correlated indication of value is a value that is arrived at through some reasonable, well-articulated, replicable, and credible process of selection, averaging or otherwise, of the total valuation evidence generated from the valuation methodologies employed. Correlating a valuation conclusion that subsumes all the information, processes, analyses, and market evidence in a valuation engagement is no simple task.The term used by some appraisers for the resulting valuation distillation is “correlated indication of value.”For valuations in which the value methodology directly results in the value definition specified in the engagement, the correlated indication of value may represent the final conclusion of value.For cases in which the value definition differs from the direct results of valuation methodology, the correlated indication of value is typically adjusted by valuation discounts or premiums (typically the former) to develop the value definition specified in the engagement. Figure 1 depicts the typical correlation framework.There are numerous variations and potential interjecting steps and adjustments.In operation, developing a correlated indication of value may appear reasonably straightforward (sometimes it is), but the considerations in the process can reach back to the smallest of details and considerations in the underlying valuation methodologies. A brief review of the global valuation approaches provides a good review for the subsequent observations. Figure 2 presents the three valuation approaches.Global Considerations in the Correlation ProcessThe following provide some global considerations used by many appraisers to navigate the correlation process (which is not to say all are best practices).These points are not listed in any order of significance because the priority of consideration changes with every appraisal.Nature and Industry of the Subject BusinessManufacturing, distribution, retail, service, professional, contracting, etc. Differing business models have differing value drivers and differing financial infrastructures.Some methods will be the primary or sole path to value for some types of businesses.The relative asset-intensity of a business may influence the selection of valuation methods. Manufacturing concerns make capital investments differently than do professional service firms; the methods weighed should reflect this basic reality.All businesses have resources at risk in the marketplace and should by logical extension rely on earnings (cash flow) as the core driver of value.In other words, the capitalized cash flow of the subject company should at least validate the value of underlying net asset value.In a very real sense, the value of capitalized cash flow defines the value of underlying net assets, based on risk, return, and growth parameters.Yet many businesses, at different points in their life cycles, are more appropriately valued based on (or with partial reliance on) underlying net assets.It is the job of the appraiser to determine the driver(s) of value in general and on a given valuation date and to utilize that perspective in fashioning a conclusion.Although all firms employ assets to generate profits, some are better at it than others.The store of value in hard assets can serve to sustain value (or soften downturns) for many types of businesses, particularly in times when profits are low or non-existent.For businesses lacking significant hard assets (and other balance sheet resources), a lack of earnings or cash flow, when coupled with poor business prospects, likely means a lack of value.Businesses that hold assets are typically valued using the appraised values of the underlying assets and/or on asset values that can be readily evidenced from an active, observable market.In such cases, a singular method such as the net asset value method may be employed.Additional analysis based on income and market methods may be used to support valuation discounts that are applied to the direct asset-based value indication.Most closely held businesses are too small or narrow in focus to be valued using the market approach.Accordingly, many (most) appraisals do not employ the guideline public company method. In similar fashion, other market methods may not apply either.Stage of Business Maturity and DevelopmentMature businesses with established performance may be valued using methods that are not appropriate for early stage businesses or businesses in decline.Start-ups or liquidating business should be valued using methods that capture the eventual or ultimate expected economic norms or outcomes for the business.In such cases, there is little correlation required because only one method may be used.Position in Industry or Economic CycleBusinesses that display periodic down cycles may be valued with more weight placed on balance sheet indications of value, particularly when projected performance is uncertain or lacking all together.However, income methods showing little to no value may be weighted as a proxy for lack of control issues (also known as minority interest discount), to capture appraiser concerns regarding the economic obsolescence of assets, or to capture anticipated financial losses for the period of time until a return to profitability or stabilized performance is can be expected to be achieved.The weighting of low-to-no value income methods serves to effectively discount the asset-based method in many valuations.Businesses performing at historic average levels and/or with continuing expectations for stability will likely be valued using income methods or with market methods that focus on earnings and cash flow.Businesses in high or low cycles may be valued using discrete projection methods that adjust the business up or down over time toward a steady state of performance that is more in keeping with proven history or is better aligned with industry performance and/or expectations.Nature of Underlying Adjustments in the Valuation MethodsAll valuation methods require underlying adjustments. Asset-based methods follow a mark-to-market discipline. Income methods may be adjusted for unusual expenses. Projections may be more or less believable in the context of history and external market expectations. Market methods may rely on market evidence that is not directly comparable or is unreliable due to an economic or industry shock.The point is that many valuations include methodologies and results that are more or less speculative than other methods. This can be acute when a business is at a peak or trough in its cycle.Under the ubiquitous standard of fair market value, appraisers must take into account the balance of considerations from both the hypothetical buyer’s and hypothetical seller’s perspectives.Standard and Level of Value (The Value Definition)An appraisal performed using the controlling interest level of value may rely more heavily on the higher value indications than on the lower value indications. This kind of consideration may serve as a proxy for the highest and best use or operation of the underlying business assets.It can also lead to error and/or alleged bias.Conversely, a minority interest value definition may influence the consideration of lower value indications or indications from methods that are believed more reflective of the expectations of investors who lack the prerogatives to bring about the changes or choices that might otherwise increase the indicated value.This too, can lead to error and/or alleged bias.Some appraisals are performed for specific purposes using a standard of value other than fair market value.In such cases, certain methodologies may be dictated and others prohibited.Fair value under FASB reporting requirements may require considerations and perspectives very different than under fair market value.Fair value (yes, a different “fair value”) under operation of law (either by statute or judicial guidance) can vary from state to state and from issue to issue.Dissenter’s rights, marital dissolution, securities fraud, and other matters in which an appraisal is developed for expert consulting or expert witness purposes may require unique valuation considerations and often include specific instruction from legal counsel concerning what “counts” in the calculations and how.In matters requiring a very specific set of defining elements, the value definition must be top of mind when developing or reviewing the work product, which is often a scope of report other than the typical appraisal opinion.The Quality and Availability of Subject Financial DataThe lack of proper financial reporting does not provide license for an appraiser to resort to obtuse measures such as total assets or gross sales as a foundation for establishing value.Some situations may require consideration of broad financial measures and/or somewhat remote market evidence as a basis for speculating on value when the quality of net worth and /or the visibility of cash flow are obscured.Such situations may require the valuation to be qualified as falling short of a formal appraisal opinion under most professional standards.In other cases, an appraiser simply has to operate with the available information.These considerations are based on experience, observations of public and private markets over time, and a dose of informed judgment; differences, both semantic and substantive, can exist from one appraiser to the next.One could ask:When should a valuation not reflect balanced consideration of all approaches and methods?The right answer is – never.It is always helpful to assess the value indications from all approaches and methods in the context of one another.However, consideration and direct reliance are different things.In many cases, there is simply not ample information, market evidence, or cause to develop values under each approach.Appraisers owe the users of their reports a credible explanation of where reliance was placed and in what proportion.There are times when financial information and valuation evidence suggest that brevity is the high road and that too much analysis along lines that are ultimately not relied upon in the valuation is confusing or misleading.Appraisers simply must use the judgments extended them by the appraisal standards to present a complete picture of the relevant methodological landscape.However, appraisers and their audiences benefit from the use of a core set of processes and considerations for deriving and displaying the correlation of value.The table in Figure 3 is provided for perspective.We note that the valuation of most business enterprises is ultimately driven by the economic returns generated on the assets that comprise the business.As such, the income approach is the primary indicator of value in most business appraisals where the business is a going concern and not simply a fund of underlying net assets.Unfortunately, the income approach can be difficult to model in certain circumstances such as a recession.For ESOP appraisals, the above perspectives can be shift based on the comfort and confidence of the appraiser/trustee in the company’s ability to maintain a sustainable ESOP benefit.Repurchase obligations ultimately require cash flow.Depending on the overall design and management of the ESOP plan, appraisers and trustees are cautioned when relying on asset-based value indications without taking into consideration the ability of the company to sustain the asset base when cash flows fall short of servicing the ESOP’s needs, let alone the needs of the business.ESOP companies that experience a decline in business activity and which have little prospects of recovering to past performance levels (or worse, remaining a going concern) should likely include consideration of a liquidation premise.The liquidation premise is often developed and studied using an asset value perspective, adjusted for the time-value and liquidation consequences that could befall the assets as they are sold.Such a premise need not be a death sentence for the ESOP or the Company, but may relevant to consider during a time of reorganization for the sponsor company.When businesses are displaying significant volatility and/or a fundamental change in business posture (particularly on the downside), appraisers and trustees are encouraged to communicate about the underlying methodology and the potential need to redefine the level and premise of value for the appraisal.Such changes could materially rebalance the consideration of the underlying approaches and methods toward the conclusion.Correlation ExamplesFollowing are some typical examples of a correlated indication of value.We have provided differing examples based on varying scenarios.The numerical values and weights are for demonstration purposes; the weights applied are not based on any rigid formula and will vary for each appraisal based on the totality of underlying factors for each appraisal.Example 1 in Figure 4. Small to medium service business; stable market, consistent performance and expectations; valuation definition is FMV minority interest, correlated value before discount for lack of marketability. Example 2 in Figure 5. Small distribution business; challenging market conditions and sub-par expectations; company owns real property and other fungible assets; valuation definition is FMV minority interest, correlated value before discount for lack of marketability.Example 3 in Figure 6.Large producer of value-added capital assets; stable markets and expectations; advanced financial management and capital resources; value definition is FMV minority interest, correlated value before discount for lack of marketability.In Figure 6, we can see that the income approach was allocated two-thirds of overall weighting. Looking deeper, if the GPCM exclusively considered cash flow calculations (say net earnings and EBITDA), then income measures were effectively weighted 100 percent in the overall valuation; the only difference being the specificity of the market evidence used to value the income and cash flows.For cases in which the GPCM is used, there may be reasons that some calculations should receive greater underlying consideration than others (say capitalized book value rather than EBITDA).This may simply be a variation of the same theme of shifting weights between asset-based and income-based methods to address issues related to business and economic cycles.Variations on these examples are almost endless.There are often circumstances in which value indications vary greatly and require thoughtful explanation about why a value that appears at one end of a spectrum was exclusively weighted.In some cases, a simple average might be appropriate but appraisers should be cautious when averaging a potentially non-meaningful indication with a meaningful indication. Rarely does the averaging of an unreliable indication make the end result correct unless additional explanation and support are provided about how the resulting correlation relates to the most meaningful valuation evidence.Accordingly, a relative value analysis, as in Figure 7, may be a useful tool in helping explain how each indication relates to other indications.Let us expand on the third example with some additional information to see how the various indications compare to each other.Such a comparison could be used in an iterative fashion to reach a final weighting scenario as well as to provide support for the conclusions reached in the report.Note that the relevant comparisons are being made at the marketable minority interest level of value. At the marketable minority interest level of value, the subject’s relative value measures can be directly compared to the relative value measures of the guideline public companies. Relative value assessments that compare subject valuation results to peer valuation evidence must be performed using an appropriate and comparative level of value for both the subject and the peer.Section 5 of Revenue Ruling 59-60 addresses the weight to be accorded to various factors in an appraisal.In the context of an operating company appraisal, judgment is required to reconcile what may be diverging indications of value among the various valuation approaches (or even methods within a single approach or method).Although averaging widely diverging indications of value from various valuation methods may be appropriate in a particular valuation, appraisers should assess why such large differences exist.Do indications from the market approach suggest that assumptions made in methods within the income approach be revisited?Or do the results from an income approach shed light on the appropriate fundamental adjustment (or selection of guideline companies)?Within the market approach, indications of value can vary widely, depending on the financial measure capitalized.The appraiser may glean hints with respect to the weight to a particular indication by considering why such differences occur.Differences between indications derived from capitalized net income and EBIT are a function of the financing mix. Differences between indications derived from EBIT and EBITDA may reveal varying degrees of asset intensity.Capitalized revenue measures provide a view of “normalized” margins – are the margins of the subject company likely to improve or deteriorate?Finally, capitalizing measures of physical volume (number of subscribers or units sold, for example) could reveal unit-pricing disparities between the subject and the selected guideline companies.There can be no fixed formula for weighing indications of value from various valuation methods.Responsible appraisers, recognizing this, should apply common sense and informed judgment in developing a correlated indication of value. ConclusionGiven the potential diversity of valuation evidence and methodology in most business appraisals, a well-reasoned and adequately documented process is required to support the initial and final valuation conclusions derived in a business valuation. In this publication we provided insight on the functional processes and analytical considerations underlying the determination of a correlated indication of value. Additionally, we discussed methods and perspectives that can be used to justify the underlying methodology and valuation evidence relied upon while providing relative value observations to support the reasonableness of a valuation conclusion.

This article first appeared as a whitepaper in a series of reports titled Appraisal Review Practice Aid for ESOP Trustees. There is a protracted and clouded legacy of information and dogma surrounding the universe of discounts and premiums in business valuation. It seems logical enough that as elements of business valuation, the underlying quantification and development of discounts and premiums should be financial in basis, just as other valuation methods are founded on financial principles. Much of the original doctrine surrounding the determination of discounts and premiums was based on reference to varying default information sources, whose purveyors continue the ongoing compilation of transaction evidence (public company merger and acquisition activity, restricted stock transactions, pre-IPO studies, etc.). After begrudging bouts of evolution, there has been maturation toward more disciplined and methodical support for valuation discounts and premiums. Perhaps as the state of the profession concerning discounts and premiums has progressed, so, too, has the divide in skill and knowledge among valuation practitioners become wider. Certainly this seems to be the case regarding many users and reviewers of appraisal work (ostensibly the legal community, the DOL and the IRS). There remains ample debate concerning numerous issues in the discount and premium domain. Unfortunately, in the quest for better clarification on the determination of discounts and premiums there has developed an arms’ race of sorts. Despite the emergence of compelling tools and perspectives, no method or approach appears to have the preponderance of support in the financial valuation community. Nowhere is this truer than with the marketability discount (also known as discount for lack of marketability or DLOM). Within the ESOP community much of the confusion over DLOMs is mitigated due to the presence of put options designed to ensure reasonable liquidity for ESOP participants. However, in the ESOP community a legacy of concern over control premiums has now become an acute issue as stakeholders and fiduciaries have increasing concerns regarding flawed valuations and prohibited transactions.The Levels of ValueRegarding the concept of control premiums and minority interest discounts (also known as “lack of control discounts”), there is less conflict and more uniformity on how and when these discounts are used in a business appraisal. That is not to say that differences among appraisers don’t exist regarding certain issues. For purposes of establishing a platform to converse on valuation discounts and premiums, let us use the conventional levels of value framework to anchor the discussion. Figure 1 provides structure about where the traditional valuation discounts and premiums are applied in the continuum of value.The integration of the basic income equation of value into the levels value chart results in the equations and relationships shown in Figure 2. It is here that we can begin to understand that valuation discounts and premiums are not devices in and of themselves. Each is the product (consequence) of the relationships among and between the underlying modeling elements that constitute financial valuation(cash flow, risk and growth). We note that the conceptual core of the mathematical relationships is generally centered on the freely traded world of the public stock markets, which is characterized as the “marketable minority” level of value (enjoying readily achievable liquidity in a regulated, timely, and efficient market). Although other levels of value can be directly observed in various markets, the marketable minority interest level of value characterizes the empirical world from which most valuation data and observations are made (i.e., Ibbotson).CF = cash flow; CFe= cash flow to the business enterprise; CFsh = cash flow to the shareholder; subscript “c,f” and c,s” denote, respectively, CF available to financial control investors and CF available to strategic control investors.R = risk as expressed by the required rate of return on investment; Rmm, Rfand Rsdenote risk as perceived through the eyes of marketable minority investors, financial control investors and strategic investors, respectively.G = growth rate in cash flow or value (see notes above on “R”). Gmm, Gfand Gsdenote growth as expected from the perspective of marketable minority investors, financial control investors and strategic investors, respectively. Gv differs from the other growth expressions in that it is an expression of the growth rate in value for the subject security in an appraisal exercise. All other expressions of “G” are growth rates in the cash flow of the business enterprise.The take away from the relationships depicted in Figure 2 is that risk is negatively correlated to value (the universal reality of the time value of money) and that cash flow and the growth rate in cash flow are positively correlated to value. According to the preceding relationships, a control premium only exists to the degree that control investors reasonably expect some combination of enhanced cash flows, lower risk, or superior growth in cash flow, all as a result of better financial and operational capacity (financial control). Taking the financial control relationships one step higher via specific synergies results in a strategic control premium (which is not considered within the continuum of fair market value and generally exceeds adequate consideration for ESOP transaction purposes). Conversely, a marketability discount exists to the degree that investors anticipate subject returns (yield and capital appreciation) that are sub-optimal in comparison to the returns of a similar investment whose primary differentiating characteristic is that it is freely traded (also known as liquid). That is to say, minority investors (buyers and sellers) in closely held businesses that have investment-level considerations such as higher risks, lower yield, and/or lower value growth require some measure of compensation to compel a transaction in the subject interest. Otherwise, the investor would seek an alternative.Perspective on the Control PremiumWhat is a control premium? The American Society of Appraisers (ASA) defines a control premium as an amount or a percentage by which the pro rata value of a controlling interest exceeds the pro rata value of a non-controlling interest in a business enterprise, to reflect the power of control. In practice, the control premium is generally expressed as a percentage of the marketable minority value.Based on this definition, it might seem that no controlling interest valuation can be developed without an explicit quantification to increase a value that is initially developed using a marketable marketable-minority interest level of value. This might be true in for circumstances in which the control value is not the direct result of the underlying methods. The fact is that most controlling interest value appraisals are developed based on adjustments and methods that result directly in the controlling interest level of value. Therefore, no explicit control premium is required. Consequently, the appraiser cannot explicitly define the magnitude of the control premium in the appraisal.In many cases, the appraiser may state that no control premium is added because all the features and benefits of control have been captured in the earnings adjustments and/or through other modeling assumptions in the underlying methods. We have seen numerous situations in which an appraiser was accused of failing to develop a control valuation because there is no explicit control premium applied to the correlated value or to the individual methods that are weighed in the correlation of value. Archaic though it may be in the context modern valuation practice, such accusations still exist even when the valuation features all the perfunctory control adjustments and treatments. For cases in which normalization and control adjustments were applied to cash flows and other elements, the additional application of a discrete control premium implies that there are further achievable control attributes. In such cases the control premium is likely quite small in comparison to typical published measures. If control adjustments are applied and a control premium is also applied, there is a potential overstatement in the valuation. This type of circumstance is a hot bed issue with the Department of Labor as such treatments could be the underpinning of a prohibited transaction. Appraisers and trustees are cautioned about the potential for double counting when applying an explicit control premium.The primary published source for control premium measurements is Mergerstat Review,published annually by Mergerstat FactSet. Mergerstat Review reports control premiums from actual transactions based on differences between public market prices of minority interests in the stock of subsequently acquired companies prior to buyout announcements and actual buyout prices. It is worth noting that Mergerstat’s analysis indicates that higher premiums are paid for public companies than for private concerns because publicly traded companies tend to be larger, more sophisticated businesses with solid market shares and strong public identities. From a levels-of-value perspective, most of the transactions reported in Mergerstat Review are believed to contain elements of strategic value, which explains the relatively high level of control premiums cited therein. This strategic attribute of the data also makes it potentially troublesome when relied upon in ESOP appraisals.Noteworthy is the now widely accepted presumption that public stock pricing evidence is reflective of both the marketable marketable-minority and controlling financial interest levels of value. Referring to the expanded levels of value chart, minority interest discounts and financial control premiums are thought to be much lower in comparison to annually published data in Mergerstat Review.Thus, the two central boxes in the four-box vertical array of the expanded levels of value chart are essentially overlapping as in Figure 3.The parity of value between financial control and marketable minority requires a few assumptions: normalized earnings adjustments are required, and these adjustments include some considerations that certain appraisers believe are not part of the minority interest equation (namely owners’ and executive compensation). We believe that return on labor and return on capital are reasonable to segregate in valuations based on all levels of value. However, there may be differences between financial control and marketable minority valuations based on enterprise capital structure. There may be some consideration for the lack of liquidity to both control and minority investors when adjusted income streams overstate the real economic cash flows available for distribution or other shareholder-level benefits (including cash flows necessary to sustain an ESOP). There may be some justifiable difference in value for situations in which the valuation subject’s capital structure appears more conservative than its peers. However, wanton manipulation of capital structures (for example, in the development of a weighted average cost of capital or WACC) in deriving the cost of capital is a frequent source of error in appraisals using a discounted future benefits (DFB) method. Such errors can lead to under- or over-valuation.Control Premiums — Substance Over FormMost appraisals that employ a controlling interest level of value definition do not (or should not) display a discrete or explicit control premium. That is because the adjustment processes underlying most individual valuation methods provide for the full consideration of control and thus do not require or justify further adjustment in the form of an explicitly applied control premium. So, despite the lack-of-control form that many control appraisals have, there is ample structure within the methodologies to capture the substance of a control premium. The following perspective plays off the basic equation to business valuation as well as the levels of value chart that depicts the relationships between risk, growth, and cash flow as one moves up and down the levels of value conceptual framework.Control premiums can be the result of earnings adjustments that eliminate discretionary expense, such as excess and non-operating compensation. Shareholder compensation paid to individuals who do not contribute to operations or management, directors’ fees paid to family or others for non-vital roles, management fees paid to retired owners, loan guarantee fees paid to shareholders whose capital resources are not required, and other similar types of expenses are often the underlying control “pick-up” in an appraisal. Arguably, many of these adjustments should be part of the normalizing process for all appraisals so that returns on capital are clearly differentiated from returns on labor. When such adjustments are used to underpin an ESOP transaction, subsequent expenses and policies of the ESOP sponsor in future periods should confirm the credibility of the adjustments.Control premiums can take the form of adjustments that place related party income and expense at arm’s length pricing. Rents paid to related parties, management fees paid to affiliated entities, optimizing value or discretionary income from non-operating assets, and many similar adjustments that optimize the subject benefit stream are all part of the control mindset.Control premiums can be related to the optimization of capital structure. Many businesses enjoy the quality of having little to no interest interest-bearing debt. Perhaps in the paradigm of today’s financial landscape, this is a better quality than previously appreciated. However, if a hypothetical investor can easily use debt in an efficient and responsible fashion to provide for the financial needs of the business, the subject’s cost of capital may be reduced and correspondingly, the return on equity of the business can be improved. That is not to say that increased debt, as low cost as it may be, does not increase the potential risk profile of equity holders. All things equal, a reasonable blend of debt in the capital structure for a bankable group of assets and cash flow will provide a potential enhancement of return on equity. Many appraisals that refer to public company debt ratios or to private peer balance sheet ratios to support an assumed capital structure that is different than actually employed at the subject entity. This can constitute a control premium. However, when taken too far or when assumed in a fashion that does not properly capture the incremental risk that a higher level of debt has on equity investors, the manipulation of capital structure can result in material valuation flaws.Control premiums can emerge from weights applied in the correlation of value. In many cases, the valuation methods used to value a business result in similar value indications for both control and minority situations. However, a control valuation may include differing weights on the value indications such that the correlated value is higher than would result from the weighting scenario applied in a minority interest appraisal. Additionally, if a guideline transaction method is used in a control valuation and is weighed toward the correlation of value, the resulting value may represent a premium to the other indications of value developed in the appraisal.In tandem, capital structure efficiencies, income and expense efficiencies, and the consideration of peer transaction evidence are significant, albeit seemingly silent, control premiums.Perspective on the Minority Interest DiscountWhat is a minority interest (lack of control) discount? The ASA defines a minority interest discount as the difference between the value of a subject interest that exercises control over the company and the value of that same interest lacking control (but enjoying marketability). In practice, the minority interest discount is expressed as a percentage of the controlling interest value. A minority interest is an ownership interest equal to or less than 50 percent of the voting interest in a business enterprise (or less than the percentage of ownership required to control the assets and/or the discretionary expense structure of a business).As with the control premium, the minority interest discount is infrequently called upon in the valuation (as an explicit treatment) of most operating businesses because the majority of methodologies used to value nonmarketable minority interests results in an initial value at the marketable minority interest level of value. Accordingly, only a discount for marketability is required to derive the end nonmarketable minority valuation result.Minority interest discount discounts are a more common feature in the valuation of certain types of investment holding entities such as limited partnerships. This is because such entities have highly diverse purposes versus the relatively narrow operating focus of most operating business models. As such, the assets owned by the entity are generally best appraised by a specialty appraiser or from direct observation of market evidence concerning the asset. That being the case, most such entities are valued using an asset-based approach, which inherently captures the controlling interest level of value for the underlying assets. This makes it necessary for the business valuation to be adjusted first for lack of control considerations and second for lack of marketability concerns. Additionally, in cases involving operating business that hold operating and/or non-operating real property assets, such assets may need to be appraised by an appropriate expert and adjusted with a minority interest discount when integrated into the minority interest enterprise value of an operating business.Although minority interest considerations are captured in the majority of appraisals by reference to returns on marketable interest investments in the public marketplace, there are techniques for developing the discount. One such method involves mathematically imputing the discount based on an assumed control premium. Other methods involve observations of securities trading values in the context of the valuation of the issuer’s underlying assets, such as the case with closed closed-end funds and other securities in which underlying assets have an observable value that can be compared to the security’s trading price.The following formula provides an expression of the percentage minority interest discount as a function of an assumed percentage control premium. Although the expression is useful in identifying the minority interest discount as a percentage of an assumed or developed measure of control value, it is rarely used in a direct sense in the valuation of minority interests.In the valuation of minority interests in asset investment entities (limited partnerships et al.) that are invested in various classes of assets, many appraisers look to the observed discount to net asset value (NAV, the market value of a fund’s asset holdings less its liabilities) that closed-end funds (CEF) typically trade at as evidence of an applicable minority interest discount for a subject partnership or similar ownership interest. As a general rule, CEFs report their net asset values and the price-to-NAV relationship typically reflects a discount. Observed discounts to NAV reflect the consensus view of the marketplace toward minority investments in the underlying portfolios of securities. That is, the discounts are illustrative of the market’s discounting of fractional interests in assets, making them somewhat comparable to a minority interest in an entity that is heavily invested in other assets (such as marketable securities and other asset classes).Discounts to net asset value for closed-end funds have been consistently observable for many years. The precise reasons for such discounts are subject to debate, but common attributes include the following factors:A lack of investor knowledge about the underlying portfolio;Absence of investor enthusiasm about the underlying portfolio;Enthusiasm, or lack thereof, about the fund’s manager;Expense ratios;Tax liabilities associated with embedded gains;Lack of management accountability; andLack of investment flexibilityAlthough closed-end funds may not be directly comparable to the subject interest in an appraisal, the discounts typically observed are evidence of the market’s discounting of portfolios of generally liquid securities, and, therefore, offers valid indirect evidence of minority interest discounts applicable to asset-holding entities and operating businesses.Marketability DiscountsThe ASA defines a marketability discount as an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability. Augmenting the consideration of marketability is the concept of liquidity, which the ASA defines as the ability to readily convert an asset, business, business ownership interest, security, or intangible asset into cash without significant loss of principal. Lack of marketability and lack of liquidity overlap in many practical regards. However, lack of liquidity is often attached to a controlling interest, while marketability discounts are used to describe minority interests.Despite the proliferation of marketability discount studies and models, most models fall into one of three primary categories. These categories are based on the underlying nature of the analysis or evidence from which each model emanates. They include market-based perspectives (commonly referred to as benchmark analysis), options-based models, and income-based (rate of return) models. Although it is not our place to define a given model as the model, we do recognize that some models (or perspectives) provide general guidance for the appraiser regardless of the specific model employed. The following is a list of the so-called Mandelbaum factors, which are derived from the Tax Court’s ruling in Mandelbaum v. Commissioner (T.C. Memo 1995-255, June 12, 1995). In essence, these factors serve a similar guidepost for the assessment of marketability, as does Revenue Ruling 59-60 for the valuation of closely held interests in general.The value of the subject corporation’s privately traded securities vis-à-vis its publicly traded securities (or, if the subject corporation does not have stock that is traded both publicly and privately, the cost of a similar corporation’s public and private stock);An analysis of the subject corporation’s financial statements;The corporation’s dividend-paying capacity, its history of paying dividends, and the amount of its prior dividends;The nature of the corporation, its history, its position in the industry, and its economic outlook;The corporation’s management;The degree of control transferred with the block of stock to be valued;Any restriction on the transferability of the corporation’s stock;The period of time for which an investor must hold the subject stock to realize a sufficient profit;The corporation’s redemption policy; andThe cost of effectuating a public offering of the stock to be valued, e.g., legal, accounting, and underwriting fees.This list extends to considerations beyond the pure question of marketability. However, the ruling is instructive in its breadth. The Mandelbaum process is characterized by many appraisers as a qualitative or scoring procedure. However, most of the parameters are mathematically represented by financial elements and assumptions under the income- and options-based models. Such parameters are also used, to the degree possible, in searching out market evidence from restricted stock transactions, which are documented in varying degrees by numerous studies over several decades. Benchmarking analysis relies primarily on pre-IPO studies and restricted stock transactions. In essence, benchmarking calls for the use of market-based evidence to determine a lack of marketability discount. Some appraisers have pointed out the oxymoron of benchmarking (market transactions) analysis for use in determining marketability discounts. On the same note, other appraisers cite the restricted stock studies for capturing market evidence that at its core demonstrates the diminution to value associated with illiquidity. Imputed evidence concerning the implied rates of return for restricted stock lends support for more specific analyses within certain marketability models. Options-based models, most of which are derivations and evolutions of the Black Scholes Option Model, are based on assessing the cost to insure future liquidity in the subject interest. Rate return models are based on modeling the expected returns to the investors as a means for determining a valuation that results in an adequate rate of return given the investment attributes of the subject interest. There is no one method that is acknowledged as superior to all others. Indeed, virtually every method employed in the valuation universe has been challenged or debated in the courts as well as by and among the professional ranks of appraisers. Perhaps the best approach, stemming from a review of the IRS’s DLOM Job Aid, which was discovered and published a few years ago, is the use of multiple disciplines in a fashion consistent with the breadth of valuation approaches called for in business valuation (principally the income and market approaches).DLOMs in ESOP ValuationNotwithstanding the previous perspectives on DLOMs and the methods and processes for developing them, most ESOP appraisals that involve a minority interest definition of value reflect a relatively minimal DLOM of 5-10%. This is due to the obligatory put option feature required for qualified retirement plans holding closely held employer stock.The virtual guarantee of a market for the ESOP participants’ interests is believed to all but eliminate the DLOM. The consensus treatment from most appraisers is that a DLOM applies and is relatively small (say 5-10%) but not 0%.Some appraisers use the DLOM as a proxy for concerns about future liquidity as it relates to the sponsor company’s ESOP repurchase obligation. If a business is floundering, has a significant bubble of participants requesting near-term liquidity, has pour cash flow, has limited financial resources or financing options, and/or any other underlying fundamental challenge, some appraisers will use a DLOM to reflect this concern.DLOMs quantified in the correct fashion may indeed be a viable approach to capturing the cash flow needed to service repurchase obligations and the associated effect on the sustainable ESOP benefit (the stock value). However, many appraisers use a more direct and explicit approach to studying and treating the repurchase obligation by iterating the associated expense into the valuation modeling (generally using an income method).The expense is determined through a repurchase obligation study which informs trustees, sponsors, and plan administrators what measure of cash flow will service the foreseeable needs of the plan. To the degree that the assumed ongoing retirement plan funding is insufficient to service the obligation, an additional expense may be applied or a single present-value adjustment may be quantified to adjust the total equity value of the business.ConclusionThe application of a discount or premium to an initial indication of value is an often controversial and necessary input to the valuation process. Fortunately, appraisers are equipped with numerous income and market methodologies to derive reasonable estimates of the appropriate discount or premium for the subject interest.As with the determination of the initial indication of value, it is ultimately up to the valuation analyst to choose the appropriate methodology based on the facts and circumstances of the subject interest.None of the available methodologies are perfect, and all of them are subject to varying degrees of criticism from the courts and members of the appraisal community. Critics of the various market approaches often cite the lack of contemporaneous transaction data that are rarely comparable or applicable to the subject interest.Arguments against the income methodologies often focus on the model’s inputs, particularly the holding period assumption, which is typically uncertain for most private equity investments.The number of discount methodologies and their respective criticisms will, in all likelihood, continue to expand into the foreseeable future. It is ultimately up to the appraiser to consider the various options and determine the appropriate model or study applicable to the subject interest.There are no hard-and-fast rules or universal truths that are applicable to all appraisals when it comes to the selection of an appropriate discount methodology. Appraiser judgment is ultimately the most critical input to any valuation, particularly in regard to the application of an appropriate discount methodology or control premium.Admittedly, the number of discount methodologies and their corresponding criticisms can be a bit overwhelming to anyone unaccustomed to reviewing or writing business valuation reports.At the end of the day, the most important thing to keep in mind is how reasonable the discount (or premium) is in light of the liquidity and/or ownership characteristics of the interest being appraised.An appraisal may have carefully considered all the pertinent discount methodologies and their criticisms, but if the ultimate conclusion is not reasonable or appropriate for the subject interest, it will probably not hold up in court or communicate meaningful information for the end user of the report. Appraisers should investigate the reasonableness of their conclusions when preparing valuation reports and related analyses.

Many investors, analysts and business appraiser’s believe1 that publicly traded price multiples / minority equity value multiples can be used to estimate enterprise value, control level value of a business, or by simply applying an incremental premium for control to a selected publicly traded minority multiple. Typically this method can be done by using a sample of comparable publicly traded companies, observing a range of P/E2 multiples and selecting a multiple within the range or typically by analyzing enterprise transaction multiples. At this point, a simple premium for control is applied and market value of debt is added to arrive at an enterprise value.For example, if a sample of comparable publicly traded companies has a P/E multiple range of 10x to 14x and the appraiser selects 12x, he would then apply a premium for control of 25% (historically observed average in studies), add the market value of debt and arrive at an enterprise value multiple north of 15x earnings.However, this mathematical calculation many times is not a supportable method to estimate a marketplace transaction for enterprise value.As business appraisers, our job is to “Mirror the Marketplace” when valuing businesses. In doing so, the above methodology and the implicit assumption made is that minority value serves as a reasonable baseline, or starting point, for enterprise value. Very few appraisers understand that the most accurate explanation of the relationship between minority value and enterprise value is that there is no functional relationship between minority multiples and enterprise value.Why is this explanation true?The reason is based on stock market dynamics and trading history, but primarily because: The economic and financial drivers that influence an enterprise buyer are fundamentally different than a minority buyer. List of drivers for the typical minority buyer:Has a contained and restricted insight into earnings and growth prospects;Has limited or nearly no insight into the long term business plan & its associated risks;May have controlled information into the competitive environment; andMay have narrow views into the future outlook for new products, pricing strategies and risk profile, etc. The opposite is often true for the enterprise buyer. These factors have a significant and dramatic impact on enterprise value. As a result, there are times when a minority price pro-rata can significantly exceed what a prudent enterprise level buyer will pay, pro-rata, for a company. Vice versa, there are times when the enterprise value can be much more than the amount indicated by an application of an average premium for control percentages.Case StudyA publicly traded restaurant company operated 22 locations across the U.S. After a brief due diligence period, it was discovered that two of these locations generated 3x to 4x the profit of an average company store, 40% of the total company annual cash flow and had short-terms remaining on their leases (3 and 5 years). These two locations were also unique in they were located in a resort area, with a landlord who had a history of increasing rent dramatically, to “milk out” the excess profits, after the initial lease period. This piece of information was not known to the public as it was a trade secret of the landlord and lessor, but not shared with the public. Therefore, it was likely that the future profits of the restaurant company from current stores would go down significantly at the end of the current lease period. As a consequence, the value, and its associated multiples, to a prudent enterprise buyer would be substantially less than the minority multiples observed in the public market.In contrast to the above case study, there are other times when new products are coming online with risk and growth prospects that are not reflected in current or historical earnings. As a consequence, when the new products hit the market, the earnings may jump and significantly increase the enterprise value above and beyond the observed minority price.ConclusionAs a result of the above Case Study, it is clear that an appraiser must go through a proper due diligence process to understand of the impact of the cost, income, and market approach to truly understand the enterprise value of a company. It is also clear that assuming a publicly traded minority value as a reasonable basis to calculate enterprise value can lead to a significant error in due diligence and negatively impacts the credibility of an enterprise value opinion.This article was originally published in Valuation Viewpoint, July 2014.Footnotes1 Based on studies and articles 2 Price to Earnings Ratios

Are you considering buying or selling an operation, have a gift or estate tax issue, buying or selling a minority equity interest in an operation, or have fair value or fair market value-related financial reporting requirements for either GAAP or tax purposes?If so, a fundamental question exists: How much is your business and assets worth? To find out, you need the experience and expertise of a business valuation expert – a business appraiser.Small businesses and big corporations often don’t know what to expect when choosing a business appraiser. Two critical questions to ask are: (1) How do I know if they are qualified; and (2) What should an appraisal cost? Appraisers play a vital role in the market, and choosing one takes a little knowledge and lots of comparing to get comfortable with your selection.Look for Professional CertificationsMany business owners, attorneys and advisers aren’t sure what qualifications a trustworthy expert business appraiser should have. Just as accountants and doctors might use CPA and M.D., respectively, business appraisers often have a set of initials confirming they have received extensive training and/or have ample experience in their field. These certifications span a broad range, but they all indicate that the business appraiser knows what he or she is doing. Here’s an overview of common certifications:ASA (Accredited Senior Appraiser) – Issued by the American Society of Appraisers (ASA). To earn this prestigious certification, applicants must have a 4-year degree, 5 years of business appraisal experience; take 96 hours of ASA’s rigorous course sets and 12 hours of oral and written exams. They must also interview with their local ASA chapter, pass an ethics test, and submit two appraisal reports before their peers. In addition, active ASAs must complete additional courses on an ongoing basis to keep their designation.CBA (Certified Business Appraiser) – Issued by the Institute of Business Appraisers (IBA). Holders must be an active member of the IBA, have a 4-year business degree, complete 6 hours of various workshops and training programs, pass the CBA exam, have submitted two demonstration reports and have 5 years of appraisal experience or 90 hours of class time. Requirements may be lessened for those who hold other business appraisal certifications prior to application.CPA/ABV (Certified Public Accountant Accredited in Business Valuation) – Issued by the American Institute of Certified Public Accountants (AICPA). Holders must have a valid CPA, complete the ABV exam, work on ten engagements and meet business valuation experience and education requirements.CVA (Certified Valuation Analyst) – Issued by the National Association of Certified Valuation Analysts (NACVA). Holders must have a valid CPA or relevant business degree, at least three personal and business references, has passed a proctored exam and two years or ten engagements of business appraisal experience. Obviously these certificates have vastly different levels of experience to satisfy the designation. Be sure and know the difference when selecting your appraiser. Of course, these certifications aren’t tell-all determinants of an appraiser’s skill or qualifications. Not all ASAs are equally experienced in the same industry. Consider their work experience, industry experience and client references. Review their website and publications made by the appraiser. While experience and expertise are really important, credentialing provides added support in litigation environment before the court, the IRS or when subjected to auditor review.Beware of Right-Hand AppraisersMake sure that your business appraiser exercises complete objectivity when appraising your firm. An appraiser’s job isn’t to promote you, but to give an unbiased assessment of your organization’s worth. Unruly “right-hand” appraisers may overstate the value of your business for personal gain. These tactics created quite the turmoil in the late 80s real estate market. Homes were frequently overvalued, encouraging banks to hand out heftier loans. When the decade turned, the market crashed.This is another area where certifications can help. Business appraisers with professional certifications are bound by a code of ethics that prohibits right-handing and other shady practices. Non-certified appraisers may also operate by these ethics, but it’s not guaranteed. Remember that appraisers aren’t on the side of buyers, sellers or loan officers; they work for the good of the free market. Before you sign anything, read the appraisal agreement and verify that there is an independence clause.Know the CostsDepending on who you hire, a business valuation can cost between a few thousand to well into the six figures, depending upon the scope of the project. The more services you require, especially those for litigation purposes, the more your appraiser will charge. Especially in “high-stake” situations, most often litigation, the credentials, experience and expertise of your valuation expert matter. Selecting a low-cost provider is often “penny wise and pound foolish” as the results may cost more in the end. Also, keep in mind that litigation services can run hundreds of dollars per hour and can easily skyrocket if proceedings drag on.Don’t sign a contract with the first appraiser you meet. Instead, compare estimates from a variety of sources, look at their qualifications, and evaluate what your situation requires. Projects that will receive a high level of scrutiny from auditors, the IRS, opposing council or judges will require significant documentation. However, if you’re a small business looking for an oral appraisal, fees should be lower as very little documentation (i.e. report writing) is required.This article originally appeared in Valuation Viewpoint, October 2014.

Many situations warrant an business appraisal / valuation. Some of the most common occurrences in which a business will need to conduct a valuation include litigation matters, preparation for the sale of a business, tax purposes, buyouts of financial stakeholders, financial reporting of acquired businesses and the issuance of a business-related insurance policy.Furthermore, conducting a business valuation takes energy and time, and should be conducted by an independent valuation specialist. Selecting a valuation specialist / business appraiser can be complex, which we discussed in a another article, "How to Choose the Best Business Appraiser."When beginning the process of a business valuation, a clear understanding of the owner’s bundle of rights is critical before any investigative and analytical procedures are started. After a clear scope is outlined, the analysis is ready to commence. We conceptualize the value principles of most operating businesses into three components: (1) Risk, (2) Growth and (3) Earnings. We believe these are key components of value in a business. Using these as a guide, we seek to understand the nature, history and operations of a business through the perspective and intimacy of the team operating the assets every day, management. To do so, we find it helpful to discuss the operations in the same way as management thinks about its business. We strive to understand the risks that management wants to minimize the growth opportunities that management wants to obtain and the earnings that provide the scorecard for historical operations. The following details the factors which impact these three key components of value in a business.RiskRisk is the measurable possibility of something happening or not happening.1 For businesses, risk can be measured in numerous ways including benchmarking against similar businesses (“guideline”) or using a more theoretical approach such as a buildup method from market observation. None of this can be done, reasonably and supportably, without understanding the key economic drivers of the business. This prerequisite entails understanding the historical and current operations, the industry and competitive environment, operating assets, liabilities (booked and/or contingent), stakeholders, growth factors and the earnings profile of the business going forward. After understanding the drivers of risk for the subject business, the same drivers may be ascertained for the guideline businesses so that a supportable comparison can be made, ideally. However, lack of publicly available information does not make this comparison simple, and professional judgment is involved. Rarely is an exact "replica" of a business found in a guideline sample. With an appropriate understanding of the risk factors, and its comparison to similar businesses, the resulting value of a business begins to form. All other factors equal, low risk translates to higher valuation and vice versa.GrowthBusiness growth is primarily discussed in the context of revenues, profits, cash flows and assets. For some companies it also can include number of locations, products, contracts, square feet, customers and employees. In addition, growth on a larger, macro scale must also be considered as it applies to economies, industries, markets and populations. These areas are an example of the growth factors which can significantly impact a valuation and careful attention must be made to fully understand these factors in context. When we investigate the nature and history of the business, we find a relative context for future growth. Many times management and business owners make decisions to enhance shareholder value, which may include attaining the highest valuation possible. These decisions are most transparent in forecasts and projections. Risk is inter-related to future growth expectations. In short, considering growth in the context of risk is critical during a business appraisal. All other factors being equal, high growth translates into higher valuations and vice versa.EarningsEarnings are naturally a key component to analyze and arguably the most important of the three. Earnings, in this context, is a broad term to discuss operating performance of a business and is inclusive of such terms as EBITDA, net income, dividends, distributions and cash flow, to name a few. Earnings are the primary financial benefit of owning a business and are indications of performance. Careful consideration of these metrics, including industry specific earnings metrics, is very important. Changes in theses metrics over time can provide clarity on operational problems and successes. In addition, appraisers may also consider the earnings of other guideline businesses in the industry. Benchmarking may provide conclusive support regarding industry specific issues in the business but also macro issues across the economy. Earnings have significant impact on businesses strategy, future investment and capital decisions. Without investigating the earnings of a business, an appraiser cannot make an informed opinion on the value of a business.SummaryAll these components can vary substantially as time passes. An appraiser cannot simply assume that growth and earnings will continue uninterrupted into perpetuity. A marketplace is organic and can change quickly. When this occurs, growth over the long term can be difficult to achieve, and people may underestimate the risk associated with high long term growth projections. Careful analysis is necessary when estimating terminal values at the end of a long term growth forecast. When it comes down to valuing a business, understanding risk, growth and earnings are paramount.This article was originally published in Valuation Viewpoint, November 2014.Footnote1 Barron’s Dictionary of Finance and Investment Terms

When facing a business transition, owners have two basic options. Sell the company to outside parties or to inside parties (other owners and employees). While there are numerous variations of the two, basically the owner can sell to an outside group, which may be a strategic buyer (someone in the industry already), or a financial buyer, which may be a private equity firm or other investor that wants to own the company. An internal buyer is either a sale to some or all of the employees directly, or through the use of an Employee Stock Ownership Plan (ESOP). ESOPs are usually very cost competitive and many times may pay the highest price. Sale to the employees individually is with “after tax” dollars and can be very tax inefficient.Until 1974, Employee Stock Ownership Programs were almost unheard of. However since then, they have increased in popularity. In fact in 2014, there were 13.5 million workers in the United States who were covered under ESOPs.There are many reasons as to why employers offer these types of programs. While some people think ESOPs are used to save companies that are about to go bankrupt, this usually isn’t the case. It’s a great way to transfer ownership from one generation to the next without needing a financing plan.As an added benefit, these programs tend to be offered as a way to motivate and reward employees. Of course, there are the numerous tax advantages to be gained too. For the most part, market shares are given to workers and they don’t have to purchase them.How Does an ESOP Work?When a company chooses to create an ESOP, funds are set aside in a trust fund. The monies are used to buy new shares of stock. Additional funds are contributed to buy new shares as well as to pay back any funds that are borrowed from the ESOP to buy additional market shares. It does not matter how the company pays for the shares, the contributions are tax-deductible as long as certain requirements are met.Within the trust there are individual employee accounts. The company, of course, decides who has the right to take part in the ESOP. For the most part, however, all employees who work full-time and are at least 21-years-old have the right. An employer decides how the market shares are distributed to each employee’s individual account, with many companies operating on a vested basis, meaning workers with more seniority are given more market shares than those who have less seniority.Employees receive the cash value of their stocks when they leave the company (most companies mandate that the employees work for them for at least five years), or when they retire. The amount of money that they receive for the stocks is based on their fair market value at the time.Employer Benefits of Executing an ESOPFor business owners without an established plan to transfer direct ownership to either children or trusted personnel, ESOPs are a strategic way to increase direct ownership to the following generation without having to purchase it outright.With the establishment of an ESOP, there are significant tax savings to be gained. In 1974 ERISA, or the Employee Retirement Income Security Act, created the modern ESOP as well as a whole host of other retirement vehicles that incentivize companies and employees directly through tax incentives to save money for retirement. Since the government sees a positive social purpose for ESOPs, it provides extraordinary tax incentives for an owner and a company to use an ESOP as a business succession and liquidity tool. Some of these tax advantages include: 1The seller of the stock may meet the requirements to defer and then avoid paying state and federal Capital Gains tax on the sale of their stock regardless of basis (i.e. IRC § 1042 exchange). It allows the seller to exchange the proceeds from the sale of stock to purchase stocks, bonds, notes or U.S. Domestic Securities (this includes, stocks, bonds or notes) that meet certain qualifications. Once the exchange is established and the owner maintains the exchange, upon death the seller receives a “stepped up basis” and the capital gains tax evaporates.The company receives a dollar for dollar annual deduction for every dollar’s worth of stock that is sold by the sellers. If the company buys $500,000 of stock, the company can realize a $500,000 tax deduction. This is realized on the tax return of the company as they pay for the stock, and is subject to certain limitations.The company can either be a “C” or an “S” Corporation to install an ESOP. There are some advantages and disadvantages to both structures, but ultimately, if the company is or becomes a “S” Corporation, and is 100% owned by the ESOP, the annual K-1 would then go to the ESOP, which is a State and Federal tax exempt trust, similar to a 401(k) and as such is no longer subject to State and Federal income tax. This makes the company “tax free” and can more than double cash flow, and places the company in an optimal operating platform. As they compete with other market players that are paying tax, they have a distinct financial advantage which they can leverage into getting jobs at lower prices and still maintain margins.Another advantage of an ESOP is that the sellers can maintain control of the company even after the sale, as the ESOP has a Trustee that can be “directed”. This directed Trustee is directed either directly by the Board, or by the ESOP Administrative Committee, which is a Board committee. Effectively, the day-to-day control of the business doesn’t change and control can be left with the selling owners until they receive all their money or control can be placed with whomever they direct, such as senior management, etc.Rewarding Employees with Market SharesIn addition to the above tax benefits, offering employees company ownership helps establishes professionalism and lines up owner goals with that of the employees. First-rate job candidates are attracted to companies that they know appreciate and reward their workers. Also, when a company shows it is interested in helping its workers succeed, it’s much more likely to retain its key employees. More so is the fact that the employees will strive to make the company succeed because they will want their market shares to be worth more money.It’s also with an ESOP that an employer can reward its workers without draining its cash flow. Instead of giving cash bonuses, market shares are issued. Furthermore, an ESOP comes with the benefit of the employer being able to strictly decide who gets the market shares and how much. With fringe benefits, specific selection is mostly prohibited.Next StepsAlthough an ESOP has significant tax advantages and provides a mechanism for current owners to exit the business at fair market value, the process requires the work of an experienced team in the creation and execution of an ESOP. Because of this, you should work with a group of advisors experienced in implementing an ESOP.This article was originally published in Valuation Viewpoint, February 2015.Footnote1 Business Transition Advisors

Peter Mahler reported on a recent New Jersey appellate level case focusing on the application of a 25% marketability discount in a statutory fair value determination in his New York Business Divorce blog. The New Jersey Appellate Division issued an unpublished decision in Wisniewski v. Walsh, 2015 N.J. Super. Unpub. LEXIS 3001 [App. Div. Dec. 24, 2015]. The case is interesting in that it attempts to determine a marketability discount in relationship to the “bad behavior” of a selling shareholder. The Wisniewski case has a long and tortuous history dating back to the mid-1990s. The case involves a successful family-owned trucking business founded by the father in 1952. Three siblings, Frank, Norbert, and Patricia owned the business equally following the father’s death. Frank assumed leadership of the business by 1973, and Norbert and Patricia’s husband also worked in the business. In 1992, Frank was sentenced to a prison term, leaving Norbert in charge of the business. Norbert stopped paying certain bills that had customarily been paid for Patricia and her husband, and diverted certain revenues from a business owned by Patricia to one in which she had no interest. In addition, even after Frank’s return, Norbert tried to exclude Patricia from a real estate deal that she ordinarily would have participated in. The litigation began around 1995. Interestingly, the trial court held that Norbert was an oppressing shareholder, and none of the parties contested that finding or the court’s later decision that Norbert should be bought out. Hold that thought, because it becomes a key factor in the court’s determination of statutory fair value. I can only call the concluded marketability discount in the matter a “bad behavior” discount.The ValuationsThe court’s valuation was determined through two trials in 2007 and 2008. Roger Grabowski of Duff & Phelps was retained by Frank and Patricia (the company) and Gary Trugman of Trugman Valuation Associates was retained by Norbert. I have been unable to locate the trial court’s decision in that matter, and so I can only write about the valuation from the perspective of the appellate decision.The trial court issued opinions in October 2007 and July 2008, which explained how and why the trial judge concluded that the fair market value of Norbert’s interest was about $32.2 million. We learn in the appellate decision that the trial court applied a separate 15% “key man” discount “to account for Frank’s importance.” If the conclusion was $32.2 million for Norbert’s interest, then the value before the discount was about $37.9 million ($32.2 / (1 – 15%)). No marketability discount was applied by the trial court. This would place an implied value of the trucking business at about $114 million.We do not know the conclusions of either Grabowski or Trugman that were considered by the trial court. According to the appellate decision, the trial judge found Trugman’s discounted cash flow analysis more credible than Grabowski’s market approach. However, the trial judge used assumptions suggested by Grabowski for certain normalizing adjustments to operating expenses for Trugman’s discounted cash flow method.The Initial Appeals and Application of a Marketability DiscountThere was an appeal of the trial court’s decisions in 2007 and 2008. The appellate court, in a decision issued April 2, 2013, held in part that “the trial judge erred in not applying a marketability discount” and remanded “for the fixing and application of a marketability discount to the extent not already subsumed in the judge’s findings…”The 2015 appellate decision states regarding the remand to the trial court in 2013:On remand, Judge Hector R. Velazquez briefly contemplated that the record might need to be supplemented with expert testimony pertaining to the narrow issues presented, but ultimately decided against it; none of the parties quarrel with that approach now. Left to resolve the matter on the record developed after the first remand, Judge Velazquez heard oral argument and issued an opinion on October 16, 2013, concluding that a discount for marketability was not embedded in the prior valuation and that a discount of twenty-five percent should be applied. He entered a second amended final judgment to that effect on January 7, 2014.And of course the parties appealed and cross-appealed.The Final (?) AppealThe appellate decision was issued December 24, 2015. To cut to the chase, the appellate court found “no merit” in the appeal and affirmed Judge Velazquez’ 2014 opinion. The appellate decision recounts that Norbert was found to be an oppressing shareholder. This turns out to be an important point, because in New Jersey, the marketability discount is typically reserved for “extraordinary circumstances” involving inequitable or coercive conduct on the part of the seller, who is Norbert in this case. The issue on appeal was whether the trial judge had erred in application of the 25% marketability discount because marketability may already have been considered in Trugman’s DCF analysis. The key facts relating to the marketability discount question, as best I can glean them from the 2015 appellate decision, include:Trugman’s Discount Rate Risk Factors. Trugman used a build-up method to develop his discount rate for his DCF analysis. The company-specific risk factors in the build-up included key man risk regarding Frank’s perceived management ability, customer relationships, customer concentrations, the closely-held nature of the trucking business, and undercapitalization. Trugman made two important additional points regarding the marketability of the business. He stated that the company is profitable, attractive, and marketable and that the company made substantial distributions on a regular basis that should offset any risks during a normal marketing period (of six to nine months). Trugman did not apply a marketability discount (or assumed it to be zero), noting that the discount rate was the “right place” to consider these risks. Recall also that the trial judge in the valuation trial had already applied a separate 15% key man discount after accepting Trugman’s DCF (as modified by Grabowski’s expense assumptions).Grabowski’s Marketability Factors. Grabowski had applied a marketability discount of 35% in his valuation. Judge Velaquez concluded that Grabowski and Trugman considered several of the same factors in reaching their discount rate and marketability discount, respectively. Grabowski’s marketability factors included heavy dependence on Frank as a key man, customer concentrations in the retail industry, the company’s size and closely held nature, its profitability, and the anticipated holding period. Grabowski per the court noted that his marketability discount was also “consistent with guidance from applicable [minority] studies and legal precedent.” Grabowski viewed the company as having a relative lack of marketability. The appellate court notes the trial court’s decision:Judge Velazquez concluded, based on that record, that although Trugman and Grabowski had considered several of the same factors in formulating their discount rate and marketability discount, respectively, that Trugman had made no adjustment for marketability in building up his discount rate — in short, the judge concluded that no marketability discount was embedded in his evaluation. The judge rejected both expert opinions, moreover, in selecting an appropriate discount, and fixed the rate at twenty-five percent.It gets more interesting for valuation professionals. The appellate court reasoned that a marketability discount was necessary because of Norbert’s bad behavior towards his fellow shareholders (there was never a finding that his behavior harmed the company in any way).The second trial judge rejected application of a marketability discount following our first remand. He considered Frank’s criminal conviction, a factor Grabowski suggested would reduce the company’s value, but noted that while the company endured a lull during Frank’s absence, it resumed its growth on his return with no apparent hindrance attributable of his criminal history. Neither that nor any other circumstance, the trial judge at the time reasoned, justified application of the discount. Although the reasoning was sound for the most part, we reversed because the judge at the time failed to consider that Norbert’s oppressive conduct had harmed his fellow shareholders and necessitated the forced buyout…[paraphrasing the New Jersey Supreme Court in Balsamides under similar circumstances]. …[A]bsent the application of a discount, the oppressing shareholder would receive a windfall, leaving the innocent party to shoulder the entire burden of the asset’s illiquidity in any future sale. Equity demanded application of the discount, or else the statute would create an incentive for oppressive behavior. (emphasis added)The appellate decision restated some of Judge Velazquez’ logic in making the following point:On remand, Judge Velazquez determined on the existing record that a marketability discount was not already embedded in the valuation. He recounted that the discount rate Trugman build up included a size premium and an adjustment for a series of company-specific factors including the company’s reliance on Frank, its customer concentration in the retail industry, and high debt. Although Grabowski had considered similar factors in formulating his marketability discount, the judge concluded that Trugman had certainly “utilized them in a different way” than to adjust for any lack of illiquidity. (emphasis added)As a business appraiser examining this case from business and valuation perspectives, the economic logic for applying a 25% marketability discount by the court is considerably strained. If a group of risk factors are considered in the DCF method that lower value in the context of that method, it is difficult to see how their further consideration for the application of an additional marketability discount is not double-counting. However, the appellate court addressed this issue as follows:Grabowski analyzed a handful of the same factors, among many others, in formulating his marketability discount, but, in contrast, focused on the inherent liquidity of closely-held companies and the anticipated holding period for a rational investor in this company. There was no clear indication in the record, then, that Trugman and Grabowski had accounted for the same risks relative to marketability, such that application of a separate marketability discount would cause double counting. (emphasis added)In the light of day, it would seem that there is double-counting to the extent that both appraisers considered the same factors that would reduce each of their values, even if they used those factors in different ways. And note that the original trial judge had already allowed for a key man discount of 15%, which occurred, obviously, after the experts had testified and provided their evidence. This discount, which certainly pertains to the “marketability” of a business, is substantial discount that had already been considered in the trial court’s conclusion. It just wasn’t labeled as a marketability discount.The Marketability (Bad Behavior) DiscountWhat it seems that we have in Wisniewski v. Walsh is a situation that is a business appraiser’s nightmare. At the original valuation trial, the court held that there should be no marketability discount. That was appealed. The appellate court then remanded back to the trial court for the application of a marketability discount to the extent that one was not already embedded in Trugman’s DCF analysis. The trial judge then, based on logic outlined above, concluded that no marketability discount was embedded in the DCF analysis and that the appropriate punitive marketability discount was 25%. This was appealed, and in this current appellate decision, the trial court’s marketability discount is affirmed.I have no problem if a court of equity wants to penalize a party for oppressive behavior to other shareholders. That is certainly one of the jobs that courts of equity are called upon to do in appropriate circumstances. And that discount can be zero, 10%, 20%, 25% or anything the court determines is appropriate in a specific case.I do have a problem with a court making an “equitable” decision and then trying to justify that decision based on parsing of valuation evidence.Assume an appraiser provided a valuation in another New Jersey statutory fair value matter involving the oppressive behavior of a selling shareholder named John. Let’s say that the value conclusion for the interest before the application of a “bad behavior discount” was $100 per share. The appraiser then concludes as follows:Based on my analysis of John’s bad behavior, I believe that a marketability (bad behavior) discount of 20% is appropriate.The appraiser might be thrown out of court. His opinion would certainly be given no weight. How then, is an appraiser to respond when the ultimate marketability, or bad behavior, discount will be determined by a judge who is responding to the equities of a matter? After all, valuation evidence pertaining to the marketability of a company or of an interest in a company has absolutely nothing to do with the behavior of any shareholder.Let’s look further at the appellate decision and we will see that the trial court’s conclusion has nothing to do with the economics of the trucking business in Wisniewski.The Court noted in Balsamides, supra, 160 N.J. at 377, 379, that marketability discounts for closely-held companies frequently ranged from thirty to forty percent, though the Court explained that selection of an appropriate rate, and the applicability of a rate in the first place, must always be responsive to the equities of a given matter. Judge Velazquez properly rejected from the outset Norbert’s suggestion that the marketability discount be set at zero percent. Indeed, we had already decided that a marketability discount was required and Judge Velazquez was bound by our mandate. After carefully canvassing the record, Judge Velazquez came to the conclusion that selecting a thirty to forty percent rate as described in Balsamides would excessively punish Norbert, the oppressing shareholder, beyond what the equities of this case required and, in light of the company’s past financial success and anticipated continued future growth, stood to “give the remaining shareholders a significant windfall.” In choosing an appropriate marketability discount after rejecting portions of both expert opinions on the issue, Judge Velazquez acknowledged our Supreme Court’s advice in Balsamides that such discounts frequently ranged from thirty to forty percent, but noted that other studies supported a broader range, reaching as low as twenty percent. He alluded to authorities from other jurisdictions approving the application of a wide range of discounts, sensitive to the equities of each individual case, and to our decision in Cap City Products Co. v. Louriero, 332 N.J. Super. 499, 501, 505-07 (App. Div. 2000), allowing application of a twenty-five percent discount. (emphasis added)If trial courts determine marketability discounts as bad behavior discounts, there really is no way that business appraisers can provide meaningful information to a court. If the court’s concern is one of “the equities” in a matter rather than in determining the fair value or the fair market value of a business or interest in a business, then there is little that appraisers can do to help. In Wisniewski, the application of a marketability discount flowed, not from the lack of marketability of the trucking business, but from the bad behavior of Norbert. Neither Trugman nor Grabowski had a chance in that determination. All we can say is that the court’s ultimate conclusion for the bad behavior (marketability) discount fell within the range suggested by Trugman (0%) and Grabowski (35%) and had nothing to do with the relative marketability of the business at hand.Peter Mahler’s ConclusionMahler concluded similarly in his blog post:If you ask accredited business appraisers whether the determination of a marketability discount rate for the shares of a particular closely-held company should be based on case precedent involving other companies, I think the vast majority will answer “no.” I wrote a piece on that very subject last year, quoting from the IRS’s DLOM Job Aid and experts in the field. Yet cases such as Wisniewski point the other way, effectively encouraging advocates and judges to select a rate within a self-perpetuating, “established” range of case precedent based as much if not more on the “equities” of the case than the financial performance, prospects, and liquidity risks of the company being valued. It’s not for me to say whether appellate courts and legislatures should decide as a matter of policy to incorporate into fair value determinations equitable considerations based on the good or bad conduct and motives of the litigants toward one another. But I am saying that if that’s the way it’s going to be, there’s an associated cost in the form of greater indeterminacy in fair value adjudications which makes it harder for lawyers and valuation professionals to advise their clients and to reach buyout agreements before they ripen into litigation.Readers can see the bad news in this appellate decision in Wisniewski. The good news, I guess, it that most statutory fair value cases do not involve bad behavior on the part of a selling shareholder.

Detective shows are usually good for automotive product placement, and the 1980s television series, Magnum, P.I., was no exception. It didn't hurt that the show's main character, Thomas Magnum, solved crimes in tropical settings throughout Hawaii, necessitating a requisite number of bikini-clad women sipping Mai Tai's in every episode. But the show's most memorable character was probably Magnum's car, a Ferrari 308. The 308 wasn't the fastest Ferrari of all time; the 3.0 liter eight cylinder motor didn't muster much more than 200 horsepower. It was small enough to have great handling (the seat had to be modified to fit Tom Selleck's 6'4" frame), it had a targa top, and at full throttle it sounded like Barry White eating wasps. With a car like that, a do-gooder role mysteriously funded by an anonymous millionaire, and a very-casual-Friday-everyday dress code, one thing was certain: Tom Selleck had a good job.The closest we get to detective work at Mercer Capital is when we're jointly retained to resolve a shareholder disagreement over a buy-out. Whether we've been court-appointed or mutually chosen by the parties to do the project, we've done enough of these over the years to learn that the process matters as much as the outcome.As a consequence, we've developed some fairly strict procedures for engagements involving buy-sell fights. The backstories for most shareholder disputes in the investment management industry have common themes: long-time partner ends up at odds, usually for economic reasons, with the rest of the ownership and is more or less forced out. There are usually lots of negative emotions on both sides, mistrust, and even impaired careers. The necessity of the buyout is obvious: the ex-partner wants to be paid so he or she can move on, and the remaining partners don't want to share the spoils of ownership (distributions) with their ex any longer than necessary.As the jointly retained appraiser, we're often in the awkward position of serving as judge and jury on the valuation, without the usual protections afforded by a judge or jury (like unlimited indemnification or an armed bailiff). So, like a private detective, we're left on our own to design and conduct an investigation to reach a reasonable outcome. If the process is sufficiently robust and fair, the two parties may not like the result, but they'll have to accept it. Doing so involves focus on a few key issues.Working in a Glass HouseThere is no substitute for transparency. We generally require that all information requested by and shared with us be shared with both parties. We also copy all parties on our communications and request that they do the same. When we conduct interviews with the parties as part of our normal due diligence, we open those meetings to both parties. Typically, the parties agree to not attend each others' interviews so that they'll feel free to speak to us more openly, and inevitably this leads to accusations at some point of our being lied to "in closed door meetings." In reality, no one is blind to the motivations of the parties in a buy-sell dispute, and we usually hear some level of hyperbole from both sides.Separating Fact from OpinionLike any valuation engagement, we start with an information request to get the basic facts of the situation: financial statements, regulatory filings, organization charts, strategic plans, etc. Then we interview the parties, and (frequently) get very different interpretations of those facts. It is not unusual for both sides to have very earnest, if diametrically opposed, opinions of why the facts are the way they are. Squaring those interpretations against what we can discern to be the reality of the situation is part of our job.The Value of Client ReviewIn a normal valuation matter, we prepare a draft report for client review to make sure we understand key elements of the enterprise being valued. In the case of a shareholder dispute, this review process is more structured. We usually have both parties review our work product independently of each other and give a written review that is distributed to us and the opposing party. Then we allow the parties to comment (also in writing) on each other's review. Our expectation is that knowledge of this cross-review process will dissuade the parties from misconstruing issues in their initial comments on our draft. That doesn't always work, but at least we have the benefit of both perspectives before we issue a final report.Economic IndependenceA client in one of these matters told us that he had heard jointly retained appraisers tended to favor the firm over the ex-partner (he was an ex-partner). I haven't heard the same thing, but it's easy to be accused of bias. One of the ways we guard against this is by structuring the engagement such that it is clear our payment is not contingent on the outcome. We start the engagement with a retainer that is applied against the final billing and stipulate that bills be paid current before we release a draft report or a final report. This assures both parties that we're not in anyone's back pocket and that we have the economic freedom to express the opinion of value we think is appropriate.No Man Can Serve Two Masters…Suffice it to say, we've learned a lot of this the hard way. It's no fun to be the punching bag between former partners who no longer want to have anything to do with each other, and business divorces are among the most fractious engagements we find ourselves in. But it doesn't help matters for us to offer to make someone else's problem our problem. Our kind of detective work involves sticking to a disciplined process that is respectful of the facts and allows both parties to openly participate. Unfortunately, it doesn't involve much intrigue, car chases, or hair gel – which probably explains why so few television series are about finance.Tom Selleck on the job as Thomas Magnum | Photo Credit: Magnum Mania!

Usually, I like to start blogposts with the story of some legendary car remembered fondly for its contributions to the automotive community. The car photographed above, a 1990 Chrysler TC by Maserati, is not an example of that. The TC was the mutant offspring of a brief tryst between Lee Iacocca, who headed Chrysler, and Alejandro de Tomaso, who owned the Maserati brand at the time. Iacocca and de Tomaso signed an agreement to jointly produce a sport coupe, and this was the worst they could come up with: a convertible based on Chrysler’s K-car platform, powered mostly by weak Chrysler engines, but tarted up with hand-stitched leather upholstery and inexplicably manufactured in Italy. One might have expected the TC to have had Italian styling and American reliability – instead it was the other way around. None of it made sense any more than the peculiar porthole window in the hardtop. Somehow, over 7,000 were sold. May they rust in peace.Despite talented people, carefully developed business plans, and the best of intentions, not every partnership goes well, and some of those that don’t go well don’t end well either. When a partner leaves an investment management practice, the potential for a major dispute over the buy-out usually looms. Internally, at our firm, we sometimes refer to these situations as “business divorces”, even though the consequent acrimony often exceeds that of a marital dissolution.For the exiting partner who was either pushed out or who left in disgust, it’s usually their last shot at their adversaries. Getting paid in full, and maybe then some, becomes a way to even not only the economic score, but the emotional score as well. For the continuing partners, overpaying risks endangering the business, while a cheap buy-out might be seen as giving the ex-partner what he or she really deserve.Usually, no one sees a business divorce coming until it’s too late to prepare. Once the negative emotions are underway, it’s too late to get the partners to sign a shareholder agreement or modify one that’s inadequately drafted. We started writing about buy-sell agreements at Mercer Capital over ten years ago with the idea that we could help firms avoid costly disputes over ownership. We have succeeded in doing some work in that area, but we are often hired as a jointed retained appraiser to try to help clean up messes after a fight broke out.It is always dangerous to make blanket statements, but I think if we’ve learned one thing from working in the shareholder dispute arena, it’s that a poorly drafted buy-sell agreement may be worse than having none at all. The words on the page look pretty innocuous when everyone is getting along, and unclear verbiage and inadequate guidance can be dismissed (“We know what we mean…”). So, to that end, here are a few mistakes we’ve seen others make, in the hopes that you read this and don’t do the same.Be Clear about the Valuation DateIn one extreme case in which we were involved, there was a $250 thousand hearing just to get the court to determine what the appropriate valuation date was to buy out a joint venture partner. You probably won’t have that big an issue, but the valuation date can be extraordinarily significant. If you have a large RIA with a stable customer base and placid markets, the valuation date may not matter. But what if markets are particularly volatile? What if you’re buying out a partner who left because of FINRA sanctions and now your clients are asking lots of difficult questions? What if a very successful client service partner left for another firm and is now working diligently to move his clients? What if the death of a key partner risks the loss of large mandates? We have seen some buy-sell agreements specify that the entity be valued at the fiscal year end prior to the trigger event for the action, as doing so would value the entity without regard to the issue at hand. That’s one way to handle it, and doing so often benefits the departing shareholder. We have also seen buy-sell agreements specify that the entity be valued at a certain point after the triggering event, to let the dust settle. Obviously, this treatment can be beneficial to the firm if the partner leaving is contemporaneous with some kind of firm trauma. But, more often than not, the valuation date is not clearly specified in the buy-sell agreement. Don’t let that happen to you.Be Clear about How to Choose an AppraiserObviously, you want a valuation expert to handle your business divorce who is both trained and experienced in business valuation and who understands the investment management industry. Your buy-sell agreement should delineate the qualifications of the appraiser or appraisal firm to do the work. But how will he or she be chosen? We have seen agreements in which the appraiser is chosen by the company, and the obvious implication of this is that the departing or departed shareholder is suspicious of conflicts. We have also seen many situations where each party to the agreement chooses an expert who is supposed to agree on a jointly retained appraiser. This works better in theory than in practice, except in instances where the two sides propose the same third appraiser. Whatever you do, be specific about the process. We have been brought in many times after the court had to be asked to intervene on behalf of one side or the other.Be Clear about the Standard of ValueIf your buy-sell agreement doesn’t already specify fair market value as the standard and makes that clear by reference to a definition such as exists in the International Glossary of Business Valuation Terms, then that’s an easy fix. We worked on a lengthy and expensive litigation which was almost entirely related to ambiguity as to the standard of value. Absent clarity, a buy-sell agreement could be settled based on investment value to either the buyer or seller, some notion of intrinsic value, or statutory fair value – particularly since in many shareholder disputes the departing partner could argue for protection under some state fair value statute.Be Clear about Valuation Discounts and PremiumsUsually, the subject interest in a buy-sell dispute is a minority interest in a closely held business. This would suggest that it could be valued, absent guidance to the contrary, at a non-marketable, minority interest level of value (inclusive of discounts for lack of control and lack of marketability). I think it’s safe to say that most partners think of their interest in an RIA as their pro rata participation in the enterprise. If the firm is worth, say, $10 million, and they own 20%, they expect their interest to fetch $2 million per the buy-sell. The acquiring firm has ample economic motivation to argue for discounts, and indeed the continuing partners will benefit if the selling partner is bought out for less than pro rata enterprise value. On the other hand, a well-crafted shareholder agreement will also specify what is meant by enterprise value. Is it going concern on a stand-alone basis (what might be considered a financial control level of value) or is it the value that could be achieved in a synergistic change of control? There is no perfect answer, but think about your firm and how you and your partners would want to buy or be bought out.Best Practice is to PracticeEven with all of the above care given to your buy-sell agreement, it’s difficult to know what will happen once the trigger event has occurred unless you find out in advance. The best practice is to have an annual appraisal done pursuant to your buy-sell agreement. With an annual valuation, you and your partners will know who is doing the work, how the process will occur, and (within a range) what the result will be. It does mean some regular investment of time and money, but the typical dispute we’ve worked on would have paid for a couple of decades of annual appraisals, not to mention the immense frustration and distraction that a shareholder disagreement causes a firm. If you can’t imagine finding yourself or your firm in that situation, now is a good time to start preparing.

The 1970s weren’t too kind to the auto industry. Between the OPEC oil embargo, new environmental regulations and disco, automotive design mostly devolved into underpowered, uninspired boxes. One noteworthy exception to all this was the Pontiac Trans Am. Neither boxy nor underpowered, the Trans Am was a hot mess with a huge motor that overpowered the car’'s weak brakes and lousy handling. All in all, though, it worked. From the driver's seat, you could forget all about the "malaise" while you stared up at the sky through the T-tops or across the giant decal of a flaming bird on the hood. As GTs go, it was no Aston Martin, but it was good enough to help Burt Reynolds smuggle a semi full of Coors across the southeast in Smokey and the Bandit.What was a perfect statement about America in 1977 is not so applicable today. Almost 40 years later, Burt Reynolds is still around, but Pontiac isn't, and people are more likely to cross state lines to buy craft beer than Coors. It's a point worth remembering when thinking about how to value your RIA for purposes of a shareholder agreement: times change.A recurring problem we see with buy-sell agreements are pricing mechanisms that are out of date. Usually, this shows up in the form of some kind of rule of thumb valuation metric that is no longer market relevant. We've also seen buy-sell agreements that cite standards of value that don't exist in the modern valuation lexicon, and even some that specify appraisers from firms that no longer exist.Keeping the language in your agreement up to date is important, but the most reliable way to avoid some unintended consequence of your buy-sell agreement is to have a pricing mechanism that specifies a regular valuation of your RIA's stock. An annual valuation accomplishes a number of good things for an investment management firm, but the main one is managing expectations.If your ownership sees a set of consistently prepared appraisals over the course of several years, they know what to expect. By this I mean there is some level of agreement over who is to provide the valuation, what information will provide the basis of valuation, and how the valuation itself will be constructed. This doesn't guarantee that everyone will be satisfied with the conclusion of value, and our experience is that partners in investment management firms often have differing opinions of the value of an RIA. Some difference of opinion is to be expected, but the process of having a regular valuation prepared by an independent party can go a long way toward narrowing that difference of opinion. If there is little difference of opinion over the values at which ownership in a firm transacts, there will be little incentive to litigate when a sizable transaction comes along.Recommending an annual valuation may sound a little self-serving and, indeed, doing that sort of work is good business for us. We also handle dispute resolutions for shareholder disagreements, however, and the cost of that work is never less than several times the cost of an annual appraisal – not to mention substantial legal fees and the immeasurable cost of management distractions. All in all, we would rather dispense the ounce of prevention than the pound of cure.P.S.: There is an updated edition of the Trans Am available.

In 1961, Jaguar stunned the automotive community by adapting its highly successful D-type race car, which had won the 24 hours of Le Mans three consecutive years in the late 1950s, to create the E-type road car. The E-type was instantly acclaimed. It had everything you could ask for in a sports car at the time: an inline six-cylinder motor that powered it to 60 mph in under seven seconds, monocoque construction, disc brakes, rack and pinion steering, independent front and rear suspension, and a top speed of over 150. Most importantly, it was gorgeous. Enzo Ferrari himself said it was "the most beautiful car ever made."No one ever said a particular buy-sell agreement was the "most beautiful" ever written (even in our office), but some are better than others. And, like a good sports car, you can break down the key elements of a buy-sell agreement that must be there for the agreement to be successful. The first hurdle to clear is for the buy-sell agreement to specify that the company is to be valued within reasonable parameters appropriate to the situation. We don't see many shareholders' agreements in the RIA community relying on "rule-of-thumb" like multiples of revenue or AUM – probably because, while simplicity is appealing, it's too easy for that kind of high level analysis to create unintended winners and losers in a buy-sell action.But that begs the question: if an asset manager's buy-sell is going to specify reasonable expectations for the value of the firm, what are they? We think there are at least four.1. A Buy-Sell Agreement Should Clearly Define the "Standard" of ValueThe standard of value is an important element of the context of a given valuation. We think of the standard of value as defining the perspective in which a valuation is taking place. Investment managers might evaluate a security from what they think it's worth (intrinsic value) as opposed to its trading price (market value) and make an investment decision based on that differential.Similarly, valuation professionals such as our squad look at the value of a given company or interest in a company according to standards of value such as fair market value or fair value. In our world, the most common standard of value is fair market value, which applies to virtually all federal and estate tax valuation matters, including charitable gifts, estate tax issues, ad valorem taxes, and other tax-related issues. It is also commonly applied in bankruptcy matters.Fair market value has been defined in many court cases and in Internal Revenue Service Ruling 59-60. It is defined in the International Glossary of Business Valuation Terms as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm's length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.The standard of value is so important, it's worth naming, quoting, and citing specifically which definition is applicable. The downsides of not doing so can be reasonably severe. Take, for example, the standard of "fair value." In dissenting shareholder matters, fair value is a statutory standard that can be very different depending on the legal jurisdiction. By contrast, fair value is also a standard of value under Generally Accepted Accounting Principles, as defined in ASC 820. GAAP fair value is similar to fair market value, but not entirely the same. In any event, it pays to be clear.For most buy-sell agreements, we would recommend one of the more common definitions of fair market value. The advantage of naming fair market value as the standard of value is that doing so invokes a lengthy history of court interpretation and professional writing on the implications of the standard, and thus makes application to a given buy-sell scenario more clear.2. Unless it is Clarified, There will be Costly Disagreement as to "Level of Value"Investment managers in publicly traded securities don't often have reason to think about the "level" of value for a given security. But closely-held securities, like common stock interests in RIAs, don't have active markets trading their stocks, so a given interest might be worth less than a pro rata portion of the overall enterprise. In the appraisal world, we would express that difference as a lack of marketability. Sellers will, of course, want to be bought out pursuant to a buy-sell agreement at their pro rata enterprise value. Buyers might want to purchase at a discount (until they consider the level of value at which they will ultimately be bought out). In any event, the buy-sell agreement should consider the economic implications to the RIA and specify what level of value is appropriate for the buy-sell agreement. Fairness is a consideration here. If a transaction occurs at a premium or a discount to pro rata enterprise value, there will be "winners" and "losers" in the transaction. This may be appropriate in some circumstances, but in most RIAs, the owners joined together at arm's length to create and operate the enterprise and want to be paid based on their pro rata ownership in that enterprise. Whatever the case, the shareholder agreement needs to be very specific as to level of value. We even recommend inserting a level of value chart, like the one you see above, and drawing an arrow as to which is specified in the agreement. 3. Don't Forget to Specify the "As Of" Date for ValuationThis seems obvious, but the particular date appropriate for the valuation matters. We had one client (not an RIA) spend a quarter million dollars on hearings debating this matter alone. The appropriate date might be the triggering event, such as the death of a shareholder, but there are many considerations that go into this.If the buy-sell agreement specifies that value be established on an annual basis (something we highly recommend to avoid confusion), then the date might be the calendar year end. Consider whether you want the event precipitating the transaction to factor into the value? If not, maybe the as-of date should be the day before the event. Or maybe it matters that, say, a given shareholder died or otherwise left the organization, and it's worth considering the impact of the departure. If that's the case, then maybe the appropriate valuation date is the end of the fiscal year following the event giving rise to the transaction.This blogpost doesn't begin to name all of the reasons that specifying an "as-of" date matters to the appraisal, but you get the idea.4. Appraiser Qualifications: Who's Going to be Doing the Valuation?Obviously, you don't want just anybody being brought in to value your company. If you are having an annual appraisal done, then you have plenty of time to vet and think about who you want to do the work. In the appraisal community, we tend to think of "valuation experts" and "industry experts."Valuation experts are known for:Appropriate professional training and designationsUnderstanding of valuation standards and conceptsPerspective on the market as consisting of hypothetical buyers and sellers (fair market value mindset)Experienced in valuing minority interests in closely held businessesAdvising on issues for closely held businesses like buy-sell agreementsExperienced in explaining work in litigated matters Industry experts, by contrast, are known for:Depth of particular industry knowledgeUnderstanding of key industry concepts and terminologyPerspective on the market as typical buyers and sellers of interests in RIAsTransactions experienceRegularly providing specialized advisory services to the industry In all candor, there are pros and cons to each "type" of expert. We worked as the third appraiser on a disputed RIA valuation many years ago in which one party had a valuation expert and the other had an industry expert. The resulting rancor was absurd. The company had hired a reasonably well known valuation expert who wasn't particularly experienced in valuations in the RIA community. That appraiser prepared a valuation standards-compliant report that valued the RIA much like one would value a dental practice, and came up with a very low appraised value – much to the delight of his client. The departing shareholder, by contrast, hired an also well-known investment banker who arranges transactions in the asset management community. The investment banker looked at a lot of transactions data and valued the RIA as if it were a department at Blackrock. Needless to say, that indicated value was many, many times higher than the company's appraiser. We were brought in to make sense of it all. The buy-sell agreement should specify minimum appraisal qualifications for the individual or firm to be preparing the analysis, but also specify that the appraiser should have experience and sufficient industry knowledge to consider the ins and outs of RIAs. Ultimately, you need a reasonable appraisal work product that will withstand potential judicial scrutiny, but you shouldn't have to explain your business model in the process.Final ThoughtsI'll cover in a later blogpost how the appraisal process itself works, and the considerations above are by no means meant to be exhaustive. But when you consider just these four elements, you can see how ambiguity in a buy-sell agreement can be highly disruptive at an investment management firm. While we do occasionally advise clients on setting up shareholder agreements, more often we are called in when an "agreement" is in dispute. We'll cover one such story in next week's blogpost.

In our view, Employee Stock Ownership Plans (ESOPs) are an important omission in the current financial environment as a number of companies and banks lack a broader, strategic understanding of the possible roles of ESOPs as a tool to manage a variety of strategic issues facing community banks. Given the strategic challenges facing community banks, we strive to help our clients, as well as the broader industry, fill this gap, and discuss some common questions related to ESOPs in the following article.We will be glad to discuss your bank’s current situation as well as the role an ESOP can play in detail. If you are interested in learning more about ESOPs, read our book,The ESOP Handbook for Banks: Exploring an Alternative for Liquidity and Capital While Maintaining Independence (you can find it in the Products section of our website). In addition, if you would like to speak to a Mercer Capital professional, contact Jay Wilson at 901.685.2120 or wilsonj@mercercapital.com.For those less familiar with ESOPs, we answer a few basic questions related to ESOPs. For those more familiar with ESOPs, skip to the question entitled “How can an ESOP help the bank deal with strategic issues?”.What Is an ESOP and How Does It Work?ESOPs are a written, defined contribution retirement plan, designed to qualify for some tax-favored treatments under IRC Section 401(a). While similar to a more typical profit-sharing plan, the fundamental difference is that the ESOP must be primarily invested in the stock of the sponsoring company (only S or C corporations). ESOPs can acquire shares through employer contributions (either in cash or existing/newly issued shares) or by borrowing money to purchase stock (existing or newly issued) of the sponsoring company. Once holding shares, the ESOP obtains cash via sponsor contributions, borrowing money, or dividends/distributions on shares held by the ESOP. When an employee exits the plan, the sponsoring company must facilitate the repurchase of the shares, and the ESOP may use cash to purchase shares from the participant. Following repurchase, those shares are then reallocated among the remaining participants.What Are Some Tax Benefits Related to ESOPs?Similar to other profit-sharing plans, contributions (subject to certain limitations) to the ESOP are tax-deductible to the sponsoring company. The ESOP is treated as a single tax-exempt shareholder. This can be of particular benefit to S corporations, as the earnings attributable to the ESOP’s interest in the sponsoring company are untaxed. The tax liability related to ESOP planholder’s accounts is at the participant level and generally deferred similar to a 401(k) until employees take distributions from the plan.Who Can Sponsor an ESOP?Both publicly traded and private banks/holding companies (C or S-Corps.) can sponsor ESOPs, but the benefits are often more profound for private institutions that are not as actively traded, as the ESOP can promote a more active market and enhance liquidity more for the privately-held shares.How Can an ESOP Help The Bank Deal With Strategic Issues?While not suitable in all circumstances, an Employee Stock Ownership Plan may provide assistance in resolving a number of strategic issues facing community banks and can offer benefits to plan participants, existing shareholders, and the sponsor company, including:Augmenting capital, particularly for profitable institutions facing limited access to external capital. Though an ESOP strategy generally builds capital more slowly than a private placement alternative or a public offering, it provides certain tax advantages and may result in less dilution to existing shareholders. For additional perspective, consider the following example. Let us assume that the holding company has $5 million of debt or preferred stock (this example could also include TARP or SBLF funding) with a five year term and an interest rate of 5%. Assuming that the subsidiary bank is the holding company’s primary source of cash (which is often the case for most community banks), the typical option to service this holding company obligation would be dividends from the bank to the holding company. However, an ESOP is another option that might be worth considering as ESOP contributions are tax-deductible expenses and this allows the bank’s capital position to benefit. In the ESOP strategy, cash contributions received by the ESOP are used to purchase newly issued shares of the sponsor’s common stock (in this case, the holding company), providing liquidity that the bank holding company then uses to service holding company’s debt. As detailed in the table below, the ESOP strategy provides the necessary cash flow to the holding company for its obligations but results in approximately $2 million of added bank capital (approximately 35% of the cash needed to service the holding company obligation) at the end of the five-year period. This higher capital could be used in a variety of ways by the underlying bank, either to fund future earning asset growth organically or through acquisitions, pay additional distributions to the holding company for shareholder dividends, or as a cushion against adverse events such as credit losses. However, there is a trade-off to augmenting the bank’s capital using the ESOP strategy, as the holding company’s shares outstanding will increase thereby causing dilution to existing shareholders.Facilitating stock purchases and providing liquidity absent a sale of the bank to outsiders by creating an "internal" stock market whose transaction activity can promote confidence in stock pricing. The ESOP offers the further advantage of providing a vehicle to own shares that is “friendly” to the existing board of directors. For example, the ESOP can offer an alternative exit strategy beyond selling the bank to outside investors through an IPO or acquisition by providing a liquidity avenue that allows for ownership transition while maintaining independence. For C-corporations, the shareholder may even have the ability to sell his or her shares in a tax-free manner subject to certain limitations related to a Section 1042 rollover, including the ESOP owning 30% or more of each class of outstanding stock after the transaction and the seller reinvesting the proceeds into qualified replacement property from 3 to 12 months after the sale; and,Providing employee benefits and increasing long-term shareholder value. ESOPs provide a beneficial tool in rewarding employees at no direct cost to themselves by providing common stock and tying their reward to the long-term stock performance of the bank/company, which can serve to increase employee morale and shareholder value over time. For example, a recent study by Ernst & Young1 found that the total return for S Corporation ESOPs from 2002 to 2012 was a compound annual growth rate of 11.5% compared to the total return of the S&P 500 over the same period of 7.1%. The measure of S ESOP returns considers cumulative distributions as well as growth in value of net assets, net of those distributions (i.e., growth in underlying value per share).What Is the First Step for Those Considering an ESOP?For those considering implementing ESOPs, the first step is generally a feasibility study of what the ESOP would actually look like once implemented at your bank. Parts of the study would include determining the value of the company’s shares, the pro-forma implications from the potential transaction/installation, as well as what after-tax proceeds the seller might expect. This will help determine whether the bank should proceed, wait a few years to implement, or move to another strategic option. There are typically a number of parties involved in implementations including among others an appraiser/valuation provider, trustee, attorney or plan designer, and administrative committee.What Are Some Potential Drawbacks to ESOPs?ESOPs are subject to both tax and benefit law provisions (such as the ERISA act of 1974). Certain negatives associated with them can include:The costs of setting up and maintaining the plansThe repurchase obligation for the sponsoring company as employees retire or exit the planRegulatory issues with the Deportment of Labor serving as primary regulator and the IRS being able to review plan activitiesFiduciary roles associated with ESOP trusteesPotential complexities related to shareholder dilution from issuing new sharesAre There Any New Developments for ESOP Trustees to Consider?For existing ESOPs, two recent legal and regulatory developments have brought up important issues for trustees to consider as well.DudenhoefferIn 2014, the Supreme Court ruled on the case of Fifth Third Bancorp v. Dudenhoeffer, which involved a public company that matched employee contributions to a 401(k) plan by contributing employer stock to an ESOP that was part of the plan. The ruling states that the standard of prudence applicable to all ERISA fiduciaries also applies to ESOPs, though ESOP fiduciaries are not required to diversify the ESOP’s holdings. The Court ruling was focused on public company ESOPs, but its implications for private company ESOPs are unclear. However, trustees should consider ensuring an investment policy statement is in place for the ESOP, stating that the policy is to invest primarily in employer stock in accordance with the purpose of the Plan; and, if applicable, the policy statement could potentially clarify that employees have diversification options through other benefit plans such as a 401(k) plan.GreatBanc TrustScrutiny related to ESOPs, particularly as it relates to certain valuation issues, has increased in recent years, with the DOL bringing a number of cases against trustees and other parties. In the case of Perez, Secretary of the DOL v. GreatBanc Trust Company, there is a process agreement that we encourage ESOP companies and their trustees to review. While the process requirements are only specific to GreatBanc, the case has received a lot of attention in the ESOP community.In October 2012, The U.S. Department of Labor filed a lawsuit against GreatBanc Trust Co. and Sierra Aluminum Co. in the U.S. District Court for the Central District of California. Among other issues identified in the suit, the DOL alleged that GreatBanc violated the Employee Retirement Income Security Act by breaching its fiduciary duties to the Sierra Aluminum Employee Stock Ownership Plan when it allowed the plan to pay more than fair market value for employer stock in June 2006. The suit also named the ESOP’s sponsor, Sierra Aluminum, as a defendant. The sponsor’s indemnification agreement with GreatBanc allegedly violated ERISA regulations. The suit focuses on the quality of the appraisal on which the trustee relied, particularly on the supportability of the assumptions used in the cash flow projection.As part of the settlement negotiations, the DOL and GreatBanc have agreed upon a specific set of policies and procedures as trustee of an ESOP. While specific to GreatBanc, the transaction procedures are presumed to be applicable to all Trustees and related appraiser relationships. The process requirements cover the following areas:Selection and Use of Valuation AdvisorOversight of Valuation AdvisorFinancial StatementsFiduciary Review ProcessPreservation of DocumentsFair Market ValueConsideration of Claw-BackOther ProfessionalsIn general, the process agreement makes clear that trustees must ensure that ESOP valuations are well documented with thoroughly supported assumptions.How Can Mercer Capital Help?Mercer Capital has been providing ESOP appraisal services for over 25 years and has extensive ESOP experience through providing annual valuations, installation advisory, feasibility studies, financial expert services related to legal disputes, and fairness opinions. Our appraisals are prepared in accordance with the Employee Retirement Income Security Act (“ERISA”), the Department of Labor, and the Internal Revenue Service guidelines, as well as Uniform Standards of Professional Appraisal Practice (“USPAP”). We are active members of The ESOP Association and the National Center for Employee Ownership (NCEO). Our professionals have been frequent speakers on topics related to ESOP valuation throughout our 32-year history. Mercer Capital professionals also co-authored the publication, The ESOP Handbook for Banks (2011), which provides insight into key ESOP-related issues affecting banking organizations.For additional ESOP resources, view our whitepapers Insights on ESOPs and Choosing a New ESOP Appraiser.Endnote1 Contribution of S ESOPs to participants’ retirement security: Prepared for Employee-Owned S Corporations of America March 2015) Report can be accessed at: http://www.efesonline.org/LIBRARY/2015/EY_ESCA_S_ESOP_retirement_ security_analysis_2015.pdf.

In recent years there has been increasing concern among ESOP sponsors and professional advisors (trustees, TPAs, business appraisers, legal counsel) regarding the scrutiny of the DOL, the Employee Benefits Security Administration (“EBSA”), and the Internal Revenue Service (“IRS”). These entities (and agencies thereof) are tasked with ensuring that ESOPs comply with the Employee Retirement Income Security Act (“ERISA”) as well as with various provisions of the federal income tax code concerning qualified retirement plans (including ESOPs). Citing concerns for poor quality and inconsistency in business appraisals, the DOL has sought in recent years to expand the meaning of “fiduciary” under ERISA to include business appraisers. In the most recent forums of exchange and deriving from various court actions, there are numerous areas of concern that DOL/EBSA appear to have regarding ESOP valuations.This whitepaper, which serves as an Appraisal Review Practice Aid for ESOP Trustees, focuses on the use of financial projections in ESOP valuations. The use (or misuse) of financial projections is often the most direct cause of over- or under-valuation in ESOPs.

ESOP valuation is an increasing concern for Trustees and sponsor companies as many ESOPs have matured financially (ESOP debt retired and shares allocated), demographically (aging participants), and strategically (achieved 100% ownership of the stock).Given these and other evolving complexities (including the proposed DOL regulation which would designate ESOP appraisers as fiduciaries of the plans they value), it is sometimes necessary or advisable for ESOP Trustees and the Boards of ESOP companies to change their business valuation advisor.This article addresses why a Trustee or sponsoring company might or should opt for a new appraisal provider, as well as what criteria, questions, and qualities drive the process of selecting a new appraiser.

In this whitepaper, we provide insight on the functional processes and analytical considerations underlying the determination of a correlated indication of value.

This whitepaper provides an overview of the primary elements of comparability and adjustments under the three primary categories of market methodology.

Debate over discounts and premiums in business valuation persists. Nowhere is this truer than with the marketability discount (or DLOM). Within the ESOP community, much of the confusion over DLOMs is mitigated due to the presence of put options. However, a legacy of concern over control premiums has now become an acute issue.

Almost every privately owned company with multiple shareholders has a buy-sell agreement (or other agreement that acts as a buy-sell agreement).If your business is like most companies, then you have one too. You likely had an attorney draft the document for you several years ago. You and your fellow shareholders might have had some discussions about the specifics of the buy-sell language at the time, but these discussions were likely minimal. You then signed the document, put it in a file cabinet in the office and have not looked at it or thought much about it since.True? Well, this might be an extreme example, but it highlights an important issue – most business owners do not have a current understanding of the details and potential pitfalls that lurk within their own buy-sell agreements. Most view these agreements as obligatory legal documents that can be forgotten about until needed. Unfortunately, when a buy-sell agreement is needed it is too late to fix any problems within the agreement.For the past several years, Chris Mercer, the CEO of Mercer Capital, has used the image of a ticking time-bomb as a metaphor of what might be awaiting some business owners within their buy-sell agreements. Would you ignore an actual bomb that was ticking away in your file cabinet? Of course not, and you should not ignore your buy-sell agreement either.The Ideal Time to Review Your Buy-Sell AgreementThe time for a comprehensive review of your buy-sell agreement is not this year or this month – it is right now. You have finished the first quarter of the year. Make it a priority now to get your buy-sell agreement out of that file cabinet and review it with your partners and appropriate professional advisors.Things to Look for When Reviewing Your Buy-Sell AgreementAs you review your buy-sell agreement, it is important to understand what the document is and what it is intended to accomplish.Buy-sell agreements are legal documents, but they are also business and valuation documents. These agreements govern how ownership will change hands if and when something significant, often called a trigger event, happens to one or more of the shareholders. Buy-sell agreements are intended to ensure the remaining owners control the outcome during critical transitions. They do this by specifying what happens to the ownership interest of a fellow owner who dies or otherwise departs the business, and mandating that a departing owner be paid, hopefully reasonably, for his or her interest in the business.Some buy-sell agreements call for fixed pricing or value the shares based on a set formula, while others lay out a specific appraisal process to develop the value of the subject interest.Fixed Price Agreements Are Typically Never UpdatedFixed price agreements are simple to start. The actual dollar price of the stock is set out in the buy-sell agreement and is intended to be updated on some regular basis based on agreement amongst the shareholders.The problem with these agreements is that they are almost never updated. When it comes time that an update must be done, such as at a trigger event, the interests of the parties may have diverged and agreement could be difficult, if not impossible.Formula Agreements Often Outgrow Their FormulaFormula agreements attempt to remove uncertainty by establishing a set calculation through which value will be determined at the appropriate date. The primary disadvantage of formula agreements is that no single formula can capture all of the complexities of change and provide reasonable and realistic conclusions over time. If your buy-sell agreement has a formula mechanism, when was the last time the formula was calculated?Valuation Process Agreements Are Often the Most WorkableBuy-sell agreements that lay out a specific valuation process as the means of valuing the shares at the appropriate date (“process agreements”) are typically preferable and tend to provide the most efficient means of achieving a fair resolution for all parties.There are different varieties of process agreements. Multiple appraiser agreements outline processes by which two or more appraisers are employed to determine value. Generally, each party will hire their own appraiser and, if needed, will jointly hire a third appraiser to either select the appropriate value from the first two appraisers or deliver their own binding conclusion of value. Single appraiser buy-sell agreements outline processes by which a single appraiser is employed to determine the price.We suggest a Single Appraiser - Select Now, Value Now process. For more information on this valuation process, see this article.Six Things That Should Be Clear in Any Valuation Process AgreementRegardless of whether a valuation process involves multiple appraisers or a single appraiser, there are six defining elements that must be in a buy-sell agreement in order for the valuation process to work smoothly and reasonably. If you have a valuation process as part of your buy-sell agreement, make certain that each of these six elements are present.While the six defining elements of a valuation process may seem obvious, they are prominent in their absence or unclear treatment in many buy-sell agreements.Standard of value. The standard of value is the identification of the type of value to be used in a specific valuation engagement. The proper identification of the standard of value is the cornerstone of every valuation. Will value be based on “fair market value” or “fair value” or some other standard? The parties to the agreement should select that standard of value. If they do not, the appraisers will have to select it and the parties may not like their choices.Level of value. Will the value be based on a pro rata share of the value of the business or will it be based on the value of a particular interest in the business? This distinction is critical to any appraisal process and to the shareholders of any business who are parties to its buy-sell agreement. If knowledgeable choices are not made by the parties to the agreement, someone else, i.e., the appraiser(s), will make it for them. The problem is that many agreements are written such that they are subject to differing interpretations regarding the appropriate level of value.The “as of” date. Every appraisal is grounded at a point in time. That time, referred to as the “as of date” or “valuation date”, provides the perspective, whether current or historical, from which appraisals are prepared. Unfortunately, some buy-sell agreements are not clear about the valuation date which should be used by appraisers. Because value changes over time, it is essential that the “as of” date be specified.Qualifications of the appraiser(s). If the parties do not decide on the kind of appraiser(s) they want to help for their buy-sell agreements, then, unfortunately, almost anyone can be named by either party to the agreement. Do you want a college professor who has never done an appraisal as the appraiser? How about an accountant who has no business valuation training? How about a broker who has no business valuation experience unrelated to transactions? How about a shareholder’s brother who has an MBA but has never valued a business before? The picture is clear. Buy-sell agreements must specify the qualifications of appraisers who may be called when trigger events happen.Appraisal standards to be followed. It is in the interest of all parties to ensure that selected appraiser(s) follow accepted business valuation standards. Some buy-sell agreements do this by naming the specific business appraisal standards that must be followed by the selected appraiser(s). Business appraisal standards provide minimum standards (criteria) to be followed by business appraisers in conducting and reporting their appraisals.Funding mechanisms. The funding mechanism is thought of separately from valuation yet is an important aspect of any buy-sell agreement. Why? Because life insurance is often purchased on the lives of one or more owners of companies having buy-sell agreements. Does the agreement tell the appraisers how the parties want the proceeds to be treated in their valuations? Appraisers will develop potentially widely divergent valuation conclusions depending on whether the life insurance is a funding vehicle (and not considered in reaching a value conclusion) or a corporate asset (and added to value prior to determining price for the agreement).A Tool to Help in Reviewing Your Buy-Sell AgreementBuy-sell agreements are important legal documents. They are also important business and valuation documents. How they operate when triggered can have huge consequences for business owners, their family, and the business. Unresolved problems within a buy-sell agreement truly are like ticking time-bombs.Do not wait for the countdown to run out, review your buy-sell agreement now with your partners and professional advisor(s). It will be far easier to get agreement on revisions made today than it will be after a trigger event.