Shannon Pratt s. Timely news, analysis and resources for defensible valuations Vol. 9, No. 4, April 2003

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1 Shannon Pratt s UPDATE BUSINESS VALUATION A Business Valuation Resources publication Timely news, analysis and resources for defensible valuations Vol. 9, No. 4, April 2003 Editor s Column: Empirical evidence shows holding period major determinant of marketability discount An incorrect and misleading assertion was contained in the article Predicting Lack of Marketability Discounts by Use of an Econometric (Statistical Regression) Model by Dr. John Kania, an economist who has been employed by the Internal Revenue Service for 11 years. The article appeared in the December 2002 Business Valuation Review. Abundant empirical support The article states some believe, without any empirical support, that the holding period is the predominant determinant of the marketability discount (emphasis supplied). 1 In fact, there is abundant empirical support for this conclusion. The purpose of this column is to review the empirical evidence in support of the conclusion that the perceived holding period is the primary determinant of the magnitude of the marketability discount. Effect of changes in SEC rules First, the markets response to changes in the SEC s rules for trading restricted stocks of public companies is evidence of investors emphasis on the holding period. From the late 1960s through the decade of the 1980s, the average of eight comprehensive, independent studies all indicated average discounts of about 33-35% on sales of restricted stocks. 2 Then, in 1990, the SEC adopted Rule 144A. Prior to 1990, a private transaction in Continued to next page... 1 John J. Kania, Predicting Lack of Marketability Discounts by Use of an Econometric (Statistical Regression) Model, Business Valuation Review (December 2002): A brief abstract of this article can be found on page Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs, Valuing a Business, Fourth Edition, p Guest Article: Valuation issues in financial reporting: FAS 141&142 and beyond! By Mark L. Zyla, CPA/ABV, CFA, ASA* Since 2001 when the Financial Accounting Standards Board released SFAS 141 and 142, valuations for financial reporting purposes have provided appraisers with a lot of work and a lot to learn. In this article Mark outlines a few essential lessons for appraisers involved in valuations for such purposes. He touches on highly practical issues such as how to work effectively with the client s auditing firm Mark Zyla and how to include synergies and deal with strategic value in fair value estimations. AN In today's environment, financial statements are receiving unprecedented scrutiny from outside parties, namely investors and the Securities and Exchange Commission (SEC). Correspondingly, auditing firms are heavily scrutinizing the work of outside experts such as valuation analysts whose work impacts financial reporting. Valuation analysts need specialized knowledge Valuation experts working on engagements related to financial reporting such as SFAS 141 (Business Combinations) and SFAS 142 (Goodwill and Other Intangible Assets) need to understand not only the technical aspects of valuation but also the valuation issues from an auditor's perspective. To satisfy company auditors and the SEC, valuation analysts working on engagements for * Mark L. Zyla, CPA/ABV, CFA, ASA is a shareholder with the Phillips Hitchner Group, Inc., a financial advisory firm located in Atlanta, Georgia, specializing in valuation and litigation services. Mr. Zyla has more than 17 years of providing financial advisory and valuation services to closely held businesses for the purposes of mergers and acquisitions, gift and estate tax planning, corporate recapitalizations, and many other purposes. He is co-author of Valuation for Financial Reporting: Intangible Assets, Goodwill and Impairment Analysis, SFAS 141 and 142; John Wiley & Sons; He can be reached at [email protected] or (404) financial reporting purposes need special knowledge beyond their valuation expertise. The heightened scrutiny of financial statements directly affects everyone involved - the company's management, its auditing firm, and the valuation analyst. Working on valuation engagements that impact INSIDE Continued to page 4... How to compute intangible assets amortization benefit DEPARTMENTS Legal & Court Case Update...6 Pro Finish USA, Ltd. v. Johnson Olaires v. Technical Cable Concepts Kimbell v. United States Reisman et al. v. KPMG Peat Marwick LLP In re the Marriage of Crawford In re the Marriage of Letendre In re the Marriage of Sims Ashlock v. Ashlock Kauffman v. Kauffman Bakala v. Bakala Schiro v. Schiro In re the Marriage of Franzen Cost of Capital Update...9 Data & Publications Update News Update Reader/Editor Exchange Calendar Update... 16

2 Shannon Pratt s BUSINESS VALUATION Publisher & Editor-in-Chief: Managing Editor: Associate Editor: Legal and Court Case Editor: Production: Staff Writer: Copy Editor: Customer Service: UPDATE Shannon Pratt Alina Niculita Tanya Hanson Linda Kruschke Laurie Morrisey Paul Heidt Rihab Hamze Janet Marcley Pam Pittock Vanesa Pancic-Meier Editorial Advisory Board MEL H. ABRAHAM, CPA/ABV, CVA, ASA Kaplan, Abraham, Burkert & Co. Wood Ranch, Calif. RONALD D. AUCUTT, Esq. McGuireWoods LLP McLean, Va. JOHN A. BOGDANSKI, JD Lewis & Clark Law School Portland, Ore. HON. WILLIAM A. CHRISTIAN N.C. 11th Judicial District Court Sanford, N.C. S. STACY EASTLAND, Esq. The Goldman Sachs Group, Inc. Houston, Texas BARNES H. ELLIS, Esq. Stoel Rives LLP Portland, Ore. JAY E. FISHMAN, ASA, CBA Kroll Lindquist Avey Philadelphia, Pa. OWEN G. FIORE, JD, CPA The Fiore Law Group San Jose, Calif. LARRY WELDON GIBBS, JD Union Resource Group, Inc. San Antonio, Texas LYNNE Z. GOLD-BIKIN, Esq. Wolf, Block, Schorr & Solis-Cohen, LLP Norristown, Pa. LANCE S. HALL FMV Opinions, Inc. Irvine, Calif. JARED KAPLAN, Esq. McDermott, Will & Emery Chicago, Ill. MAURICE KUTNER, Esq. Maurice Jay Kutner & Associates, P.A. Miami, Fla. GILBERT E. MATTHEWS, CFA Sutter Securities Incorporated San Francisco, Calif. JAMES J. PODELL, Esq. Podell & Podell Milwaukee, Wis. JOHN W. PORTER Baker & Botts, LLP Houston, Texas JAMES S. RIGBY, ASA, CPA/ABV Financial Valuation Group Los Angeles, Calif. ARTHUR D. SEDERBAUM, Esq. Patterson, Belknap, Webb & Tyler New York, N.Y. DONALD S. SHANNON, Ph.D., CPA School of Accountancy, DePaul University Chicago, Ill. BRUCE SILVERSTEIN, Esq. Young, Conaway, Stargatt & Taylor, LLP Wilmington, Del. GEORGE S. STERN, Esq. Empirical evidence shows holding period major determinant of marketability discount...continued from front page restricted stock was required to be registered with the SEC. Rule 144A relaxed the restrictions by allowing qualified institutional investors to trade unregistered securities among themselves without filing registration statements. Restricted stocks thus became more liquid, and average discounts on blocks of restricted stocks dropped to the mid-20s. Holding period lowered to 1 year The latest change in the SEC requirements was in 1997, when they reduced the required holding period for restricted stocks from two years to one year. In the only study published since the 1997 change in the holding period, Kathryn Aschwald of Columbia Financial Advisors concluded that typical discounts fell to the 13-15% range (See Exhibit 1 on page 1). 3 This led Aschwald to opine that: The chronology of these events and the evidence pointing to what has happened to discounts on restricted securities provides us with important information regarding how the market reacts to varying levels of liquidity. That is, as liquidity increases, discounts for lack of liquidity decrease. The evidence also leads to the conclusion that, for purposes of determining discounts for lack of marketability of privately held securities, restricted stock studies relying on transaction data EXHIBIT 2: DISCOUNT VERSUS BLOCK SIZE Lower than 20% Greater than 20% Greater than 25% EXHIBIT 1: RESTRICTED STOCK DISCOUNTS UNDER CHANGING SEC REQUIREMENTS Years SEC Requirements Average Discount year holding period and registration required 33-35% year holding period, but no registration required 1997-present after 1990 are no longer relevant. 4 Median discount 21% in post-1997 data More recently, we, at Business Valuation Resources, analyzed the full 187 post-1997 transactions from the FMV Opinions Restricted Stock Database. The mean discount was 23.8% and the median discount was 21%. 5 Several studies have shown that the block size relative to the number of shares outstanding is a major factor in observed restricted stock transaction discounts. For example, the Silber study states discounts are larger when the block of restricted stock Continued to next page... Median Average mid 20s 1-year holding period 13-21% Shannon Pratt s Business Valuation Update (ISSN ) is published monthly by Business Valuation Resources, L.L.C., for $209 a year. Please call or write for multiple-subscription rates. Periodicals postage paid at Portland, Oregon. POSTMASTER: Send address changes to Business Valuation Resources, L.L.C., 7412 S.W. Beaverton-Hillsdale Hwy., Suite 106, Portland, OR 97225, phone (503) or (888) , fax (503) , [email protected], Web page: Editorial office and subscription requests should go to the above address. Please note that by submitting material to Shannon Pratt s Business Valuation Update, you are granting permission for the newsletter to republish your material in electronic form. Although the information in this newsletter has been obtained from sources that Business Valuation Resources believes to be reliable, we do not guarantee its accuracy, and such information may be condensed or incomplete. This newsletter is intended for information purposes only, and it is not intended as financial, investment, legal, or consulting advice. Copyright 2003, Business Valuation Resources, L.L.C. (BVR). All rights reserved. No part of this newsletter may be reproduced without express written consent from BVR. Greater than 30% Greater than 35% 0% 10% 20% 30% 40% 50% 60% Source: Compiled from FMV Opinions Restricted Stock Study, distributed by Business Valuation Resources, 3 Kathryn F. Aschwald, Restricted Stock Discounts Decline as Result of 1-Year Holding Period, Shannon Pratt s Business Valuation Update (May 2000): Ibid, p. 1 5 Business Valuation Resources plans to add these post 1997 transactions to the FMV database in the near future. 2 Shannon Pratt s Business Valuation Update April 2003

3 Empirical evidence shows holding period major determinant of marketability discount...continued is large relative to total shares outstanding. 6 The following explains the relationship between the block size relative to shares outstanding and the holding period. Impact of SEC dribble out rule Higher discounts for larger blocks of restricted stock (relative to shares outstanding) is evidence that the holding period is a major factor because of the SEC s dribble out provision of Rule 144. The dribble out provision limits the number of shares that investors affiliated with the company may sell per quarter (after the required holding period) to the higher of 1 percent of the outstanding stock or the average weekly volume over a four-week period prior to the sale. Thus, a person holding 4% of the outstanding shares could sell them into the open market within a year after the expiration of the minimum required holding period, but someone holding 40% of the outstanding shares would require 10 years to complete the sale of his holdings! See Exhibit 2 (page 2) for a bar chart showing the discounts relative to block size as a percentage of outstanding shares for the period. This phenomenon prompted Lance Hall of FMV Opinions to declare: The illiquidity of large % blocks of restricted stock are more similar to the illiquidity of any % size stock of private company stock than small % stocks of restricted stock. 7 Evidence from private transactions So far, I ve presented empirical evidence from studies of transactions in restricted stocks of companies for which there is an already established public market. There is even more compelling evidence from transaction in stocks of private companies prior to going public. A strong piece of evidence in the latter EXHIBIT 4: DISCOUNTS VERSUS TIME BETWEEN TRANSACTIONS AND IPO EXHIBIT 3: VALUATION ADVISORS LACK OF MARKETABILITY DISCOUNT STUDY MEDIAN MARKETABILITY DISCOUNT BY PRE-IPO TIMEFRAME AND BY TRANSACTION YEAR Median Marketability Discount 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Months 4-6 Months 7-9 Months Months 1-2 Years IPO Year 0-3 Months 4-6 Months 7-9 Months Months 1-2 Years Count % 54.2% 75.0% 76.9% 82.2% % 45.1% 61.5% 68.9% 76.6% % % % % % % % % % % 81 1 Median is based on between 9 and 18 data points and may not be statistically significant 2 The count indicates the number of transactions where stock or options were issued prior to an IPO and it is not the IPO count Pre-IPO Timeframe = IPO date - Transaction date category is from the Valuation Advisors Lack of Marketability Discount Study. Every year, those transactions in private company stocks go at larger discounts from the IPO price the longer the transaction occurs before the IPO. (See Exhibit 3). This phenomenon certainly is far too pronounced and consistent to be coincidental. Emory study shows similar results Finally, even though the Emory pre-ipo database goes back for its transactions only five months prior to the IPO, analysis of this database clearly shows this pattern even month by month. (See Exhibit 4). Evidence presented in testimony On several occasions, I have used empiri- Pre-IPO Timeframe cal evidence from the restricted stock and pre-ipo databases successfully to support discounts for lack of marketability in testimony. For example, I recently presented testimony that a study over the entire range (1980-present) of the FMV Restricted Stock database for blocks between 30% and 50% of the outstanding shares, revealed a median discount of 40%. Yes, Dr. Kania, there is strong and consistent empirical support for the proposition that the holding period is the predominant determinant of the marketability discount. Best wishes, Days Mean Median Count % 25% Total 543 Source: Emory, John D. Sr., F.R. Dengel III, and John D. Emory Jr., Discounts for Lack of Marketability Emory Pre-IPO Studies as Adjusted October 10, Business Valuation Review (December 2002): William L. Silber, Discounts on Restricted Stock: The Impact of Illiquidity on Stock Prices, Financial Analysts Journal (July- August 1991): Other studies observing this include the SEC Study, the Standard Research Consultants Study, and the Management Planning Study. These findings are summarized in my book on Business Valuation Discounts and Premiums, pages Lance S. Hall, The Value of Restricted Stock, ASA Annual International Conference, Aug , 2002, San Diego, Calif. April 2003 Shannon Pratt s Business Valuation Update 3

4 ...continued from front page financial statements requires that the valuation analyst understand not only the responsibilities of each party but also the unique conceptual challenges of these engagements. Previously, the heaviest scrutiny of a valuation for financial reporting purposes centered on the analyst's qualifications and experience. While these are obviously still important, the scrutiny is now more focused on the reasonableness of the assumptions behind the valuation. This increased attention to the underlying assumptions requires greater coordination among auditors, valuation analysts, and management. 4 Valuation issues in financial reporting: FAS 141&142 and beyond! Management's responsibilities Management is ultimately responsible for the presentation of the financial statements. Often management will retain a valuation expert to assist them in estimating the fair values of assets, particularly the intangible assets acquired in a business combination, or to assist them in estimating the fair values of reporting units to test for the potential impairment of goodwill. Thus, management is also responsible for retaining a qualified valuation specialist, that is, one who has not only the appropriate valuation expertise but also the requisite experience in valuations for financial reporting. As part of its responsibility for the presentation of the financial statements, management must identify the acquired intangible assets to be allocated in an acquisition. Additionally, management is responsible for supplying the appropriate documentation of the supporting assumptions behind the valuation. This can be challenging because many companies' accounting systems are not set up to capture some of the specific data that may be needed for the valuation. The auditor's responsibilities It is incumbent upon the auditor to test management's assumptions that provide the basis for the estimate of fair value of assets for financial reporting purposes. The valuation analyst should test management's assumptions as well; one way is to review contemporaneous documents that can either corroborate or contradict management's expectations. Examples of the types of in- 1 AICPA Practice Aid, "Assets Acquired in a Business to be used in Research and Development Activities: A Focus on Software, Electronic Devises, and Pharmaceutical Industries", Page See 3 Statement of Financial Accounting Standards No. 141, Appendix F, Page 123. formation 1 that should be reviewed to substantiate management's assumptions include: Offering memoranda Due diligence reports Board of director materials prepared to support the acquisition Research reports of analysts Technology development plans Product plans and budgets Web site content and press releases The auditing firm uses the valuation specialist's work as part of its requirement to obtain sufficient competent audit evidence to provide reasonable assurance that the stated fair values conform to Generally Accepted Accounting Principles (GAAP). To meet its obligations under GAAP, the auditor might test the assumptions of the valuation models. The auditor might not only scrutinize the valuation report, but also ask to see the supporting documents in the valuation specialist's workpapers. Often the auditing firm employs its own valuation specialist either to review the specialist's report or to prepare a "shadow" valuation to compare the results with those of management's expert. The valuation analyst's additional responsibilities All of these responsibilities, in turn, affect valuation analysts and their work product. Management and the auditor now place higher expectations on the analyst's work product, particularly the information used and the assumptions made. Valuation analysts should have detailed documentation in their workpapers about the assumptions supporting their methods. Additionally, analysts' files should contain supporting information about how they tested management's assumptions. The analyst also should be aware of valuation concepts unique to financial reporting. Fortunately, new information is available to help valuation analysts and auditors sort out the complexities of their respective responsibilities. The American Institute of Certified Public Accountants (AICPA) recently has issued tools kits both for auditors and for valuation analysts to help them understand the unique requirements of measuring fair value for financial reporting purposes. 2 The recent changes in the financial reporting environment noted above complicate the fair value estimation process. A valuation analyst should understand several concepts that are unique to valuations for financial reporting purposes. These concepts are: The fair value standard of value The concept of "Market Participants" Synergy in an allocation of purchase price Observable market prices are the preferred approach Working with the client's auditing firm Fair value standard The first concept in auditing fair value measurements is the applicable standard of value. The analyst needs to know which standard applies because it determines the appropriate assumptions and methodologies for estimating value. In financial reporting, the standard of value is fair value. Fair value is defined as "the amount at which the asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale." 3 Fair value in financial reporting is often confused with other more established standards of value. Fair value is not investment value, which is the value to a particular buyer. Fair value is not fair market value, which describes the value to a hypothetical willing buyer and seller and is the standard of value for tax reporting requirements. Fair value as defined by accounting literature also is not the fair value standard common to many disputes. While the fair value standard is still evolving in authoritative accounting literature, several characteristics have been established. Fair value is: Generally established on an assetby-asset and a situation-bysituation basis Normally a control value Individual assets do not include buyer's synergies. Synergies are included as part of goodwill. May include tax amortization benefits Net of "cost to sell" Only considers "market participants" in the assumptions Market participants The second concept to understand is that, under the standard of fair value for finan- Continued to next page... Shannon Pratt s Business Valuation Update April 2003

5 Valuation issues in financial reporting: FAS 141&142 and beyond!...continued cial reporting, the Financial Accounting Standards Board (FASB) emphasizes that the assumptions used in the valuation should include one of the "market participants." Although the concept of market participants is still evolving, it generally requires the valuation analyst to use assumptions that encompass all potential buyers who: Actively manage businesses May or may not be engaged in negotiations with seller Excludes buyers without current operating and market data available such as financial buyers or passive investors 4 The market participant concept is important because the assumptions that the valuation specialist uses in the valuation analysis, particularly in projecting financial information, should include only those that a "market participant" could realize. Synergy A third concept that the valuation analyst should understand is how synergies in an acquisition are allocated to a purchase price. Fair value as defined in the accounting literature incorporates only assumptions that would affect market participants. Synergy by definition includes benefits to a specific buyer, not market participants. In estimating fair value of specific assets for financial reporting purposes, a valuation analyst should not include any strategic or synergistic benefits in the underlying assumptions. Fair value should include only assumptions that incorporate benefits that market participants would enjoy. Any value from strategic or synergistic benefits should be included as part of goodwill. For example, if the valuation analyst uses a discounted cash flow analysis to estimate the fair value of an acquired intangible asset, the elements of the discounted cash flow analysis (the cash flows, discount rate, etc.) should reflect only what market participants wound enjoy. 5 Many if not most business combinations are priced based on some perceived level of synergy. In estimating fair value of individual assets for a purchase price allocation, any 4 AICPA Practice Aid, "Assets Acquired in a Business to be used in Research and Development Activities: A Focus on Software, Electronic Devises, and Pharmaceutical Industries", Page 4. 5 IBID, page 8 6 See Appendix I: Valuation Approaches to Estimating Fair Value; Auditing Fair Value Measurements and Disclosures, pg 28, 7 Auditing Fair Value Measurements and Disclosures, Page 28. value related to synergies is allocated to goodwill. Using the three approaches to value to estimate fair value 6 Valuation analysts are familiar with the concept of the three approaches to value the cost, market, and income approaches. Most analysts would agree that these three approaches, in theory, should all point to similar indications of fair value. In reality, however, only one or two approaches may be appropriate given the type of intangible asset or business interest. For example, certain intangible assets may lend themselves more to a cost or income approach, since there usually is not an established market for certain intangible assets. Despite the theory that all approaches should provide similar indications of value, the FASB has expressed a preference for the use of observable market prices under the market approach as a primary indication of fair value whenever there is sufficient available information. 7 Consequently, the valuation specialist should focus on the market approach as a primary method when appropriate, supported by the cost and income approaches. Whatever the approach used, the valuation specialist should use assumptions that reflect overall market participants in each of the methods under the three approaches to estimating fair value. In estimating fair value for financial reporting, however, the market approach is first among equals. Working with the client's auditing firm The changes brought on by FAS 141 and 142 have affected the relationships among the company's management, the company's auditors, and outside valuation analysts. Previously, auditors relied on the valuation specialist's work product based on the specialist's qualifications and experience. While these are still important, auditors and thus valuation analysts currently are held to a higher standard to test the reasonableness of management's assumptions behind the valuation. One such test is to perform sensitivity analysis on management's assumptions. Analysts should be prepared for the auditor to ask the analyst to perform a sensitivity analysis to test the value drivers. Additionally, auditors will need to fully comprehend the analyst's methods and assumptions and cannot simply rely on the specialist's conclusions. Finally, both the valuation analyst and the auditor should understand the valuation concepts that are unique to financial reporting. Auditing fair value measurements requires a new level of cooperation among auditors, management, and valuation specialists. Although the valuation specialist is retained by management, the auditor often will need to feel comfortable with management's selection before the engagement commences. The auditor should carefully review the analyst's resume and statement of qualifications. The analyst should have experience not just with valuation issues in general, but also specific experience in valuations related to financial reporting. The auditor should ensure that the valuation specialist fully understands the concept of fair value under GAAP and has experience with these types of engagements. The valuation specialist should make the auditor feel comfortable with the specialist's methods and assumptions during the course of the engagement, rather than at the end of it. The analyst would be wise to meet with the client and its auditor at the beginning of the engagement and have them agree to the valuation methodologies and certain assumptions prior to starting the engagement. Conclusion The latest pronouncements from the FASB relating to the financial statement presentation of business combinations and the accounting treatment of goodwill requires a valuation analyst to have a specific level of understanding of estimating fair value. The complexities involved often require the management of an acquiring company to retain the services of an outside valuation specialist. The work of the outside specialist often is used to audit evidence on the fair value of the acquired assets. The valuation analyst must therefore understand several basic valuation concepts related to measuring fair value. One issue is understanding the standard of fair value and how that impacts the methods and assumptions underlying the valuation. A second is knowing how the concept of market participants impacts assumptions and how synergy in a transaction is allocated. A third is understanding the importance of the market approach in relation to the three basic approaches to value, and a fourth is knowing how to work closely with the client's auditing firm. Understanding these concepts will help a valuation analyst prepare appropriately the analysis for financial reporting purposes. BVU April 2003 Shannon Pratt s Business Valuation Update 5

6 LEGAL & COURT CASE UPDATE DISSENTING SHAREHOLDER Fair value is pro rata share of sale price in arm s-length asset sale Pro Finish USA, Ltd. v. Johnson, 2003 Ariz. App. LEXIS 16 (Ariz. Ct. App. Feb. 6, 2003). Judge Lankford. Dissenting shareholder, Fair value, Asset sale, Present value, Prior sale, Appreciation, Best evidence, Third-party sale, Discount for lack of control, Marketability discount, Pro rata share, Nail care products, Personal care products Experts: Stephen K. Clarke, CPA/ABV (for dissenting shareholders) James A. Larson (for Pro Finish) In this case of first impression under the Arizona dissenters rights statute, the corporation appealed a trial court ruling accepting the dissenting shareholders expert s conclusion of fair value over that of the corporation s expert. The supreme court affirmed the trial court and held that fair value was the pro rata share of the sales price in an arm s-length sale of substantially all of the corporation s assets. It also upheld the trial court s ruling that no discounts should be applied in determining fair value. Facts In 1998 a buyer agreed to pay $5 million for substantially all of the assets of Pro Finish USA, Ltd., a seller of nail care polishes, finishes, and other personal care products. The buyer also agreed to assume almost all of the company s $1 million in liabilities. The dissenters voted against the sale and the corporation paid them each $1,200 per share. The shareholders objected to the $1,200 price and the corporation filed suit for a determination of fair value under the state dissenters rights statute. Valuation evidence and trial court findings The shareholders expert, Stephen Clarke, based his calculations on the asset sale price and determined that the fair value was $ per share. Clarke did not apply either minority or marketability discounts. The corporation s expert, James Larson, discounted the payment stream to present value and compared that figure to the price per share in a previous minority shareholder stock sale. Larson applied both minority and marketability discounts. He concluded that fair value was $977 per share. The trial court accepted Clarke s fair value conclusion and Pro Finish appealed. Holding on appeal and rationale The court of appeals first considered whether Arizona law required fair value to be determined without regard to the asset sale. Pro Finish first argued that fair value could not be based on the asset sale because it would take into account appreciation in anticipation of the corporate action. However, the court noted that the Arizona statute permitted such consideration if exclusion would be inequitable. Even if appreciation could not be considered, the court stated that the asset sale did not cause an appreciation in the stock value, but merely provided the best evidence of the existing value. The common-sense answer to the question of an asset s value is what a thirdparty is willing to pay for it. Methods of valuation short of third-party sales value are guesswork and merely a second best substitute for valuing the property in an actual third party sale. Thus, the best evidence of value, if available, is thirdparty sales value, and reliable evidence of third-party sales should be considered in determining fair value. The court further said that the risk of appreciated value was greater in a merger than in an asset sale, and it saw no reason why the shareholders should not share in the fruit of an advantageous price for the corporate assets. No discount for fair value Finally, the court agreed with the trial court s refusal to apply minority and marketability discounts to the dissenting shareholders pro rata share of the sale price. Noting the trend in this direction among other jurisdictions, it held that the focus should be upon the value of the firm as a whole, which should be prorated equally. BVU CORPORATE DISSOLUTION Minority shareholder cannot invoke Cal. Corp. Code 2000 Olaires v. Technical Cable Concepts, 2003 Cal. App. Unpub. LEXIS 45 (Cal. Ct. App. Jan. 3, 2003). Judge Rylaarsdam. Corporate dissolution, Involuntary dissolution, Partnership agreement, Option agreement, Fair value, Fair market value, Net asset value, Investment value, Liquidation value, Minority interest, Goodwill, Cable company This case is an action for involuntary dissolution of a corporation. The trial court valued the minority s interest and offered the majority shareholder the option to buy out the minority. The minority appealed on three issues. The court of appeals upheld the trial court s failure to follow the procedure of Cal. Corp. Code 2000 because the majority shareholder did not elect to buy out the minority. The court of appeals also upheld the trial court s findings regarding no goodwill and the size of the minority s interest in the corporation. BVU Estate fails to meet 2036(a) requirements Kimbell v. United States, 2003 U.S. Dist. LEXIS 523 (N.D. Texas Jan. 15, 2003). Judge Buchmeyer. ESTATE TAX Estate tax, Partnership interest, Arm s-length transaction, Bona fide sale exception, Adequate and full consideration, Retained rights or income exception, Partnership agreement After decedent s death, her estate filed returns listing the value of decedent s 99% partnership interest as $1.257 million. The IRS audited the returns and found the value of decedent s interest to be $2.463 million. The estate paid the additional taxes and brought this action seeking a refund of $837,089 for the IRS s overvaluation of the estate. The government moved for partial summary judgment, as did the estate. The district court found that the estate failed to prove either of the exceptions to IRC section 2036(a) and thus the partnership s assets were included in the decedent s gross estate. It granted the government s motion and denied the estate s. BVU 6 Shannon Pratt s Business Valuation Update April 2003

7 FRAUD No proof of loss causation required in fraud claim Reisman et al. v. KPMG Peat Marwick LLP, 2003 Mass. App. LEXIS 51 (Mass. Ct. App. Jan. 15, 2003). Judge Lenk. LEGAL & COURT CASE UPDATE Valuations based on redemption price upheld In re the Marriage of Crawford, 2003 Iowa App. LEXIS 59 (Iowa Ct. App. Jan. 29, 2003). Judge Sackett. MARITAL DISSOLUTION Stock redemption price is reliable evidence of value In re the Marriage of Letendre, 2002 N.H. LEXIS 209 (N.H. Dec. 31, 2002). Judge Broderick. Fraud, Negligent misrepresentation, Reliance, Posttransaction loss, Loss causation, Damages, Software corporation In this action for fraud and misrepresentation against an accounting firm for deceptive financial reporting, the auditors moved for summary judgment on the grounds that the plaintiff investors could not show that their losses were caused by the misrepresentations. The trial court granted the motion. The court of appeals reversed, holding that the plaintiffs only had to prove that their reliance, not their loss, was caused by the misrepresentation. Measure of damages Damages are the difference between the price paid for the stock and the value received as measured at the time the misrepresentation was discovered. The court of appeals phrased the measure of damages the Reismans were entitled to as the actual value of the stock purchased minus the price paid for the stock: Thus, where a person has been induced to purchase shares of stock in reliance on a false representation, the measure of damages is the difference between the price paid and the value of the item received, as measured by the market value of the shares at the time the misrepresentation has been discovered. This means that the jury is allowed to take subsequent events into account (i.e., as reflected in the market price after the falsity of the representation has been revealed) in arriving at the actual value of the shares at the time of purchase, which is then compared to and subtracted from the price paid. The court of appeals also held that the actual value of the shares is determined without attempting to separate out general market conditions or other factors that also might have contributed to the loss in value. BVU Marital dissolution, Redemption price, Book price, Engineering firm The court of appeals upheld the trial court s valuation of the husband s interest in Sundquist Engineering, PC, and SEA Corp., an S corporation, because the values were within the range of evidence presented at trial. Evidence of the redemption price set by the boards of directors supported the trial court s valuations. Valuation of Sundquist The husband owned 45 of 255 shares outstanding of Sundquist. The only evidence of Sundquist s value was the redemption price set by the corporation. At the end of 2001, that redemption price was set at $1,395 per share to be effective Dec. 31, Based on this evidence, the trial court valued the husband s stock at $62,775. On appeal the husband argued that the stock should have been valued at $28,000, based on the 2000 redemption price. The court of appeals upheld the trial court s valuation because there was no evidence that the husband would withdraw from the corporation before the end of 2002, or that he would accept less than the $1,395 pershare value for his stock. Valuation of SEA Corp. SEA Corp. owned real estate that it leased to Sundquist. The husband owned 21,000 of 73,298 outstanding shares. Evidence of the value of SEA Corp. included the most recent redemption price of $1.50 per share and the book price of $1.17 per share. The trial court valued the husband s interest at $31,500 based on the redemption price. On appeal the husband argued that the trial court erred in adopting the redemption price instead of the book price. The court of appeals upheld the trial court s valuation because it was supported by the evidence. BVU Marital dissolution, Fair market value, Stock redemption agreement The trial court excluded the husband s expert s testimony and valued the husband s one-third business interest based on the last stock redemption price set by the shareholders. The supreme court affirmed. The husband and two others formed Letendre Moore & O Connell, Inc. (LMO) in Each shareholder received 50 shares. In 1984 the shareholders adopted a stock redemption agreement. Beginning in 1992, the shareholders met annually to determine current share value, and set the 2000 redemption price at $6, per share. No experts testified. The court disallowed the husband s proposed expert testimony because the husband did not comply with the discovery deadline. The husband testified that the stock redemption price of $6, per share was not based on a professional appraisal and did not represent fair market value. The wife and the corporation s accountant also testified, although the opinion does not give details about either of their testimony. Trial court findings The trial court relied on the last stock redemption price set by the shareholders and valued the husband s 50 shares at $339,270. The court awarded the wife 50% of this amount. Holding on appeal and rationale On appeal the husband argued that the trial court lacked competent evidence upon which to value his business stock and that it erroneously relied upon the stock redemption agreement option price as evidence of the stock s fair market value. The supreme court, in affirming the trial court, noted that the trial court did not rely exclusively on the stock redemption agreement in valuing the stock, but also heard testimony from the wife, as well as from the corporation s accountant. It also received corporate tax returns and financial statements. BVU April 2003 Shannon Pratt s Business Valuation Update 7

8 LEGAL & COURT CASE UPDATE MARITAL DISSOLUTION Court rejects acquisition value for minority interest In re the Marriage of Sims, 2003 Wash. App. LEXIS 86 (Wash. Ct. App. Jan. 23, 2003). Judge Schultheis. Marital dissolution, Asset-based approach, Income approach, Goodwill, Minority interest discount, Marketability discount, Technology corporation, Printer manufacturer Experts: Kevin Williams (for wife) Scott Martin (for husband) OTHER CASES Ashlock v. Ashlock, 2003 Ore. App. LEXIS 119 (Or. Ct. App. Feb. 5, 2003). Judge Kistler. Marital dissolution, Business debt, Dot.com business, Multilevel marketing company In this marital dissolution, the court of appeals held that, as a general rule, when a court awards a business entirely to one party, the debts associated with that business should go with it. Kauffman v. Kauffman, 2003 Mo. App. LEXIS 120 (Mo. Ct. App. Jan. 31, 2003). Judge Breckenridge. Marital dissolution, Classification of property, Gift, Limited partnership, Construction business, Handyman business The issue in this marital dissolution was the classification of three business interests either as the husband s separate property or as marital property. Bakala v. Bakala, 2003 S.C. LEXIS 21 (S.C. Jan. 27, 2003). Judge Floyd. Marital dissolution, Asset value, Nonexpert opinion testimony, Full-service investment bank, Investment company, Restaurants In this marital dissolution, the supreme court upheld the trial court s valuation of the husband s business interests because they were supported by evidence in the record. The husband failed to appear at the trial or to contest the non-expert opinion testimony of the wife. At issue was the value of a minority interest in the common stock of Output Technology Corporation (OTC), a manufacturer of high-speed dot matrix printers. Wife s expert posits acquisition value Wife s expert, Kevin Williams, based his valuation on what the stock would be worth if the entire company was sold to a publicly-traded company, not on what it would be worth if (husband) sold only his shares. The trial court found that the $2 million value was way too high because Mr. Williams failed to provide a minority deduction. The trial court based its opinion on the testimony of husband s expert, Scott Martin, with some modifications. Martin used an asset approach and an income approach, weighted equally, and an unspecified minority interest discount and a 30% discount for lack of marketability for a value of $1.05 per share. Court adds unexplained goodwill value The court added $.95 per share for goodwill value with no discussion of how it arrived at that figure. The resulting value of $2 per share was multiplied by 341,221 shares to arrive at the value for husband s stock of $682,442. The appellate court affirmed. BVU Goodwill in tile laying business considered part of marital value Schiro v. Schiro, (La. App. 5 Cir., 01/28/03), 2003 La. App. LEXIS 72 (La. Ct. App. Jan. 28, 2003). Judge Edwards. Marital dissolution, Goodwill, Capitalized excess earnings method, Asset approach, Tile laying business Experts: Albert J. Derbes, III, CPA (for wife) The Derbes Law Firm, LLC Kern Shafer (for husband) Eric Rigby (for husband) Bruce Miller (for husband) At issue was the value of husband s 50% interest in Schiro-Del Bianco Enterprises, Inc., a tile-laying business. Mr. Schiro was responsible for the administrative aspects of the business such as estimating job costs, coordinating work crews and accounting. His partner, Del Bianco, was a highly skilled tile layer. Business operates out of home The business operated out of the husband s mother s home. It generated about $1 million revenue per year. Aside from the equipment it used, the corporation did not keep any inventory in stock. Wife s expert, Albert J. Derbes, III, CPA, testified that, based upon a capitalized excess earnings method, the value of Schiro- Del Bianco Enterprises was $1,105, Husband s experts include no goodwill Husband retained three experts who testified to the value of Schiro-Del Bianco Enterprises as follows: Kern Shafer: $ 75,000 Eric Rigby: $136,000 Bruce Miller: $132,500 None of husband s experts values included the value of goodwill. Husband argued that the value should be calculated as if it was a professional practice (as opposed to a commercial business) because Louisiana case precedent does not include the value of goodwill in a professional practice for marital property purposes. The trial court concluded that it should be valued as a commercial business, including goodwill. Goodwill figure a little bit high The trial court said [Mr. Derbes] had the goodwill at five times the earnings, and I thought that was a little bit high. The trial court concluded a value of $800,000 for the enterprise and $400,000 for Mr. Schiro s interest. The appellate court affirmed. SP Comment: While the written opinion said five times earnings, I interpret this to mean five times excess earnings, since the opinion said that Derbes used the excess earnings method. That strikes me as excessively high for a tile-laying business! BVU 8 Shannon Pratt s Business Valuation Update April 2003

9 LEGAL & COURT CASE UPDATE MARITAL DISSOLUTION Value set by EBITDA but debt not deducted In re the Marriage of Franzen, 2003 Wisc. App. LEXIS 72 (Wis. Ct. App. Jan. 29, 2003). Judge Snyder. Marital dissolution, Fair market value, EBITDA multiples, Income approach, Marketability discount, Minority interest discount, Grocery store Experts: Wayne M. Wallschlaeger, CPA (for wife) William K. Jacobson (for husband) William K. Nortman, CPA (for husband) At issue was the value of husband s 50% interest in Rick & Vic s, which owned and operated a Piggly Wiggly grocery store. Trial court uses 5.5 times EBITDA Based on wife s expert s testimony, the trial court used Standard & Poor s multiple of 5.5 times 2001 EBITDA to value the company at $1,082,868. It then took a 20% discount for lack of marketability and 20% for lack of control, for a fair market value for the company of $649, It then valued husband s 50% interest at $324, Husband claimed that the following should have been deducted from the value arrived at by a multiple of EBITDA: $500,000 debt to Firstar Bank $212,000 debt to Fresh Brands (the franchiser) $138,833 unfunded pension liability $43,049 negative cash Husband s experts testified that the company had a negative value because the projected operations were insufficient to support the debt. VALUE BVLibrary.com Wherever you see this symbol in the Legal & Court Case Update section, you will find additional materials relating to that particular case at BVLibrary.com either an expanded version of the case abstract or the full text of the court s opinion, or both. Court rejects deducting debt The trial court rejected the debt deductions because of the accelerated rate at which the debt was being paid down. The appellate court affirmed the trial court s valuation. SP Comment: A multiple of EBITDA produces a market value of invested capital, not a value of equity. It seems to me that at least the $712,000 of interest bearing debt should have been deducted before getting at the undiscounted value of the equity. Incidentally, the numbers indicate that the minority and marketability discounts were applied additively (total of 40%) rather than the more conventional (and generally accepted) procedure of applying the discounts sequentially. BVU ADDITIONAL EDITOR S COMMENTS ON THE CASES IN RE THE MARRIAGE OF SIMS, SCHIRO V. SCHIRO AND IN RE THE MARRIAGE OF FRANZEN A common set of threads runs through the cases of In re the Marriage of Sims, Schiro v. Schiro, and In re the Marriage of Franzen. Apparently, from reading the cases, none of the experts in any of these three cases had any business valuation credentials whatsoever. The methodology used seems to be misapplied, resulting in what seems to be unreasonably high values in two of the three cases. In all three cases the appellate court affirmed the trial court s conclusions as being reasonably supported by the evidence in the record, even though none of the appellate opinions are clear as to exactly how the trial court reached its opinion. The quality of expert testimony consistently seems to be weakest in family law matters, and this leads to inequitable results. The judges have to rely on evidence presented and are not financial experts. Family law attorneys should be educated to retain qualified experts. BVU Arithmetic mean equity risk premium 2 Treasury yields 1 S&P 500 NYSE day: 1.18% 8.8% 8.0% 5-year: 2.75% 7.8% 7.1% 20-year: 4.73% 7.4% 6.6% Micro-Cap size premium S&P 500 Benchmark % Micro-Cap size premium NYSE Benchmark % 10th-decile-size premium S&P 500 Benchmark % 10th-decile-size premium NYSE Benchmark % Prime lending rate: % Dow Jones 20-bond yield: % Barron s intermediate-grade bonds: % High yield estimate: 1 Mean 13.83% Median 9.88% Dow Jones Industrials P/E ratios: 3 Current On 02 operating On 03 operating earnings: earnings est.: 15.4 earnings est.: 13.4 Long-term inflation estimate: % Long-term rate of growth GDP: % 1 Wall Street Journal, March 3, Premium in excess of CAPM from Stocks, Bonds, Bills, and Inflation : Valuation Edition 2002 Yearbook (Chicago: Ibbotson Associates, Used with permission. All rights reserved.) We highly recommend that analysts using Ibbotson data for cost of capital have the current year s book and thoroughly understand the derivation of the numbers used. 3 Barron s, March 3, ECONOMIC OUTLOOK UPDATE Starting with the 1Q 1003 issue of the Economic Outlook Update (available May 2003), this report will be offered on a subscription basis. The 1-year and 2-year subscription prices were set to be very competitive compared to other providers reports. The prices are lower for subscribers to Shannon Pratt's Business Valuation Update. The prices are $149 for a 1-year subscription for subscribers to BVU (as compared to $225 for non-subscribers) and $249 for a 2- year subscription (as compared to $350). On top of these savings if you sign up throuh April 2003 you can take off 10% by using the EOU0403 priority code when ordering online or talking to our customer service reps. COST OF CAPITAL 4 10-year forecast; Federal Reserve Bank of Philadelphia, Livingston Survey, December year forecast; Federal Reserve Bank of Philadelphia, Livingston Survey, December April 2003 Shannon Pratt s Business Valuation Update 9

10 Applying traditional DCF to high risk businesses results in over valuation Monte Carlo Simulation in the Valuation of High Risk Businesses, Benjamin C. Alamar, Business Valuation Review, December 2002, pp A low probability of success and high chance of failure is what start-up, high-tech, and biotech firms have in common. This article illustrates the use of the Monte Carlo simulation in applying a discounted cash flow (DCF) analysis to such high-risk businesses. Monte Carlo simulation attempts to solve the discrepancy in levels of risk between sales and costs flows when forecasting cash flows in a DCF model. Appraisers customarily forecast a constant growth rate for revenues and assume that costs will be stable at a certain proportion of sales. This approach works fine for traditional stable businesses but results in overvaluation of high-risk companies. In the example in the article, the traditional DCF application resulted in a $1,794 value, while the Monte Carlo simulation resulted in a $1,283 value. To correct for this difference, the discount rate used in the traditional analysis would have to be raised to 23.25% from the 15% originally used. The difference in discount rates reflects the risk differential not accounted for by the traditional DCF method. For those interested in applying the Monte Carlo simulation analysis, it can be purchased as an add-on to most spreadsheet programs or programmed in a computer language such as Visual Basic. BVU How to apply the Silber model in a valuation Predicting Lack of Marketability Discounts by Use of an Econometric (Statistical Regression) Model, John J. Kania, Business Valuation Review, December 2002, pp This article includes a presentation of the Silber 1 model to determine marketability discounts. The Silber model is a statistical regression model that explains the discount for lack of marketability by using multiple independent variables. Silber s regression DATA & PUBLICATIONS UPDATE ARTICLES model includes the following factors as independent variables: Net sales prior to valuation date representing firm size Size of the share block divided by total shares outstanding A dummy variable that takes the value of 1 for positive earnings to shareholders and 0 for negative earnings to shareholders A second dummy variable that takes the value of 0 when no special relationship exists between buyer and seller and otherwise takes the value of 1 The balance of the article includes an illustration of how to use the Silber model to determine a marketability discount, responses to questions about the model, and a recommendation as to how to present the Silber model in a valuation report. BVU QMDM or restricted stock studies? The Discount Alchemy of QMDM, Lance S. Hall, Business Valuation Review, December 2002, pp In this article Hall criticizes the Quantitative Marketability Discount Model (QMDM) and identifies several reasons why the restricted stock studies are a better tool to determine the discount for lack of marketability (DLOM). Hall begins by discussing several court cases in which the court rejected the QMDM notably, Weinberg, Janda, and Mandelbaum. Other criticisms of the QMDM that Hall mentions are: QMDM may be measuring other factors besides the DLOM. QMDM requires a precise estimate of when a liquidity even will occur, which is very difficult to measure. The author also notes several advantages of restricted stock studies: They reveal factors that impact the DLOM such as firm s revenues, assets, profit, profit margin, distributions, underlying market value, leverage, and volatility. They show that the DLOM is not affected by the industry in which the company operates, except for the financial institutions. They show that the incremental required rates of return to compensate an investor for the illiquidity of the restricted stock decline over the expected time horizon. BVU Benchmark averages misleading when estimating control premiums/minority discounts Accurate Use of Takeover Statistics, Shannon P. Pratt, Valuation Strategies, November/December 2002, pp This article by our editor-in-chief urges appraisers to use caution when applying benchmark averages to estimate control premiums or minority discounts. He believes that analysts should identify transactions that are comparable to the subject company and apply the resulting control premium or minority discount. As an example of how benchmark averages can be misleading, Pratt cites from an article by Daniel McConaughty, Negative Takeover Premia and Stock Price Levels in Internet Stocks, (Valuation Strategies, March/ April 2002, abstracted in Shannon Pratt s Business Valuation Update, June 2002, p. 11). In his article, McConaughty notes that many of the 120 takeovers in the Internet industry from November 1998 through April 2001 were at negative premiums. Pratt presents additional evidence from previous research on transactions in the Mergerstat/ Shannon Pratt s Control Premium Study database, saying, Many people are surprised to learn that, over the last 17 quarters, over 16% of all takeovers of public companies were at prices below their public trading prices. While the industry averages computed by Mergerstat exclude transactions with negative premiums, the online tool Mergerstat/Shannon Pratt s Control Premium Study (available at BVMarketData.com sm ) allows the user to search and find comparable transactions and to include negative premium transactions to get a more realistic picture of the market benchmarks. BVU 10 Shannon Pratt s Business Valuation Update April 2003

11 DATA & PUBLICATIONS UPDATE SOFTWARE Wiley s EBV software useful tool for automating and standardizing valuation process EBV most appropriate for firms with simple financial statements Express Business Valuation for Microsoft Office, Wiley ValuSource, August Product info [email protected], Phone , Fax ; Tech support [email protected], (719) , Fax (719) US $395.00, Software, CD- ROM. The first thing you notice after opening the Express Business Valuation (EBV) software is that it opens in a Microsoft Excel window. The EBV software was built using the menus, look, and feel of the Excel program that valuation analysts are already very familiar with. Project setup After choosing the Create a new file option, a Project setup screen comes up along with the Navigator window. The Navigator tool in EBV is what Windows Explorer is to your PC a tool that allows the analyst to navigate the multitude of schedules and screens of the valuation analysis. To customize and change certain fields in EBV, you have to switch to the Excel mode. (To do this, choose EVB on the toolbar and click on Switch to Excel mode. ) This will bring up the Excel interface and allow customization by the user. To switch back to EBV interface and mode, click on the EBV button on the toolbar and choose Switch to EBV mode. Choosing the valuation methods When ready to move on, the Navigator window helps bring up the next schedule that allows you to choose as many of the appraisal methods as you like: Going concern method Liquidation value method Capitalization of earnings method Discounted cash flow method Capitalization of excess earnings method Market data method Industry data method Subject company transactions method Selecting the methods is easy just check or uncheck a box. This screen also includes a button that links to the SIC index. Entering financial statement data The next category of schedules is the Financial Statements and consists of input, historic financial statements, and adjustments to financial statements. Four of these schedules are actually built-in graphs that are created automatically when data is input: Historic assets, liabilities, and equity; Historic income statements; Cash flow from operations; and Adjusted income statement. Two of the schedules allow for data entry of the historic balance sheet and income statement data. Because the financial statements in this software are the short form, you may find that they are not detailed enough for your purposes. In our mock valuation we did not have preset rows for the following balance sheet and income statement accounts: Short-term investments Accrued and other expenses Deferred income taxes Common stock Additional paid-in-capital Retained earnings Selling, general, and administrative expenses Net income before accounting change Cumulative effect of accounting change Customizing financial statements As a result, we tried to add rows to the data entry financial statements (after switching to Excel mode) and found out that it is not done easily. First, the message that appears on the screen before switching to Excel reads: Changing the Express Business Valuation workbook in Excel could corrupt the integrity of the workbook. Do not delete rows as the program uses data outside April 2003 Shannon Pratt s Business Valuation Update the viewable area. Custom changes to schedules are not supported by technical support. Are you sure you want to continue? Second, after adding rows in the financial statements, other schedules such as the historical as well as the common size statements displayed cells with the #REF! error message in them, and the historical charts became corrupted. After calling technical support, we learned that there are three ways to add accounts to the financial statements: 1. It is possible to add account rows to the financial statements if the additions are consistent and done on multiple schedules. 2. The user can create a data input sheet using Excel where the user uploads the more detailed statements and then, using formulas, links it to the one less detailed already used by the software basically, multiple rows are added together and collapsed so that the resulting statements are the ones reviewed by the software. 3. Users needing extensive customization can buy Valu Source Pro, a more advanced and more expensive valuation software sold by Wiley. EBV was not designed to allow for easy custom changes of this nature and is intended to be a simpler, more basic tool aimed at people who want a quick, easy value figure. EBV allows downloads from valuation databases The next schedules are the analysis schedules and include common size statements, common size adjusted statements, and financial ratio analysis. Again, the software automatically creates the common size historic charts. At the analysis stage, the analyst can download data from the RMA Fi- Continued to next page... 11

12 12 Wiley s EBV software useful tool...continued from previous page nancial Ratios and the IRS Ratios databases to compare to the subject company (sold separately). The Appraisal schedules consist of the following: General Schedules; Asset approaches; Income approaches; and Market approaches. 20 valuation methods and hot-linked report writer The Conclusion of Value schedule contains a list of 20 methods and their value conclusions. The analyst can choose which values to use in the weighting for the final value conclusion. When the time comes to write the valuation report, the EBV provides a report writer that creates a hot-linked report in Microsoft Word. The report is fully customizable with the analyst choosing which numbers, tables, and charts to include. The report EBV created for our sample valuation was 27 pages. The system requirements are Microsoft Office 1997, 2000, or XP. The tech support includes free online video tutorials, free telephone training, and online support. Conclusion EBV is a good tool for organizing the valuation analysis and the report writing process for engagements that involve companies with simple financial statements and little or no customization needs at the data entry stage. Using this software, though, cannot replace solid valuation knowledge and experience. The advantages of using EBV are that: It uses the familiar Microsoft Word and Excel software programs already commonly used by valuation analysts. It provides the analysts with a set of linked spreadsheets and hotlinked documents that save hours of editing, proofing, inputting formulas into Excel spreadsheet, and other otherwise time-consuming manual operations. It automates and standardizes the activities needed to be performed during the analysis and reporting stages of the engagement. Editor s Note: A more comprehensive review of the EBV software is available to subscribers of BVLibrary. BVU DATA & PUBLICATIONS UPDATE BOOK What s new in the 2003 edition of Tom West s Business Reference Guide 2003 Business Reference Guide, 13 th edition, Tom West, Business Brokerage Press. Available from Business Valuation Resources, LLC SW Beaverton-Hillsdale Hwy., Suite 106, Portland, OR (888) BUS-VALU [ ], fax (800) [email protected]. $92, 747 pp., 5 ½ by 8 ½, softcover. The 13 th edition of the 2003 Business Reference Guide is an indispensable reference tool for any professional involved in buying or selling a privately held business. It has the latest pricing, rules of thumb, and general business information, including sample forms, checklists, agreements, guest articles, and court decisions. New edition highlights To expand and include more details in the most significant Rules of Thumb chapter, substantial changes have been made to the book. The following are the new edition s highlights: The Franchise/Business Opportunity Issues chapter has been eliminated and its contents are now included in chapter four on Buying a Business. The Legal Issues chapter also has been eliminated and its court cases are now dispersed throughout the book. The chapters on Business Brokerage Information and Business Brokerage Issues have been combined. The Rules of Thumb chapter is longer and includes more detailed information; for the first time, the author used the services of a researcher to obtain additional data. For each entry, the author added the approximate number of businesses in that field; SIC and NAICS codes also were included wherever applicable. Content summary Chapter one, General Business Data, includes general brokerage data as well as general small business data such as size breakdown and revenue figures. Chapter two, Business Brokerage Issues, explores in great detail the primary issues faced by anyone in this profession. Subjects covered include standards and codes of ethics, licensing, the agency relationship, property disclosure, interstate brokerage, and stock sales versus asset sales. Chapter three, Selling a Business, offers a guide for brokers on how to list, word, and withdraw from a sale; it also covers fees and commissions and includes sample forms, sample agreements, letters, and checklists. Chapter four, Buying a Business, examines the process of buying a business and is an indispensable resource for anyone considering buying a business. Chapter five, Financing the Business Sale, focuses on seller financing, earnouts, and information on Small Business Administration loans, as well as documentation samples and checklists. Chapter six, Closing the Sale, examines every aspect of the closing process. It includes an article on allocation of purchase price, in addition to sample wording, forms, agreements, and checklists. Chapter seven, Business Valuation and Pricing Issues, examines the various methods and approaches used to value a business, as well as examples of each and helpful hints to avoid common mistakes. Chapter eight, Rules of Thumb, is the most popular and widely used tool in the guide. The rules are arranged alphabetically by type of business, and the author uses the most common names for businesses and then cross-references them to variations on the names. Also included are pricing tips, general business information, lists of resources (including industry experts and trade associations), seller financing, and industry trends. Chapter nine, Industry Experts, includes a directory of industry experts. This 700-plus page book is a must have for everyone involved in privately held business transactions. BVU Shannon Pratt s Business Valuation Update April 2003

13 DATA & PUBLICATIONS UPDATE BOOK Business valuation by dealmakers a how to guide for entrepreneurs and valuation analysts The Business Valuation Book: Proven Strategies for Measuring a Company s Value, Scott Gabenhart and Richard J. Brinkley, American Management Association, Available from Business Valuation Resources, LLC, 7412 S.W. Beaverton- Hillsdale Highway, Suite 106, Portland, Oregon (888) BUS-VALU [ ], fax (800) , bvstore. $39.95, 309 pp., approx. 7 by 10, hardcover. A special feature of this book is the inclusion of the results of a comprehensive survey distributed to agents working within the Venture Resources Business Brokers (VRBB) network. VRBB is an international network of independent business brokerage franchises located throughout the United States, Canada, and several other countries. Richard Brinkley, coauthor of this book, is the former president and a major shareholder of VRBB. The survey addresses several valuation methodologies and pools business brokers responses on various topics, including: Use of and types of rules of thumb Commonly used valuation techniques in general Critical determinants of business value Valuation of fixed assets (i.e., furniture, fixtures, and equipment) The VRBB Valuation Survey results are included on the CD-ROM that accompanies the book and provide interesting insights into the way business brokers value businesses. The results of the survey also include a list of factors that, in the respondents opinions, affect the valuation multiple of cash flow and business value in general. The authors of this book, both seasoned entrepreneurs and business valuation professionals, develop a business valuation approach that any businessperson can use to develop a credible valuation. It is called the ARM approach and consists of three factors: Adjusted cash flow Rules of thumb Market comparables The ARM approach contains a questionnaire of more than 200 questions covering all valuation parameters in the valuation assignment. This questionnaire is then used in conjunction with the Five-Page Tool a methodology that helps the analyst to use the company s financial statements correctly. The ARM approach Questionnaire and the Five-Page Tool are standalone valuation tools that can be used to generate business valuation estimates. The questionnaire is also included on the CD-ROM that comes with the book, along with other resources of great interest to the analyst: A 52-page review of the asset approach to business valuation A 55-page document containing a list of rules of thumb by industry from accounting and tax practices to travel agencies. Most of the rules were collected through the VRBB Valuation Survey. A 10-page accounting primer A 64-page comprehensive review of the Small Business Administration (SBA) loan programs and SBArecommended valuation techniques A case study illustrating various techniques to value small manufacturing businesses. The techniques range from rules of thumb to discounted cash flow (DCF) analysis. A copy of the full questionnaire and the condensed version are included here in digital format for easy inclusion in a valuation report According to the authors, the main purpose of this book is to teach the business owner how to value his or her business. Business brokers and intermediaries and other valuation professionals who operate in the trenches of dealmaking are also sure to find this book useful and make it a reference resource for their day-to-day work. BVU ARTICLE Technology value highest for most advanced stages of clinical development Valuation of Biotechnology Stage of Clinical Development Is Most Important, Jeremy Webster, Trevor Philippon, and Mykhaylo Hotsaliuk, Business Valuation Review, December 2002, pp The road from an idea for a drug to its commercial sale is long and complex. The authors identify several stages and their expected durations: Research: two to three years Preclinical development: one year Clinical development: six years (This stage consists of three phases I, II, and III) Review and approval: one to two years CommercializationThe research, preclinical, and clinical development stages together usually last an average of 10 years. The research, preclinical, and clinical development stages together usually last an average of 10 years. In this brief article the authors test the hypothesis that the stage of clinical development is the most important factor in determining the value of biotechnology companies. To test this hypothesis they used a sample of 30 biotechnology companies that they divided into three groups based on their stages of clinical development: Preclinical and Phase I Phase II Phase III Then they calculate the technology value for each company in the sample, measured as the market capitalization less cash and marketable securities. Their conclusions are: The stage of clinical development incorporates other important value drivers such as expected time to market, management, and intellectual property. Stage of clinical development is the most important factor when determining the value of biotechnology companies. BVU April 2003 Shannon Pratt s Business Valuation Update 13

14 14 DATA & PUBLICATIONS UPDATE ARTICLES ABA FAMILY LAW SECTION FOCUSES ON VALUING THE BUSINESS IN DIVORCE All of the following articles were published in the Winter 2003 issue of Family Advocate, a quarterly publication of the American Bar Association Family Law Section. Each issue of Family Advocate generally focuses on a specific theme of interest to family law attorneys. This quarter the topic is valuing the business. Some of the articles apply to this topic in general terms, while others focus on presenting the valuation case with respect to a specific type of business or industry. Although the discussion of valuation approaches is not as detailed as would be found in a periodical geared toward appraisers, many of the articles are nonetheless instructive for appraisers involved in divorce litigation, providing a glimpse into the level of knowledge of the attorneys they work with. The Judicial Perspective, Joy M. Feinberg, Family Advocate, Winter 2003, pp In this insightful article, the author presents the results of her interview of two family law judges on the topic of business valuation experts. The judges reveal what they most want from appraisers, and what most hurts the credibility of appraisers in their eyes (and in the courtroom). The opposing views of the two judges highlights the importance of learning as much as possible about any judge you will be appearing before as an appraiser. Eric Nath Eric Nath, ASA, has recently relocated his office and incorporated under the name Eric Nath & Associates, LLC. With his associate, Steve Rooney, Nath is focusing on valuations for estate, gift, and income taxation, litigation support, SFAS 141 and 142, fair value reporting, Section 2000, mergers and acquisitions, stock options, fairness opinions and other transaction-related valuations. "More than ever there is a need for fully independent, high quality business and intangible valuation work, as you know. We have been benefiting from this need, and are seeing a strong, positive response from the legal and accounting communities to the reopening of the office," Nath said when we contacted him. "We intend on growing the business over the next couple What is Value?, Barry S. Sziklay, Family Advocate, Winter 2003, pp The author discusses the various standards of value, including fair market value, investment value, intrinsic value, and fair value. He concludes this condensed version of his full article with a plea for a unique standard of value in the family law context, what he calls divorce value. Selecting & Working with a Business Appraiser, Virginia (Lanny) Martin and Jeffrey W. Brend, Family Advocate, Winter 2003, pp Want to know what attorneys look for when seeking an appraiser? Then read this article. It addresses what attorneys consider when assessing credentials, knowledge, and communication skills. Valuing the Cash Business, Bruce L. Richman, Family Advocate, Winter 2003, pp This article addresses the ways in which a business appraiser or forensic accountant might uncover or estimate unreported cash revenue for a business. It includes a discussion of using a cost-benefit analysis in deciding whether this type of investigation is warranted. NEWS UPDATE COMPANY NEWS Eric Nath, ASA, relocates and forms LLC of years in an orderly way such that the quality of our product remains at the high end." Nath has over 17 years experience as a business valuation professional, and is the creator and teacher of the "Business Valuation Discounts and Premiums" course for the Center for Advanced Valuation Studies (CAVS). He has both his BA and MBA from the University of Washington. Previously a member of the Business Valuation Committee of ASA, he is currently a member of that committee's Standards Subcommittee. "The initial phase of standards development is coming to a close for the business appraisal profession." he comments. Eric Nath & Associates is located at 50 California Street, Suite 3330, San Francisco, CA His new phone is (415) , fax (415) An updated Web site for the firm is located at You can contact him by at: [email protected]. BVU Documents, Jeffrey W. Brend, Family Advocate, Winter 2003, pp. 19, 41. This article is an extensive checklist of documents that the attorney should gather or request from the opposing party. It also serves as a great checklist of the documents the appraiser should be reviewing as part of the appraisal process. Cross-Examining the Financial Expert, Catherine Holland Peterson and Joanne Ross Wilder, Family Advocate, Winter 2003, pp This article is really two separate articles, one by each author. Peterson s article focuses on the importance of organization and preparation for cross-examination. She includes a number of specific questions regarding methodology that an appraiser might expect the prepared attorney to ask on crossexamination. Wilder s article focuses on pinning down the appraiser on the standard of value and methodology during cross-examination. A caveat about this article is that the author incorrectly references a revenue ruling as binding in divorce actions, and she fails to consider the effect of Kumho Tireon the Daubert gatekeeping duty of the court in evaluating an appraisal expert. Grant Thornton acquires Brueggeman and Johnson Effective January 2, 2003, Neil Beaton of Brueggeman and Johnson, P.C. announced that his Seattle valuation practice was acquired by the international accounting and business advisory firm Grant Thornton, who serves largely middle-market companies. Beaton and his partner Bob Duffy will be heading up Grant Thornton s national valuation practice. Neil Beaton For the next three months their office will remain at 999 Third Avenue, Suite 4250, Seattle, WA 98104, at which time they will relocate to the Convention Center Office Tower. They can be reached at (206) , fax (206) , [email protected], Web site: BVU Shannon Pratt s Business Valuation Update April 2003

15 READER/EDITOR EXCHANGE How to compute intangible assets amortization benefit I would appreciate if I can get a numerical computation of the Amortization Benefit Formula as shown on pages 54 and 55 of the book I recently purchased, Valuation for Financial Reporting by Mard and Hyden. Also, is this add back to the value of the intangible only considered if the intangible is not being amortized for book purposes but is taxed under federal income tax regulations over 15 years, or do all intangibles require this computation to get to the fair value of the intangible? I would appreciate your immediate response. Thank you. Gil Ostrick, CPA Oppenheim & Ostrick, CPAs Value Added Advisors Culver City, Calif. Editor s Note: We forwarded this question to Steve Hyden, one of the authors of the book referenced in the question. Below is his response. The explanation at right demonstrates the calculation of the Tax Amortization Benefit shown in Exhibit 3.6, page 55. Please refer to the section entitled Tax Effects on pages 24 and 25 for a more detailed description. The add back to the value of the intangible is appropriate if the intangible qualifies for amortization under section 197 of the Internal Revenue Code, as it is worth more if the buyer can amortize it for tax purposes. BVU AB = PVCF*(n/(n-((PV(Dr,n,-1)*(1+Dr)^0.5)*T))-1) Where: AB = Amortization benefit PVCF = Present value of cash flows from the asset n = 15-year amortization period Dr = Discount rate PV(Dr,n,-1)*(1+Dr)^0.5 = Present value of an annuity of $1 over 15 years, at the discount rate T = Tax rate Thus, AB = 6,024,750 * (15 / (15 - ((PV(0.18,15,-1) * ( ) ^ 0.5) * 0.40)) - 1) = 6,024,750 * (15 / (15 - ((PV(0.18,15,-1) * 1.18 ^ 0.5) * 0.40)) - 1) = 6,024,750 * (15 / (15 - (( * 1.18 ^ 0.5) * 0.40)) - 1) = 6,024,750 * (15 / (15 - (( * ) * 0.40)) - 1) = 6,024,750 * (15 / (15 - ( * 0.40)) - 1) = 6,024,750 * (15 / ( ) - 1) = 6,024,750 * (15 / ) = 6,024,750 * ( ) = 6,024,750 * = 1,042,321 (rounded) NEWS UPDATE ASSOCIATION NEWS CICBV grants new equivalency credit for ASA BVs The Canadian Institute of Chartered Business Valuators (CICBV) voted to approve new equivalency credit for those applicants for the CICBV s CBV designation who already possess the ASA in Business Valuation credential. For many years now, the ASA has allowed CBV designation holders to waive the ASA training and testing requirement. Currently the requirements to obtain the CBV credential are: (1) Submit a registration form and a membership application; (2) Take the course and pass the examination for four core courses (Introductory Business and Securities Valuations, Intermediate Business and Securities Valuations, Advanced Business and Securities Valuations, Law and Tax in Business Valuation); (3) Take the course and pass the examination for three elective courses (Litigation Support I Basic Concepts, Litigation Support I Basic Concepts, Advanced Open Market Transactions, Corporate Finance); (4) Fulfill the requirement of two years fulltime valuation experience; and (5) Pass the MME comprehensive examination. The equivalency credit for the ASA in Business Valuation includes: (1) A waiver of the requirement to take the first three core courses; (2) The option to challenge the examination for the fourth core course without having to take the course unless the exam is failed; and (3) The option to challenge the examination for two elective courses without having to take the courses unless the exam is failed. Mike Bolotsky, chairman of the ASA s Business Valuation Committee, expresses his hope that many ASA BVs will take advantage of this new opportunity. BVU April 2003 Shannon Pratt s Business Valuation Update 15

16 Jim Hitchner joins the Financial Valuation Group The Financial Valuation Group (FVG) has announced that James R. Hitchner, CPA/ABV, ASA has joined the firm as a managing director in its Atlanta office. Hitchner will continue to serve his existing client James R. base in all industries and Hitchner service areas, including financial reporting (SFAS 141/142), litigation, and tax. Before joining FVG, Hitchner worked at the Phillips Hitchner Group in Atlanta for the last seven years, a company he cofounded. He is also a co-founder of the Financial Consulting Group, a national organization of independently owned accounting, business valuation, and financial services firms. The FVG Atlanta office is located at 1360 Peachtree St., NE, Suite 950, Atlanta, GA Their contact information is as follows: phone (404) ; Web site: for Hitchner: [email protected]. BVU NEWS UPDATE COMPANY NEWS Pratt book donated to law library Victor E. Jarosiewicz, ABV, CVA, informed us that his firm donated Shannon Pratt s book, The Lawyer s Business Valuation Handbook, to the Brevard County Law Library on January 21, Pratt had autographed the book To the Brevard Law Library when he met Jarosiewicz at the ASA BV committee meeting in Orlando in October By making this resource available to attorneys and the public, we hope to increase awareness of and raise the expectations for a standard of quality in business valuations, said Jarosiewicz. This is currently the only copy of the book available in a public library within the Eighteenth Judicial Circuit, which includes Brevard and Seminole counties. Jarosiewicz is one of two business valuation analysts on the staff of Hoyman, Dobson & Company, P.A., a CPA firm that provides accounting, tax, auditing, and advisory services to businesses throughout Pictured left to right, are: Victor Jarosiewicz, AVA, business valuation analyst, Barbara Oswalt, CPA/ABV, director of valuation services at Hoyman, Dobson & Company, P.A., Susan Szymula, Brevard County Law Library director, and Brian Onek, Brevard County Bar Association law library liaison. central Florida. Their office is located at 215 Baytree Drive, Suite 1, Melbourne, FL They can be reached at (321) , fax (321) , [email protected], Web site: BVU SEND US YOUR NEWS & UPDATES We invite you to send news or calendar items for inclusion in this department. Please news items to [email protected], mail them to the BVU Editorial, 7412 S.W. Beaverton-Hillsdale Hwy., Suite 106, Portland, OR 97225, or fax them to the Managing Editor at (503) April 30 - May 2 26th Annual ESOP Conference Washington, D.C. Omni Shoreham Hotel (866) April 30 - May 3 ACG InterGrowth 2003 San Diego, Calif. Hotel del Coronado (800) May AIMR Annual Conference Phoenix, Ariz. Arizona Biltmore Hotel (434) May NACVA Annual BV Conference New York, N.Y. The Grand Hyatt (801) June 1-4 IBA 2003 Business Valuation Conference Orlando, Fla. Disney Contemporary Resort (800) New item added or changed this issue CALENDAR UPDATE 2003 June 1-7 IBBA 37th Conference Orlando, Fla. Rosen Plaza Hotel (888) 686-IBBA July ASA Annual International Conference Tampa, Fla. Tampa Marriott Waterside Hotel & Marina (800) ASA-VALU October ASA Advanced BV Conference Chicago, Ill. Hyatt Regency (800) ASA-VALU November 2-8 IBBA Conference Las Vegas, Nev. Flamingo Hilton Hotel (888) 686-IBBA November AICPA Conference Phoenix, Ariz. J.W. Marriott Desert Ridge Hotel (888) Forthcoming appearances by Shannon Pratt May th AAML Tampa, Fla. May 22 Houston Trial Advocacy Institute Houston, Texas May 23 Virginia Society of CPAs Conference Richmond, Va. June 1-4 IBA Conference Orlando, Fla. June 9 NY CPA s New York, N.Y July ASA International Conference Tampa, Fla. Aug BV-201 with Jay Fishman Lisle, Ill. Sept. 25 AM&AA Class Dallas, Texas Oct. 2 & 4 Certified Business Counselors Conference Scottsdale, Ariz. Oct ASA Advanced BV Conference Chicago, Ill. Dec. 4 AM&AA Class Orlando, Fla. 16 Shannon Pratt s Business Valuation Update April 2003