Business Valuation. Panelists

Transcription

1 Business Valuation Panelists G. Warren Cole, Houston Douglas K. Fejer, Dallas Patrice Ferguson, Houston Michael P. Geary, Addison Richard Orsinger, San Antonio Moderator R. Scott Downing, Dallas State Bar Of Texas th 39 Annual Advanced Family Law Seminar August 5-8, 2013 San Antonio, Texas Chapter 55

2 Table of Contents I. Introduction... 1 II. What s Not Value... 1 III. Steps in the Appraisal Process... 1 IV. Legal Precedent... 2 A. Texas Pattern Jury Charges - Family Fair Market Value Value to the Owner... 2 B. Revenue Rule C. Other Revenue Rulings Revenue Ruling Excess Earnings Approach Revenue Ruling Revenue Ruling Revenue Ruling C.B V. Standards of Value... 4 A. Fair Market Value... 4 B. Value to the Owner... 4 C. Market Value... 5 D. Investment Value... 5 E. Intrinsic Value a/k/a Fundamental Value F. Special or Pecuniary Value... 6 G. Fair Value... 6 H. Replacement Value... 6 VI. Premises of Values a/k/a Transactional Assumptions A. Going Concern... 7 B. Assemblage of Assets C. Liquidation Value (Orderly Dispositions)... 7 D. Liquidation Value (Forced Liquidation)... 8 VII. Valuation Approaches and Methodologies... 8 A. Asset Based Approach Adjusted Net Asset Method Excess Earnings Method... 9 B. Income Based Approach Discounted Cash Flow (DCF) or Discounted Future Earnings Method (DFEM) Capitalization of Earnings Method Capitalization of Dividends Method C. Market Based Approach Guideline Publicly Traded Company Method Comparative Transaction Method Merger and Acquisition Transaction Method Industry Method or Rule of Thumb Method VIII. Discounts and Premiums A. Control Distinguished from Marketability B. Discount for Lack of Control Page - i

3 1. Degrees of Control Element of Control Quantifying the Lack of Control Discount C. Discount for Lack of Marketability Degrees of Marketability Benchmark for Marketability Quantifying the Lack of Marketability Discount D. Lack of Voting Rights E. Control Premiums IX. Buy/Sell Agreements A. Cases Involving Buy-Sell Agreements B. Execution of Buy-Sell Agreement by the Non-Owner Spouse X. Covenant Not to Compete XI. Value to the Owner - Valuation When There is No Market Value A. What is Value to the Owner? B. Value to the Owner and Evidentiary Issues XII. Owners Testimony of Values A. Texas Rules of Evidence, Rule B. Decisions Prior to Natural Gas Pipeline Co C. Property Owner Rule and Natural Gas Pipeline Co. of America v. Justiss XIII. Goodwill A. Personal Goodwill B. Commercial Goodwill XIV. Expert Credentials and Reports XVIII. Conclusion Page - ii

4 Business Valuation I. Introduction Property valuations are one of the most important tasks that an attorney will be confronted with in handling divorce cases. Regardless of the size of the community estate, it is critical for family law lawyers to understand the concepts and principals available in determining value. These include the standards of value, premises of value, the valuation approaches and the underlying valuation methodologies that expert witnesses utilize in valuing certain types of investments and closely-held businesses. This article will focus on the concepts and principals in determining the value of a closely-held business, as well as several difficult valuation issues that the attorney and expert will be confronted with when attempting to value closely-held business interests. It will address the fundamental approaches to determining value and what discounts and premiums are available and when it would be appropriate to apply them. The paper will also discuss buy-sell agreements and how they effect business valuation as well as an analysis of the property owner rule and the new standard established by the Texas Supreme Court in its holding in December There is also an analysis of the secondary standard to be used in valuing property in a divorce proceeding, value to the owner, and what factors the court should consider in reaching an opinion on value. Finally, the American Institute of Certified Public Accountants ( AICPA ), the American Society of Appraisers ( ASA ), the Canadian Institute of Charter Business Valuations, the National Association of Certified Valuation Analysts and the Institute of Business Appraisers collectively developed the International Glossary of Business Valuation Terms ( IGBVT ). Unless otherwise indicated, all definitions used in this paper are those promulgated by the IGBVT. II. What s Not Value Simply put, Book Value. Although discussed below under the standards of value, in the context of a divorce proceeding, and the valuation of a closely held business, Book Value is not value and has no relevance to the economic value of a business entity as a going concern. Book Value is the difference between the historical acquisition costs of a company s assets less the related liabilities of the company. Book Value does not take into consideration the actual market value of a company s tangible assets nor the existence and value of a company s intangible assets which may not always appear on a company s balance sheet. Further, Book Value also fails to reflect the true depreciation of an asset. It only reflects the depreciation of the assets for tax purposes. Under existing case law, Book Value is entitled to little, if any, weight in determining the value of corporate stock. Bendalin v. Delgago, 406 S.W.2d 897 (Tex. 1966). Book Value is an improper method of determining the value of a partnership upon dissolution of the partnership. Cheek v. Humphreys, 800 S.W.2d 596, 598 (Tex. App. Houston [14th Dist.] 1990, writ denied). Many other factors must be taken into consideration. Therefore, the Book Value of stock constitutes nothing more than a scintilla of evidence as to its reasonable worth. Bendalin, supra. III. Steps in the Appraisal Process It is important to understand the steps of the appraisal process. The attorney and the expert must come to a meeting of the minds regarding the specifics of the appraisal assignment. Otherwise, the failure to communicate may well result in mis-directed efforts and invalid conclusions regarding the appraisal of the specific asset. See, e.g. the majority opinion in RVK v. LLK, 103 S.W.3d 612 (Tex. App. San Antonio [4th Dist.] 2003, no pet.) In the publication by Shannon Pratt, Robert F. Reilly and Robert F. Schweihs, Valuing Small rd Businesses and Professional Practices (3 Edition McGraw-Hill 1998), the elements of a valuation assignment are: (1) the identification of the exact property to be valued; (2) the effective valuation date; (3) the standard of value to be utilized in the valuation process; (4) the premises of value to be applied to the standard of value; (5) relevant ownership characteristics of the asset to be value; (6) the intended use or uses of the appraisal; (7) the scope of the written and/or oral report; (8) access to information sources and any known limiting conditions with respect to the appraisal assignment; (9) any special instructions with respect to the appraisal assignment; and (10) the contractual relationship with the client. The IGBVT defines the standard of value as the identification of the type of value being utilized in a specific engagement; for example, fair market value, fair value, investment value. 1

5 Premise of value is defined as an assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation; for example, going concern, liquidation. (See: Paragraph VI below for a discussion on premise of value.) IV. Legal Precedent A. Texas Pattern Jury Charges - Family 1. Fair Market Value The primary standard of value in Texas matrimonial cases is Fair Market Value. Texas Pattern Jury Charge for Family Law 203.1, states: The value of an asset is its fair market value unless it has no fair market value. Fair market value means the amount that would be paid in cash by a willing buyer who desires to buy, but is not required to buy, to a willing seller who desires to sell, but is under no necessity of selling. Texas Pattern Jury Charge - Family (2012)( PJC ). Fair market value was historically defined in the Internal Revenue Code Revenue Ruling as follows: 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. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property. Finally, the IGBVT defines fair market value as follows: The price, expressed in terms of cash equivalence, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms 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. While the definition of fair market value set forth in the Texas Pattern Jury Charges, Revenue Ruling and IGBVT all differ in some respects, the primary principles, and assumptions for all three definitions are the same. Furthermore, while some of the assumptions and principles are more specifically set forth in the definition of fair market value utilized by IGBVT and Revenue Ruling 59-60, one of the primary assumptions of all definitions for fair market value is that the property would have been exposed on the open market for a period long enough to allow the market forces to interact to establish the value. Additionally, as can be seen from the definition of fair market value in IGBVT and in Revenue Ruling 59-60, both of these definitions refer to both the willing buyer and willing seller having reasonable knowledge of relevant facts and that the property has been exposed to the open market for a reasonable amount of time. While these two phrases are not specifically set forth in the Family Law Pattern Jury Charges, it would appear that the reasonable knowledge element and the open market element are implicit in the definition. 2. Value to the Owner The secondary standard of value utilized in Texas matrimonial cases is value to the owner. In PJC 203.1, this secondary standard of value is as follows: If it is determined that an asset has no fair market value, then the standard of value is the actual value to the owner, as determined by the evidence. See Crisp v. Security National Insurance Co., 369 S.W.2d 326 (Tex. 1963); Wendlandt v. Wendlandt, 596 S.W.2d 323 (Tex. Civ. App. Houston [1st Dist.] 1980, no writ); and Beavers v. Beavers, 675 S.W.2d 296 (Tex. Civ. App. Dallas 1984, no writ). (See: Paragraph XI. below for a discussion on the methodology for determining value to the owner.) B. Revenue Rule The purpose of Revenue Ruling is to generally outline the approach, methods and factors to be considered in valuing the capital stock of closely-held 2

6 corporations. A review of these factors to be considered in the valuation of a closely-held business indicates a distinction between intrinsic and extrinsic factors relative to the valuation. The intrinsic factors are: a. the nature and history of the business; b. the earning capacity of the company; c. book value and the financial condition of the business; d. any intangible assets, such as goodwill of the business; and e. the dividend paying capacity of the business. The extrinsic factors are: a. the economic outlook in general and business trends; b. investment market conditions and momentum; c. the condition and outlook of the specific industry; d. sales of the stock and the size of the block to be valued; e. the market price of stocks of publicly-traded comparable companies being actively traded; and f. the firm s competitive posture. Revenue Ruling indicates that the valuation of closely-held corporate stock entails the consideration of all relevant factors... Depending upon the circumstances in each case, certain factors may carry more weight than others because of the nature of the company s business. C. Other Revenue Rulings 1. Revenue Ruling Excess Earnings Approach Revenue Ruling discusses the utilization of the capitalization of earnings in excess of a fair rate of return on net tangible assets to determine the fair market value of the intangible assets of a business. (Emphasis added.) The question set forth in Revenue Ruling is: Whether the formula approach, the capitalization of earnings in excess of a fair rate of return on net tangible assets, may be used to determine the fair market value of the intangible assets of a business. Under the IGBVT, excess earnings is defined as that amount of anticipated economic benefits that exceeds an appropriate rate of return on the value of a selected asset base (often net tangible assets) used to generate those anticipated economic benefits. In using the excess earnings approach, the appraiser attempts to determine the component of business income attributable to a return on tangible net assets. Any earnings above this amount are attributable to intangible assets, including goodwill. The income attributable to intangibles is then divided by a suitable capitalization rate to arrive at a value of the intangible assets of the business. If the business is a sole proprietorship or partnership, it is necessary to subtract from earnings the reasonable value of the services of the owner. (Emphasis added.) This Revenue Ruling goes on to indicate, for businesses with small risk factors and a history of stable and regular earnings, that an 8% rate of return and a 15% capitalization rate would be appropriate; but that for a business with elevated risk factors and no history of stable or regular earnings, a 10% rate of return with a 20% capitalization rate may be appropriate. However, these rates are only examples and that factors that influence the capitalization rate include (1) the nature of the business, (2) risk involved, and (3) the stability or irregularity of earnings. Although there are several legally recognized ways in which to value a closely-held business intangible assets, at least two Texas cases have approved the use of the capitalization of excess earnings approach. See discussion of Morgan v. Morgan, 657 S.W.2d 484 (Tex. Civ. App. Houston [1st Dist.] 1983, writ dism d); Taormina v. Culicchia, 355 S.W.2d 569 (Tex. Civ. App. El Paso 1962, writ ref d. n.r.e.). Caution: The excess earnings method has been highly criticized for being outdated and for its formalistic approach. Furthermore, even this revenue ruling warns that the formula approach should be used for determining the fair market value of intangible assets of a business only if there is no better evidence available for which the value of intangibles can be determined. Therefore, while this method is still used, it can be wrought with errors and the application of its principals 3

7 (methodology) can be misapplied. As a result, any expert s opinion which has as its basis the excess earnings method should be carefully scrutinized. 2. Revenue Ruling discusses the valuation of restricted and often unregistered securities (sometimes referred to as Rule 144 stock) and in quantifying discounts for marketability. 3. Revenue Ruling discusses the guidelines set forth by the IRS in the valuation of preferred stock in a closely-held business. 4. Revenue Ruling C.B Family Attribution Rules: Discounts for minority interests allowed when valuing transfers of closely held company stock within the family. V. Standards of Value After it is determined by the attorney and the expert what specific property or asset is to be valued, one of the next questions that must be answered is: what standard of value is to be used when arriving at a value? (Emphasis added.) A. Fair Market Value As indicated above, fair market value is the primary standard of value to be used in Texas in determining the value of assets in divorce proceedings. The term fair market value has been defined a number of ways. See discussion above. A key concept to all the definitions of fair market value is the assumption that (1) the sale will be in cash; (2) the property will be exposed to the market for a sufficient period of time; and (3) the valuation will be made under the existence of prevailing economic and market conditions on the date of valuation. Shannon P. Pratt, Robert F. Reilly and Robert F. Schweihs, Valuing Small Business and Professional Practices, Chapter 3, rd page 39 (3 Edition McGraw-Hill 1998). (Emphasis added.) Therefore, when someone states that, for example, the value of XYZ Company stock is really much more or less than the price it s selling for on the New York Stock Exchange, the standard of value that individual has is something other than fair market value. Again, the concept of fair market value means the price at which a transaction could be expected to take place under market conditions existing at the valuation date. Pratt, supra; see also What is Value by Shannon Pratt, ABA Family Advocate (Volume 25; No ). It is interesting to note in discussing the fair market value standard of value with several real estate appraisers, it is their view that the phrase fair market value is antiquated, they usually only hear the use of fair from attorneys, and they do not use it in the appraisal process. Instead, they use the term market value. Furthermore, as will be discussed below, the standard of market value refers to the most probable price as opposed to the price as used in the definition of fair market value. B. Value to the Owner See paragraph XI below for a more detailed analysis of this topic. As indicated in PJC - Family 203.1, if an asset has no fair market value, then the value of the asset is to be determined by showing the actual value of the property to the owner. Beavers v. Beavers, supra, Wendlandt v. Wendlandt, supra, and Mandell v. Mandell, 310 S.W.3d 531 (4 Tex. App. Ft. Worth, April 15, 2010, no pet. h.). Unlike the fair market value standard, the value to the owner standard contemplates that the owner is not selling the property, but rather maintaining it in its present form or, due to certain circumstances, such as a buy-sell agreement, the asset being valued has no market value. See Mandell v. Mandell, supra, Star Houston, Inc. v. Kundak, 843 S.W.2d 294, 298 (Tex. App. Houston [14th Dist.] 1992, no writ); Bueckner v. Hamel, 886 S.W.2d 368, 373 (Tex. App. Houston 1st Dist.] 1994, writ denied); Crisp v. Security National Insurance Co., supra; Shannon P. Pratt, Valuing of Business: The Analysis and Appraisal of Closely-Held Companies, th 946 (5 Edition McGraw-Hill 2008). The term actual value has been defined to mean: An inherent value not established by market forces; a personal or sentimental value; the true, inherent, or essential value of the thing itself; the value of the property s use to its owner; a concept of value based upon the fundamental or real value of the asset. 4

8 In determining the value of the asset to the owner, such evidence may consist of the original cost and cost of replacement, the opinions upon value given by qualified witnesses, the gainful use as to which the property has been put, as well as any other facts reasonably tending to shed light upon the subject. Crisp v. Security National Insurance Co., supra. Finally, the actual value to the owner has sometimes been referred to as intrinsic value. However, as will be seen below, the intrinsic value standard is not the same as the actual value to the owner standard. C. Market Value As indicated above, the market value standard of value is primarily used by the real estate appraiser industry. It is defined as follows: The most probable price that a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Pratt, What is Value, supra. (Emphasis added.) Implicit in this definition is the consummation of a sale, as of a specified date, and the passing of title from seller to buyer under the following conditions: Pratt, supra. 1. Buyer and seller are typically motivated; 2. Both parties are well informed or well advised, and acting in what they consider their best interests; 3. A reasonable time is allowed for exposure in the open market; 4. Payment is made in the United States dollars or other comparable financial arrangements; and 5. The price represents the normal consideration for the property sold, unaffected by special or creative financing or sales concessions granted by anyone associated with the sale. D. Investment Value Under the IGBVT, investment value has been defined as the value to a particular investor based on individual investment requirements and expectations. The differences in market value and investment value can primarily be attributed to the: Differences between the individual investor s estimates of future earnings power; Differences in the individual investor s perception of the degree of risk of the investment; Difference in the individual investor s income status; Synergies with other operations owned or controlled by the specific investor. Pratt, Valuing Small Businesses and Professional rd Practices, Chapter 3 (3 Edition McGraw-Hill). In the case of RVK v. LLK, 103 S.W.3d 612, 613 (Tex. App. San Antonio 2003, no pet.), the Court used the term enterprise value and defined it as the amount a willing buyer realistically would pay for the enterprise as a whole on the statutory valuation date. (Emphasis added.) The Court also referred to a case out of Oregon that appeared to indicate that enterprise value was the same thing as investment value. (Emphasis value.) First and foremost, enterprise value and investment value are not the same. Second, enterprise value is not even a defined term in the IGBVT. Third, it appears that the definition of enterprise value used by the Court in RVK is closer to the standard of value known as fair value, which is discussed below. The Court in RVK, supra, held that enterprise value is not the appropriate standard of value to use when valuing a minority position in stock which was subject to a buy/sell agreement for purposes of divorce. See RVK, supra, at 619. E. Intrinsic Value a/k/a Fundamental Value Intrinsic value, also known as fundamental value, is defined as: The value that an investor considers, on the basis of an evaluation or available facts, to be 5

9 the true or real value that will become the market value when other investors reach the same conclusion. In the analysis of stocks, intrinsic value is generally considered the appropriate price for a stock according to a security analyst who has completed a fundamental analysis of the company s assets, earning power and other factors. Therefore, intrinsic value means that while a stock may be selling for $10.00 a share, an analyst, after having analyzed all of the underlying assets of a company, may determine that the fundamental or intrinsic value of the business should be $20.00 a share. For example, one of the jobs of a Wall Street security analyst is to identify stocks in which they determine that the intrinsic value of a company s stock is greater than the actual selling price of the stock. Hence, these stocks make their buy recommendations. Conversely, stocks that are determined to have a higher price than the determined intrinsic value would potentially make the sell list. Finally, intrinsic or fundamental value differs from Investment value in that it represents an analytical judgment, a value based on the perceived characteristics inherent in the investments, not tempered by characteristics peculiar to any one investor. Pratt, supra. F. Special or Pecuniary Value Texas has developed the concept of special or pecuniary value. In some situations, an asset may not have a fair market value. Additionally, the value to the owner standard would also be inappropriate. Under this standard of value, the sentimental value of the asset is considered a component whereas under the value to the owner concept, sentimental value is not a part of the definition. See Petco Animal Supplies, Inc. v. Schuster, 144 S.W.3d 554 (Tex. App. Austin 2004, no writ) citing the case of Heiligmann v. Rose, 81 Tex. 222, 16 S.W. 931, 932 (1891). G. Fair Value The standard of value known as fair value is not defined in the IGBVT. As a general rule, fair value is a statutory standard of value that is strictly applicable in cases involving the dissenting stock holder s appraisal rights. Under the Texas Business Organizations Code ( TBOC ), the concept of fair value involves a domestic entity subject to dissenter s rights. This would include domestic for profit corporations, professional corporations, professional associations and real estate investment trusts. Unless the governing documents provide for dissenter s rights, it does not apply to a partnership or limited liability company. In (b), the concept of fair value of ownership interest provides that consideration must be given to the value of the domestic entity as a going concern without including in the computation of value, any control premium, any minority ownership discount, or any discount for lack of marketability. If the domestic entity has different classes or series of ownership interests, the relative rights and preferences of and limitations placed on the class or series of ownership interest, other than relative voting rights, held by the dissenting owner must be taken into account in the computation of value. Tex. Bus. Orgs. Code (Emphasis added.) H. Replacement Value Replacement value is defined as the current cost of a similar new property having the nearest equivalent utility to the property being valued. Therefore, it could be said that replacement value would represent the maximum value of a business. Replacement value is not applicable to the valuation of raw land or to the value of a closely-held business. Instead, as a general rule, it would be used for purposes of determining the value of personal property. However, even in those situations, the item of personal property will usually have a fair market value or value to the owner. VI. Premises of Values a/k/a Transactional Assumptions After the selection of the standard of value to be used in the appraisal, the next decision to be made is to determine the premise of value to be used. Premises of value are a set of transactional assumptions that may be applicable to the business or property being valued. In Pratt, Valuing Small Businesses and Professional rd Practices (3 Edition McGraw-Hill 1998), the selection of the appropriate premise(s) of value is one of the most critical decisions in the application of the asset accumulation method of business valuation. This is because even under the same standard of value, the subject business can have a materially different value 6

10 conclusion given the premise or premises of value selected for valuing the various assets. It would appear that a lot of lawyers assume or overlook the premise of value (or the transactional assumption to be utilized) in the appraisal process. As stated above, the definition of a premise of value, as set forth in IGBVT is as follows: An assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation: for example, going concern and liquidation. The selected premise of value describes the assumed market conditions under which the willing buyer and willing seller will meet and transact. In other words, will the willing buyer and willing seller transact their business: (1) during the sale of an up and running business ( going concern ); (2) during the sale of a temporarily closed business (assemblage of assets); (3) during a brokerage sale of individual assets (orderly liquidation); or (4) during the auction sale of individual assets (forced liquidation). Pratt, et al, Valuing Small rd Businesses and Professional Practices (3 Edition, McGraw-Hill 1998). Furthermore, according to Pratt, supra, there are two other factors that directly influence the selection of the appropriate premise of value. They are: 1. The actual condition and operation of the subject assets; that is whether the subject assets are in use, place, or held out for sale in an orderly disposition or forced liquidation environment; and 2. The highest and best use of the subject assets; that is, the premise of value that would result in the greatest estimated value for the subject business enterprise. There are four basic premises of value. A. Going Concern Going concern is defined as: The value of a business enterprise that is expected to continue to operate into the future. The intangible elements of going concern value result from factors such as having a trained work force, an operational plant, and the necessary licenses, systems and procedures in place. For purposes of valuing a closely-held business in the divorce context, the Texas Pattern Jury Charge - Family does not identify a premise of value to be used in the valuation analysis. Nevertheless, under normal circumstances, it would appear that in divorce cases, the going concern premise would be the primary premise of value to be utilized by the professional appraiser in valuing an operating closely-held business. Therefore, by way of example, if the standard of value is fair market value, then the appraiser is to determine the fair market value of the closely-held business as a going concern, i.e. an operating business enterprise. B. Assemblage of Assets Under this premise of value, the appraiser assumes that the underlying assets of the closely-held business entity would be sold. It is further assumed that all of the underlying assets, while capable of being in full operation, are not currently operating as an income producing business enterprise. Furthermore, this premise of value usually assumes the exclusion of some of the contributory value of an ongoing concern such as a trained and assembled workforce and other intangible value such as goodwill. Pratt, et al, Valuing Small rd Businesses and Professional Practices (3 Edition McGraw-Hill 1998). (Emphasis added.) C. Liquidation Value (Orderly Dispositions) Under IGBVT, liquidation value is defined as the net amount that would be realized if the business is terminated and the assets are sold piecemeal. Liquidation can be either orderly or forced. The IGBVT defines orderly liquidation value as the liquidation value at which the asset or assets are sold over a reasonable period of time to maximize proceeds received. This premise of value assumes that the underlying assets of a closely-held business are sold piecemeal and not as a part of a mass assemblage. It is further assumed that the assets are given an adequate level of exposure to the marketplace for the purposes of maximizing the overall value to the individual assets. Therefore, under the orderly disposition premise, it contemplates an orderly liquidation of the assets in order to maximize the values of the assets being sold on a piecemeal basis. Pratt, supra. 7

11 D. Liquidation Value (Forced Liquidation) The IGBVT defines forced liquidation value as liquidation value at which the asset or assets are sold as quickly as possible, such as an auction. Under the forced liquidation premise of value, it is assumed that the assets are sold on a piecemeal basis. It further assumes that the assets are not allowed a normal level of market exposure to their normal secondary market in order to maximize the value of the assets. Instead, the assets are subject to an abbreviated level of exposure to the market and are usually subject to being sold to the highest bidder, usually in the auction environment. Pratt, supra. VII. Valuation Approaches and Methodologies Once the attorney and the expert have agreed upon the standard of value and the premise of value to be utilized in the analysis, a valuation approach will then need to be selected. There are three types of valuation approaches. They are: (1) asset based approach; (2) income approach; and (3) market approach. According to one expert, it has been his experience that during the last twenty-five (25) years there has been a significant shift from relying upon the market approach in favor of the income approach. Stated differently, there has been a shift from basing valuations on real world data in favor of making up numbers using the income approach. See discussion below. As a general rule, the approach to be utilized by the expert will be dependent upon not only the asset being valued, but the purpose of the valuation. For example, the real estate appraiser, when valuing residential properties, invariably always settles upon the market approach. However, if the property were an income producing property, then the real estate appraiser might use the income approach. Likewise, in valuing closelyheld businesses, the approach to be utilized will be dependent upon the type of business being valued, whether the business has underlying investments, and if so, what kind of underlying investments, and the purpose of the appraisal. For example, you may be valuing a closely-held business whose only asset is real estate. In that situation, the expert would probably utilize the market approach unless the underlying real estate investment is an income producing asset, in which case the income approach might be appropriate. A. Asset Based Approach The asset based approach is defined as: A general way of determining a value indication of a business, business ownership interest, or security using one or more methods based on the value of the assets net of liabilities. The primary focus under the asset based approach is to value the business by valuing its underlying assets. The asset based valuation approach is primarily used for businesses that have a significant amount of its value in its tangible assets, or for businesses in which the underlying assets represent the true value of the company, such as a real estate holding company. There are two methods primarily utilized under the asset based approach. They are: (1) the adjusted net asset method; and (2) the excess earnings method. 1. Adjusted Net Asset Method The most commonly used methodology under the asset based approach is the adjusted net asset method. The IGBVT defines the adjusted net asset method a/k/a adjusted book value method as: A method within the asset approach whereby all assets and liabilities (including off-balance sheet, intangible and contingent) are adjusted to their fair market values. Under the adjusted net asset method, the appraiser adjusts the cost basis value of the company s assets and liabilities from the cost of the asset to the fair market value of the asset and uses the current liabilities of the company. The use of fair market values are appropriate if the company is being valued as a going concern. However, for example, if the company is to be liquidated and its assets are to be sold separately, then liquidation value should be used. Therefore, the value of the assets would be adjusted to reflect liquidation value and under this approach either orderly liquidation or forced liquidation. The adjusted net asset methodology is also used when the projected income of the company does not reflect the company s true value. The shortcomings of the adjusted net asset method 8

12 involve the valuation of a company s intangible assets. Unless the company has acquired an intangible asset, the intangible assets will generally not appear on the company s balance sheets. Therefore, and as the definition above indicates, the utilization of this method requires an identification of off-balance sheet actual and contingent assets or liabilities, including intangible assets. Examples of these would be assets which have fully depreciated, but are still in service; inventory or accounts receivable which have been internally written off but are still collectible; expected proceeds or costs related to existing or potential lawsuits; and liability for corporate gains and taxes on appreciated assets. Bronstein, The Importance of Proactive Lawyering: Business Valuation Reports, American Academy of Matrimonial Newsletter Summer The adjusted net asset method is usually inappropriate for the valuation of operating entities, particularly in dealing with a minority interest. Usually the focus for operating entities tends to be more on the income approach or market approach. However, there are a number of situations where valuations based either entirely or partially on the adjusted net asset methodology is appropriate. These situations include: start up companies; holding companies; financial institutions; agricultural businesses or other assetintensive businesses; and companies that may not be financially viable as an operating company. Because personal goodwill is not a divisible asset in Texas, the net asset value methodology is commonly utilized when examining a medical, legal, consulting or other personal service practice where the intangible value of the business is primarily personal goodwill. Evans, Business Valuation, and Then Some - State Bar of nd Texas 32 Annual Marriage Dissolution Institute (2009). 2. Excess Earnings Method Excess earnings is defined in the IGBVT as: That amount of anticipated economic benefits that exceeds an appropriate rate of return on the value of a selected asset base (often net tangible assets) used to generate those anticipated economic benefits. The Excess Earnings Method is defined in the IGBVT as: A specific way of determining a value indication of a business, business ownership interest, or security determined as the sum of (a) the value of the assets derived by capitalizing excess earnings; and (b) the value of the selected asset base. See the discussion above with respect to Revenue Ruling B. Income Based Approach The income based approach is defined as: A general way of determining a value indication of a business, business ownership interest, security, or intangible asset using one or more methods that convert anticipated economic benefits into a present single amount. The income approach is based upon the premise that the money an investor pays for a business is a function of the amount of money that investor will receive over time as a benefit of ownership. The income based approach should primarily be used when a company has a history of positive earnings and those positive earnings are expected to continue. Additionally, this approach should be used when the earnings of the company represent a company s estimated true value. Under this approach, there are two primary methodologies. They are: (1) discounted future income methodology; and (2) the capitalization of income methodology. It has been said that the capitalization of income methodology and the discounted cash flow methodology are in fact the same. By way of example, adding is the same methodology as multiplying 5x3. The capitalization of income methodology and the discounted future income methodology will have the exact result if profit margins are held constant and growth is held constant. Therefore, under either approach you will get the exact same result only if there is no difference in the profit margins and in growth. The capitalization of income approach is also a shortcut for doing the discounted future earnings if you assume constant profit margins and constant growth. Under the discounted future income methodology, one can use either the discounted cash flow methodology or the discounted future earnings methodology. The discounted future income methodology should be used when a company s future income is expected to differ significantly from current income. The capitalization of 9

13 income methodology should be used when a company s income in the future is expected to closely resemble the past. Bronstein, supra. An appraiser will use either earnings (net income from the income statement or cash flows from the cash flows statements) as the preferred measure of economic income. While an appraiser s use of either earnings or cash flow may be appropriate in certain cases, the practitioner should be aware that cash flow tends to be more reliable and less subject to manipulation than earnings from an income statement. Bronstein, supra. The income approach starts with a company s income statement. The first step in the income approach is to normalize the income statement. The objective is to make adjustments to the income statement in order to estimate the true earning power of the entity assuming they will continue to operate, although independent of its current owner. The analysis should also include an examination of the company s historical income while taking into consideration estimates for growth and margins in the particular industry. The appraiser should also eliminate from historical income (1) any nonrecurring income; (2) any non-recurring expenses; and (3) any 1 time events in order to smooth out recurring income expenses thereby normalizing the income. See Evans, supra. Always question the appraiser on the adjustments, or lack thereof, made in the normalization of income estimates. Even small adjustments made to historical income can magnify when growth and capitalization rate assumptions are applied to the estimate. 1. Discounted Cash Flow (DCF) or Discounted Future Earnings Method (DFEM) The discounted cash flow method is an income approach that either uses cash flow of the existing business or the future anticipated earnings of the existing business. Discounted cash flow is defined as: A method within the income approach whereby the present value of future expected net cash flows is calculated using a discount rate. Discounted future earnings method is defined as: A method within the income approach whereby the present value of future expected economic benefits is calculated using a discount rate. Discount rate is defined as: A rate of return used to convert a future monetary sum into a present value. Cash flow is defined in the IGBVT as: Cash that is generated over a period of time by an asset, group of assets, or business enterprise. It may be used in a general sense to encompass various levels of specifically defined cash flows. When the term is used, it should be supplemented by a qualifier (for example, discretionary or operating ) and a specific definition in the given valuation context. Under the discounted future income methodology, the appraiser will do the following: (1) forecast or use the company s forecast of projected future earnings or cash flow; and (2) discount the projections to present values using an appropriate discount rate. It is important to make sure that the projections and the future earnings use a realistic terminal year growth rate, and that the projections go far enough in the future where the company can realistically be forecasted to have reached a steady and sustainable long-term growth rate. A red flag in this methodology is when the forecast or projections show the company growing at an above average growth rate into perpetuity. Under this circumstance, the appraiser in the report should be reviewed and questioned at length. Bronstein, supra. Remember, the discount rate is the appraiser s estimate for the rate of return an investor in the subject company would require, given the risk associated with the investment in the company. The discount rate is the main driver in the overall valuation of a business using this approach. The higher the discount rate, the lower the net present value of the cash flow will be. Generally, a more risky company with less than predictable future cash flows will have or should have a higher discount rate, and therefore, a lower valuation. Bronstein, supra. An appraiser determines the discount rates by combining a risk-free rate, such as the return for U.S. Treasury bonds, with one or more risk premium 10

14 estimates. Discount rates are highly subjective and can vary widely depending upon the underlying assumptions employed by the appraiser. Most business appraisers of closely-held businesses use the methodology called the build up method to arrive at a discount rate. Bronstein, supra. (Emphasis added.) as: 2. Capitalization of Earnings Method The Capitalization of Earnings Method is defined A method within the income approach whereby economic benefits for a representative single period are converted to value through division by a capitalization rate. Like the discounted cash flow method, the capitalization of earnings method converts anticipated income to a present value. However, the difference between the discounted cash flow method and the capitalization of earnings method is the treatment of anticipated changes in future income. In the discounted cash flow method, changes over time in the expected income are treated specifically in terms of the present value. In the capitalization of earnings method, changes over time in the expected income are treated as a single average percentage change. Evans, supra. Under the capitalization of earnings method, the appraiser will select a base year estimate of the company s normalized income and then multiply that single income estimate by a capitalization rate to arrive at a valuation. The issue with this method is that the appraiser is assuming a constant stream of income which will grow ( the growth rate ) at the same rate into perpetuity. As a result, the appraiser is attempting to reasonably estimate what a company s sustainable level of income will be in the future. You should always question the appraiser on his/her selection of the longterm growth rate. It has been said that a normal growth rate would be between 0% to 3%. Anything higher is usually overly optimistic and unsustainable. Bronstein, supra. As indicated above, under both the Discounted Cash Flow method and the Capitalization of Earnings Method, the appraiser has to normalize the income statement. However, where the discounted cash flow method projects the economic income flow the business is expected to produce for its owner over discreet periods of time, the capitalization of earnings method requires projecting a single normalized amount of economic income flow. The projected income flow is then capitalized. Capitalization involves dividing the projected income by an appropriate rate. This rate is commonly referred to as the cap rate. The cap rate is a variable rooted in the discount rate. While there is clearly a similarity between the discount rate and the cap rate, the two rates are in fact two different concepts. The discount rate is applied to all the economic income expected. The cap rate is applied to a single amount of economic income at some point in time. Therefore, the cap rate differs from the discount rate by the amount necessary to reflect the expected return (the growth rate). As with other valuation variables, the cap rate is a subjective determination made by the analyst. The capitalization of earnings method should primarily be used for companies whose future income is highly predictable and not expected to differ from historical past. The problem with the capitalization of earnings method is that it does not take into consideration the time of future changes in economic income, the greater the difference is in the anticipated change over time, especially in the early years, the less effective the method becomes. In companies with short or intermediate super growth, or that experience erratic and unpredictable changes, the capitalization of earnings method may not provide an accurate indication of fair market value. Evans, supra. 3. Capitalization of Dividends Method This methodology compares a publicly traded company s dividend returns (dividend divided by price) with private companies on dividend payment history and/or capacity. This methodology is good to use when valuing minority interests where dividends can or have actually been paid. See Dockery v. Commissioner, T.C. Memo , Brookshire v. Commissioner, T.C. Memo Valuation of Closely Held Business Interests th - ABA 14 Annual Real Property, Estate Planning Symposium, April 2003 by William A. Lockwood. As one might imagine, the capitalization of dividends methodology is rarely used in the valuation of a closely-held business in a divorce proceeding. Furthermore, the author is not aware of any case law that 11

15 has approved or adopted this methodology in the valuing of a closely-held business in matrimonial cases in Texas. C. Market Based Approach The market based approach is defined as: A general way of determining a value indication 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. The market based approach attempts to develop a value by comparison with actual transactions of shares of either comparable publicly traded corporations or with transactions involving the subject company s own shares. The problem with this methodology when attempting to value a closely-held business, is that it is difficult to find comparable transactions of publicly traded companies that would be comparable to a closelyheld business enterprise. One of the most important criteria using this particular approach is to what extent the subject company can reasonably be compared to other public or private companies for which transaction data exists. The more distant a subject company is from its comparables, the less reliable a market based methodology will be. Bronstein, supra. In addition, identifying comparable companies using the market based approach also involves adjusting for inappropriate items in the income statements and balance sheets of the comparable companies, and determining applicable multiples. Finding comparability is important, but generally difficult to achieve because of: 1. Size; 2. Capital structure, accounting methods; 3. Trends in operations; and 4. Lack of information. Therefore, the more distinct the company you are attempting to value is from its comparables, the less reliable this approach becomes. Furthermore, often times the appraiser will not find comparable companies. As a result, the expert will use comparables involving a business in a similar industry. However, once again, adjustments will have to be made to try to adjust the comparables that are found to the specific business being valued. This approach is similar to the valuation of real estate where the real estate appraiser will find recent sales and make adjustments in their report based upon the types of improvements that the subject property has as compared to the comparables. For example, in valuing a residence without a pool, the appraiser may find a house that he or she believes is comparable, but with a pool. Therefore, an adjustment will be made to the comparable to try to bring it in line with the property being appraised. Under the market approach, there are usually four types of approaches that can be utilized, only two of which however would primarily be applicable in the valuation of a closely-held business in a divorce case. 1. Guideline Publicly Traded Company Method The guideline publicly traded company method should be used for businesses that have good public market comparisons. This method has been defined as follows: A method within the market approach whereby market multiples are derived from market prices of stocks of companies that are engaged in the same or similar lines of business that are actively traded on a free and open market. Under this methodology, the appraiser should provide an exhaustive analysis of how a subject company compares to the guideline public company it is being compared with. Additionally, a thorough analysis of the financial information for the subject company should be performed. In most instances, a review of the financial statements of the subject company should be for at least five (5) years. An analysis for shorter periods will often not reveal cyclical industry trends, economic changes or significant non-recurring events for the subject company. It is also important for the financial information to be current through the date as close as possible preceding the valuation date. Finally, the appraiser should apply the matrix to the publicly traded prices for the guideline companies to determine a series of relevant market multiples - for example, price to sales ratio. Bronstein, supra. In deciding whether a particular publicly traded company may be considered as a guideline company with respect to the subject company, some of the factors that are often considered include: (i) products; (ii) markets; (iii) management; (iv) earnings; (v) dividend 12

16 paying capacity; (vi) book value; (vii) position of the company in its industry; (viii) capital structure; (ix) credit status; (x) depth of management; (xi) personal experience; (xii) nature of the competition; and (xiii) maturity of the business. Evans, supra. 2. Comparative Transaction Method The comparative transaction method is similar to the guideline public company method in that data from transactions involving comparable companies is used to develop value measures which are then applied to the financial data of the subject company. However, under the comparative transaction method, the transactions usually involve all or most of the target company s invested capital. This method is considered under the market approach because the pricing multiples are derived from empirical market transactions and involve data from arms-length transactions. The problem with this method is obtaining reliable and consistent transactional data on sales of private companies. There are only a few databases available for the business appraisers. The ones primarily used are Biz Comps and Pratts Stats. The values derived from the comparable transaction method is usually an indication of transaction prices of substantial and, more often than not, a controlling ownership interest in the company. Therefore, unlike the guideline publicly traded company method, in valuing a minority ownership interest using the comparative transaction method, it is usually necessary to apply minority discount. 3. Merger and Acquisition Transaction Method This methodology is defined as a method within the market approach whereby pricing multiples are derived from transactions of significant interests in companies engaged in the same or similar line of businesses. 4. Industry Method or Rule of Thumb Method This valuation approach is defined as a mathematical formula developed from the relationship between price and certain variables based on experience, observation, hearsay, or a combination of these; usually industry specific. VIII. Discounts and Premiums Note: the following has been taken primarily from the article written by Sherry A. Evans for the 32 nd Annual Marriage Dissolution Institute in Fort Worth in Once the business appraiser has determined the overall value of the subject business in accordance with Revenue Ruling 59-60, subtracted out the value of any personal goodwill, and calculated the owner s pro-rata share of the overall value (ownership percentage), it is then necessary to determine what discounts, if any, should be applied. In most instances, there must be an analysis of the control and marketability of the subject entity. When an owner is not able to personally control the financial, operational, or legal aspects of the subject business, it is known as a non-controlling, or minority, interest. This lack of control often results in a situation where a particular ownership interest in a business is worth less than its pro rata percentage of the overall business enterprise value. This valuation adjustment is the lack of control discount. Additionally, an ownership interest in a small business is worth less if it is not readily marketable. By their very nature, closely held business interests are illiquid relative to most other investments. The concept of marketability deals with the liquidity of the subject ownership interest and how quickly that ownership interest can be converted to cash. This valuation adjustment is the lack of marketability discount. A. Control Distinguished from Marketability Analysts often fail to distinguish between a discount for lack of control and a discount for lack of marketability. Although there is some interrelationship between the two, they are distinct and separate concepts and must be analyzed independently. The concept of lack of control deals with the relationship between the ownership interest being valued and the total business enterprise. The primary factors bearing on the value of a minority interest in relation to the value of the total entity is how much ownership control the minority ownership interest does or does not have over the particular entity. The concept of marketability deals with the liquidity of the subject ownership and how quickly it can be converted to cash at the owner's discretion. In performing their analysis, the professional business valuation experts usually make a distinction between the concepts and calculations of the lack of control and marketability discounts. This practice has 13

17 also been encouraged by the U.S. Tax Court. A 1982 estate tax decision articulated the distinction very clearly: In their arguments, neither petitioner nor respondent clearly focuses on the fact that two conceptually distinct discounts are involved here, one for lack of marketability and the other for lack of control. The minority shareholder discount is designed to reflect the decreased value of shares that do not convey control of a closely held corporation. The lack of marketability discount, on the other hand, is designed to reflect the fact that there is no ready market for shares in a closely held corporation. Although there may be some overlap between these two discounts in that lack of control may reduce marketability, it should be borne in mind that even controlling shares in a nonpublic corporation suffer from lack of marketability because of the absence of a ready private placement market and the fact that flotation costs would have to be incurred if the corporation were to publicly offer its stock. Estate of Andrews v. Commissioner, 79 T.C. 938 (1982). B. Discount for Lack of Control The discount for lack of control is defined as: An amount or percentage deducted from the pro rata share of value of 100% of an equity interest in a business to reflect the absence of some or all of the powers of control. Control in the context of a business valuation can be outlined by the prerogatives of ownership present in the subject business. Evidence of control includes the ability to appoint management, determine management compensation, set policy, acquire or liquidate assets, register the company's stock for a public offering, declare and pay dividends, and change the articles of incorporation or bylaws. 1. Degrees of Control The issue of minority versus control ownership is a matter of degree along the following spectrum: a. 100 percent control; b. Slightly less than 100 percent control: minority interests might be a nuisance; c. Less than 80 percent control: cannot consolidate financial statements for tax purposes; d. Less than supermajority where a supermajority is required for certain corporate actions: sometimes state law and/or articles of incorporation and bylaws require a supermajority (twothirds) vote to effect certain corporate actions; e. 50 percent interest: potential for deadlock; neither control nor minority interest; 50 percent owner has blocking power but cannot force things to happen; f. Swing vote minority block: when a block can combine with another block to effect corporate action; and g. High enough percentage to bring a minority oppression dissolution action. 2. Element of Control Because the minority equity interest lacks control of the business, the value of that minority interest is discounted. This lack of control results in the owners inability to personally control the financial, operational, or legal aspects of the subject business. Pratt, Valuing Small Businesses and Professional Practices, Chapter rd 24, Page 427 (3 Edition McGraw-Hill). Common prerogatives of ownership control include: Appointment of management Right to determine management compensation and prerequisites Right to set policy and change the course of business Right to acquire and liquidate assets Right to select people with whom to do business and award contracts Right to liquidate, dissolve, sell our or recapitalize the company Right to declare and pay dividends Right to change articles of incorporation and by-laws Thus, the owner of controlling interest in the business has very valuable rights that a non-controlling interest owner does not have. Id. Page Quantifying the Lack of Control Discount While the lack of control concept is easy to 14

18 understand, quantifying the degree of discount is not an easy task. Apparently, there is no universal agreement between business appraisers on how to ascertain a discount for a minority or lack of control interest. For the family law attorney, it is most important to realize that there is a great degree of analyst subjectivity involved in determining the appropriate discount for lack of control. This is primarily because the empirical evidence available is limited and does not precisely isolate the minority versus control factor from other factors that may influence transaction prices. Because there are virtually no data currently available on transactions of minority interest in closely held companies, analysts are usually left to use data on publicly traded securities or companies that are at least comparable to the subject company. Beyond that, the analyst is usually left to present a narrative description of the minority status of the subject company to support a final estimate of the impact of the lack of control. However, while the empirical data is not totally satisfactory, it does demonstrate that minority interest discounts are a very real factor in the marketplace. C. Discount for Lack of Marketability Marketability is the ability to convert the subject business to cash quickly, with minimum transaction and administrative costs and with a high degree of certainty of realizing the expected amount of net proceeds. The discount for lack of marketability has been defined as: An amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability. 1. Degrees of Marketability As with the issue of control, the marketability or lack thereof is also a matter of degree along the following spectrum: a. Registered with the Securities and Exchange Commission (SEC) and with an active trading market; b. Registered with the SEC and fully reporting, but with a somewhat thin trading market; c. A stock with contractual "put" rights: right of the owner to sell, usually to the issuing company, under specified circumstances and terms; d. Registered with the SEC, but not required to file l0-k and other reports ("non-reporting company"); e. Private company with an imminent or like public offering; f. Private company with frequent private transactions; g. Private company with few or no transactions; h. Private company with interests subject to restrictive transfer provisions; and i. Private company with ownership interests absolutely prohibited from transfer (e.g., tied up in trust). 2. Benchmark for Marketability It is generally accepted within the appraisal profession that the standard for marketability of minority interest in closely held businesses is "cash in three days." In other words, sellers of publicly traded securities with active markets can achieve liquidity on the third business day, at the very near or market price prevailing at the time of the sale. Z. Christopher Mercer, Quantifying Marketability Discounts 6 (1997). This "cash is three days" benchmark for marketability is commonly referred to by business appraisers as the "publicly traded equivalent value." 3. Quantifying the Lack of Marketability Discount The empirical evidence available for guidance in quantifying discounts for lack of marketability is much stronger and more clear-cut than the evidence for quantifying discounts for lack of control. There are two extensively researched and widely recognized studies that help quantify discounts for lack of marketability: restricted stock studies and pre-ipo studies. Many companies that have publicly traded stock also have otherwise identical shares of stock that are not registered for public trading or that are restricted from public trading for some period of time. These shares are called restricted stock. Due to these restrictions, the sale of restricted stock is discounted compared to the same day's public market price. However, because the restricted stocks are otherwise identical to the stock sold in the public market, differences in the prices of the restricted stock transactions and the same day's public market price help to isolate the discount attributable to the lack of marketability. Studies of restricted stock 15

19 transaction prices have been conducted for over thirty years. In 1977, the Internal Revenue Service issues Revenue Ruling , which specifically recognizes the restricted stock transaction data as relevant evidence for quantifying the discount for lack of marketability. To address the question of how much greater the discount might be for private company stock than for restricted stock of public companies, two firms independently undertook to develop a line of studies now generally referred to as the "pre-ipo studies." When a company goes public for the first time - initial public offering (IPO) - it is required to file a registration statement with the Securities and Exchange Commission. One of the disclosures required, along with financial statement information, is details of all transactions in the company's stock during the three years prior to filing. These details include transaction date, transaction price, number of shares, and identities of buyers and sellers. From these and the financial statement date, it is possible to compute price/earnings ratios, transaction size as a percent of shares outstanding, and other analytical details, including the value of marketability. D. Lack of Voting Rights The discount for lack of voting rights is defined as an amount or percentage deducted from the per share value of a minority interest voting share to reflect the absence of voting rights. There are a number of studies and Internal Revenue Service court cases that have accepted a discount for non-voting shares. Furthermore, in studies involving publicly traded companies, it is clear that non-voting shares trading in the marketplace have generally showed that the non-voting shares traded at a lower price than the voting shares. In the case of Okerlund v. Commissioner, U.S. Court of Claims No T and 134T, August 23, 2002, the Tax Court accepted a 5% discount for non-voting shares. E. Control Premiums On the other end of the spectrum, there is also a premium known as the control premium. The control premium has been defined 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. Control value has been defined as: The price paid by a buyer to acquire an ownership position with elements of control; the value of a block of stock in which the holder (owner) either directly or indirectly has the ability to influence and control the allocation of cash and other assets, and generally benefit from the prerequisites of control. Lockwood, supra. IX. Buy/Sell Agreements A. Cases Involving Buy-Sell Agreements A buy-sell agreement is an agreement between the owners of a business which established rules and restrictions applicable to changes in ownership upon certain triggering events such, as death or divorce, including a formula or method on how the valuation of a partnership interest or shareholder interest will be determined. Cases using values other than what is indicated in the buy-sell agreement: Finn v. Finn, supra. Keith v. Keith, 763 S.W.2d 950 (Tex. App. Ft. Worth 1989, no writ) Von Hohn v. Von Hohn, 260 S.W.3d 631 (Tex. App. Tyler 2008, no pet.) Cases which give credence to buy-sell provisions: R.V.K v. L. L. K., supra. Mandell v. Mandell, 310 S.W.3d 531 (Tex. App. Ft. Worth 2010, pet. denied) B. Execution of Buy-Sell Agreement by the Non- Owner Spouse Some buy-sell agreements provide for the spouse of a partner or shareholder to execute the buy-sell agreement acknowledging (1) receipt of the agreement and (2) the provisions with respect to the valuation and disposition of the stock or partnership interest upon the happening of an event, such as divorce or death. Therefore, does the non-owner spouse have to execute a buy-sell agreement before he or she would be bound by its terms? The case of Mandell, supra, involved a Stock Purchase Agreement which set forth a specific dollar amount for valuing Dr. Mandell s interest in Oncology- Hematology Consultants, P.A. (the Association ). The 16

20 Stock Purchase Agreement specifically addressed stock transfers, including voluntary transfers such as the retirement or withdrawal of a shareholder, and involuntary transfers such as the divorce of a shareholder. In each situation, the Association or the shareholders had the right to purchase the shares at $.50 per share. The Stock Purchase Agreement further provided that in the event of a divorce, and the divorced shareholder did not receive stock in the entity as a part of the property division, it required the shareholder to purchase all of his stock back from his former spouse and set the purchase price at $.50 per share. In the event the shareholder fails to exercise this right, then the Association had the right to purchase the shares at $.50 per share. Dr. Mandell subsequently bought 22,000 shares of stock at $.50 per share for a total purchase price of $11,000. Neither Dr. Mandell nor Mrs. Mandell executed the Stock Purchase Agreement. During the divorce proceedings, the trial court ruled that due to the specific terms of the Stock Purchase Agreement, the value of Dr. Mandell s stock in the Association was worth no more than $11,000. The trial court further held, as a matter of law, that the Stock Purchase Agreement between Dr. Mandell and the Association was valid and enforceable as to Mrs. Mandell. During the trial, Mrs. Mandell attempted to present expert testimony on the value of Dr. Mandell s shares in the Association. However, the trial court refused to allow the testimony. As a part of Mrs. Mandell s offer of proof, the chief financial officer for the Association testified that the book value of the Association was $5,000,000. Additionally, Mrs. Mandell s expert business appraiser testified as to three different types of value: (1) book value; (2) the fair market value of Dr. Mandell s interest in the Association as a stand alone business; and (3) the value of Dr. Mandell s interest in the Association as a result of the Association s equity in a holding company. The expert testimony proposed three different values for Dr. Mandell s one-fourth (1/4) interest in the Association: (1) $794,300 (representing book value under GAAP); (2) $1,100,100 (representing fair market value considering Association equity as a stand alone business); and (3) $943,400 (representing fair market value considering the Association s equity as a component of another entity known as Matrix). There was also evidence presented at trial that there had been three previous shareholders of the Association who had retired or left the practice and they were paid only $.50 per share for their shares in the Association in accordance with the Stock Purchase Agreement. The appellate court, citing Beaver v. Beaver, supra, stated that fair market value is an inappropriate valuation method when a community estate owns shares in a closely held corporation and, by agreement, any sale of the shares of stock is restricted to the corporation or other shareholders. The appellate court indicated that when the sale of stock is restricted, then essentially the fair market value of the stock is zero. However, under these circumstances, the parties may show the actual value of the property to the owner. In determining value to the owner, the appellate court stated: Such evidence might include the value of being able, by virtue of ownership of the closely held stock, to drive a new automobile, to have health insurance paid for by the company, to have a company-financed life insurance policy, to belong to a country club at company expense, and other similar financial benefits. Mrs. Mandell relied on the cases of Von Hohn, 260 S.W.3d at , Keith v. Keith, 763 S.W.2d 950, 952 (Tex. App. Ft. Worth 1989, no writ), and Finn v. Finn, 658 S.W.2d 735, 740 (Tex. App. Dallas 1983, writ ref d. n.r.e.) to support her position. However, the appellate court indicated that these cases were not applicable to the current situation. First, the cases cited above involve partnerships and partnership profits, whereas Mandell involved a for profit corporation. Second, the appellate court stated that: partnership profits, by law, belong to the individual partner; the assets and profits of a professional association belong to the entity. [Citing Texas Business Organizational Code (c) (providing that each partner in a partnership is credited with an equal share of the partnership s profits) and comparing it with (providing that profits of a professional association are distributed in accordance with governing documents of the association).] Thus, increases in the value of a partnership that accrue during a partner s marriage may be an asset of the community estate, while increases in a corporation s net worth are generally not an asset of each of the corporation s shareholders [compare Von Hohn, 360 S.W.3d at 634, (recognizing 17

21 that each partner was assigned an undivided profits accounts and a capital account ; which was clearly a community asset) with Legrand- Brock, 246 S.W.3d at 322 (explaining that corporation s earnings and surplus funds are not a community asset). The appellate court affirmed the trial court s ruling in denying Mrs. Mandell the right to submit expert testimony on the valuation of the stock in the Association. Next, Mrs. Mandell argued on appeal that she was not bound by the buy-sell provisions in the Stock Purchase Agreement because she never signed the agreement. The appellate court in holding that Mrs. Mandell was bound by the agreement noted that it was undisputed that Dr. Mandell could never sell his 22,000 shares of stock for more than $.50 per share. As a result, the stock s value in the Association is contractually set at $11,000. Furthermore, because the evidence established that there had been comparable sales in the past using the specific valuation as set forth in the Stock Purchase Agreement, the trial court did not abuse its discretion by valuing the stock at $11,000 under the comparable sales valuation method and as mandated by the Stock Purchase Agreement even though Mrs. Mandell did not sign the Stock Purchase Agreement. Consequently, the appellate court ruled that Mrs. Mandell was bound by the terms of the Stock Purchase Agreement even though she never executed it. The appellate court seemed to indicate that Mrs. Mandell could have put on evidence as to the value to the owner but failed to do so. As a result, she was bound by the provisions of the Stock Purchase Agreement. Finally, and although not a divorce case, the appellate court held in Annazell Lemaster, Individually and as Independent Executrix of the Estate of Ronald Lewis Lemaster v. Top Level Printing Ink, Inc., that even though Mrs. Lemaster did not execute a shareholder purchase agreement which valued the shares of stock held by her deceased husband, she was bound by the shareholders agreement. In Lemaster, the court found, through the evidence, that Mr. Lemaster had purchased the stock from an account in his sole name and the stock was issued in his sole name. As a result, the court ruled that the stock was Mr. Lemaster s sole management control community property. The appellate court first concluded that the appellees conclusively established (1) the stock was purchased with funds held in the decedent s name alone, and (2) the stock was held in the decedent s name alone. Consequently, appellees were entitled to rely on Ronald s authority to deal with the property absent evidence of fraud or actual or constructive notice that he lacked authority. Mrs. Lemaster argued that appellees had notice of Ronald s lack of authority because the stockholders sought to acquire the signatures of their wives on the Stock Purchase Agreement. However, the appellate court held that this fact alone did not constitute evidence the stockholders had notice that the stock was not under the sole management and control of the respective stockholders. As a result, the Stock Purchase Agreement was not invalid because it was never executed by Mrs. Lemaster. The appellate court also noted that because the stock was Mr. Lemaster s sole management community property, Mrs. Lemaster was not required to sign the agreement to make it valid. X. Covenant Not to Compete A Covenant not to Complete, a/k/a a noncompetition covenant is defined in Blacks Law Dictionary as A promise, usually in a sale-of-business, partnership, or employment contract, not to engage in the same type of business for a stated time in the same market as the buyer, partner, or employer. Non competition covenants are valid to protect business goodwill in the sale of a company. Blacks Law th Dictionary (9 Ed. 2009). The Texas Business and Commerce Code states that a covenant not to compete is enforceable if it is ancillary to or part of an otherwise enforceable agreement at the time the agreement is made to the extent that it contains limitations as to (1) time; (2) geographical area; and (3) scope of activity to be restricted that are reasonable and do not impose a greater restraint than is necessary to protect the goodwill or other business interest of the promissee. TBCC (Emphasis added). As we all know, the value attributable to the personal goodwill of a divorcing spouse must be excluded from the value of the business or professional practice being appraised. However, the Houston Court of Appeals in Rathmell v. Morrison, 732 S.W.2d 6(Tex. th App. Houston [14 Dist.] 1987, no writ) held that the 18

22 trial court had to determine the present value of the business as if the party participating in the business will no longer continue to do so and will be free to compete directly with it. In Rathmell, the husband requested that the trial court make a finding as to what portion, if any, of the value of the Rathmell companies was attributable to: 1. The personal goodwill of John Rathmell, and/or 2. the time, toil and talent of John Rathmell to be expended following the divorce, and/or 3. John Rathmell s willingness not to compete with the companies. (Emphasis added). The trial court refused. On appeal, the Houston Court of Appeals reversed the trial court and remanded the case for a new trial stating that although the trial court did not have to find a value including the abovelisted factors and then make separate findings of what portion of such value is attributable to each factor; the trial court did have to make a finding clearly showing that the value found by the court excluded the above three (3) factors. Id. at 18. Rathmell seems to be consistent with Dillon v. Anderson, 358 W.W.2d 674 (Tex. Civ. App. Dallas 1962, no writ). Dillon involved a suit by an administrator of an estate against the decedent s widow. The administrator contended that the proceeds from the covenant not to compete signed by the widow prior to the death of the decedent were community property. The court rejected the administrator s argument and held that the covenant not to compete was personal to the widow. Id., 358 S.W.2d at 696. It is interesting to note that in an earlier version(s) of the Pattern Jury Charge, the committee had adopted a limiting or excluding instruction in light of the Rathmell v. Morris case as follows: PJC : Factors to Be Excluded For Valuation of Business. You are to determine the present value of the ownership interest in the business as if the party participating in it will no longer continue to do so and will be free to compete directly with it. It had previously been argued that the holding in Rathmell v. Morrison, supra, and the prior Jury Charge instruction were inconsistent with accepted valuation principles, and that a covenant not to compete is inherent in the concept of willing buyer/willing seller. In other words, you cannot have a truly willing buyer unless the seller signs a covenant not to compete. The limiting instruction in the earlier version of Pattern Jury Charges was in conformity with Rathmell, supra. Today however, the current version of the Pattern Jury Charges has excluded this specific instruction, but the comment to PJC still contains a reference to the Rathmell decision. Therefore, why the specific limiting instruction was removed from the Pattern Jury Charges is unknown. Finally, it is clear that a trial court as a part of its division cannot order a non-compete provision as a part of its judgment. See Ulmer v. Ulmer, 717 S.W.2d 665 (Tex. App. 1986, no writ). On appeal, Mr. Ulmer argued that the non-compete provision ordered by the trial court deprived him of his separate property, i.e. the right to engage in his chosen profession. The Court of Appeals held that (A)n individual s ability to practice his professional does not qualify as property subject to division by the court. Ulmer, 717 S.W.2d at 667. This ruling is consistent with Rathmell, supra, and Dillon, supra. XI. Value to the Owner - Valuation When There is No Market Value A. What is Value to the Owner? As previously indicated, the primary standard of value in matrimonial cases is fair market value. However, in the event an asset has no fair market value, then the asset is to be valued based upon its value to the owner, as determined by the evidence (emphasis added). In 1963, the Texas Supreme Court discussed the value to the owner concept in the case of Crisp v. Security National Insurance Co., 396 S.W.2d 326 (Tex. 1963). The issue in Crisp was the determination of the value of household goods that were destroyed in a fire. During the trial, Mrs. Crisp testified as to the price and date of purchase of the various personal property lost in the fire. She further testified that she had taken good care of these furnishings and they were worth as much to her as when they were new. Additionally, a dealer who sold her much of her furniture testified that the quality was of a high type. Another dealer had sold to her over a period of several years approximately $1,800 of the 19

23 best grade carpeting. Photographs of the damaged goods were also admitted into evidence. Evidence was also submitted with respect to the condition of the home, as well as the size of the home and how it had been decorated. As a result of the evidence presented, Mrs. Crisp was awarded the sum of $7, The Court of Appeals reversed the trial court saying that the correct measure of damages was not the actual value to Mrs. Crisp of the property at the time and place of its loss, but the reasonable cost of replacing the property with material of like kind and quality, making allowance for depreciation. The Supreme Court in affirming the trial court, indicated that it was common knowledge and the courts uniformly accepted that used household goods, clothing and personal effects have no market value in the ordinary meaning of that term. They may be sold, but only at a considerable sacrifice which by no means represents the value of the articles to the owner. The court, in ruling that the measure of damages should not be based upon the proceeds obtainable on a secondhand market as well as replacement costs, stated that the measure of damages that should be applied in case of destruction of this kind of property is the actual worth or value of the articles to the owner for use in the condition in which they were at the time of the fire, excluding any fanciful or sentimental considerations. Furthermore, when determining value to the owner of property, such as household goods and wearing apparel that have no recognized market value, the actual value to the owner must be determined without resort to market value. The Supreme Court further indicated that there was a distinction between marketable chattels possessed for purposes of sale and, as in this case, chattels possessed for the comfort and well being of their owner. In this instance you measure the loss, not by their value in a secondhand market, but by the value of their use to the owner who suffers from their deprivation. The Court also stated that: the trier of fact should consider the original cost and cost of replacement of the damaged or lost goods as well as the opinion upon value given by qualified witnesses, to gainful use as to which the property has been put, as well as any other facts reasonably tending to shed light upon the subject. The court went on to state that since they were not concerned with market value, the jury could have well determined that household furniture, which was well cared for, depreciates slower as far as the use and value to the owner is concerned. In the case of Wendlandt v. Wendlandt, 596 S.W.2d 323 (Tex. Civ. App. Houston [1st Dist.] 1980, no writ), the question of the value of personal property was the sole point on appeal. During the trial, Mrs. Wendlandt called a witness and qualified him as an expert in the field of appraising personal property. However, the expert was not allowed to testify as to the fair market value or the trade value of various items of community personal property. The basis of the objection was the fact that the expert considered improper criteria in reaching his conclusion as to the fair market value of the personal property. In the offer of proof, the expert testified that he based his fair market valuation on the items based upon a liquidated or distressed sale. The Wendlandt court, in following the holding in the Crisp case, stated that: the expert s appraisal was based, in part, upon prices that would be brought at a forced or distressed sale which is not a relevant criteria in determining either fair market value or actual value to the owner. In Beavers v. Beavers, 675 S.W.2d 296 (Tex. Civ. App. Dallas 1984, no writ), the main issue on appeal involved, what Mr. Beavers claimed, as the overvaluing of a one-third (1/3) interest in restricted stock owned by the community estate in a company known as Great West Energy, Inc. The trial court assigned a value of $170,000 to the stock for the purposes of making a division of the community estate. The evidence presented during the trial by both parties experts was that because the sale of the shares in Great West were restricted by a requirement that they first be offered to other shareholders at book value, the experts testified that due to this restriction, the market value of the stock was zero. Nevertheless, the trial court assigned a value of $170,000 to the stock. The Beavers court stated while market value is usually the best evidence of the value of the personal property, in the absence of a market value, the actual value of the property to the owner may be shown. Bryant v. Stohn, 260 S.W.2d 77, 83 (Tex. Civ. App. Dallas 1953, writ ref d n.r.e.). During the trial, there was expert testimony from Mrs. Beavers witnesses that based on the value of the assets of the company, a one-third (1/3) interest in Great West Energy, Inc. would be worth as much as $395,850. According to Mr. Beavers expert witness, the book value of the company was $173,000 when substantial oil reserves were valued at only developmental costs. The 20

24 appellate court stated that in assigning values to closely held corporations in contested divorce cases, those considerations given here by the trial judge to company assets and to the realities of corporate control are appropriate. As a result, the appellate court affirmed the trial court s valuation of $173, In Mata v. Mata, 710 S.W.2d 756 (Tex. Civ. App. Corpus Christi 1986, no writ), the majority of the points of error dealt with the challenging of specific findings on the value of the parties property, including the value of a closely held business. First, the appellate court stated that where the uncontested evidence establishes only one value, the trial court cannot draw a different inference. When several values are given, or a witness concedes that a value may be higher or lower than his or her estimate, the court s finding on value should be within the range of values in evidence. In this case, Mrs. Mata was a licensed realtor. In her sixth point of error, she claimed that the trial court erred when it valued a business known as Gold Key Real Estate at $5,000 and awarded it to her. She argued that the business had no value as a matter of law. During trial, Mrs. Mata testified that Gold Key Real Estate was a name and phone number only and it had no assets and no office. She further testified that at the time of trial she was not presently working as a realtor and at a subsequent hearing post-trial, testified that she was employed as a broker by another real estate firm and that Gold Key Real Estate no longer existed. The appellate court found that there was insufficient evidence to value Gold Key Real Estate at $5,000 and therefore sustained Mrs. Mata s sixth point of error. Mr. Mata was a doctor. By her fourteenth point of error, Mrs. Mata contested the valuation of Dr. Mata s business at $25,000. Mrs. Mata s expert testified and compiled a valuation report that was admitted into evidence. The cover letter of the report stated the following: V.H. Mata, M.D. has elected to omit substantially all of the disclosures normally included in a financial statement presentation. If the omitted disclosures were included in the financial statements, they might influence the user s conclusions about the financial condition of V.H. Mata, M.D. and the financial statements have been prepared on an income tax basis of accounting which is a comprehensive basis of accounting other than generally accepted accounting principles. The report also indicated that the books of the business were not audited and testified that the transactions were from one bank account. The valuation listed the net income of the business as $166, The trial court s valuation of the business, which included the equipment and automobiles, at less than its yearly net income was not within the evidence and therefore sustained the appellant s fourteenth point of error indicating that the trial court abused its discretion in valuing the appellee s medical practice at $25,000. B. Value to the Owner and Evidentiary Issues Question 1: As a result of the holding in Mandell, supra, is a spouse entitled to introduce evidence showing the value to the owner notwithstanding the existence of a valid and enforceable buy-sell agreement that contractually fixes the value of a partnership interest or shareholder interest? Question 2: If the buy-sell agreement is valid and enforceable, would it be permissible for a trial court to find, under the value to the owner standard of value, that value of the partnership interest or shares in the corporation to be more than the value established by a contractually binding buy-sell agreement? XII. Owners Testimony of Values A. Texas Rules of Evidence, Rule 701 Rule 701 of the Texas Rules of Evidence sets forth the requirements for opinion testimony by a lay witness. The Rule provides as follows: If the witness is not testifying as an expert, the witness testimony in the form of opinions or inferences is limited to those opinions or inferences which are (a) rationally based on the perception of the witness and (b) helpful to a clear understanding of the witness testimony and the determination of a fact in issue. B. Decisions Prior to Natural Gas Pipeline Co. Prior to the Texas Supreme Court s decision in Natural Gas Pipeline Co. of America v. Justiss, 397 S.W.3d 150 (Tex. 2012), 56 Tex. Sup. J. 151, decided in 21

25 December 2012, the key to the admissibility of lay witness testimony on the issue of value under Rule 701 was the witness s personal familiarity with both the property and its value. Reid Road Mun. Util. Dist. No. 2 v. Speedy Stop Food Stores, Ltd., 337 S.W.3d 846 (Tex. 2011). Therefore, a lay witness could give his or her opinion as to value if the witness testifies that (1) they have knowledge of the general value - standard of things in that particular class; and (2) the witness has knowledge of the particular thing to be valued. Furthermore, the witness must have a knowledge of the market value (if there is one) in the vicinity and it must be based, in some degree, on personal observations. The owner's "testimony must show that it refers to market, rather than intrinsic or some other value of the property. The owner's testimony is probative if it is based on the owner's estimate of market value and not some intrinsic or other value such as replacement cost. Porras, supra; Redman Homes, supra; Ford Motor Co. v. Cooper, 125 S.W.3d 794 (Tex. App. Texarkana 2004, no pet.). In the case of Laprade v. Laprade, 784 S.W.2d 490, (Tex. App. Ft. Worth 1990, writ denied), the court held that if a witness has personal knowledge of facts from which an opinion is derived, and a rational connection exists between the opinion and facts and such opinion is helpful, then it is within the trial court s discretion to allow the lay person to express an opinion on value. (Wife was allowed to express her opinion on the fair market value of the Husband s trucking company because she had worked for the business for five years, knew how much was paid for each truck and knew the value of other similar businesses for sale.) While trial courts have wide discretion in allowing opinion testimony by lay witnesses regarding the value of property in which they own, and contrary to the factual situation in Laprade, supra, it would appear to be questionable to allow a spouse who (1) is not employed by the closely held business; and/or (2) who has spent little or no time in the management or operations of the business to testify regarding his or her opinion relating to the value of the business. It would seem that the testimony of the non-participating spouse who has not been involved in the management or operations of the business would not be rationally based on the perception of the witness. Furthermore, it would also appear that a spouse who has not worked in the business should not be allowed to testify nor would he or she be qualified to testify because he or she would have insufficient knowledge about the market value of the business in the area the business was located. In the case of Bogle v. Bogle, 2007 Tex. App. LEXIS 7151 (Tex. Civ. App. Corpus Christi 2007), a memorandum opinion, the court stated that when several values are in evidence regarding the same piece of property, the court s finding on value must be within the range of values in evidence. In this case, Mr. Bogle, the appellant, produced printing plates for stationary through a printing business which he operated out of the parties marital residence. Mrs. Bogle, in her testimony, claimed the value of the business was $18,000, but presented no evidence to support this valuation. Mr. Bogle contended that the business was only worth the cost of the business equipment, which he appraised at $3,000. The parties income tax returns, which were submitted into evidence, revealed that the business had produced a gross income of $28,374 and $18,150 in 2002 and 2003, respectively. The returns also showed that the business claimed no net profit in 2002 and a net profit of $7,841 in Mr. Bogle testified that the business had provided him with an income of approximately $1,500 to $2,000 a month. The court valued the business at $18,000 which included the equipment. The appellate court, in reaching its decision, first stated that basing a valuation on Diane s testimony alone would be in error because Diane never revealed that she helped operate the business, that she had adequate knowledge of the business accounts receivable and equipment, or that she knew the value of similar businesses. As a result, it was never proven that Diane s knowledge would be competent evidence to predicate a valuation. The appellate court indicated that the record did not disclose whether the valuation of the business found by the trial court was derived from the wife s testimony, the gross income stated in the 2002 and 2003 tax returns, or Mr. Bogle s testimony regarding his monthly income. Nevertheless, the appellate court concluded that the trial court s valuation derived from the income tax return(s) and Charles testimony as to the monthly income he received from the business. As a result, the trial court did not err in rejecting Charles valuation of $3,000. C. Property Owner Rule and Natural Gas Pipeline 22

26 Co. of America v. Justiss As seen from the decisions in Porras v. Craig, supra, Laprade v. Laprade, supra, and Reid Road Mun. Util. Dist. No. 2 v. Speedy Stop Food Stores, Ltd., supra, an owner of property was permitted to testify on his or her opinion of value for property in which they were an owner if they simply testified that they were familiar with the property and the market value of similar property. However, in December of 2012, the Texas Supreme Court decided the case of Natural Gas Pipeline Co. of America v. Justiss, supra, which overruled its prior decisions relating to the ability of an owner to testify as to value and set forth a new standard holding property owners to the same standard as an expert witness. In Natural Gas Pipeline Co. of America v. Justiss, the Supreme Court stated: As we explained in Porras v. Craig, supra, opinion testimony concerning [damages to land] is subject to the same requirements as any other opinion evidence with one exception: the owner of the property can testify to its market value, even if he cannot qualify to testify about the value of like property belonging to someone else. We noted, however, that a property owner s testimony must be based on market, rather than intrinsic or some other speculative value of the property. We stated that this requirement is usually met by asking the witness if he is familiar with the market value of his property. In the Porras case, Craig testified as to value of his property. However, Craig s testimony referred to personal rather than market value. Porras failure to object to the testimony was immaterial, because irrelevant evidence, even when admitted without objection, will not support a judgment. The Supreme Court stated: so while the property owner rule establishes that an owner is qualified to testify to property value, we insist that the testimony meet the same requirements as any other opinion evidence. Since Porras, we have further explained when expert testimony will support a judgment. See Coastal Transportation Company v. Crown Central Petroleum Corp., 136 S.W.3d 227, (Tex. 2004). In Coastal Transportation, we held that a qualified expert s bare conclusions, even if unchallenged at trial, would not support a gross negligent finding. We observe that although expert opinion testimony often provides valuable evidence in a case, it is the basis of the witness opinion and not the witness qualification or his bare opinions alone that can settle an issue as a matter of law; a claim will not stand or fall on the mere testimony of a credentialed witness. (Emphasis added.) If an expert brings to court little more than his credentials in a subjective opinion, his testimony will not support a judgment. We later observe that an expert s testimony is conclusory as a matter of law if he simply states a conclusion without any explanation. Citing Arkoma Basin Exploration Co. v. FMF Associates 1990-A, Ltd., 249 S.W.3d 380, 389 (Tex. 2008). Any testimony is speculative if it is based on guesswork or conjecture. The Supreme Court, after discussing a number of federal and state court decisions regarding the opinions of value testified to by owners of property, stated: Because property owner testimony is the functional equivalent of expert testimony, it must be judged by the same standards. Thus, as with expert testimony, proper valuations may not be based solely by a property owner s ipse dixit, [a Latin term defined by Black s th Dictionary, (9 edition) as he himself said it or something asserted but not proved. It has also been defined as an unsupported statement that rests solely on the authority of the individual who makes it, but is an assertion made without proof]. An owner may not simply echo the phrase market value and state a number to substantiate his diminished value claim; he must provide the factual basis on which his opinion rests. This burden is not onerous, particularly in light of the resources available today. Evidence of price paid, and by sales, tax valuations, appraisals, online resources, and any other relevant factors may be offered to support the claim. But the valuation must be substantiated; a naked assertion of market value is not enough. Of course, the owner s 23

27 testimony may be challenged on cross examination or refuted with independent evidence. But even if unchallenged, the testimony must support a verdict, even if conclusory or speculative statements do not. See Kestembaum, 514 F.2d at 699, Coastal, 136 S.W.3d at 233. The Supreme Court, in its final disposition, stated that generally when there was no evidence to support a judgment, we would render a judgment against the party with the burden of proof. But we have remanded a case to the trial when we have changed our precedent or when the applicable law has otherwise evolved between the time of trial and the disposition of appeal. In Porras, we stated that market value could be shown merely by asking the witness if he is familiar with the market value of his property, and we have never before explained the interplay between Porras and Coastal. Because the landowners may have relied on Porras in presenting their evidence on their property s diminution in value, we conclude that a remand is appropriate. It should be noted that as a result of this change in precedent, and based upon the Supreme Court s holding in Reid Road Mun. Util. Dist. No. 2 v. Speedy Stop Food Stores, Ltd. it would appear that all witnesses, even lay witnesses, including the parties in a pending divorce, must be disclosed and designated as experts if they are going to express an opinion of value. In Reid Road Mun. Util. Dist. No. 2, supra, the court held that a witness who will be giving opinion evidence about a property s fair market value must be disclosed and designated as an expert pursuant to discovery and other applicable rules. Due to the ruling in Natural Gas Pipeline Co. of America v. Justiss, supra, and the new standard set for a property owner to give his or her opinions of value, and not withstanding the discretionary powers of the trial court, it would seem that the testimony of the nonparticipatory spouse, who has never participated in the management or operations of a closely-held family owned business, would not be qualified to testify as to the value of the business since he or she would not have any personal knowledge of the facts regarding the management and operations of the business, its competitors, or the potential market for the business. His or her testimony would be strictly speculative and obviously self-serving. XIII. Goodwill The term goodwill is defined in the IGBVT as that intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified. In business valuation, one of the subjective and hard to define concepts is goodwill. Business valuation experts agree that goodwill exists, but few agree on exactly what it is. In Texas, there are primarily two types of goodwill - commercial or enterprise goodwill and personal or professional goodwill. As to the former, and as the definition above indicates, commercial or enterprise goodwill is goodwill that is created by the business enterprise itself as a going concern due to location, customer service, reputation, or other factors not associated with any particular person. On the other hand, personal or professional goodwill is created by and attributable to an individual due to reputation, skill and talent of the individual. In the case of Finn v. Finn, 658 S.W.2d 735 (Tex. App. Dallas 1983), the Dallas Court of Appeals established a two prong test to assess the existence of divisible goodwill. First, goodwill must be determined to exist independently of the personal ability of the professional spouse. Second, if such goodwill is found to exist, then it must be determined whether that goodwill has a commercial value in which the community estate in entitled to share. Finn at 741. As indicated in Rathmell v. Morrison, supra, the court stated that personal goodwill attached to the person of the professional man or woman as a result of confidence in his or her skill and ability. Id. at 763. Personal goodwill does not possess value or constitute an asset separate and apart from a professional s person, or from his individual ability to practice his profession. Personal goodwill will extinguish in the event of the professional s death, retirement or disablement. Id. at 764. Note: Some business appraisers agree that the profession is just now beginning to recognize that there are actually two types of personal goodwill - transferable personal goodwill and non-transferable goodwill. According to one appraiser, this is basically the difference in value between signing the non-compete and not signing the non-compete. For example, a dentist can sell his personal goodwill with a non-compete agreement and also an employment contract. However, a surgeon 24

28 has personal goodwill, but it is not transferable, even with a non-compete. A. Personal Goodwill 1. Goodwill is an intangible, salable asset arising from the reputation of a business and its relations with its customer, distinct from the value of its stock and other tangible assets. In a business valuation, it is critical that the valuation expert segregate the personal goodwill of the owner from the commercial goodwill of the entity. a. Personal goodwill attaches to the owner and is based on the individual s knowledge, skill, experience and training. Nail v. Nail Geesbright v. Geesbright b. Personal goodwill of all owners excluded from the valuation. Salinas v. Rafati B. Commercial Goodwill Commercial goodwill includes: Location Reputation of entity Workforce in place Computer/ phone systems Client base Extended operating hours Phone number The current volume of Texas Pattern Jury Charges - Family in PJC 203.2, Factors to be Considered for Valuation of Business, provides as follows: XIV. Personal goodwill is the goodwill that is attributable to an individual s skills, abilities and reputation. In determining the value of a party s (type of practice) you are not to include the value of personal goodwill or the value of time and labor to be expended after the divorce. However, you may consider the commercial goodwill, if any, of the practice that is separate and apart from personal goodwill. Expert Credentials and Reports When dealing with business valuation experts, the practitioner needs to be familiar with the various organizations that certify or license business appraisers and what those certifications mean and the requirements, if any, a business appraiser must follow in doing a business appraisal and the accompanying report. There are a number of professional designations that are offered for someone to become an expert in the field of business valuation. The forensic and valuation services section of the American Institute of Certified Public Accountants ( AICPA ) offers two credentials: (1) the Certified Financial Forensics (CFF) credential; and (2) the Accredited in Business Valuation (ABV) credential. In order to become either a CFF or an ABV, an individual must successfully pass either the CFF exam or the ABV exam, as well as meet minimum experience and educational requirements. Another designation for a business appraiser is the Accredited Senior Appraiser (ASA), which is a credential issued by the American Society of Appraisers. There is also a Certified Valuation Analyst (CVA), which is issued by the National Association of Certified Valuation Analysts ( NACVA ). Finally, there is a society called the Certified Financial Analyst ( CFA ). This designation is usually obtained by Wall Street analysts and is typically not required for a business valuation analyst. One should be familiar with the ASA Business Valuation Standards (2009), the AICPA Statement on Standards for Valuation Services-Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset ( SSVS #1")(June 2007), and the Uniform Standards of Professional Appraisal Practice ( USPAP ) which has ten (10) sections, sections 9 and 10 of which cover business appraisals. The USPAP has not been adopted by the AICPA or the NACVA. However, all members of the ASA must comply with the USPAP standards. The SSVS #1 covers overall engagement considerations including professional competence and valuation services. The standards set forth in SSVS #1 apply to all CPAs who are members of the AICPA. The SSVS #1 also has certain minimum requirements with respect to written business valuation reports. A detailed report should be structured to provide sufficient information to permit the intended users to understand the data, reasoning, and analysis underlying the valuation analyst s conclusion of value. Under SSVS #1, an engagement to determine the 25

29 value of a business interest results in either an expression of (1) a conclusion of value; or (2) a calculated value. A conclusion of value requires more procedures to be performed than a calculation, and is an engagement where the valuation analyst is free to apply the valuation approaches and methods he or she deems appropriate under the circumstances to estimate the value of a subject interest based on their professional judgement. A calculation of value is where the valuation approaches and methods are limited by agreement with the client and do not include all the procedures required for a valuation engagement. The attorney needs to be aware that under the SSVS #1, a litigation exception exists when it comes to a written valuation report. Under this exception, it would appear that the requirements for a detailed report and the minimum requirements for a summary report are not required to be included if the report involves a litigation matter. Therefore, it would also appear, due to the litigation exception, that for a detailed report or a summary report, neither report would have to contain information, for example, explaining how the discount rate was derived or what the estimate of reasonable compensation was or how it was arrived at. There is no such litigation exception for written reports under USPAP. Furthermore, the USPAP and ASA have requirements that must be met when writing a business valuation report. The contents of a written business valuation report under SSVS #1 are couched in what should be contained in a written valuation report and not what must be contained in the written report as set forth in USPAP. As a result, the contents of a written valuation report prepared under SSVS #1 do not appear to be mandatory, but merely suggestive. Therefore, if this interpretation is correct, this would allow the appraiser or CPA to provide less information and guidance to the litigants than if the requirements of ASA and USPAP were followed. A CPA who is a member of the AICPA, but who is not a member of the ASA does not have to follow any standards when writing a report for a litigation matter because the USPAP has not been adopted by the AICPA or the NACVA. On the other hand, a business appraiser who is a member of the ASA, must comply with the ASA and the USPAP requirements for a written valuation report, notwithstanding the litigation exception under the SSVS #1. As one professional business appraiser stated, the biggest area he sees people taking advantage of is the area of written reports. Both the USPAP and the SSVS #1 dictate that a reader of the report should be able to determine how the value was arrived at from the report. However, in a litigation matter, a CPA who is not bound by the standards and requirements of USPAP apparently can provide limited data or information in his or her written report and by doing so is not in violation of any standards. PRACTICE TIP: Whether you are working with your own expert or questioning the other side s expert, you might want to consider asking the following questions: Always question the business appraiser as to what professional standards he or she is applying. (Again, if they are a member of ASA, they are required to follow USPAP notwithstanding the litigation exception under the SSVS #1.) Always inquire as to whether the twenty-three (23) minimum requirements for a summary written report under SSVS #1 are included in the report. Always ask the appraiser what he/she would have to change in the report in order to comply with USPAP and/or SSVS #1 standards, notwithstanding the litigation exception. Always ask the opposing experts if they are aware of any rules or ethics violations committed by your expert. Ask the business appraiser if there have been any discussions with the attorney regarding the standards of ethics? Is the expert planning to state any opinions regarding standards, etc.? XVIII. Conclusion In Texas, the lawyer needs to understand that in matrimonial cases there are two basic standards of value - fair market value and value to the owner. While there are other recognized standards of value, they are not applicable when it comes to valuing a closely-held business in a divorce case in Texas. The attorney should be aware of the different approaches and methodologies available to determine value. The premise of value is often overlooked or assumed by the lawyer. Premises of value are a set of transactional circumstances in which a valuation is to take place. In Texas, the primary premise of value for 26

30 valuing a closely-held business is the going concern premise. The fair market value standard presupposes a hypothetical buyer and seller. Furthermore, it assumes that a business is to be valued based upon a fair market value as a going concern. While going concern value is usually assumed, it may not necessarily be applicable in your case. While the attorney in Texas is bound to either the fair market value standard or the value to the owner standard, there is no case law which requires the business appraiser to follow the going concern premise. In fact, it may not be necessarily applicable in every case. It is important to remember that if a buy-sell agreement, shareholder agreement or partnership agreement effectively eliminates the fair market value standard, then the attorney must attempt to value the business interest under the value to the owner standard. Prior to the Supreme Court decision in Natural Gas Pipeline Co. of America v. Justiss, supra, an owner of property could testify as to his or her opinion of value under Rule 701 of the Texas Rules of Evidence as long as the owner/witness testified that they had personal familiarity with the business or other asset being valued and the market for such property and/or business interest. However, following the Supreme Court s holding in Natural Gas Pipeline Co. of America, it would appear that the owner of a business, because they are now being held to the same standard as an expert witness, must also be prepared to state the basis for his or her opinion, including the factual basis on which the witness rests his/her opinion. Finally, when working with, or against, an expert on the valuation of a closely held business, attorneys should become familiar with the professional designations that an expert in the field of business valuation has and what the ethical standards that particular expert must comply with in preparing and/or giving his or her opinion as to value. 27

31 BIBLIOGRAPHY nd State Bar of Texas, 32 Annual Marriage Dissolution Institute: Business Valuation, and Then Some by Sherri A. Evans th State Bar of Texas, 35 Annual Advanced Family Law Course: Valuation-The Impact of Buy Sale Agreements by Becky A. Beaver th State Bar of Texas, 35 Annual Advanced Family Law Course: Due Diligence of the Valuation of the Expert by Haran D. Levy th State Bar of Texas, 36 Annual Advanced Family Law Course: Valuation: Approaches, Assets and Authority by R. Scott Downing th State Bar of Texas, 37 Annual Advanced Family Law Course: Business Valuations and Relevant Family Law Cases by Autumn Kraus, CPA/ABV, JD The Standard of Value is Critical in the Valuation of a Business in Divorce by Shannon P. Pratt and Alina v. Niculitc, FamilyLawyerMagazine.com (October 25, 2011) State Bar of Texas, New Frontiers in Marital Property Law: Valuation of Business Interests, Business Valuation of Divorce: Current Theories, Practices and Case Law by Jack W. Marr th State Bar of Texas, 26 Annual Advanced Family Law Course: Personal Goodwill vs. Commercial Goodwill vs. Other Intangible Assets - a Valuation Expert s Perspective by Jim Penn, CPA-ABV American Academy of Matrimonial Lawyers Quarterly Report - Winner 2011: Market Approach in Valuation: What is Comparable? by Lisa J. Cruikshank American Academy of Matrimonial Lawyers Quarterly Report Summer 2010: The Importance of Proactive Lawyering: Business Valuation Reports - by Peter E. Bronstein th Valuation of Closely Held Business Interests - ABA 14 Annual Real Property, Estate Planning Symposium, April 2003 by William A. Lockwood Valuing Small Business and Professional Practices by Shannon P. Pratt, Robert F. Reilly and Robert P. Schweihs rd (3 Edition McGraw-Hill 1998) What is Value by Shannon P. Pratt, ABA Family Advocate (Volume 25; No ) American Society of Appraisers Business Valuation Standards (2009) American Institute of Certified Public Accountants Statements on Standards for Valuation Services Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset (2007) Uniform Standards of Professional Appraisal Practice ( Edition) International Glossary of Business Valuation Terms which appears at ry+of+business+valuation+terms.htm. The Valuation Process Of Closely Held Corporate Stock by Sheldon E. Richie and Jeff C. Lamberth, Texas Bar Journal (June 1991) 28