Business Valuation Update

Business Valuation Update From From the the developers of Pratt s of Pratt s Stats Stats Timely news, analysis, and resources for defensible valuations Vol. 17, No. 5, May 2011 Selecting Guideline Companies When Valuing Unprofitable Banks The past couple of years have been hard on the banking industry. In fact, the number of institutions on the FDIC s problem list rose from 860 to 884 in the fourth quarter of 2010. Many banks are burdened by high levels of non-performing assets, loan growth has been a challenge, many remain dependent on real estate lending, and there is greater regulatory scrutiny. Mercer Capital s Andrew Gibbs points out that the selection of guideline companies is unusually problematic in the banking industry because a few large banks dominate, and the performance of those banks varies significantly from the smaller and unprofitable banks. To get a better picture of which comparables provide the best valuation guidelines, Gibbs created a community banking industry universe consisting of 3,800 banks with assets between $100 million and $5 billion. This universe provides us a pretty fair representation of the state of the community banking industry, he says. And Gibbs also has analyzed the 354 banks in the SNL Financial database that trade on the NYSE or NASDAQ. After these studies, and based on his professional experience, Gibbs recommends considering the following factors in selecting guideline public companies: Type of entity (whether it s a bank or a thrift) Asset size Profitability (determined by the return on equity or return on assets) continued on page 4... More Valuation Market Demographics From BVR s BV Firm Economics Report How many BV firms are there? CPA firms with BV partners? How big are they, and what other services, if any, do they provide? These are critical questions for any strategic planning discussion. The answers to these and many other questions appear in the 2011 BV Firm Economics and Best Practices Guide, released this month. The survey is conducted every two years, and reports on BV firm data for fiscal years ending in 2010. We ve included some highlight data here as a benefit to BVU readers. continued on next page... INSIDE THIS ISSUE Selecting Guideline Companies When Valuing Unprofitable Banks............................ 1 More Valuation Market Demographics From BVR s BV Firm Economics Report....................... 1 One Solution to the Option Pricing Overvaluation Problem: Using Down and Out Call Options................... 6 Report from ACG: Transaction Costs and Risks Rise, and Buyers Change................. 12 How Components of Ancillary Let s Build on the New NACVA/IBA Standards Unification.... 15 Revenue A f fect M edic al Impact of Government Contracts on Subject Company Risk... 17 Practice Values Sources of International Reports on Economies and Industries. 19 Legal & Court Case Updates..................... 21 Insignia Systems, Inc. v. News America Marketing In-Store, Inc.. 21 In re American Home Mortgage Holdings, Inc............ 22 In re Spansion............................ 24 Fulton Co. Employees Retirement System v. MGIC Investment Corp........................... 26 In re Marriage of Meek-Duncomb................. 28 Rolfe State Bank v. Gunderson................... 28 Reis v. Hazelett Strip-Casting Corp................. 29 The Citrilite Co. v. Cott Beverages, Inc............... 32 Enpat, Inc. v. Budnic........................ 34 Linton v. United States....................... 35 Victory Records, Inc. v. Virgin Records America, Inc........ 36 BVR s Economic Outlook for the Month............... 38 CALENDAR............................... 39 COST OF CAPITAL........................... 40 BVResources.com

More Valuation Market Demographics From Bvr s Bv Firm Economics Report Business Valuation Update Executive Editor: Jan Davis Legal Editor: Sherrye Henry Jr. CEO, Publisher: David Foster Managing Editor: Janice Prescott Contributing Editors: Adam Manson, Vanessa Pancic, Doug Twitchell Graphic & Technical Designer: Monique Nijhout Customer Service: Stephanie Crader Sales and Site Licenses: Linda Mendenhall President: Lucretia Lyons Editorial Advisory Board Christine Baker CPA/ABV/CFF ParenteBeard New York, NY Neil J. Beaton CPA/ABV, CFA, ASA Grant Thornton Seattle, Wa john A. Bogdanski, Esq. Lewis & Clark Law School Portland, Or Nancy J. Fannon ASA, CPA/ABV, MCBA Fannon Valuation Group Portland, Me Jay E. Fishman Fasa, cba Financial Research Associates Bala Cynwyd, Pa Lynne z. Gold-Bikin, Esq. Wolf, Block, Schorr & Solis-Cohen Norristown, Pa Lance s. hall, ASA FMV Opinions Irvine, Ca james r. hitchner cpa/abv, asa The Financial Valuation Group Atlanta, Ga jared Kaplan, Esq. McDermott, Will & Emery Chicago, Il Gilbert E. Matthews CFA Sutter Securities Incorporated San Francisco, Ca Z. Christopher Mercer ASA, CFA Mercer Capital Memphis, TN John W. Porter, Esq. Baker & Botts Houston, Tx Ronald L. Seigneur MBA CPA/ABV CVA Seigneur Gustafson Lakewood, Co Bruce silverstein, esq. Young, Conaway, Stargatt & Taylor Wilmington, De Jeffrey S. tarbell ASA, CFA Houlihan Lokey San Francisco, Ca Gary R. Trugman ASA, CPA/ABV, MCBA, MVS Trugman Valuation Associates Plantation, Fl Kevin R. Yeanoplos CPA/ABV/CFF, ASA Brueggeman & Johnson Yeanoplos, P.C. Tucson, AZ Business Valuation Update (ISSN 1088-4882) is published monthly by Business Valuation Resources, LLC, 1000 SW Broadway, Suite 1200, Portland, OR, 97205-3035. Periodicals Postage Paid at Portland, OR, and at additional mailing offices. Postmaster: Send address changes to Business Valuation Update, Business Valuation Resources, LLC, 1000 SW Broadway, Suite 1200, Portland, OR, 97205-3035. The annual subscription price for the Business Valuation Update is $359. Low cost site licenses are available for those wishing to distribute the BVU to their colleagues at the same address. Contact our sales department for details. Please feel free to contact us via email at customerservice@ BVResources.com, via phone at 503-291-7963, via fax at 503-291-7955 or visit our web site at BVResources.com. Editorial and subscription requests may be made via email, mail, fax or phone. Please note that by submitting material to BVU, you are granting permission for the newsletter to republish your material in electronic form. Although the information in this newsletter has been obtained from sources that BVR believes to be reliable, we do not guarantee its accuracy, and such information may be condensed or incomplete. This newsletter is intended for information purposes only, and it is not intended as financial, investment, legal, or consulting advice. Copyright 2011, Business Valuation Resources, LLC (BVR). All rights reserved. No part of this newsletter may be reproduced without express written consent from BVR. What is your primary business? Respondents primary business is reported in Table 1. The largest plurality of practice units continues to be CPA firms with business valuation services, following by BV-only firms. Table 1. What Is Your Firm s Primary Business? 2010 2008 2006 Public Accounting Tax or A&A 37.3% 45.6% 36.3% Public Accounting Forensic 6.0% NA NA Business Valuation 39.0% 32.8% 41.2% Management Consulting 6.7% 4.6% 2.5% M&A/Broker 6.0% 4.6% 8.3% Investment 0.7% 0.9% 0.5% Other 6.3% 11.4% 11.3% Definition of small, mid-size, and large BV practices. Table 2 shows that, while there have not been formal definitions of small, mid-sized, or large business valuation firms, the BVR results fall neatly into groupings at around the $300,000 and $1,000,000 gross revenue marks. Several patterns can be seen in these revenue classifications for business valuation firms. First, the small BV-only firms (less than $300,000 in revenues) tend to be solo practitioners or have a maximum of one partner. While there are presumably some highly profitable mid-size BV firms with just one owner, the majority of firms in the $300,000 to $1,000,000 total revenues range begin to have multiple partners and some formal administrative structure. The largest BV firms (more than $1,000,000 in revenues) begin to show diversification of revenues, often into areas such as mergers and acquisitions, business consulting, forensic accounting, or financial planning. CPA firms with business appraisal partners similarly show natural size groupings, often aligned with their market position as small local firms, leading local firms, and then the largest regional 2 Business Valuation Update May 2011

More Valuation Market Demographics From Bvr s Bv Firm Economics Report Table 2. Percent of BV Practice Units by Size Range BV and CPA firms 2010 2008 Small BV firms (<$300K in total billings) 22.3% 13.5% Mid-size BV firms ($301K- $1MM in total billings) 10.8% 8.6% Large BV firms (>$1MM in total billings) 12.7% 12.6% Small CPA firms with BV practice (<$1MM in total billings) 9.6% 11.3% Mid-size CPA firms with BV practice ($1MM-5MM in total billings) 17.2% 27.5% Large CPA firms with BV practice (>$5MM in total billings) 27.4% 26.6% and national practices. Some of these firms clearly do as few as one business valuation a year (one small CPA firm responded that it had $4,100 in total business valuation revenues in the preceding 12 months, and three CPA firms who responded and claimed to have business valuation practices reported no revenue from valuation activities in 2010). Thirteen other small CPA firms reported business appraisals totaling less than $30,000 during the preceding year. The percent of total billings received from business valuation engagements is shown in Table 3. Some clear patterns can be seen here. First, as mentioned above, smaller and mid-sized business valuation firms receive the vast majority of their revenues from their core business. In fact, 64% of these firms report no other source of revenues. Those that do have multiple revenue sources offered comments such as we got our first brokerage client this year or my valuation business was down but I ve had some forensic accounting engagements to fill the gaps. Second, the larger business valuation firms face either market opportunities or pressures to expand their services in order to grow. It s at this size that business valuation firms develop material ancillary revenues. Typical of this trend is a comment from the managing director of a $2.9 million BV firm: We added a partner who s Table 3. Percent of Revenue From BV Activities 2010 2008 Small BV firms (<$300K in total billings) 87.9% 87.3% Mid-size BV firms ($300K- $1MM in total billings) 87.4% 88.2% Large BV firms (>$1MM in total billings) 81.1% 79.1% Small CPA firm (<$1MM in total billings) 13.2% 14.6% Mid-size CPA firms ($1MM- 5MM in total billings) 7.8% 7.1% Large CPA firms (>$5MM in total billings) 5.5% 5.4% Other/M&A/Consulting/ Investment 14.3% 16.0% a management consultant and her practice was the fastest growing for us this year. This trend must be taken into account as part of the strategic planning for any growing BV practice. CPA firms derive less than one-eighth of their revenues from business appraisals and related work and this number has stayed relatively stable over the last years. Even at the smallest CPA firms, where BV work is most significant, the picture that emerges is, for example, similar to that of a Boston four-partner firm where one partner spends somewhat less than half of his time on business appraisals. The larger CPA firms, often with a business valuation department, seem to be stable from the data here. Business valuation at these large CPA firms is dwarfed by tax and audit and accounting revenues... but it s still important. It appears that the much-discussed risks for large audit firms doing valuations have not driven them out of the business. Firms that reported businesses other than business valuation or public accounting as their prime business (brokers, bankers, etc.) indicated that about one-sixth of their revenue comes from business appraisals. BVR s 2011 BV Firm Economics and Best Practices Repor t is available at w w w.bvresources.com or from BVR at 503-291-7953 or customerservice@bvresources.com. May 2011 Business Valuation Update 3

Selecting Guideline Companies When Valuing Unprofitable Banks Selecting Guideline Companies When Valuing Unprofitable Banks...continued from front page Location (for example, is the bank in a state with more distressed real estate conditions?) Composition of the loan portfolio (this often matters because there could be a concentration of construction loans versus other types of loans that are considered less risky) Level of nonperforming assets Participation in TARP (which can distinguish banks based on the market s concern about the bank s ability to redeem that without issuing capital in a diluted transaction) Repayment status and whether the dividends on TARP are in deferral Dividend deferral Sorting company data by return on equity, asset size, and asset quality can help valuation practitioners select the banks most comparable to their subject companies, Gibbs believes. The smaller banks are more likely commanding lower price to tangible book value multiples, holding profitability constant. Table 1. Pricing Multiples Based on Return on Equity Sorting the guideline company data by return on equity. A clear demarcation exists among the pricing multiples based on return on equity (see Table 1). Banks with higher levels of profitability measured by their return on tangible equity have the highest price-to-book multiples. Banks that have generated a return on equity over 10% have the highest price-to-book multiples and have generated a cumulative return of about 12% over three years based on their stock price and dividends. The worst banks those with return on equities of less than negative 5% have lost 82% of their value during the same period. The price to tangible book multiples 74% are a little bit skewed for the group with the lowest return on tangible equity, says Gibbs. I think that s because some of those banks have lost most of their tangible equity so your denominator is artificially low. Another trend Gibbs has observed recently is that the smaller banks are more likely commanding lower price to tangible book value multiples, holding profitability constant. Sorting the guideline company data by asset size. Controlling for profitability, pricing/tangible book value multiples tend to decrease as the bank s size decreases. For example, Gibbs split the banks with return on tangible equities 4 Business Valuation Update May 2011

Selecting Guideline Companies When Valuing Unprofitable Banks of greater than 10 percent into three categories by asset size: $5 to $10 billion; $1 to $5 billion; and less than $1 billion (Table 2 below). The banks that are the biggest trade at the highest price to tangible book multiples, 252 percent. Then if you drop to the smallest group in terms of assets, it s only 112 percent, Gibbs explains. Gibbs also points out there is a profitability difference in the group presented in Table 2. The return on tangible equity is higher for the biggest banks, which reflects some of the efficiencies of banks that size. But nonetheless, there s a fairly big pricing discrepancy, and that continues even if you look at banks with lower levels of profitability, he adds. Table 2. Sorting by Asset Size Table 3. Sorting by Asset Quality May 2011 Business Valuation Update 5

One Solution to the Option Pricing Overvaluation Problem: Sorting the guideline company data by asset quality. Even if you control for profitability, price to tangible book value multiples still declines as the level of nonperforming assets increase, Gibbs explains. We can measure nonperforming assets by the so-called Texas ratio the level of nonperforming assets relative to tangible equity and loan loss reserves. The top panel of banks in Table 3 shows the banks with return on tangible equity of greater than 10%; if their non-performing assets are less than 10% of equity in reserves, the price to tangible book value multiple is 173%. When the multiple falls to 83%, the banks have a higher level of nonperforming assets, even if they are profitable. The same correlation exists for banks with higher levels of nonperforming assets or higher Texas ratios. You see a pretty much continued decline in price to tangible book value multiples, says Gibbs. One Solution to the Option Pricing Overvaluation Problem: Using Down and Out Call Options By Ronald H. Schmidt and Lawrence D.W. Schmidt Introduction Recent articles have pointed to concerns about the validity of using option pricing models (OPM) to determine the value of common stock in 409(a) valuations. 1 At issue is the question of whether OPMs provide appropriate methodologies to establish the appropriate fair market value of common stock. The OPM approach has been embraced by the accounting community and the AICPA due to its mathematical elegance and the limited assumptions required to operationalize the model. Unfortunately, the experience in much of the valuation profession is that the OPM approach, particularly when used in back-solving to determine 1 James Walling and Cindy Moore, Does Black Scholes Overvalue Early Stage Company Allocations?, Business Valuation Update, Vol. 16, No. 1, January 2010; Scott Beauchene and Stillian Ghaidarov, Lognormal Distributions vs. Empirical Observation a Defense of the Option Pricing Method, Business Valuation Update, Vol. 16, No. 3, March 2010; and Bruce Pollock and Ronald Schmidt, Avoiding Distortion When Using An OPM to Allocate Value: Selecting the Option Term, Business Valuation Update, Vol. 16, No. 5, May 2010. enterprise value, appears to yield unrealistically high values for common stock. As we discuss in this article, part of the problem involves the use of simple Black-Scholes assumptions that do not properly account for path dependence of results. Specifically, use of standard Black-Scholes algorithms will overstate the value of common stock by not properly modeling the impact of failure scenarios. We argue that claims to equity of early-stage companies may be more appropriately modeled as down and out call options, rather than traditional European call options (as required by the Black-Scholes formula). Like Black-Scholes, these options still have the benefit of a simple, closed-form solution, but they better account for the path dependence of enterprise value and allow for a higher probability of failure. We demonstrate that these alternative option pricing models can be used to either estimate enterprise value (back-solving) or to allocate value, and that their use can result in more reasonable estimates of common stock when compared with Black-Scholes. Black-Scholes and Path Dependence The Black-Scholes model (BSM) is not path dependent. By that, we mean that the value of an option in a BSM framework depends on the potential distribution of outcomes at a given end 6 Business Valuation Update May 2011

One Solution To The Option Pricing Overvaluation Problem point (the term). This distribution can be solved in a closed form solution (i.e., there is a mathematical solution) or through simulations involving millions of paths, where each path involves taking a starting point (the price) and taking a random draw from a distribution described by Brownian motion over time. The BSM does not consider where those paths go along the way, simply the likely distribution of final results. In many situations, however, the path matters, and this is well recognized in the academic literature and in practice. A good example of this is the use of Hull-White trinomial lattice models in calculating the cost of options to a company for purposes of FAS 123(R) financial reporting. In those models, paths matter for example, in cases where prices rise, option holders may exercise before the term is reached. 2 This approach is a simple form of barrier option, that is, an option in which individual paths can be truncated if they reach certain values. In the case of valuing corporate securities, Brockman and Turtle present empirical evidence suggesting that the addition of barriers significantly improves the performance of an option pricing model. 3 They employ a down and out barrier option pricing model (to be described below) that shows that barriers appear to be priced into actual option prices, with the barriers surprisingly high relative to the price of the asset. 4 2 John Hull and Alan White, How to Value Employee Stock Options, Financial Analysts Journal, Vol. 60, No. 1, pp. 114-119, January/February 2004. 3 Paul Brockman and H.J. Turtle, A Barrier Option Framework for Corporate Security Valuation, Journal of Financial Economics, 67 (2003), pp. 511-529. 4 Note that Wong and Choi ( Estimating Default Barriers from Market Information, Quantitative Finance, 9 (2009), pp. 187-196) address some econometric issues which could help explain the high implied barriers calculated by Brockman and Turtle. Down and Out Call Options The use of a DOC model allows for the reality that there are some paths that may be stopped in their tracks well before the term used in an OPM. So what is a down and out call option (DOC)? It is a contract that is like a standard call option except that it expires worthless if the stock price ever drops below a specified level, referred to as the barrier. In some cases, the seller will offer a rebate to the buyer, which is only payable if the barrier is breached. For example, if the barrier is $80 and the rebate is $5, the person who bought the option would receive $5 if the stock price dropped below $80. As we will discuss later, in the context of early-stage company valuations, the notion of a rebate will be quite useful for incorporating liquidation preferences into the barrier option pricing framework. Essentially, the DOC pricing model modifies BSM (or binomial lattice models) to include a barrier. This barrier can be thought of as a value at which the controlling investors or creditors might choose to pull the plug on a company. It could also be considered an outcome in which the company is forced to head in a different direction, change management, and often change the capital structure of the company. In these cases, the vast majority of the value of the firm would be transferred to the preferred stockholders, while those holding the common would receive nothing. The use of a DOC model allows for the reality that there are some paths that may be stopped in their tracks well before the term used in an OPM. Sufficiently poor results will not be allowed to continue, so that even if a BSM might ultimately revive that outcome through a string of subsequently positive results, those positive results will not occur because the path is truncated. Figure 1 provides a graphical illustration of how the DOC option works. We present three hypothetical price paths, calculated using the discretized version of Brownian motion commonly used in binomial tree pricing models. May 2011 Business Valuation Update 7

One Solution To The Option Pricing Overvaluation Problem Stock Price $160 $140 $120 $100 $80 $60 $40 $20 Figure 1. Examples of Hypothetical Stock Price Paths Path A Path B Path C Strike Price $0 0.0 0.3 0.6 0.9 1.2 1.5 1.8 2.1 2.4 2.7 3.0 Time Barrier Price In this example, the current price is $50, the strike price is $75, and the barrier value is $35. Path C is always above the barrier and ends in the money. Path B ends below the barrier, well out of the money. Both of these price paths would result in the same valuation in the BSM and DOC frameworks. However, path A goes below the barrier but ends in the money. In the DOC model, this path would result in the option expiring worthless (or the buyer receiving a rebate), while the BSM would count this option as being in the money. Including a barrier has direct implications for the distribution of final outcomes. Figure 2 demonstrates the impact of barriers on the distribution of Figure 2. Simulated Distribution of Exit Multiples Panel A: Volatility = 0.3 Panel B: Volatility = 0.5 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 58% 79% Less than 1 31% 13% 8% 5% 2% 2% 1% 1% 1.0-2.0 2.0-3.0 3.0-4.0 Greater than 4.0 Black-Scholes 50% DOC 100% 90% 65% DOC 80% 80% DOC 70% 68% 60% 50% 40% 30% 20% 10% 0% 91% Less than 1 18% Black-Scholes 50% DOC 65% DOC 80% DOC 7% 3% 2% 3% 1% 4% 2% 1.0-2.0 2.0-3.0 3.0-4.0 Greater than 4.0 Panel C: Volatility = 0.7 Panel D: Volatility = 0.9 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 76% 95% Less than 1 11% Black-Scholes 50% DOC 65% DOC 80% DOC 5% 2% 5% 1% 1% 1% 2% 1.0-2.0 2.0-3.0 3.0-4.0 Greater than 4.0 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 83% 97% Less than 1 7% Black-Scholes 50% DOC 65% DOC 80% DOC 3% 2% 5% 1% 0% 0% 1% 1.0-2.0 2.0-3.0 3.0-4.0 Greater than 4.0 8 Business Valuation Update May 2011

One Solution To The Option Pricing Overvaluation Problem exit multiples, assuming a lognormal distribution. 5 Each bar represents the percentage of final outcomes with exit values at a given multiple of current value assuming a given barrier. For example, the results show that with 30% volatility, the BSM will generate values at the end of the term below the current value 58% of the time (a multiple less than 1), while a DOC model with an 80% barrier will yield exit multiples less than one 5 Each graph is calculated using 100,000 simulated paths assuming a lognormal distribution with an expected return equal to the risk-free rate of 2%. We assumed a five-year term, which was discretized into one thousand intervals. These simulations closely approximated the Black-Scholes option prices for all options of interest. in 79% of the paths. 6 (Detailed results are shown in Table 1). Figure 2 points to two key results. First, DOC options result in a significantly higher proportion of outcomes in which the exit multiple is less than one. While this does not mean that it is necessarily predicting a higher failure rate than in a BSM, 6 The key advantage of maintaining the lognormal assumptions is that closed form solutions exist for these option prices. For these solutions, see Robert C. Merton, Theory of Ration Option Pricing, The Bell Journal of Economics and Management Science, Vol. 4, No. 1 (1973), pp. 141-183. However, this assumption can be relaxed using simulation methods from alternative distributions. Table 1. Simulated Distribution of Exit Multiples Barrier Percentage Volatility Exit Multiple Range BSM - 0% 50% 65% 80% 0.3 Less than 1 57.6% 59.3% 66.0% 78.8% 1.0-2.0 31.3% 29.8% 23.6% 13.3% 2.0-3.0 7.7% 7.6% 7.1% 5.2% 3.0-4.0 2.1% 2.1% 2.0% 1.6% Greater than 4.0 1.3% 1.3% 1.3% 1.1% 0.5 Less than 1 68.3% 75.5% 82.8% 90.5% 1.0-2.0 17.9% 12.3% 7.6% 3.5% 2.0-3.0 6.5% 5.5% 4.0% 2.3% 3.0-4.0 3.0% 2.7% 2.1% 1.3% Greater than 4.0 4.3% 4.0% 3.5% 2.4% 0.7 Less than 1 76.4% 86.2% 91.1% 95.2% 1.0-2.0 11.3% 5.1% 2.7% 1.2% 2.0-3.0 4.5% 2.8% 1.8% 1.0% 3.0-4.0 2.3% 1.6% 1.1% 0.6% Greater than 4.0 5.5% 4.3% 3.2% 2.0% 0.9 Less than 1 83.2% 92.4% 95.2% 97.4% 1.0-2.0 7.2% 2.3% 1.2% 0.5% 2.0-3.0 3.0% 1.3% 0.8% 0.4% 3.0-4.0 1.7% 0.8% 0.5% 0.3% Greater than 4.0 4.9% 3.2% 2.3% 1.3% Notes: Calculated using 100,000 simulated paths of Brownian motion, where a 3 year term was divided into 1,000 discrete intervals. We used a risk-free rate of 2.0%. May 2011 Business Valuation Update 9

One Solution To The Option Pricing Overvaluation Problem Option Value Option Value $40 $35 $30 $25 $20 $15 $10 $5 $0 $40 $35 $30 $25 $20 $15 $10 $5 $0 Figure 3. Option Prices (with Rebates) by Strike Price and Barrier Level Panel A: Volatility = 0.3 Panel B: Volatility = 0.5 Black-Scholes 50% DOC 65% DOC 80% DOC $15 $23 $31 $39 $47 $55 $63 $71 $79 $87 $95 $103 $111 $119 $127 $135 Strike Price Strike Price Panel C: Volatility = 0.7 Panel D: Volatility = 0.9 $15 $23 $31 $39 $47 $55 $63 $71 $79 $87 $95 $103 $111 $119 $127 $135 Strike Price Black-Scholes 50% DOC 65% DOC 80% DOC Notes: Option values calculated using a current price of $50, a risk-free rate of 2%, and a term of 3 years. We account for liquidation preferences by adding a rebate equal to max(barrier-strike price,0). This causes the kink in each graph around the barrier level. Option Value Option Value $40 $35 $30 $25 $20 $15 $10 $5 $0 $50 $40 $30 $20 $10 $0 Black-Scholes 50% DOC 65% DOC 80% DOC $15 $23 $31 $39 $47 $55 $63 $71 $79 $87 $95 $103 $111 $119 $127 $135 $15 $23 $31 $39 $47 $55 $63 $71 $79 $87 $95 $103 $111 $119 $127 $135 Strike Price Black-Scholes 50% DOC 65% DOC 80% DOC it is consistent with observation that investors tend to intervene frequently when the situation is deteriorating, and they seldom will simply let the company go along without such intervention. Second, as volatility rises, the percentage of cases where the exit multiple was less than one rises sharply for all cases. The implication of these results is that a BSM, by not incorporating the option of the controlling investors to pull the plug early or force other changes, will tend to overvalue the upside potential. Consequently, using an OPM without barriers will (a) overstate estimated value of the company in a back-solving model, and (b) overstate the value of the least preferred shares common stock in an allocation context. Note further that this methodology could easily be extended to allow for upside barriers (i.e., allowing for the home run ) as well as downside barriers. One could think of our model as being the continuous analogue to the probability weighted expected return method (PWERM), where the upper and lower thresholds are chosen to represent the home run and failure scenarios, respectively. Barriers and Control In the context of business valuation using a DOC or BSM, determining the appropriate barrier becomes a key factor in either estimating the value of the firm s equity based on a recent investment or in allocating value among classes of equity. If the barrier is set at zero, the DOC result collapses to the BSM value. In our view, the magnitude of the barrier can be linked with the degree of control held by investors, 10 Business Valuation Update May 2011

One Solution To The Option Pricing Overvaluation Problem particularly the most recent investors. In cases where the investors have significant control, they are more likely to set a higher barrier, whereas when they have no control, the barrier may approach zero. To illustrate this point, consider preferred shareholders in a Series A round who have been granted a high level of control. Those shareholders will be more likely to act in situations where the value of the firm is dropping: they might change management, force a change in product development or business model, force a liquidation, or demand a greater share of equity in restructuring associated with new financing. In any of these cases, the DOC approach would recognize that on those paths where the company is spiraling downward, the investors are likely to act before value drops to zero. In the case of no control, on the other hand, the investor may have no recourse if the company is heading toward failure other than to not reinvest. In that case, the DOC would have a zero barrier and the model would collapse to BSM. Intuitively, setting a non-zero barrier implies that investors value the control options they receive, recognizing that they have some ability to minimize losses if the company appears headed for failure. When using the barrier option pricing model for early-stage equity valuations, practitioners must determine how the value of the firm should be allocated when the barrier is imposed. The simplest possible assumption would be that the company s assets are liquidated, with the proceeds from the sale (equal to the value of the firm) distributed among the stakeholders according to the payoff matrix. This approach is easy to implement by adding a rebate equal to each tier s payoff in the event of a liquidation worth the barrier amount. As an example, consider a company that is currently worth $5 million. Let Series B stakeholders In the case of no control, on the other hand, the investor may have no recourse if the company is heading toward failure other than to not reinvest. have a claim on the first $2 million in the event of a liquidation and Series A stakeholders have a claim on the next $5 million. Above $7 million, both series would convert to common stock. If the barrier is $2.5 million, Series B would have a barrier option with rebate of $2 million while Series A would have a rebate of $0.5 million. Common stockholders and any other lower priority claims would receive no rebate. 7 Figure 3 demonstrates the impact of the barrier on the resulting option prices, assuming a current price of $50, a risk-free rate of 2%, and a term of three years. If the strike price is less than the barrier, we add a rebate equal to the difference between the barrier and the strike price in order to account for liquidation preferences. One can observe that values of options with higher strike prices (i.e., common stock) are monotonically decreasing with respect to the barrier level, and the effect of the barrier becomes more pronounced as volatility increases. Impacts of DOC on Valuing Common Stock BSM approaches are frequently used in business valuation both to infer the value of a company based on a recent investment and to allocate value among classes of equity. The use of the DOC approach directly impacts both of these uses. In the case of back-solving, in which a recent financing transaction is used to infer the value of the company, the BSM takes into consideration the economic claims to value received by the most recent investors. By taking into account those rights, the BSM approach can calculate the market value of equity of the firm that would 7 It is also straightforward to use the model to allow for the possibility that the firm s assets can only be sold for a fraction of the barrier value in the case of liquidation. One simply needs to modify the rebate amounts accordingly. May 2011 Business Valuation Update 11

Report from ACG: Transaction Costs and Risks Rise, Buyers Change justify the value they invested given the rights they received. 8 However, by ignoring the additional rights, such as those to intervene and change directions of the company in certain adverse situations, represented by a barrier option, the BSM overvalues the company by undervaluing the barrier option to that class. In the case of a DOC, the company will need to have less value to justify the investment if the investor has more control rights, since the investor with those rights places value on the ability to make changes if conditions deteriorate. Consequently, if there is greater control given to the investors, the backsolved value for the company will be lower than one in which there is little or no control. 8 The OPM approach incorporates economic rights for each class, but does not directly include other control features, such as participation on the Board and the ability to force changes in management or force a sale. In the case of allocating value, a DOC model will allocate a greater proportion of value to more preferential claims. The DOC allocates value to the additional option granted claimants with higher priority who can exercise control. The higher priority claims get the additional value allocated to them associated with the DOC option, and less is allocated to the lower priority claims since they do not have the control residing with the highest priority claimants (and in fact may be the victims of actions taken by the higher priority claims, as in a cram down ). Consequently, use of a DOC model will result in less value being allocated to the common than when using a standard BSM. Ronald Schmidt, Ph.D., AVA, is CEO of Schmidt Associates, LLC, and Lawrence Schmidt, M.A., is a senior consultant for Schmidt Associates and a Ph.D. student at UC San Diego. Report from ACG: Transaction Costs and Risks Rise, and Buyers Change BVU has attended three of the major intermediary meetings in the last several months, beginning with the IBBA and AM&AA annual meetings. But the dean of the group is InterGrowth, held last month in San Diego. This is the largest gathering of members and leaders of the Association of Corporate Growth (ACG). Different market segments, different messages. At the most general level, IBBA members deal with the smaller main street deals, AM&AA members focus on the lower end of the middle market, and ACG members include the VC s, private equity, and I-bankers who drive upper middle market M&A activity. So it s no surprise that the IBBA membership is suffering and many are leaving the business; the AM&AA membership is struggling but hopeful, and the ACG membership believes that boom times have returned. This reflects the North American economy generally PitchBook and many others confirm that more and more investment capital continues to pour into private equity firms (those institutional investors have to do something with their money) but have you tried to get a loan for your corner restaurant in the last three years? If you haven t been to an ACG meeting recently, it s an impressive affair. Good suits and good haircuts abound; these are the private market buyers, sellers, funders, and brokers for some of the biggest deals in the country, so the tone of success is strong. There are more networking meetings on the agenda than there are educational sessions, and the large law, private capital, and CPA firms who are key sponsors to the ACG invest a lot to reach these movers and shakers (note: BVR s partners PitchBook and Duff & Phelps were waving their flags strongly too). The ACG s motto is Driving Middle Market Growth, and BVU readers who want to build their PPA or M&A valuation practices would benefit from attending either local or national meetings of the association. Here are some of the trends from the intermediary events BVU covered this spring, 12 Business Valuation Update May 2011

Report From Acg: Transaction Costs And Risks Rise, And Buyers Change particularly from the movers and shakers at the ACG Intergrowth session trends that influence the best practices in business valuation: Strategics are paying more. Many of the discussions BVU shared confirmed that strategic buyers are often the highest bidders if they can see a clear synergy. You re seeing some high multiples to EBITDA or return on acquired assets from these buyers, one private equity manager told BVU. They re paying for future earnings like the old days. That being said, PE firms are laden with cash. The time of PE firms hunkering down is past. First, as PitchBook reported, total cash flows to major PE firms since 2002 are cash positive; they ve brought in over a trillion dollars in investment funds, and only distributed $750 billion. In addition, PE firms sold and took losses last year. Said one ACG attendee, for example: Our PE firm was an active seller in 2010, but now we have cash and we re on the other side of the table. Bidding has increased, so sellers are starting to control deal terms again. In the last year we re avoiding seller notes, a partner from a big Philadelphia law firm told BVU. Buyers are demanding all cash and, for the most part, getting it. Is there still room for contingent terms in negotiations? Another investment banker said, Yes, but the contingencies are looking more like the last creative options to give the deal the final carrot for sellers who stay on. The ACG s motto is Driving Middle Market Growth, and BVU readers who want to build their PPA or M&A valuation practices would benefit from attending either local or national meetings of the association. as everyone at intermediary meetings is fond of saying) or preferred stocks are diminishing. Competition for deals is tough, but at least the financing terms are simpler than they had been, another AM&AA attendee said. Lenders are looking at smaller deals again. On the lender side after too much exuberance followed by two years of withdrawal, middle market lenders are at least coming back to the table and will consider the smaller transactions that make up the vast majority of dealflow again. You may get restrictive terms but at least the lenders aren t locking their doors when they hear you have a deal with less than $5 million EBITDA, a business broker at ACG told BVU. Even mezzanine financing at perhaps 12% cost of capital has returned for smaller deals. It s very active now in the less than $10M EBITDA market. The stable mezz lenders are definitely back. If the senior piece is less than $5M, with the mezz, you re seeing 11.5% to 12% all in. LIBOR floors are still there, but a banker who spoke on financing at ACG predicts they ll start to go away as the recovery extends. Industry is even more of a factor than it has been. Despite the optimism of the two points above, all bets are off if an industry is unfamiliar or problematic: senior lenders aren t attracted, and mezz pricing goes through the roof. It becomes necessary to find the specialized lenders who work only in these industries. Lower middle market deal financing is less complicated. A number of ACG buyers said that they were doing deals with affordable coupons, often free of warrants, so complications like mezzanine financing (or mezz, Transaction effort, and cost, is increasing. A number of new issues can affect value. First, there s increasing business regulation, which makes due diligence in those industries more costly than ever. Second, May 2011 Business Valuation Update 13

Report From Acg: Transaction Costs And Risks Rise, And Buyers Change many people commented that the beginning transition of baby boomer family businesses means high costs for non-competes, key employee lockdowns, key customer contract negotiations and just managing the emotional issues of a family transition. There s a class of companies run by baby boomers who do not have family members ready to take it to the next level, and these transactions are beginning to percolate, said one attendee in San Diego. Small business unionization is a final issue that increases transaction costs and risks, several people commented. More businesses are passthroughs, so asset transfers are even more common. So many of the small companies formed in the last 20 years are LLCs and S corps these companies are now coming to market. Customer concentration and seasonality seem to be more common. There s often one customer that causes all the EBITDA, or you have a company that s done 60% of the business in the first nine months, but no business in the final three that s always a worry. The lawyers keep running up bills on the same topics. You can expect the same negotiations on escrow (the buyers want 18 to 24 months and the sellers want zero to 12 and the lawyers battle over whether it turns out to be 5% or 20% of deal value). And costly legal negotiations about indemnification caps (still most frequently in the 10% to 50% range after all the legal wrangling every time) continue, particularly for fraud, where all bets are off these days, in the words of a lawyer at the AM&AA meeting earlier this year. Deductibles on escrow are 1% to 2%, typically, but these points are being fought as strongly as ever. One bit of advice from a PE firm director go for a true deductible to avoid arguing over little stuff. Don t expect lower transaction costs just because it s a smaller deal. For middle market companies, you may be dealing with compiled statements or even worse. The top accounting person is a spouse. This means that the quality of earnings team will require higher-level staff. As one ACG attendee explained: We delegate bigger deals to more junior staff working off a checklist there s a CFO, audited statements, and all the stuff you d expect to see. In the smaller deals, you may have to explain GAAP. And, you have systems that don t correlate. The GL may not match the AR system, or you may not have any way to measure product line profits, typically. Gross margins by product may be so far beyond the capabilities of the accounting staff that it s not worth asking. Carveouts of bigger companies are a bigger part of the dealflow now. One of the hardest analytical parts of carveouts is that you re dealing with accounting allocations, all of which need to be replaced by standalone costs. Uncoupling of assets, particularly human resources, is hugely time consuming. And uncoupling brands with transition services agreements takes a ton of service times. Corporate parents are also very tough on reps and warranties, so expect higher legal costs if nothing else. Private equity firm registration will put more pressure on due diligence teams. The Dodd-Frank Act includes a provision requiring private equity funds with more than $150 million in total assets under management to register with the SEC. This requirement is scheduled to begin in July 2011, though, as usual, the SEC may push off implementation of this rule for one year. Not surprisingly, the ACG has come out strongly against this provision. BVR s Industry Transaction & Profile Annual Report on HVAC Companies Includes industry overviews, HVAC company profiles, trends and forecasts and actual transaction reports with ratios and multiples. $249 (+ $9.95 S&H) www.bvresources.com/publications 14 Business Valuation Update May 2011

Let s Build On The New Nacva/iba Standards Unification Let s Build on the New NACVA/IBA Standards Unification By Ed Dupke, Mark Hanson, and Nancy Fannon Business valuation standards provide guidance to practitioners on practice issues and the application of valuation techniques. Perhaps more importantly, however, standards are necessary to uphold, maintain, and support the interests of users. Each of the U.S. s four primary valuation organizations has had its own set of professional standards. Members of NACVA and the IBA have recently agreed on a unified set of business valuation standards that are principles-based and compatible with the Statement on Standards for Valuation Services 1 (SSVS1), the valuation standards of the AICPA released in 2007. Each organization plans to have implementation guidance to support the standards, which will be effective June 1, 2011. Evolution of Unification Efforts by Appraisal Organizations Each of the U.S. s four primary valuation organizations has had its own set of professional standards. In 2000 and again in 2004, the Appraisal Foundation solicited input from business valuation credentialing organizations regarding USPAP (Uniform Standards of Professional Appraisal Practice) changes by creating the Business Valuation Professional Task Force. Representatives from the AICPA, ASA, IBA, and NACVA provided comments and recommendations to the Appraisal Standards Board on changes to the business valuation standards of USPAP. Successful Unification of NACVA and IBA Standards The feasibility and desire to move to a common set of industry standards was also discussed in other meetings such as the 2008 AICPA/ ASA Business Valuation Conference. This most recent effort was prompted by discussions between Parnell Black, CEO of NACVA, and Howard Lewis, executive director of IBA. Standards unification has been addressed in some form over a number of years. During the 1990s, an ASA business valuation pioneer, Jack Bakken from Colorado, assembled a group of practitioners from ASA, AICPA, NACVA, IBA, and the CICBV to discuss valuation standards. Jack named the practitioner group CLARENCE. He described the group as a Coalition of Loyal Associations, Resource Exchanging, but Not Communicating Elsewhere. (Jack, please forgive us if we have some of the terminology mixed up). The overriding focus of the CLARENCE group meetings was that our organizations had much more in common than in competition. It was this group that produced the now commonly referenced International Glossary of Business Valuation Terms. Many of the accredited members of both NACVA and IBA are also certified public accountants (CPAs). A conscious effort was made by NACVA and by IBA to have their common professional standards be in conformity with SSVS1. It is our belief that the unification and resulting conformity with AICPA will enhance clarity for both preparers and users of valuation reports. If a valuation analyst adheres to either of these two sets of professional standards in performing the valuation or calculation engagement, then the valuation analyst will likely be in compliance with both sets of standards. Standardization by Other Interested Parties Professional valuation organizations have not been the only groups interested in standardization. The IRS, FASB, and the SEC have all May 2011 Business Valuation Update 15

Let s Build On The New Nacva/iba Standards Unification considered and commented on guidance for the process of valuing a business. The Internal Revenue Service released the IRS Business Valuation Guidelines in 2006. Still in effect today, these guidelines, developed with reference to the available sets of standards from the various appraisal organizations, were designed to improve the consistency and enhance the quality of valuation reports throughout their program. Recently, the IRS issued Internal Revenue Code Sec. 6695A, which provides guidance on the administration of the penalty process for substantial and gross valuation misstatements attributable to incorrect appraisals. In 2007, the Financial Accounting Standards Board (FASB) considered whether and how it should get involved in providing valuation guidance for financial reporting. The FASB issued an Invitation to Comment on Jan. 15, 2007, which included questions assessing the need for valuation guidance and the level of participation existing appraisal organizations should have in the process. Some of their constituents believed that existing appraisal organizations should not have a role in establishing valuation guidance for financial reporting issues because they are the principal individuals or organizations applying the guidance, which creates a conflict of interest. Others believed that existing appraisal organizations should set the principal standards because of their experience. In addition, the Securities and Exchange Commission has been active in commenting on the The development team should include not only valuation analysts from the collective North American organizations, but also Appraisal Foundation representatives and international valuation experts. BVR s Industry Transaction & Profile Annual Report on Auto Dealerships Includes industry overviews, dealership profiles, trends and forecasts and actual transaction reports with ratios and multiples. $249+S&H www.bvresources.com/bvstore importance of standards and the standard-setting process. The SEC notes that standards must be crafted in the interest of investors, and that the standard-setting process must be transparent, objective, and consistently applied. In recent years, there has been much discussion in the valuation profession about international business valuation standards. Such international standards would be similar to the effort currently under way to develop International Financial Reporting Standards (IFRS). The focus of this discussion on international business valuation standards is primarily on fair value financial reporting rather than on the broad spectrum of business valuation work performed in North America. Where do we go from here? In order for these financial reporting-related valuation standards to succeed, the development team should include not only valuation analysts from the collective North American organizations, but also Appraisal Foundation representatives and international valuation experts. In addition, this development effort should include auditors, preparers of financial statements, and users of financial statements, ensuring that all interested parties are represented. On the positive side, the similarity of the NACVA/ IBA valuation standards and the AICPA valuation standard is a testament to the efforts these organizations have made in the development process. Such efforts provide strong encouragement for the valuation profession moving forward. Edward J. Dupke CPA/ABV, CFF, ASA, is a senior consultant at Clifton Gunderson LLP in the firm s Phoenix office. Mark A. Hanson, CPA, CVA, ABV, is a shareholder with Schenck Valuation & Litigation Support Services in Appleton, Wisconsin. Nancy J. Fannon, ASA, CPA/ABV, MCBA, is the owner of Fannon Valuation Group, a business valuation and litigation support services firm in Portland, Maine. 16 Business Valuation Update May 2011

Impact Of Government Contracts On Subject Company Risk Impact of Government Contracts on Subject Company Risk Companies that generate a large part of their revenues from the federal government have different characteristics than those that don t particularly regarding risk factors. BVU asked Dan Golish, CPA/ABV, CVA, CFF, of Skoda Minotti about engagements in this market segment. BVU: What are some of the unique factors that you should consider when valuing these types of companies? Dan Golish: Most of the firms we ve valued in this category are consulting firms, such as information technology (IT) firms, or engineering firms, that provide mission-based or project-based consulting services. But there are all types of firms that fall into this category manufacturing or otherwise. So the first challenge, as with any valuation engagement, is that you really have to understand the nature of the business you are valuing. As we valuation practitioners are well aware, consulting work is generally project-based, so there is an additional risk factor due to the uncertainty of consistent work. But the interesting dynamic we ve found with government contractors is that there is a lot more stability in revenues because there are long-term budget-based contractual agreements. Many firms are able to secure longer-term contracts with the government and can lock in future cash flows, which has a very meaningful downward impact on the discount rate. In the traditional consulting world, you may have a specific company risk rate in the 5% or 10% range due to the uncertainty in future cash flows associated with the project-based nature of the business. With government contractors, the specific company risk can be much lower as that uncertainty in cash flows is much less significant. I ve even seen people argue for a negative specific company risk, so it s just a matter of The relationship between the government and the contractor is so tight that the government is unlikely to shop the work because the current contractor has such significant internal knowledge. the level of stability of future cash flows and the expectation of that benefit. So that s one of the bigger challenges. On the other hand, there is risk associated with the concentration in a single source of revenue. The federal government is a very reliable customer it typically pays its bills. But budgets change with new administrations, so in election years you have to contemplate risk a little bit differently than you would in nonelection years. Thus it is important when you are putting together projections that you consider that concentration in a primary customer and that customer s ability to pay. And, if things change, such as when a new administration takes office, actual cash flows can be very, very different from what may be projected under the current administration. Another consideration is the barriers to entry, which can vary depending on the nature of the work. Some firms offer services that are highly classified in nature. The relationship between the government and the contractor is so tight that the government is unlikely to shop the work because the current contractor has such significant internal knowledge. These barriers to entry can really drive down the risk rate and, in turn, drive up the value of the business. In addition, the subject company typically needs to have very sophisticated and educated personnel, along with great relationships, to get those projects with high authorization levels. Depending on the nature of the work, the required security clearance levels can vary. While some government contractors may only generate modest cash flows, there can be meaningful value in these businesses due to strong backlogs, stability in earnings, and high barriers to entry. These factors really drive down the risk rate, resulting in higher values. May 2011 Business Valuation Update 17

Impact Of Government Contracts On Subject Company Risk BVU: How long is the typical government contract? DG: We valued one firm that had locked in over 90% of its projected revenue for the next three years. As I mentioned, this really drove down the risk rate because there was so much stability in the expected cash flows. One might argue that, from a risk perspective, ownership interest in a business with such stable cash flows more closely resembles a bond than an equity interest! We ve also valued firms with shorter year-to-year contracts. In many cases, there are still longstanding relationships between the key decision makers at the subject company and the relevant decision makers in the government. Such a scenario, while not necessarily creating a significant backlog, can still result in a lower risk rate. We have to be more mindful of government budgetary concerns in these situations, however, because the nature of the relationship is not contractual. This leaves more exposure to uncertainty in cash flows due to changes in budgets. On balance, however, these relationships generally create more stability than your typical business or consulting firm. BVU: How important are government budgets when developing projections? DG: We ll consider the budget in as much detail as we can, particularly when we are applying a projected cash flow methodology. What is more important, though, is that management s projections are realistic and they can back up those projections with support in the form of explanations, documentation, or other. We will ask management tough questions if we need to, like how are you going to sustain X% revenue growth from now until 2015? They may respond by saying they have 96% of their revenues for that period locked in and all they need to do is sell a little more and we can believe that, especially if they have shown Many times when we value a typical company using projections, we ll add a meaningful component to the risk rate simply because we are using projections, depending on how aggressive those projections are in light of past performance. this to be attainable using historical results. But where it gets interesting is as you move down the income statement what happens to margins over that period? A lot of the employees for these firms are highly educated professionals, and if the company is highly profitable, there may be more demands on salary expense, benefits, and so forth. You can get a lot of volatility or noise in the margins depending on how you look at it. Government spending certainly has an impact on a company, but in our reports we speak to the issue in more general terms, such as more spending is expected and therefore we re going to have a marginal decrease in the risk rate from a specific company or industry perspective. We really try to capture that concept in the cash flows that we use if we can, rather than playing too much into that black box of a risk rate. In some scenarios, however, the cash flows are not locked in, and thus you have no choice but to use the risk rate. The way that we contemplate the speculative nature of projections in our risk rate is key. We often anticipate that management is overly optimistic with their projections because they ve locked in contracts. It is not unusual, however, to find that they re often quite conservative because they only consider what they ve locked in and not any additional sales efforts they might implement. Therefore, these projections are pretty sound, which is not common in our experience in other industries. Many times when we value a typical company using projections, we ll add a meaningful component to the risk rate simply because we are using projections, depending on how aggressive those projections are in light of past performance. We just see that there s some inherent risk with using that methodology due to the speculative nature of projections. We ll add a little bit of risk on most cases, but we wouldn t be as likely to do so in the case of a government contractor if it has contracts to back it up or a meaningful backlog, because we have found that 18 Business Valuation Update May 2011

Sources of International Reports on Economies and Industries there s more precision in projections for government contractors than other industries. BVU: Can you use the market approach? DG: You can apply a market approach, but we always focus on the nature of the business first and make the government contracting component secondary. We haven t had a lot of success finding a lot of comparables. There are transactions out there, but you have to be very careful with the multiples and make a compelling argument as to why you think they are comparable. Say you can find 15 comparable transactions in IT consulting. You can work off a median, then move the needle off of the median based on the qualitative and quantitative analysis you ve performed, such as considering the barriers to entry and the company s stability and earnings performance. It is most common for us to use the market approach as a sanity check as opposed to a primary indicator of value in these engagements. We still believe expected cash flows provide the most meaningful indictor of value in this industry. BVR: What words of advice do you give to someone who has never valued this type of company before? DG: Valuing a company that generates most of its revenue from government contracts requires a different perspective the perspective by which you apply a risk rate and related benefit stream. You need to do your homework on the industry, understand the line of work that they re in, and don t forget about the reality of concentrations and backlogs and what they do to the value of a business. Sources of International Reports on Economies and Industries Valuation practitioners preparing reports for businesses with operations outside of the United States need industry and economic data. BVU staff pulled together some of the best sources of international industry and economic data. While it is not a comprehensive list, the sources serve as a good starting point for your research. Some of this data is available for free; however much of it is for a fee. Business Monitor International (BMI) www.businessmonitor.com UK-based BMI is a leading provider of proprietary data, analysis, ratings, rankings, and forecasts covering 175 countries and 22 industry sectors. Industry reports contain analyses, 5- and 10-year industry forecasts, and competitive intelligence on leading multinational companies. Report examples: Algeria Agribusiness Report and Belgium Oil & Gas Report Datamonitor www.datamonitor.com The Datamonitor Group is an established provider of premium global business information for the following industry groups: automotive, consumer packaged goods, energy & sustainability, financial services, logistics & express, pharmaceutical & healthcare, retail, sourcing, technology and telecoms. Report examples: Construction & Engineering in Italy and Control Systems Industry Profile: Asia-Pacific Economist Intelligence Unit (EIU) store.eiu.com/ From the publisher of the Economist, the EIU provides country analysis and forecasts for over 200 countries. Each report highlights political, May 2011 Business Valuation Update 19

Sources Of International Reports On Economies And Industries economic, and business developments in all significant markets, both established and emerging. The EIU also publishes analysis, data and forecasts for six key strategic industries and 26 subsectors. Reports are available through the Online Store. Report examples: Consumer Goods and Retail Forecast Finland and Automotive Report Mexico. Factiva www.factiva.com Owned by Dow Jones, Factiva.com provides articles from more than 28,500 global news and information sources from 200 countries in 25 languages. Sample publications: ISI Emerging Markets Africa Wire and Valor Economico Freedonia Group www.freedoniagroup.com Since 1985 the Freedonia Group has been publishing industry research studies. Each report contains analysis on market forecasts, industry trends, threats and opportunities, competitive strategies, market share determinations and company profiles. Report examples: World HVAC Equipment to 2012 and World Emulsion Polymers to 2014 Organisation for Economic Co-operation and Development (OECD) www.oecd-ilibrary.org The OECD ilibrary is the gateway to OECD s analysis and data and contains all the publications and datasets released by the OECD, International Energy Agency (IEA), Nuclear Energy Agency (NEA), OECD Development Centre, PISA (Programme for International Student Assessment), and the International Transport Forum. The ilibrary is a subscriptionbased service and requires proper access to view some full-text titles, but many content areas are freely available to any site visitor, such as the OECD Factbook, Working Papers, OECD Key Tables, and more. Example of data series available: Wheat production by country and World prison population rate World Bank data.worldbank.org/ The World Bank provides profiles for over 200 countries and economies and data for over 1,200 economic indicators. Most indicators cover several decades. Get These Library Essentials for Valuing Intellectual Property... Licensing Trade Secrets: Overview and Sample Agreements $299.00 (+$9.95 S&H) Royalty Rates in Copyright Agreements: A Guide to Full-Text Licensing Agreements $595.00 (+$9.95 S&H) Royalty Rates in Biotech: BVR s Guide to Full-Text Licensing Agreements $595.00 (+$9.95 S&H) BVR s Guide to Intellectual Property Valuation $199.00 (+$9.95 S&H) View Table of Contents & Order Today at: www.bvresources.com/ip Or contact BVR at: (503) 291-7963 or (888) 287-8258 20 Business Valuation Update May 2011

Insignia Systems, Inc. V. News America Marketing In-store, Inc. Legal & Court Case Updates After Passing Daubert, Lost Profits Expert May Have Won Settlement for Client Insignia Systems, Inc. v. News America Marketing In-Store, Inc., 2011 WL 167259 (D. Minn.)(Jan. 14, 2011) This is the second case we ve covered against News America Marketing, a subsidiary of News Corp. (owner of the Wall Street Journal and Fox television network). In both cases, the plaintiffs competed with News America in the in-store marketing industry and claimed millions of dollars in lost profits due to unlawful disparagement and antitrust violations. After failing to exclude the plaintiff s damages experts under Daubert in the first lawsuit, Floorgraphics, Inc. v. News Am. Mktg. In-Store, Inc., 546 F.Supp.2d 155 (D. N.J. 2008), the defendant paid $30 million to settle all claims. (For the digest of the federal court s Daubert opinion, see the April 2008 BVU.) Defendant tries Daubert again. In this latest case, the plaintiff s lost profits and economic damages expert estimated that the defendant s anti-competitive behavior caused losses ranging from $121 million to $214 million. The expert used two approaches to estimate damages. Under the first, he measured the adverse impact of the defendant s bad acts on the plaintiff s going concern value by selecting a cohort of publicly traded firms to serve as a proxy for the plaintiff s market performance and market capitalization. The firms were from various industries, but were similar to the plaintiff s size, performance, and market cap prior to the defendant s alleged harm. Under his second approach, the expert broke down the damages into categories of harm, such as lost profits on lost sales, lost profits on actual sales due to increased costs, and incremental cost incurred because of the destructive acts. To calculate these losses, the expert asked plaintiff s management to provide its best estimates of the company s future performance during the loss period (late 2002 through early 2003). These resulted in conservative damages estimates, the expert said, because they assumed the plaintiff was not adversely impacted prior to the loss period. Before trial, the defendant challenged the expert s evidence under Daubert on numerous grounds, including: 1) his market approach failed to use truly comparable companies and failed to account for alternative causes of loss; and 2) the projections he relied on to calculate lost profits came from biased and unverified sources. To defend against these charges, the plaintiff s expert noted that in a market with so few players, it would make little sense to compare the plaintiff s performance against competitors that were not affected by the defendant s antitrust violations. Nevertheless, he submitted a supplemental report, which recalculated damages by using a different set of comparable companies, including advertising businesses and firms that physically placed ads in stores. The resulting damages estimate ranged from $195 million to $207 million, or within the estimated range of his first report. In short, the expert said, his estimates were not overly sensitive to the composition of the comparables... and there is no justifiable reason to prefer [this second set] to my original set. The law is clear that comparable companies must be as similar as possible, the court held. However, in this case, the expert s rebuttal report compared the plaintiff to companies in the same market and found similar results to his comparison with firms in various markets, and his analysis met the legal standard, the court held. Confusing correlation with causation. At the same time, the expert s comparable companies analysis attributed the entire amount of the plaintiff s market losses to the alleged misconduct. A more obvious, alternative explanation would be the company s disappointing fourth quarter earnings in 2002, which were released in February 2003, followed by a 28% drop in stock price. Yet May 2011 Business Valuation Update 21

In Re American Home Mortgage Holdings, Inc. in his report, the expert maintained that this very pronounced abnormal loss occurred at the same time as the defendant s disparagement, and the record does not indicate that there were any other factors that would have been associated with such significant losses. This is a strange statement, the court observed, since it seems clear that it is at least possible that a poor earnings report could cause a drop in stock price. The expert s comments and conclusions in his report lent credence to the defendant s claims that he might have confused correlation with causation. However, the expert s determinations were within his purview to make, the court said. Although the expert could have considered a poor quarterly report, he was not required to do so. The wisdom of such decisions is best challenged on cross-examination, the court held, and admitted his market approach as reliable and likely to be helpful to the jury. Turning to the expert s reliance on management projections, the court found that they were based on the company s typical budgeting process and the best estimates of experienced personnel. Their optimistic forecasts predicting revenue increases more than five times any prior increase were supported by an institutional report that predicted a significant, multiyear revenue and earnings ramp of 40% to 50% per year. The expert also vetted the projections and their assumptions and rejected the aspects that he could not verify. Given these facts, any alleged bias in the figures could be tested on cross-examination, the court held, and admitted the expert s lost profits conclusions. Ignoring inconvenient evidence. As a final matter, the defendant claimed the expert s damages estimates were flawed by his failure to account for various economic realities and other inconvenient evidence, such as customer demand, increasing competition, and the presence of exclusive vendors. Essentially, the defendant was arguing with how the expert did his analysis and what factors he should have considered, the court said. These arguments may have been relevant, but they went primarily to the weight and not the admissibility of the expert s evidence and could be explored more thoroughly at trial. The court also held that the expert did not have to disaggregate damages to fit the various claims of the case. In an antitrust case, so long as some of the alleged acts support damages, an award will be sustained, the court said. Moreover, in this case, the expert s rebuttal report provided a specific way to allocate the plaintiff s losses between its disparagement claims and its antitrust claims. Any objections to his method were better suited for cross-examination than exclusion, the court held, and denied the defendant s Daubert challenge in full. Editor s note: Less than a month later, after the parties made their opening statements at trial but before the presentation of evidence, the defendant settled the lawsuit for $125 million. (See www.bloomberg.com/news/print/2011-02-09/ news-corp-pays-125-million-to-settle-insigniasuit-ending-federal-trial.html.) 3rd Circuit Confirms DCF to Value Mortgage Portfolios in Dysfunctional Markets In re American Home Mortgage Holdings, Inc., 2011 WL 522945 (C.A. 3 (Del))(Feb. 16, 2011) The numbers in this bankruptcy case are staggering: In 2006, the debtors sold 5,700 mortgage loans worth $1.2 billion pursuant to a repurchase ( repo ) agreement. Less than a year later, the debtors defaulted under the agreement and the participant accelerated the debtors repurchase obligations, claiming over $478 million in damages under Sec. 562 of the Bankruptcy Code. In particular, Sec. 562(a) provides that if a participant accelerates a repo agreement, then damages are measured as of the acceleration date; if there are no commercially reasonable determinants of value available on that date, then damages are measured on the earliest subsequent date on which such determinants become available. The participant argued that Sec. 562 22 Business Valuation Update May 2011

In Re American Home Mortgage Holdings, Inc. permits only the market or sale value to measure damages; since there was no active (or functional) market available on the 2007 acceleration date, then damages should be measured as of August 2008, the earliest date when it could have obtained a reasonable sale price for the loans. In response, the debtors claimed that a commercially reasonable determinant of value namely, the discounted cash flow (DCF) method existed on the acceleration date. Under this method, the value of the loan portfolio exceeded the repurchase price and therefore no damages were due. The federal bankruptcy court (Delaware) agreed with the debtors, and the loan participant appealed to the U.S. Court of Appeals for the Third Circuit. (For the digest of the bankruptcy case, see the December 2009 BVU.) An issue of first impression. Although the amounts at stake were dazzling and the issue was one of first impression in the jurisdiction, the Third Circuit found that the issue came down to fairly routine statutory construction namely, whether Sec. 562 permitted the use of any commercially reasonable valuation method to determine damages after the rejection and/or acceleration of a repo agreement. The parties refocused their claims on appeal. The centerpiece of the participant s argument was that a market or sale price is the only reasonable determinant of value permitted by Sec. 562. Since all the parties (and the bankruptcy court) agreed that the secondary mortgage market was dysfunctional on the acceleration date, it would not have been reasonable to sell the portfolio at this time. Instead, the earliest possible resale date would have been August 2008. At that time, the loans would have been worth 10 cents to 50 cents on the dollar, according to the participant s expert, resulting in the $478 million deficiency (damages) claim. The debtors agreed that reliance on market value was not commercially reasonable on the acceleration date but claimed that other commercially reasonable determinants of value were available at the time. In fact, its expert testified that the DCF methodology was particularly apt at valuing debt instruments such as mortgage loans, because the owner holds the assets for the cash flow, not for the distress sale in the market. To value the entire portfolio as of the acceleration date, the expert determined the DCF value of the individual mortgages, adjusting the individual interest rates to reflect market conditions and actual delinquency rates. Under this approach, the expert concluded the portfolio was worth $1.067 billion to $1.66 billion, depending on whether servicing rights were included. Since the entire range of value exceeded the repo price on the acceleration date, no damages were due. Preventing a moral hazard. The Third Circuit reviewed the parties evidence as well as the bankruptcy court s reliance on the first principles of statutory construction. The appellate court agreed that the primary purpose of Sec. 562 was to preserve liquidity in the relevant assets and to align the risk and rewards associated with investing in them. Importantly, the statute seeks to avoid the moral hazard that would result if damages were measured at any other time than as of the acceleration date, such that the repo participant could hold the assets at little or no risk while the debtor became the insurer of the risk despite having no management or control over the assets. Moreover, as the bankruptcy court noted: There is nothing in Sec. 562 that would imply a limitation on any methodology used to determine value, provided it was commercially reasonable. Indeed, the use of the word determinants suggests just the opposite that any commercially reasonable valuation may be used. The Third Circuit agreed with this reasoning, its concern with preventing a moral hazard as well as its confirmation that the DCF method fell within the statute s provision for reasonably commercial determinants of value. It also found that the bankruptcy court had honed in on the intrinsic flaw in the participant s case: i.e., that it never intended to sell the loans, and indeed had retained the portfolio as well as its income. Finally, it agreed with the debtors arguments. By interpreting Sec. 562 to permit a valuation methodology other than sale value (in a dysfunctional market), the May 2011 Business Valuation Update 23

In Re Spansion result is not to deprive the repo participant of damages, but to confirm that it incurred none. If Congress had intended 562 to be limited to market or sale price, it would have said so, the Third Circuit found, and sustained the bankruptcy court s orders expunging the loan participant s deficiency claims. Mgmt. Projections, DCF Discount Rate, & More Are Key to Bankruptcy Valuation In re Spansion, 426 B.R. 114 (April 1, 2010) This decision demonstrates what has and is now occurring in many of the larger Chapter 11 cases, according to the federal bankruptcy court (Delaware). Trading of claims can begin even before the filing, creating various constituencies of creditors most often institutional investors such as hedge funds and secondary traders who purchase debt at various levels and then seek to advance their claims by proposing competing plans. Valuation issues become paramount in the proceedings, in particular, whether a proposed plan undervalues the debtors at the expense of dissenting creditors, which can now include these seasoned, strategic debt investors. Third-largest maker of flash memory. In 2008, they held 14% of the flash memory market, outpaced only by rival manufacturers Toshiba and Samsung. At the time, half of the debtors flash memory sales came from the wireless market. They entered bankruptcy in part to refocus on the more profitable embedded applications, such as those used in gaming, automotive, and industrial electronics. After lengthy negotiations, an ad hoc committee of converted noteholders (the Convert Committee ) offered $112 million in equity financing, based on a 12% discount derived from a total enterprise valuation for the debtors of $1.5 billion. The debtors rejected the offer, and a month later proposed a plan supported by senior noteholders. Not surprisingly, the Convert Committee objected, claiming the proposal understated total enterprise value (TEV) and its equity incentive provisions allocated too much value to management-employees. In deciding whether the debtors proposed plan was fair and equitable, the court heard from three valuation experts. The debtors expert concluded that the company s TEV ranged from $700 million to $850 million. The expert for the senior noteholders said TEV ranged higher, from $799 million to $944 million. The Convert Committee s expert advocated the highest range, $1.054 billion to $1.419 billion. The court also heard from additional objectors to the plan, who argued that the debtors value could best be determined from the active market for buying and trading its bankruptcy claims. However, this evidence did not rise to the required level of accuracy. There is no record on the number of such trades, over what period of time such trades occurred, [and] how open the market is to participants, the court said. As a result, its value determination would turn on a cautious scrutiny of the three hired experts, with particular attention to their underlying assumptions and data. Management projections: worst case or base case? During bankruptcy, the debtors prepared a base forecast consisting of management s best estimates for an aggressive but achievable performance as of May 2009. Two months later, they prepared a contingency forecast that adjusted the base projections to account for potential risks and downsides through 2012. In conducting their valuations, experts for the debtors and the secured noteholders relied on both projections, but weighted the base case more heavily (75% and 85%, respectively) than the contingency case (25% and 15%). Some of the contingency risks had mitigated by the time of confirmation hearing, the experts said, while others remained present. The Convert Committee s expert excluded the contingency forecasts entirely because they failed to recognize the mitigated risks as well as certain growth opportunities; he also believed the base forecasts resulted from a bottoms-up, two-month, rigorous business planning process. However, the court found it proper to include both forecasts, weighting the base case more heavily than the 24 Business Valuation Update May 2011

In Re Spansion contingency case, and credited the noteholders expert with the proper apportionment. All three experts favored the discounted cash flow (DCF) approach, but each accused his opponents of emphasizing certain inputs and assumptions to manipulate ultimate values. In particular: 1. Discount rate. The debtors expert calculated a weighted average cost of capital (WACC) at 15%, compared to the secured noteholders 14.7% and the Convert Committee s 13.8%. The first two experts criticized the third s beta analysis, claiming he used an overly broad peer group to achieve the lower rate. The experts also noted that prior valuations of the bankrupt debtors used rates ranging from 14% to 16%. 2. Terminal value. The debtors and secured noteholders expert agreed on a perpetuity growth rate of -2.5% to +2.5%, with a midpoint of zero. The zero growth rate relied on industry forecasts that the debtors market share would grow even while individual sectors declined. Despite this evidence, the debtors expert used a terminal growth rate of zero to 3%, with a midpoint of 1.5%. 3. Out-years projections. Under its restructuring plan, the debtors management planned to outsource 100% of production over five to 10 years. Accordingly, the Convert Committee s expert gradually reduced the debtors free cash flows from 2012 to 2019 (the out years ). By contrast, the secured noteholders expert assumed the debtors would outsource 100% by 2013 and used this as the out year. At the same time, he prepared a sensitivity analysis that used the gradual out-years projections with the zero growth rate and 14.7% WACC to produce a higher TEV. Market approach focuses on appropriate multiples and M&A transactions. In addition to their DCFs, the three experts employed a comparable companies analysis, based on EBITDA multiples. Only the Convert Committee s expert also used a revenue multiple, which significantly increased his value conclusion from a range of $871 million to $1.14 billion (EBITDA multiple) to a range of $1.3 billion to $1.9 billion (revenue multiple). This variance is too great to ignore, the court said, and credited the comparable companies analysis by the debtors and senior noteholders expert. Finally, all three experts applied a comparable transactions (M&A) approach, but only the debtors and senior noteholders experts focused on two recent deals related to the company s primary competitor, which they believed were very relevant. (To ignore these deals would be foolish and reckless, one expert said, like me valuing Pepsi and ignoring Coke. ) Only the Convert Committee s expert looked at five M&A transactions involving memory companies, from which he calculated an implied revenue multiple range (1.2x to 1.7x) much broader than those calculated by his opponents focus on the two key deals (0.60x to 0.72x). However, when applied to the debtors 2010 revenues, this higher range of multiples resulted in an enterprise value so far above the ranges calculated by [the same expert s] other methodologies that its soundness and therefore its usefulness is doubtful, the court held. Overall, after weighing each expert s evidence and criticisms of the others reports, the court concluded that the valuation by the senior noteholders expert was appropriately weighted and rested on the most sound assumptions for determining the debtors current value in its industry. It was also more transparent than the report by the debtors expert, and more in line with common valuation practices than the Convert Committee s expert. At the same time, the court believed the DCF analysis by the senior noteholders expert should be adjusted to account for a more gradual decline in EBITDA over a longer period of out years (as performed by his sensitivity check.) Based on these observations, the court found the debtors TEV ranged from $872 million to $944 million. After adding various assets available for distribution such as auction rate securities, net operating losses, and litigation recoveries the court found a net distributable value range of $1.25 billion to $1.3 billion. Given this valuation, the debtors proposed plan treated all unsecured creditors fairly, the court ruled. At the same time, May 2011 Business Valuation Update 25

Fulton Co. Employees Retirement System V. Mgic Investment Corp. it found the debtors proposed equity incentive plan favored management with a disproportionate allocation of equity value. Certain third-party releases also violated bankruptcy law, and the court declined to confirm the plan in its present form. Note: Within two weeks of this decision, the Convert Committee raised more than $419 million to fund its rival plan and requested the court to delay proceedings to consider the proposal. The debtors rushed to amend their plan, cutting more than $14 million from its equity incentives, and obtained court confirmation on April 15, 2010. See www.reuters.com/article/2010/04/16/ spansion-idusn1613444520100416. Financial Experts May Be Required at Initial Pleading Stages of Securities Litigation Fulton Co. Employees Retirement System v. MGIC Investment Corp., 2010 WL 5095294 (E. D. Wis.)(Dec. 8, 2010) In the wake of the recent financial crisis and subprime fiasco, the resulting securities fraud litigation focuses on whether shareholders can show that a company s failure to write down impaired assets caused their damages, typically the loss of shareholder value. Under tightening federal securities standards, however, the complaint may not survive a motion to dismiss if the plaintiffs fail to enlist a financial expert to help them evaluate and apply fair value accounting concepts and techniques in the initial allegations. Subprime venture collapses in 2007. The plaintiffs in this case were institutional investors in MGIC, an insurer of residential home mortgages. MGIC also held a 46% interest in C-BASS (Credit-Based Asset Serving and Securitization), a joint venture with another mortgage insurer, which likewise held a 46% interest. The privately held venture specialized in purchasing subprime single-family residential mortgages and packaging them into mortgage-backed securities. By 2006, the venture contributed 24% of MGIC s profits and had a material impact on MGIC s stock price. At the beginning of 2007, C-BASS held $8.8 billion in subprime and low-grade MBS. It also had $6.14 billion in secured debt, subject to cash margin calls by the lenders if and when they believed the portfolio s value had declined. As the subprime crisis began to unfold and millions of dollars of margin calls began to come in, MGIC engaged in a fraudulent scheme to inflate the value of its assets, the plaintiffs alleged, by failing to report their impairment according to the thenapplicable financial accounting standards (FAS 115 and 157). Moreover, the company hoped to merge with its joint venture partner, but had to sell much of its subprime assets to free the combined entity from carrying too many on its balance sheet. Thus MGIC intended to mislead market investors until it could close the merger by the third quarter 2007. The merger never went through, however. The joint venture collapsed in August 2007 and MGIC wrote off its entire investment of $516 million. All of these events impacted MGIC s stock price, the plaintiffs claimed, leading to substantial damages. Court recognizes extreme difficulty of fair value accounting. In assessing the defendant s motion to dismiss, the federal district court began by examining whether the complaint adequately alleged that C-BASS overstated its subprime earnings. This means pleading facts showing that the assets were not valued properly for financial accounting purposes, the court explained. This type of valuation is not an exact science, it added. Rather, these principles tolerate a range of reasonable treatments, leaving the choice among alternatives to management. Accordingly: It is important to recognize that there was no single value that could have been applied to C-BASS s portfolio and deemed the true value of the portfolio during the first half of 2007. Instead, there was a range of reasonable valuations, and statements that reported the value 26 Business Valuation Update May 2011

Fulton Co. Employees Retirement System V. Mgic Investment Corp. of the portfolio could have been false only if the reported value was not within the range. Further, the plaintiff must plead sufficient facts to show that the reported valuations were outside the reasonable range. In this case, the complaint must 1) identify the accounting principles that govern the valuation of C-BASS s assets and 2) plead facts giving rise to a reasonable belief that C-BASS did not properly apply such principles. Adding to these difficulties, the subprime assets that comprised C-BASS s portfolio fell on the extremely difficult end of the [valuation] spectrum, due to the limited number of observable transactions involving such assets, the court observed. Because this fair value determination is so complex, requiring so many technical interpretations, the complaint must contain enough background information to enable the court to conclude that a fraudulent statement (or omission) regarding asset value had occurred. It is not enough merely to list the asset values and then simply assert that they were not reported at fair value. Instead, the complaint must explain why the listed values show the defendant failed to comply with applicable accounting principles and/ or were beyond the range of reasonable values. In other words, a plaintiff must take the pleaded facts, run them through the fair-value machinery, and show that one could not reasonably come up with the values that the defendants reported, the court held. According to the plaintiff, three facts raised sufficient red flags about the defendant s valuation techniques. First, the ABX index an index that tracked 20 baskets of subprime mortgagebacked securities declined significantly over the first half of 2007. Second, during the same time, C-BASS lenders made those hundreds of millions of dollars in margin calls. Third, several confidential witnesses, all former C-BASS employees, were willing to testify that the subprime portfolio was overvalued. Moreover, C-BASS admitted to using all three elements in its disclosures to investors. Thus, the drop in the ABX index, the rush of margin calls, and its own employees suspicions adequately pointed to an accounting violation, the plaintiffs claimed. The problem is that none of it tells me anything about whether the values that C-BASS reported were justifiable, the court pointed out. During the first half of 2007, for example, C-BASS wrote down the value of its assets by $100 million. Thus the relevant question is not whether C-BASS s assets declined in value, but by how much. That the inputs into the fair value determination pointed downward did not sufficiently indicate the magnitude of the write-offs that should have been taken, the court said. Instead, the plaintiff should show that it was highly unlikely that C-BASS could have applied good faith, fair-value principles and come up with only a $100 million write-down in the face of ABX declines, margin calls, and internal suspicions. Clear, cogent, expert fair valuation determinations required. Regarding the margin calls, the plaintiffs did try to show that their amount revealed a greater decline in C-BASS s assets than reported. The plaintiffs calculation was extremely convoluted and relied on a number of unsupported assumptions, the court said. The key defect... is that it assumes... a oneto-one correspondence between margin calls and the fair value of an asset. However, the plaintiffs failed to show that applicable accounting principles required such a one-to-one correspondence. The plaintiffs also highlighted the statements by one particular confidential witness, whose work for C-BASS included using certain models to value the subprime assets. The witness was willing to testify that, in his opinion, C-BASS was overvaluing its portfolio, especially compared to the ABX index. But the plaintiffs failed to indicate that the witness had any financial accounting expertise or was familiar with fair value determinations, in particular the valuation of subprime assets. The complaint also failed to allege that the witness had competently formed his opinion or that his understanding of value was in any way similar to the accounting concept of fair value, the court said. As a result, the court rejected the plaintiffs claims that the defendants overstated earnings. For much the same reasons, it also rejected the May 2011 Business Valuation Update 27

In Re Marriage Of Meek-duncomb and Rolfe State Bank v. Gunderson plaintiffs claims that the defendant misled market investors regarding C-BASS s liquidity. Their allegations did not in any way indicate that the defendants knew that the end was near or recklessly disregarded the risk that it was, the court said, and dismissed the entire suit. Divorce Court Discredits Uncertified Appraisal for Small Trucking Business In re Marriage of Meek-Duncomb, 2011 WL 768831 (Iowa. App.)(March 7, 2011) After purchasing a semi-truck in 2007, the husband began his own trucking business. He hauled freight for a single customer, from which he also had to lease trailers. In 2007, the husband reported a net business loss of just over $200. In 2008, he reported a profit of nearly $50,000. His estimated profit for 2009 was $41,000. At his divorce trial in 2010, the husband said his business had essentially no value outside of a job. Although the semi was worth approximately $32,000, it carried an outstanding loan balance of nearly $63,000. CPA doesn t certify appraisals. The wife presented a CPA with 31 years of accounting experience. In addition, he has valued business for approximately 20 of those years but admitted that he did not perform certified evaluations. The CPA reviewed the trucking business s tax returns from 2006 through 2009, as well as its 1099 forms for 2009 and some Excel spreadsheets. Using a combination of three valuation approaches (book value, capitalization of earnings, and dividendpaying capacity), the CPA assigned the business a fair market value of $145,000. The trial court rejected the CPA valuation, finding it was less formal than a business audit. Among other factors, the expert failed to consider the business s assets or its debts; how many customers it had; or the likelihood its customer(s) would continue. Instead, the court credited the husband s testimony that his business was worth no more than his salary, and the wife appealed. On review, the appellate court confirmed the trial court s determinations that the business had minimal value, and that the expert s report carried little weight. The CPA had insufficient information to provide a valid or reliable estimate of the value of the business, the court said, citing the trial court s factual findings. He prepared his informal evaluation without any information regarding the business s assets, debts, source of revenues, or strength of customer relationships. Given that the business had only one asset of any value (the semi tractor) and had no trailer of its own to haul freight, the trial court could not conceive of any reasonable buyer who would be willing to pay even $10,000 for the trucking business, and the appellate court affirmed. Iowa Resolves Clash Between FV and FMV in Banking Appraisal Statutes Rolfe State Bank v. Gunderson, 2011 WL 480685 (Iowa)(Feb. 11, 2011) Compare this case to the Delaware Chancery s decision in Reis v. Hazelett Strip- Casting Corp. (page 29). Both concern minority shareholders subject to a majority squeeze out by way of reverse stock split, but the courts arrive at very different remedies based on interpreting the specific statutes applicable in the case. Issue of first impression. When the board of directors of an Iowa bank authorized a reverse stock split, it retained a valuation firm to independently appraise the bank s shares. After applying discounts for lack of marketability and control, the bank s appraisers concluded a fair market value of $1,857 per share. Accordingly, the board approved the stock split at $2,000 per share, as did the majority shareholders, the regulators, and all but one of the minority shareholders, who exercised their general statutory appraisal rights pursuant to the Iowa Business Code (Sec. 490). At trial, the minority shareholders claimed their shares were each worth $2,700, without the application of discounts. The bank asserted that an alternative provision of the Iowa Banking Code 28 Business Valuation Update May 2011

Reis V. Hazelett Strip-casting Corp. (Sec. 524) specifically applied a fair market value standard, including discounts, when appraising the minority shares of a bank in a reverse stock split. The trial court disagreed, however, finding that Sec. 524 applied only to mergers and other transactions involving bank holding companies, and the bank appealed on an expedited basis to the state Supreme Court. The case presented the Iowa Supreme Court its first opportunity to interpret Sec. 524, which provided that notwithstanding any provision in Sec. 490 related to a fair value determination of a shareholder s interest in a bank or bank holding company, in a transaction or event in which the shareholder is entitled to appraisal rights, due consideration shall be given to valuation factors recognized for federal tax purposes, including discounts for minority interests and discounts for lack of marketability (emphasis by the court). The bank argued that the language of Sec. 524 was unambiguous. The phrase in a transaction or event is open-ended, and applies not only to bank mergers but to any transaction by a bank that triggers appraisal rights under Sec. 490, including reverse stock splits. This was indeed one interpretation of the statute, the court said but not the only reasonable one. As the minority shareholders argued, the phrase transaction or event appears within the context of the Banking Code that specifically applies to mergers (not reverse stock splits). Moreover, the phrase does not modify the term bank but only bank holding company, which immediately precedes it. Given these two competing interpretations, the court concluded the statute was ambiguous. Although the language at first blush appears to be broad, the court agreed with the minority shareholders that it would be odd for the Legislature to have buried an apparent sweeping change in banking appraisal law in a section of the Code dealing only with mergers. Moreover, it appeared that after a 1996 Iowa Supreme Court decision precluding discounts in determining the appraisal rights of a bank s minority shareholders in reverse stock splits, the state legislature amended Sec. 524 to permit fair market valuation discounts under this section, which dealt solely with mergers. The statutory change did not apply to bank holding companies and did not apply to transactions that were not mergers, the court held. In 2000, the legislature revisited the issue by further amending Sec. 490 to provide that the fair value of shares in a bank holding company would be determined by the fair market value standard in Sec. 524. This language applied only to bank holding companies, the court emphasized. The 2000 amendments also expanded the application of marketability and minority discounts to mergers and other transactions involving the shares of bank holding companies. Finally, the legislative explanation noted that notwithstanding the provisions Sec. 490, a bank holding company could elect to have its fair value determined under the FMV standard of Sec. 524. Given this overall historical context, the court concluded that the legislature intended to expand the valuation factors available in Sec. 524 to bank holding companies, but did not intend to affect the pre-existing law with respect to banks. Put another way, the legislature did not intend to extend marketability and minority discounts to the valuation of shares of a bank in a reverse stock split. As a result, the court affirmed the grant of summary judgment on behalf of the minority shareholders. DE Chancery Cobbles Capitalization of Earnings Value from Dueling Experts Reis v. Hazelett Strip-Casting Corp., 2011 WL 303207 (Del. Ch.)(Jan. 21, 2011) Founded in 1929, the Hazelett Corporation manufactures large strip-casting machines, selling from zero to four units per year for up to $16 million apiece. By far, the bulk of revenues for the Vermont-based, family-run company comes from servicing existing machines and selling spare parts. Older brother wants to keep control. In 1956, the founder turned over the company to his two May 2011 Business Valuation Update 29

Reis V. Hazelett Strip-casting Corp. sons, giving the eldest 800 shares (or nearly 70% of the equity) and the younger 350 shares. When the younger brother died in 2002, he left his 350 shares to 169 individuals, primarily past and present employees. By then, the older brother was CEO, president, and chairman of the board. According to court records, he deeply disliked the idea of their family owned company suddenly being opened up to outsiders. To preserve the company intact, the older brother/ CEO authorized it to pay $1,500 for each of the 350 shares held by the younger brother s estate, for a total of roughly $560,000. The price was not based on any current valuation; in fact, he later testified that he pulled the number out of the air. The beneficiaries held out for a higher value, and the CEO used a reverse stock split to force a buyout. An appraisal firm valued the entire company at $1.83 million, making a fractional interest worth approximately $1,600 per share at the time (Oct. 2005). The board amended the company charter to complete the measure, but failed to effectively file the amendment until January 2008. In the meantime, one of the 169 beneficiaries challenged the reverse split in the Delaware Chancery Court, alleging that the company, its CEO, and the board had breached their fiduciary duties to shareholders and violated Sec. 155(2) of the Delaware General Corporation Law (requiring a company to pay fair value for repurchasing fractional interests). After initial litigation, the court held that the effective date of the reverse split was January 2008. Before making a fair value determination, however, the court first clarified the review standard and burden of proof. When a controlling stockholder uses a reverse split to freeze out minority stockholders without any procedural protections, the court ruled, then the entire fairness standard applies and the burden under Sec. 155(2) shifts to the defendant/fiduciary to show it was fair. Applying the standard to this case, the court found that the older brother directly controlled the board of directors, which authorized the reverse split without implementing any shareholder safeguards such as an independent committee or a majority-of-the-minority vote. There was no dealing in this case that could be called fair, the court concluded. Proper valuation standard. In fashioning an appropriate remedy, the court noted that Sec. 155(2) uses the term fair value without referring to the definition of fair value in Sec. 262, Delaware s appraisal statute. At the same time after an extensive discussion of the remedies available in an entire fairness case versus an appraisal proceeding the court found that the fair value standard is... economically efficient and should be applied consistently to freezeouts, regardless of form. The same policies that animate using a fair value standard to evaluate a squeeze-out merger calls for its use when the freeze-out is implemented by a reverse split, the court added. After failing to implement a fair process in this case, the defendants did not serendipitously arrive at a fair price when they offered to buy out the plaintiff s shares at the initial $1,500 offer or the subsequent $1,600 appraised value, the court held. In an effort to prove fair value for trial purposes, both parties submitted competing appraisals. The defendants offered a second report from the same firm that appraised the company at the time of the reverse split. This time, the firm reached a going concern value as of January 2008 of $1.745 million, or $1,500 per fractional interest nearly $100 per share less than its prior valuation. The plaintiff/minority shareholders expert responded with an appraisal that valued the company s total equity under various approaches at $6.3 million, or nearly $5,490 per fractional interest. Under the guideline public company analysis, however, the expert selected comparables that were substantially bigger than the Hazelett Corporation and had more diversified customers, better access to capital, deeper management teams, and different economic drivers. The comparables also generated more stable revenues from new sales rather than parts and servicing. Even with adjustments, the differences were so large that the court found the method was meaningless in this case. 30 Business Valuation Update May 2011

Reis V. Hazelett Strip-casting Corp. The court also rejected the capitalized free cash flow analysis from the plaintiff s expert, because it required too many normalizing adjustments to produce a reliable going concern value. For example, the expert used only an average of two recent periods (fiscal 2007 and annualized 2008) to derive a cash flow projection. This did not adequately account for the company s fluctuating revenues and the court declined to modify the expert s work, especially since it was redundant of the many adjustments the court decided to make to the third and final approach. Appropriate methodology and adjustments. Both party experts applied the capitalized earnings method, which boasts a considerable Delaware pedigree as one of the methodologies comprising the Delaware Block Method, the court observed. Using forecasted earnings is preferable, but when reliable projections are not available, historical averages are acceptable if calculated across a multiyear period. Under the Delaware block method... a five-year period [is] the norm, the court said. In this case, the record was devoid of company projections; thus both experts looked to historical performance. However, the defendants expert failed to make any normalizing adjustments to earnings, enabling him to reach a result conveniently close to the original $1,500 buyout price, the court said. At the same time, the plaintiff s expert made several adjustments that were inconsistent with Delaware law. Accordingly, the court used the valuation by the defendants expert as a starting point, with the following adjustments, adapted from the plaintiff s expert: 1. Research and development (R&D) costs. The industry average for R&D was approximately 5% of revenues, according to the plaintiff s expert, and from 2003 to 2007, the company s R&D hovered around these levels, but when the economy began to decline in 2007, it reallocated the expense of idle employees to R&D, nearly doubling its cost. As result, the plaintiff s expert added back $1.3 million of R&D in 2007. However, the company had a general policy of retaining rather than laying off employees during down cycles, and this operative reality was in line with maximizing shareholder value. Since only a new controller would adjust R&D expense to align with a new operative strategy, the court held, the expert s adjustments would reflect a third-party sale rather than a going-concern value, and it rejected the 2007 add-back to earnings. 2. Controller self-dealing. This raised trickier issues, the court said. The company also had a general policy of giving the CEO several taxadvantaged returns, such as a high compensation rate (set at a flat 2% of gross revenues) and maintaining a marine and hotel division, which had nothing to do with the company s main operations but were tax-efficient ways for the CEO to enjoy his love of sailing. The company also leased five machine tools from a CEO-owned entity. Under Delaware law, the Chancery court was inclined to adjust company earnings for all three expenses but interestingly, the plaintiff s expert declined to say whether the CEO s compensation and the lease payments were market rate. The expert did adjust for the marine division, and the court adopted the same as a reflection of controller self-dealing. 3. Non-recurring revenues. The plaintiff s expert deducted revenue resulting from non-recurring sales of fixed assets and from the 2006 sale of company-owned real estate. These are standard and appropriate normalizing adjustments, the court held, and adopted them as well. 4. Tax rate. The court also adjusted the company s earnings by its historic (fiscal years 2003 to 2007) tax rate and a normalized rate of 40% for calendar 2003 and 2008. 5. Earnings period. The court adopted the six year average earnings trend of $283,000 per year, as calculated by the plaintiff s expert. But it also believed that some portion of the CEO s compensation and equipment lease expenses should drop to the net income line; thus this earnings estimate risked undervaluing the minority interest. 5. Capitalization rate. Due to the lack of sufficient peer company comparables, both experts used the build-up method (BUM) to derive a cap May 2011 Business Valuation Update 31

The Citrilite Co. V. Cott Beverages, Inc. rate 18% for the plaintiff s expert, compared to 21% for the defendants. The defendants expert also included a healthy company-specific risk premium (CSRP) of 6%, the court observed, compared to 2% by the plaintiff s expert. Because of inherent dangers of overestimating the CSRP and because the court believed the earnings figures underestimated the company s real economic returns, it replaced the defendants 6% CSRP with the plaintiff s 2%, resulting in a cost of equity of 17%. Before using the inverse of the cost of equity as the capitalization rate, the court needed to deduct an appropriate growth factor. After speaking with management, the defendants expert applied a 4.4% growth rate, compared to 4% by the plaintiff s expert. Since the defendants expert had better access to operations and more incentive to be conservative, the court subtracted his higher growth rate (4.4%) from its cost of equity (17%) to produce a cap rate of 11.6%. Dividing the company s six-year average earnings base ($283,000) by the cap rate yielded an equity value of just over $2.44 million. The court added another $260,000 for the value of non-operating assets, primarily real estate, a net operating loss carry-forward. It did not add another $244,000 for research and other tax credits, however, because the plaintiff failed to ask for it. It also rejected a $560,000 adjustment to reflect the amount the company had already paid the plaintiff and other beneficiaries of the younger brother s estate, because the payment did not come from excess cash but from the company s line of credit. The court could not back out the costs of this debt, however, because the plaintiff s expert did not provide this amount. Overall, the court reached an equity value of $3.65 million for the company under the capitalization of earnings approach, or $3,175 for a fractional interest. Book value is troubling. Net asset or book value can be an appropriate appraisal method for a company that derives significant value from its physical assets, the court noted. Although the method may undervalue a business with substantial intangible asset value, it can also serve as a conservative check against a going-concern valuation. In this case, the company s books reflected a book value of $7.7 million, a figure that had remained relatively stable over the base earnings period. Despite recognizing that asset value typically establishes a floor against which to check operational value, the defendants expert rejected the approach without any credible explanation, the court found. Moreover, the wide disparity between the court s $3.65 million entity valuation and the company s historic $7.7 million book value remains troubling and reinforced its concern that controller self-dealing depressed earnings. To counter this, the court gave an 80% weight to its capitalization of earnings approach and 20% to book value. It also added the $560,000 payment to the estate beneficiaries to book value. Using this blended average approach, the court reached a final fair value determination for the company of $4.57 million, or $3,980 for a fractional interest. Regression Analysis of Cumulative Data Sets Unreliable Under Daubert? The Citrilite Co. v. Cott Beverages, Inc., 2011 WL 284915 (E.D. Cal.)(Jan. 25, 2011) Not many courts have addressed the inherent reliability of specific statistical methods used to calculate economic damages. In this case, the federal district court considers a fairly common statistical technique a regression analysis of two cumulative data sets against claims that the method is per se inadmissible under the Daubert standard. The case also illustrates that, no matter how sophisticated the expert evidence, damages may often be limited by a relatively simple law or contract term. Defendant backs out after good year. In 2003, the plaintiff the producer of the zero-calorie Slim-Lite drink entered into an exclusive distribution agreement with the defendant. In exchange, the defendant agreed to pay $0.50 per case sold, with a guaranteed annual royalty of $350,000 plus an option to purchase the plaintiff for $1 million. 32 Business Valuation Update May 2011

The Citrilite Co. V. Cott Beverages, Inc. The defendant also promised to use commercially reasonable efforts to market and sell the Slim-Lite drink to maximize the royalty payments and enhance the plaintiff s goodwill. The contract provided for automatic two-year renewals but allowed the defendant to terminate for any reason on 60 days notice. Prior to the agreement, the plaintiff had placed its product in 248 Sam s Club stores and conducted in-store demonstrations, but had consistently operated at a loss. In 2004, during the first year of the contract, sales peaked, with 524 Sam s Clubs carrying the Slim-Lite brand. The defendant also continued the in-store demos, which boosted sales by 20% during demo weeks. Despite this success, the defendant began to cut back on the costly in-store demos and failed to implement a packaging change; placement fell to 90 Sam s Clubs. In October 2005, the defendant terminated the contract, and the plaintiff sued for breach. The defendant requested summary judgment, arguing the plaintiff could not show breach or causation. The court denied the motion, finding that the defendant s actions were sufficient to create a factual dispute. In particular, the evidence suggested that demos drive sales, they are preferred by Sam s Club, and they demonstrate a supplier s commitment to the product, the court held. Importantly, however, the 60-day termination clause barred the plaintiff s recovery for lost profits beyond the term of the agreement, the court emphasized. Accordingly, it specifically precluded the plaintiff s damages expert from predicating any theory on the purely imaginary and speculative assumptions that the defendant would have renewed the contract and/or exercised its purchase option. Expert did not follow orders? In preparation for trial, the plaintiff s expert presented three different damages scenarios. In the first, the defendant renewed the contract five times, through 2015. In the second, the defendant purchased the plaintiff for $1 million in 2006, and continued to sell Slim-Lite through 2015. In the final scenario, the defendant terminated the agreement in 2005, after which the plaintiff sold its drink until 2015, when it would sell or earn the present value of future profits. Under any of these, the plaintiff s damages amounted to millions of dollars. To calculate these damages, the plaintiff s expert conducted a least-squares multivariate linear regression analysis to establish the cumulative weekly number of Slim-Lite cases sold as a function of three factors: 1) the cumulative number of demos, Friday through Sunday); 2) the cumulative number of demos, Monday through Thursday; and 3) the number of stores carrying Slim-Lite. The expert concluded that the weekend demos at Sam s Club were cost-effective, but the weekday demos were not. The defendant challenged the evidence under Daubert, claiming the expert s regression analysis was neither relevant nor admissible. Any two cumulative data sets may appear to demonstrate a relationship, the defendant argued, and thus regression analysis of such data sets is inherently unreliable. Moreover, the method has not gained acceptance in the field and statistical analysts warn against using cumulative analysis of data sets, because of its propensity to incorrectly imply a causative relationship. In support, the defendant presented its own expert, who said he d never seen cumulative demo activity to explain cumulative sales. In more technical terms, he d never seen a specific application of a least-squares multivariate linear regression analysis in which cumulative sales was used as the dependent variable. At the same time, the defense expert conceded that regression analysis of cumulative data sets is a generally accepted scientific practice, albeit one that is subject to scrutiny in light of its pitfalls. In fact, the expert had prepared his own regression analysis, which purported to show that in-store demos of Slim-Lite at Sam s Club were not profitable because they failed to generate sufficient sales to cover costs. Accordingly, there is some relationship between cumulative demos and sales, the court said, with emphasis. Whether the plaintiff s expert overstated this relationship by magnifying the positive correlation arising out of the inherent upward trend between the two data sets went to the May 2011 Business Valuation Update 33

Enpat, Inc. V. Budnic weight and not admissibility of his analysis, the court held, denying the Daubert motion to strike the expert s methodology. The expert s damages calculations were another matter. All three of [the expert s] scenarios are inadmissible to ascertain lost profit damages, as all three incorporate projections of lost profits inuring after the contract term, the court ruled. The plaintiff tacitly conceded that in preparing his opinion on damages, its expert did not review or follow the court s orders on summary judgment. As a result, his damages projections were only relevant to the extent they projected lost goodwill value based on the plaintiff sales, not the defendant s. In particular, his third scenario, evaluating the value of Slim-Lite s goodwill but for the defendant s breach and the plaintiff taking over sales from 2005 to 2015 appears reasonable, the court said, but only to the extent that such projections are sound. The defendant criticized the goodwill calculations, claiming they failed to subtract the value of tangible assets at the time of breach. The expert should have endeavored to do so, the court agreed, and ordered the parties to submit additional pre-trial briefs to explore the substantive merits of the expert s goodwill values under his third damages scenario. More Proof That Fed. Courts Require More Precision in Calculating Patent Damages Enpat, Inc. v. Budnic, 2011 WL 768092 (M.D. Fla.)(Feb. 28, 2011) The defendant failed to appear to contest the claims that it used (and continues to use) an aircraft modification kit protected by the plaintiff s patents. The plaintiff requested a default judgment and award damages. The federal district court found a sufficient factual basis to support a default entry of liability, leaving it only to resolve the amount of compensatory damages and the plaintiff s request for a permanent injunction. Minimal damages requested. The plaintiff asked for only $3,450 for the defendant s past infringement of the patent, calculated as a reasonable royalty based on Georgia-Pacific factors and two actual licensing agreements. Both agreements granted a third party a non-exclusive license to use the patented device on an aircraft for the life of the patent, and both were executed toward the end of 2010. The Federal Circuit has recently discussed the evidentiary value of past licensing agreements for estimating reasonable royalties, the court observed. For example, in Lucent Technologies, Inc. v. Gateway, 530 F.3d 1301 (Fed. Cir. 2009), the Federal Circuit determined that past lump sum licensing agreements arising from divergent circumstances and covering different materials were too dissimilar to the patents-in-suit to justify the jury s substantial award. Further, in ResQNet. com v. Lansa, Inc., 594 F.3d 860 (Fed. Cir. 2010), the court found that comparisons of past licenses to present infringement disputes must account for the technological and economic differences between them. Finally, in Wordtech Systems, Inc. v. Integrated Network Solutions, Inc., 609 F.3d 1308 (Fed. Cir. 2010), the court rejected the use of prior licenses when they failed to describe the parties calculations, their intended products, or their intended production. (All three Federal Circuit opinions are available at BVLaw, and we just digested the ResQnet.com and Wordtech cases in last month s BVU.) In the present case, the past agreements did cover a non-exclusive license for the patent-insuit, and thus met some comparability threshold to the hypothetical license the parties might have negotiated. On the other hand, while the past licenses extend for the life of the patent, the court said, with emphasis, here the plaintiff requested a reasonable royalty rate for past infringement. To reach this figure, the plaintiff suggested that the court prorate the average license fee by subtracting the percentage of the fee that corresponds to the future life of the patent. The court denied the request, however, finding insufficient evidence that the proposed proration of past license fees was comparable to the 34 Business Valuation Update May 2011

Linton V. United States reasonable royalty rate that the parties would have reached during hypothetical negotiations. Accordingly, it denied damages at this juncture, but permitted the plaintiff to resubmit evidence that would enable the court to determine an appropriate reasonable royalty. The court also declined to issue a permanent injunction unless the plaintiff submitted additional proof that monetary damages would be inadequate compensation. Taxpayer Victory in 9th Circuit Family LLC Case Linton v. United States, 2011 WL 182314 (C. A.9 (Wash))(Jan. 21, 2011) The Lintons formed a limited liability company (LLC) in Washington state. On Jan. 22, 2003, they met with their tax attorney to sign and date several documents pertaining to the LLC, including a quit claim deed to transfer certain real property to the LLC and a letter authorizing the transfer of cash and securities. At the same meeting, they signed but did not date agreements creating trusts for each of their four children, and documents purporting to give each of the trusts an equal share of LLC interests. Attorney error. A couple of months later, the Lintons tax attorney filled in the missing dates on the trust and gift agreements as January 22, 2003 but later testified that he meant to insert January 31, 2003. The Lintons accountant and appraiser corroborated this testimony, as did the following: 1. The LLC s federal tax return, prepared by the accountant/appraiser, initially credits the contributions to the Lintons individual capital accounts and then shows subsequent capital transfers to the children s trust accounts. 2. The Lintons individual federal gift tax returns, prepared by their tax attorney, listed the gifts as gifts of percentage interests in the LLC dated January 31, 2003. 3. The LLC s membership ledger, also prepared by the attorney in March or April, 2003, showed that the Lintons owned 100% of the transferred assets, and then transferred subsequent percentage interests in the LLC to the children s trusts; however, none of these entries were dated. 4. An LLC valuation, prepared by the accountant/appraiser, states that the LLC interests were transferred on January 31, 2007. In their gift tax returns and pursuant to the LLC appraisal, the Lintons applied a 47% combined discount for lack of marketability and control. The IRS rejected the discount, claiming that the Lintons made indirect gifts of property to their children s trusts; or, in the alternative, the step transaction doctrine collapsed the transfers into a single gift. The Lintons paid the assessed deficiencies and applied to the federal district court (Washington) for a refund. On the government s summary judgment motion, the court relied on the express language of the trust and gift documents to find that the Lintons contributions occurred either simultaneously with or after their gifts of LLC interests to the children s trusts, and thus constituted indirect gifts of the cash and property. In the alternative, even if the LLC contributions occurred prior to the gifts of LLC interests, the step transaction doctrine applied. The Lintons made no affirmative decision to delay the gifts, the district court noted, and no evidence suggested that the trust property was exposed to real economic risk during the alleged nine-day interim between the contributions to the LLC and the gifting of LLC interests to the children s trusts. The taxpayer appealed to the U.S. Court of Appeals for the Ninth Circuit, which reviewed the elements required to complete a gift under applicable (Washington state) law. These elements included the donor s intent to make the gift, a delivery of the gift, and acceptance by the donee. Of these, donative intent is both the decisive element and the most difficult to determine, the court said. In fact, it was likely that Washington May 2011 Business Valuation Update 35

Victory Records, Inc. V. Virgin Records America, Inc. law would collapse the delivery of the gift into an analysis of intent. In this case, the signing and dating of the relevant documents created a considerable objective ambiguity as to when the Lintons intended their gifts to become effective. To resolve this ambiguity, the court looked to when the donor put the gift documents beyond retrieval. Thus, the execution of the documents on January 22, 2003 was not sufficient, by itself, to effectuate the gifts on that date. In addition, the attorneys retained the documents without specific instructions from the Lintons that the gifts should be made effective on January 31 or any other date. Based on the current record, either the Lintons left the January 22 meeting with undated copies of gift documents that nevertheless manifested sufficient objective intent to make the gifts immediately effective, the court said (with emphasis); or they empowered their attorney to make the gifts effective at a later date most likely when he prepared the ledger a few months later and gave his clients copies of the signed gift documents. In the alternative, a gradual accretion of events could manifest the required intent prior to the LLC funding. Because the evidence was incomplete on these points, the Ninth Circuit remanded the case to the district court to resolve when the Lintons objectively manifested the intent to donate the LLC interests by putting the gift documents beyond retrieval. LLC is a business activity that makes sense. To apply the step transaction doctrine, one of the three tests must apply. The end result test asks whether a taxpayer intended a series of steps to produce a particular result, and if so, it treats the steps as one. In this case, ample evidence supported the Lintons intention to convey LLC interests to their children without also conveying ownership or management interests. This result was consistent with the tax treatment they sought. Thus, even if the steps could somehow be merged, the court held, the Lintons would still prevail, because the end result would be that their gifts of LLC interests would be taxed as they contend. The second test asks whether the first step of the transaction triggered a binding commitment to fulfill the remaining steps. This test only applies to transactions spanning several years, the court held, and so did not apply here. The final test asks whether the steps were so interdependent that the legal relations created by one would have been fruitless without completion of the remainder. This typically requires comparing the transactions at issue with those found in bona fide business settings. In this case, the placing of assets into a limited liability entity such as an LLC is an ordinary and objectively reasonable business activity that makes sense with or without any subsequent gift, the court held, citing the Tax Court s decision in Holman v. Commissioner, 130 T.C. 170 (2008) (available at BVLaw.) The Lintons creation and funding of the LLC enabled them to specify the LLC terms and to contribute a desired type and amount of assets. These reasonable and ordinary business activities did not meet the requirements of the interdependence test, the court held, and reversed summary judgment based on the step transaction doctrine. Lessons From Daubert: Verify Client Projections, Comparables, & Causation Victory Records, Inc. v. Virgin Records America, Inc., 2011 WL 382743 (N.D. Ill.)(Feb. 3, 2011) The plaintiff sought millions of dollars (and $25 million in punitive damages) for the defendant s alleged interference with its multi-album recording, publishing, and merchandising contract with the rock band Hawthorne Heights. Prior to trial, the defendant challenged the plaintiff s damages expert, a music industry accountant, under the Daubert standard. In particular, the expert proposed to testify regarding the profits that the plaintiff allegedly lost on the band s second and third albums (which were released), and the band s fourth 36 Business Valuation Update May 2011

Victory Records, Inc. V. Virgin Records America, Inc. unreleased album. To calculate lost profits, the expert used the before and after methodology, comparing what the plaintiff s sales would have been absent the alleged interference, as well as the yardstick analysis, which looks to profits produced by industry comparables. Under both methods, the expert s assumptions must rest on adequate bases and cannot be the product of mere speculation, the federal district court observed. Expert relied on internal projections. Under his before and after approach, the expert began with the numbers of the second album that the plaintiff shipped to stores, added the number of downloaded tracks (for a total of approximately 1.09 million units), and then applied the rate of return that the first album earned (8.4%). The 1.09 million sales figure reflected the low end of the expert s sales projections for the second album; he also calculated a median and high end based on sales by another, comparable, rock band (Paramore). To determine projected sales for the third and fourth albums, the expert reduced the second album s projected sales by 25% and 35%, respectively. While [the expert s] methodology may be opaque in certain respects, the court said, one aspect is crystal clear: the starting point for [his] lost profits analysis... is [the expert s] assumption that... [the plaintiff s] internal sales projections were correct. When a party s internal projections rest on its say-so rather than statistical analysis, they are unreliable under Daubert, the court held, citing cases that have excluded an expert when he did not independently verify the data and assumptions underlying the client s financial projections. This is particularly so where, as here, the proposed expert offered no basis in the two-page narrative portion of his expert report or at his deposition for concluding that [the plaintiff s] projections provide an acceptable foundation. Although a lay witness might present the same internal projections under Rule 701 of the Federal Rules of Evidence, such projections may not be delivered by a witness with the gloss of expertise under Rule 702, the court held. Further, the expert s opinion suffered because his yardstick methodology rested on a single comparable the rock band Paramore. The expert s report did not even attempt to establish that a sample size of one was an appropriate yardstick among experts in his field. Exacerbating matters, the court said, the expert selected the single band based not on his experience but on the plaintiff s recommendation. Even though the expert asked the plaintiff for as much detail as possible regarding its recommendation, the plaintiff s brief email response ( same demographics, fans, started at the same time; Paramore is THE band to compare with ) provided a rather paltry foundation, the court found, insufficient to meet the reliability requirements of Rule 702. Ignorance is no excuse. Finally, the expert failed to consider alternative explanations for the second album s drop in sales. This decline was so substantial, his report said, that it could not be explained by general marketing or industry trends, but only by the defendant s actions. The evidence showed, however, that the plaintiff so wanted the second album to eclipse sales of another band that it issued a so-called Manifesto characterizing the competition as a battle between rock and hip-hop. It also emailed its street teams to hide copies of the competitor s CDs in music stores. The Manifesto fell flat among potential consumers, who perceived it as racist. The street tactics email led to substantial negative controversy for the rock band to the extent that the band sued the plaintiff for its outrageous conduct in an effort to terminate their relationship. The expert was unaware of these incidents when preparing his report but the court did not excuse him for failing to evaluate whether they might have caused the second album to underperform, in addition to or instead of the defendant s alleged actions. Given this significant gap in [the expert s] knowledge and analysis, he cannot testify with the reliability demanded by Rule 702, the court held, and excluded the expert s evidence in its entirety. May 2011 Business Valuation Update 37

BVR s Economic Outlook for the Month BVR s Economic Outlook for the Month (excerpt from the March 2011 Economic Outlook Update) Consensus Economics, Inc., publisher of Consensus Forecasts - USA, forecasts real GDP to increase at a seasonally adjusted annual rate of 3.3% and 3.4% in the first and second quarter of 2011, respectively. Every month, Consensus Economics surveys a panel of 28 prominent U.S. economic and financial forecasters (the forecasters ) for their predictions on a range of variables including future growth, inflation, current account and budget balances, and interest rates. The forecasters believe GDP will grow 3.1% in 2011 and 3.3% in 2012. They forecast that personal consumption will increase at a rate of 2.7% and 3.0% in the first and second quarter of 2011, respectively. They expect personal consumption to increase 3.1% in 2011 and 2.9% in 2012. The forecasters expect industrial production to increase at a rate of 4.8% in both the first and second quarter of 2011. They forecast that industrial production will increase 4.7% in 2011 and 4.2% in 2012. The forecasters believe the 3-Month Treasury Bill rate will be 0.2% at the end of the first and second quarter of 2011, and will increase to 0.3% at the end of 2011 and 1.7% at the end of 2012. They forecast that the 10-Year Treasury Bond yield will be 3.5% and 3.7% at the end of the first and second quarter of 2011, respectively. They believe the 10-Year Treasury Bond yield will rise to 4.0% at the end of 2011 and 4.5% at the end of 2012. They also believe consumer prices will rise at a rate of 3.8% and 2.2% in the first and second quarter, respectively. They expect consumer prices to increase 2.3% in 2011 and 2.0% in 2012. They expect producer prices to increase at a rate of 6.6% in the first quarter and 2.6% in the second. The forecasters project producer prices will rise 3.8% in 2011 and 1.7% in 2012. The forecasters believe unemployment will average 9.1% in the first quarter of 2011 and 9.0% in the second. They believe unemployment will average 8.9% for all of 2011 and 8.3% for 2012. Historical Economic Data 2004-2010 and Forecasts 2011-2019 HISTORICAL DATA CONSENSUS FORECASTS ** 2016 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015-2019 Real GDP* 3.6 3.1 2.7 1.9 0.0-2.6 2.8 3.1 3.3 3.4 3.1 2.9 2.6 Industrial Production* 2.3 3.2 2.2 2.7-3.3-9.3 5.8 4.7 4.2 3.6 3.4 3.1 2.8 Personal Consumption* 3.5 3.4 2.9 2.4-0.3-1.2 1.8 3.1 2.9 2.7 2.8 2.7 2.5 Real Business Investment* 6.0 6.7 7.9 6.7 0.3-17.1 5.6 9.0 9.1 7.2 6.1 5.2 4.2 Nominal Pre-Tax Profits* 24.0 16.8 10.5-6.1-16.4-0.4 29.4 6.9 6.1 6.7 6.4 5.4 4.9 Government Spending* 1.4 0.3 1.4 1.3 2.8 1.6 1.0 0.3-0.1 NA NA NA NA Consumer Prices* 2.7 3.4 3.2 2.8 3.8-0.4 1.6 2.3 2.0 2.1 2.1 2.1 2.3 Unemployment Rate 5.6 5.1 4.6 4.6 5.8 9.3 9.6 8.9 8.3 NA NA NA NA Housing Starts (millions) 1.956 2.068 1.801 1.355 0.906 0.554 0.587 0.660 0.900 NA NA NA NA Source of historical data: U.S. Department of Commerce, U.S. Department of Labor, U.S. Census Bureau and The Federal Reserve Board. Source of forecasts: Consensus Forecasts - USA, March 14, 2011. Notes: *Numbers are based on percent change from preceding period. Consumer Prices are the percent change between annual averages. **Forecast numbers are based on percent change from preceding period (excludes Unemployement Rate and Housing Starts). Consumer Price Index information is the percent change between annual averages. Real Business Investment is also known as Nonresidential Fixed Investment. Unemployement Rate is the annual average rate. Personal Consumption includes spending on services, durable, and nondurable goods. Government Spending includes federal, state, and local government spending. Every month, Consensus Economics surveys a panel of 28 prominent United States economic and financial forecasters for their predictions on a range of variables including future growth, inflation, current account and budget balances, and interest rates. 38 Business Valuation Update May 2011

BVR TELECONFERENCES & LIVE EVENTS To register for any of our conferences, or for more information, visit our website at www.bvresources.com/training or call (503) 291-7963. May 5, 10:00am 1:00pm Pacific Time Advanced Workshop on Management Projections and Forecasts Christine Baker June 1-2, Cambridge, MA Valuation of Early Stage Technologies: Tools, Methods & Case Studies Mike Pellegrino May 16, NYSSCPA Headquarters, New York City FAE Business Valuation Conference Conference Chair: Edward F. Esposito June 14, 10:00am 11:40am Pacific Time Valuing Clinical Co-Management Arrangements Greg Anderson and Ann Brandt May 17, 10:00am 11:00am Pacific Time A Guided Tour of ktmine Jeffrey Cozza May 19, 10:00am 11:00am Pacific Time The Appraiser s Role in ESOP Valuations: The New Regulation That Makes Appraisers ERISA Fiduciaries Jared Kaplan May 24, 10:00am 11:40am Pacific Time Valuing Management Services Contacts Between Physicians and Hospitals Randy Biernat May 26, 10:00am 11:40am Pacific Time Pass Through Entity Valuation Update: The Significant Impact of Academic Research on the Debate Nancy Fannon and Keith Sellers CALENDAR June 16, 10:00am 11:40am Pacific Time Valuing Alternative Investment Management Companies: Private Equity and Hedge Funds Jay Fishman and Scott Nammacher June 29, 10:00am 11:40am Pacific Time Valuing Law Firms Ron Seigneur and Pete Peterson July 14, 10:00am 11:40am Pacific Time Goodwill in Divorce Jim Alerding and Drew Soshnick = Webinar = Online Healthcare Symposium = Live Event May 2, 2011 ASA: Current Topics in Business Valuation New York, NY PricewaterhouseCoopers (877) 998-8259 www.asabv.org May 8-11, 2011 CFA Institute Annual Conference Edinburgh, Scotland www.cfainstitute.org May 12-13, 2011 34th Annual ESOP Association Conference Washington, DC Renaissance Washington Hotel www.esopassocation.org May 12-13, 2011 IBBA Spring 2011 Conference for Professional Development New Orleans, LA Marriott new Orleans French Quarter www.ibba.org May 15-20, 2011 AICPA Family Law Conference Las Vegas, NV Bellagio (888) 777-7077 www.cpa2biz.com May 18, 2011 ASA Third Annual National IRS Symposium Los Angeles, CA JW Marriott LA Live (877) 998-8259 www.appraisersla.com June 6-7, 2011 AICPA Fair Value Measurement and Reporting Conference Las Vegas, NV (888) 777-7077 www.cpa2biz.com June 8-11, 2011 The NACVA/IBA 2011 Annual Consultants Conference San Diego, CA The Hilton San Diego Bayfront (800) 677-2009 www.nacva.com July 18-20, 2011 AICPA Advanced Estate Planning Conference Boston, MA Marriott Copley Place (888) 777-7077 www.cpa2biz.com September 21, 2011 AICPA National Forensic Accounting Conference Chicago, IL (888) 777-7077 www.cpa2biz.com October 10-12, 2011 ASA BV Conference Chicago, IL Palmer House Hilton www.bvconference.com November 6-8, 2011 AICPA Business Valuation Conference Las Vegas, NV (888) 777-7077 www.cpa2biz.com For an all-inclusive list of valuation-related Seminars and Conferences, BV Education classes and credentialing programs plus BVR Conferences, go to BVResources.com, and click on the BV Calendar menu.

PERIODICALS Business Valuation Resources, LLC 1000 SW Broadway, Suite 1200 Portland, OR 97205-3035 COST OF CAPITAL Treasury yields 1 30-day: 0.03% 5-year: 2.24% 20-year: 4.27% Duff & Phelps 2011 Premiums Over Long-Term Risk-free Rate 2 Historical Equity Risk Premiums: Averages Since 1963 Data for Year Ending December 31, 2010. Measure Used for Size 3 1st 13th 25th 5-Year Average EBITDA 4.0% 8.9% 13.3% 5-Year Average Net Income 3.8% 8.9% 13.5% Sales 5.4% 9.2% 12.4% Total Assets 4.1% 8.8% 13.1% Prime lending rate: 1 3.25% Dow Jones 20-bond yield: 4 3.93% Barron s intermediate-grade bonds: 4 6.49% High yield estimate: 4 Mean 8.2% Median 6.2% Dow Jones Industrials P/E ratios: 4 On current earnings: 15.0 On 2011 operating earnings est.: 12.7 On 2012 operating earnings est.: 11.4 Long-term inflation estimate: 5 2.5% Long-term rate of growth GDP: 5 2.8% 1 Source: The Federal Reserve Board as reported by the BVR Risk-Free Rate Tool, located in the Free Downloads section at BVResources.com, April 1, 2011. 2 Source: 2011 Risk Premium Report Duff & Phelps LLC. All rights reserved. Report includes premiums where size is measured by market value of equity, market value of invested capital, book value of equity, and number of employees. We highly recommend that analysts using Duff & Phelps data for cost of capital have the current year s Report and thoroughly understand the derivation of the numbers used. Complete current and historical Duff & Phelps cost of capital data available at BVResources.com. 3 Each measure for size is organized by Duff & Phelps, LLC into 25 portfolio ranks, with portfolio rank 1 being the largest and portfolio rank 25 being the smallest. Smoothed average premiums are presented here because they are considered a better indicator than the actual historical observation for most of the portfolio groups. Premiums may be adjusted for differences between historic market risk premiums and expected equity risk premium as described in the Report. 4 Barron s, April 4, 2011. 5 10-year forecast; Federal Reserve Bank of Philadelphia, Livingston Survey, December 9, 2010.