BUSINESS VALUATION IN A LITIGATION CONTEXT

PRESENTED: JANUARY 13, 2011

David R. Bogus, ASA

Zachary C. Reichenbach

Overview• Standard of Value• Valuation Approaches and Methods• Application of Discounts

• Discount for Lack of Control• Discount for Lack of Marketability

• S Corporation Income Adjustments• Court Case Examples – Delaware Chancery Court• Court Case Examples – Tax Court• Questions

Standards of Value

Standard of Value

• U.S. Tax Court: Fair Market Value

• According to Internal Revenue Code Section 2031(a) and Regulation 20.2031-1(b), Fair Market Value is defined as:

• “...the price at which property would change hands between a willing seller and a willing buyer, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”

Standard of Value (cont.)• Delaware Chancery Court: Fair Value

• Fair Value is defined by the Model Business Corporation Act, Section 13.01 (3) (1998) as:

• “The value of the shares immediately before the effectuation of the corporate action to which the dissenter objects, excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable.”

• Section 262 of the Delaware General Corporation Law provides that Fair Value shall be determined:

 • “exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation….”

 • Further, in determining Fair Value: 

• “the Court shall take into account all relevant factors.” • Finally, Fair Value in an appraisal context measures: 

• “that which has been taken from the shareholder, viz., his proportionate interest in a going concern.”

Differences in Standard of Value

U.S. Tax Court

• Fair Market Value• Can be on a Controlling or

Noncontrolling Basis• Typically Subject to:

• Discount for Lack of Control AND Discount for Lack of Marketability

Delaware Chancery Court

• Fair Value• “Going Concern Basis”• Typically Not Subject to

Discounts

Valuation Approaches and Methods

Valuation Approaches and Methods

Cost Approach

• Cost (or Asset-Based) Approach – Determines a value indication of a business, business ownership interest, or security, by using one or more methods based directly on the value of the assets of the business less liabilities

• Arrives at a value indication on a controlling interest basis• Based on the economic principle of substitution• Least commonly applied approach for valuing an

operating company

Asset Accumulation Method - Example

FMV AdjustedAs of December 31, 2011 Book Value Eliminations Adjustments Book Value

Assets

Current Assets 21,000$ (4,000)$ -$ 17,000$

Property, Plant & Equipment, Net 75,000 (75,000) 100,000 100,000

Total Assets 96,000$ (79,000)$ 100,000$ 117,000$

Liabilities and Shareholder's Equity

Total Liabilities 80,000$ -$ -$ 80,000$

Total Shareholder's Equity 16,000 (79,000) 100,000 37,000

Total Liabilities and Shareholder's Equity 96,000$ (79,000)$ 100,000$ 117,000$

Fair Market Value - 100% Equity Intereston a Controlling Interest Basis 37,000$

Income Approach• Income Approach – Estimates value by converting

anticipated future benefits into a present single amount• Value indication dependent upon income (benefits)

stream• Can arrive at a value indication on either a controlling or

noncontrolling interest basis• Value indication depends on adjustments and/or

assumptions made in developing cash flow stream • Based on the economic principle of anticipation

(expectation)

Adjustments to Income Stream• Types of Adjustments:

• Normalizing - removes unusual non-recurring expenses• Controlling - make adjustments that require control of Company

• Includes adjustments to salaries, perks

• Synergistic - adjustments are specific to buyer

• Applicability of Adjustments Depends on the Nature of the Assignment

Weighted Average Cost of Capital (WACC)• Required rate of return required to attract funds to an

investment• Risk is the key factor in determining cost of capital• Risk is the likelihood of achieving the expected returns• Two Components:

• Cost of Equity• Cost of Debt

Cost of Equity

• Capital Asset Pricing Model (CAPM)• Cost of Equity = Rf + (β x ERP) + SPs + SCs• Definitions

• Rf = Risk-free rate• β = Beta of specific company• ERP = Equity risk premium• SPs = Size (or small company) risk premium• SCs = Specific company risk premium

Cost of Debt

• Based on the rate at which a company can borrow money

• If company has debt, look at rates on existing debt

• If debt-free, estimate based on market rates

WACC – Capital Structure

•A weighted average of the expected returns on all of a company's securities•Can be based on company’s capital structure or industry/market indicated capital structure

WACC - Example

Type of Financing

Cost of Financing

XPercentage of Total

=Weighted Cost of Financing

Debt 5% x 40% = 2%

Equity 25% x 60% = 15%

WACC 17%

Discounted Cash Flow Method - Example

For the Year Ending December 31, 2012 2013 2014 2015 2016 Terminal Value

Net Cash Flow 1,750$ 2,100$ 2,415$ 2,657$ 2,789$ 2,929$

Capitalized Terminal Net Cash Flow(at 17% discount rate less 5% perpetuity growth rate) 24,408

Periods to Discount 0.50 1.50 2.50 3.50 4.50 4.50 Present Value Factor (at 17% discount rate) 0.9245 0.7902 0.6754 0.5772 0.4934 0.4934

Present Value of Net Cash Flow 1,618 1,659 1,631 1,534 1,376 12,043

Total Present Value of Net Cash Flow 19,861

Concluded Enterprise Value (rounded) 19,900$

Forecasted

Differences Between the Courts

U.S. Tax Court

• Adjustments to Income Stream if on a Controlling Basis

• Specific Company Risk more commonly used

• Use of company’s capital structure in determining WACC

Delaware Chancery Court

• Adjustments to Income Stream on a “Going Concern” Basis

• Specific Company Risk is less commonly used

• Use of industry average capital structure in determining WACC

Market Approach• Market Approach – Estimates value by comparing the subject

to similar businesses or business ownership interests that have been sold

• Can arrive at a value indication on either a controlling or noncontrolling interest basis

• Value indication dependent upon level of ownership interest that was sold

• Based upon the related economic principals of competition and equilibrium (i.e. in a free and unrestricted market, supply and demand factors will drive the price to a point of equilibrium)

• Methods:• Guideline Merged & Acquired Company Method • Guideline Publicly Traded Company Method

Guideline Merged & Acquired Company Method

• Based on the premise that the value of the business interest is estimated by comparing the subject company to guideline companies that have been merged or acquired during a period of time reasonably near the valuation date

• Arrives at a value conclusion on controlling basis• Merger and acquisition prices may be representative of

fair market value, investment value, or somewhere in between

Guideline Merged and Acquired Company Method - Example

Guideline Guideline Guideline SubjectTransaction A Transaction B Transaction C Average Company

Financial DataPurchase Price 300,000$ 1,000,000$ 550,000$ Sales 500,000 1,800,000 400,000 250,000 EBIT 100,000 400,000 115,000 65,000 EBITDA 125,000 450,000 100,000 70,000

Implied Value ofMultiples Subject Interest

MVIC/Sales 0.60 0.56 1.38 0.84 210,880 MVIC/EBIT 3.00 2.50 4.78 3.43 222,790 MVIC/EBITDA 2.40 2.22 5.50 3.37 236,185

Guideline Publicly Traded Company Method• Based on the premise that the value of the business

interest is estimated based on what astute and rational capital market investors would pay to own an equity interest of the subject company

• Arrives at a value conclusion on a noncontrolling basis

Guideline Publicly Traded Company Method - ExampleXYZ COMPANY, INC.

Guideline Guideline Guideline SubjectCompany A Company B Company C Average Company

Sales 90,000$ 60,000$ 40,000$ 30,000$ EBIT 12,000 8,000 5,000 4,000 EBITDA 19,000 13,000 8,000 6,500

Market Price Per Share 6.00 5.00 25.00 Shares Outstanding 10,000 6,000 1,000 1,000 Market Value of Equity 60,000 30,000 25,000 Plus: Market Value of Debt 30,000 20,000 10,000 MVIC 90,000 50,000 35,000

Implied Valueof Subject

MVIC/Sales 1.00 0.83 0.88 0.90 27,083 MVIC/EBIT 7.5 6.3 7.0 6.9 27,667 MVIC/EBITDA 4.7 3.8 4.4 4.3 28,076

Application of Discounts

Application of Discounts• Two Discounts

• Discount for Lack of Control• Discount for Lack of Marketability

• The application of discounts should always be taken in the context of:• The level of value the discount is applied to• Legal documents that control the rights and restrictions of the

interest holder• The ultimate rate of return produced for the investor

* Failure to consider these elements could often result in indications of value which are overstated or understated.

Determining Value

Controlling, Marketable InterestControlling, Marketable Interest

Control Premium (20%) Discount for Lack of Control (16.6%)

Combined Discount of

45.8%

$120 per share

Noncontrolling, Marketable InterestNoncontrolling, Marketable Interest(as if freely traded)(as if freely traded)

$100 per share

Discount for Lack of Marketability (35%)

Noncontrolling, Nonmarketable Noncontrolling, Nonmarketable InterestInterest

$65 per share

Discount for Lack of Control• A noncontrolling interest has a lower value than a controlling interest because the holder of a noncontrolling interest in a closely-held entity would have no authority or control to:

• Change management• Appoint Board members• Determine management compensation• Manage business assets• Select target markets• Liquidate the business• Effect IPO or M&A transactions• Declare dividends

Discount for Lack of Marketability• An investment is worth more if the security is marketable

since investors prefer liquidity

• Things to consider:• Relative ease and promptness with which a security or commodity

may be sold when desired without significant concession in price• Amount of time required to convert an asset into cash or pay a

liability

Influential Factors on Discount for Lack of Marketability• Put rights• Potential buyers• Size of interest (trading block)

• Buyer’s ability to obtain information

• Restrictive transfer provisions

• Size of distributions or dividends

• Size of revenues• Size of earnings• Revenue growth and stability

• Earnings growth and stability

• Product risk• Industry risk

S Corporation Income Adjustments

S Corporation Economic Adjustment• Income tax attributes are different between C

Corporations and S Corporations.• C Corporations

• Income taxed at the corporate level• Dividends taxed at shareholder level

• S Corporations• Income taxed at shareholder level

S Corporation Economic Adjustment (cont.)

C Corp. S Corp.

Income before Income Taxes 100,000$ 100,000$ Corporate Income Taxes at 35% (35,000) N/ANet Income 65,000 100,000

Dividends to S Corporation Shareholders N/A 100,000 Income Tax Due by S Corporate Shareholders at 35% N/A (35,000) Net Cash Flow to S Corporation Shareholders N/A 65,000

Dividends to C Corporation Shareholders 65,000 N/AIncome Tax on Dividends at 15% (9,750) N/ANet Cash Flow to C Corporation Shareholders 55,250 N/A

Net Cash Flow to Shareholders 55,250$ 65,000$

Court Case Examples – Delaware Chancery Court

Reis v. Hazelett Strip-Casting CorporationIssued February 1, 2011

Judge Laster

Summary:• The controller of Hazelett Strip-Casting Corporation

cashed out the minority shares held by the estate of his deceased brother via a reverse stock split. The plaintiff sued on behalf of the beneficiaries of the estate who would have received shares, but for a reverse split.

Reis v. Hazelett Strip-Casting Corporation• Issues of the case:

• Applicability of normalizing adjustments• Applicability of cost approach and market approach • Determination of company specific risk premium and

perpetuity growth rate

Reis v. Hazelett Strip-Casting Corporation• Conclusions of the case:

• Relied upon the capitalization of earnings method and made certain normalizing adjustments

• Also, considered book value of company, but discarded guideline company analysis

• Replaced defendant’s expert’s company specific risk premium with plaintiff’s expert

• Utilized defendant’s growth rate

S. Muoio & Co. LLC v. Hallmark Entertainment Investments Co.

Issued March 9, 2011

Judge Chandler

Summary:• The action challenges the fairness of the June 29, 2010

recapitalization of Crown Media Holdings, Inc. orchestrated by Crown’s controlling stockholder and primary debt holder, Hallmark Cards, Inc. and its affiliates. Plaintiff contends that the recapitalization was consummated at an unfair price and drastically undervalued Crown.

S. Muoio & Co. LLC v. Hallmark Entertainment Investments Co.• Issues of the case:

• Use of multiple valuation methodologies• Consideration of third party indications of value• Reliance on management’s projections

S. Muoio & Co. LLC v. Hallmark Entertainment Investments Co.• Conclusions of the case:

• Use of single valuation methodology made the plaintiff expert’s analysis less credible

• Contemporaneous market indications of value are credible• Found it unreasonable to reject management’s projections• Found it unreasonable to project DCF out further than

management

Sunbelt Beverage Corp. Shareholder Litigation• Issued January 5, 2010• Judge Chandler• Summary

• This consolidated breach of fiduciary duty and appraisal proceeding arises out of the August 22, 1997 merger of SBC Merger Corporation with and into Sunbelt Beverage Corporation. One consequence of the merger was the cash-out of a minority shareholder in Sunbelt. Plaintiff contents that the cash-out was at an unfair price.

Sunbelt Beverage Corp. Shareholder Litigation• Issues of the case:

• Reliance on previous transactions in company stock

• Use of multiple valuation methods• Determination of discount rate• Benefits of S corporation status

Sunbelt Beverage Corp. Shareholder Litigation• Conclusions of the case:

• Discarded earlier transactions in company stock utilized by defendant’s expert as the transactions were based on a formula price

• Discarded plaintiff expert’s transaction analysis due to insufficient comparability with subject

• Examined two elements of DCF discount rate• Small company risk premium• Company specific risk premium

• Did not consider effects of a conversion to Subchapter S Status despite both experts considering this benefit

Hanover Direct, Inc. S’holders Litig.• Issued September 24, 2010• Judge Chandler• Summary

• A going-private merger consummated on April 12, 2007, in which the public stockholders of Hanover Direct, Inc. were cashed out of the company for $0.25 a share. Hanover was a financially distressed company that had been heading toward insolvency.

Hanover Direct, Inc. S’holders Litig.

• Issue of the case:•Use of multiple valuation approaches

Hanover Direct, Inc. S’holders Litig.

•Conclusion of the case:•Found respondent expert’s use of several methodologies to be a more robust approach

Golden Telecom, Inc. v. Global GT LP• Issued December 29, 2010• Judge Steele• Summary:

• After a tender offer, Golden Telecom, Inc. merged into Lillian Acquisition, Inc. Golden remained as the surviving entity and all tendering Golden shareholders received $105 per share. Global GT LP, Golden shareholders, sought appraisal.

Golden Telecom, Inc. v. Global GT LP• Issues of the case:

• Calculation of equity risk premium• Determination of perpetuity growth rate• Calculation of an appropriate beta

• Equity risk premium• Terminal growth• The calculation of an appropriate beta

Golden Telecom, Inc. v. Global GT LP• Conclusions of the case:

• Rejected use of arithmetic mean equity risk premium calculation

• Beta calculation based on previously utilized methods

Berger v. Pubco Corp.• Issued September 24, 2010• Judge Chandler• Summary:

• Delaware’s short-form merger statute does not impose onerous burdens on parent corporations seeking to make sure of its expeditious process for merging with subsidiaries. It simply mandates that the minority shareholders of the subsidiary be notified of their statutory right to appraisal. Such notice must include a copy of the appraisal and implicates the parent’s fiduciary duty to disclose all material information with respect to shareholder’s decision whether or not to seek appraisal.

Berger v. Pubco Corp.• Issues of the case:

• Should capital gains tax effect on securities portfolio have been considered

• Should control premium be a part of the valuation analysis; ruled it should not have been applied to DCF and book value methodologies

• Should a control premium be applied to the GPC method

Berger v. Pubco Corp.• Conclusions of the case:

• Capital gains tax effect on securities portfolio should not have been considered

• Control premium as part of the valuation analysis and ruled it should not have been applied to DCF and book value methodologies

• Appropriate to add a control premium to GPC method

Court Case Examples – U.S. Tax Court

Estate of Natale B. Giustina et al. v. CommissionerIssued June 22, 2011

Judge Morrison

Summary:• The IRS valued the Estate’s ownership interest in Giustina

Land and Timber Company at $35,710,000, while the Estate’s expert determined a value of $12,678,117. The IRS issued both a deficiency and a Sec. 6662 accuracy related penalty of $2,531,501.

Estate of Natale B. Giustina et al. v. Commissioner• Issues of the Case

• Use of the Income Approach and financial projections• Pre-tax cash flow vs. After-tax cash flow• Specific Company Risk Premium• Discount for Lack of Marketability• Weightings to Valuation Methods

Estate of Natale B. Giustina et al. v. Commissioner• Conclusions of the Case

• Reduction in the Specific Company Risk Premium• Reduction in the Marketability discount to the Income Approach

method; no marketability discount to the Cost Approach method• Financial Projections based on several historical years is better

than one year to consider the effects of volatility• Income Approach weighted higher than Cost Approach

Estate of Gallagher- T.C. Memo 2011-148 Issued June 28, 2011

Judge Halpern

Summary:• The IRS determined a deficiency of $7,000,000 in Federal

estate tax due from the estate of Louise Gallagher. The deficiency arose out of a difference of opinion between the IRS and the estate over the fair market value as of July 5, 2004 of 3,970 units of Paxton Media Group, LLC (“PMG”) included in the decedent’s gross estate. These units represented 15% of the total units outstanding.

Estate of Gallagher- T.C. Memo 2011-148

• Issues of the Case:• Financial statement adjustments• Market based valuation approach (guideline public

company method)• DCF valuation method• SEAM adjustment

Estate of Gallagher- T.C. Memo 2011-148

• Conclusions of the Case• Adjustments to historical financial statement must prove

validity and must be non-recurring• Guideline public company approach must have ample

comparable public companies to be effective• Not taxing cash flows better indication of value than the

SEAM adjustment

Questions?