|
It Has to Make Sense:
Business Appraisals Need to be Clear, Logical and Persuasive
By John A. Kirby, J.D., A.S.A.
SINGER LEWAK GREENBAUM & GOLDSTEIN LLP
A twelve year old Tax Court decision still provides valuable lessons for appraisers and the attorneys who use them. On June 12, 1995, the U.S. Tax Court decided Bernard Mandelbaum. et al. v. Commissioner of Internal Revenue, T.C. Memo. 1995-255. The case concerned the valuation of common stock in a closely held corporation for gift tax purposes. Of great significance is the fact that the Court disregarded the opinions of the business valuation experts offered by both sides and performed its own analysis. This and subsequent cases supports the perception that the Tax Court is demanding increasingly relevant and persuasive evidence in valuation matters brought before it.
The central issue at Tax Court was the appropriate amount by which to discount the value of the stock because it was not freely marketable. One method for valuing the common stock of a closely held company is to multiply the financial statistics of the company by valuation multiples derived from the trading prices of stocks of similar companies that are actively traded on public stock exchanges. For a simplified example, if the price/earnings ratio of a group of similar publicly traded companies is 9.5, and the closely held company's earnings per share is $1.00, then one indication of the value per share of the closely held company is 9.5 x $1.00, or $9.50. However, shares in closely held companies are not as easy to sell as shares in publicly traded companies which, all else being equal, makes them less valuable. Consequently, if the "freely traded" value of a closely held company has been estimated by using valuation multiples of publicly traded companies, the value of the shares of the closely held company must be discounted for this "lack of marketability" in order to arrive at the fair market value of the stock.
In Mandelbaum, the IRS and the taxpayers stipulated to the freely traded value of the company's common stock, so that the only valuation issue to decide at trial was the appropriate level of marketability discount to apply to the freely traded value of the stock to arrive at the stock's fair market value. Both the IRS and the taxpayers presented expert testimony concerning the appropriate marketability discount. Both experts were highly qualified business appraisers, senior members of the American Society of Appraisers in business valuation, and directors of valuation services at large international accounting firms. Both experts relied, to a great extent, on various published studies that are commonly used by business appraisers to estimate appropriate marketability discounts.
In its opinion, the Court discussed the merits of the expert evidence presented by both parties, and ultimately decided that neither side's valuation expert presented persuasive evidence. In general, the Court did not believe that the experts effectively tied the results of the published studies to the facts and circumstances of the case. Consequently, the Court conducted its own analysis. It began by accepting the general range of marketability discounts indicated by the published studies—35% to 45%—and then analyzed various factors about the subject company and indicated whether it believed each factor increased or decreased the appropriate marketability discount. The Court analyzed: 1) the company's financial performance, 2) the company's dividend policy, 3) the company's nature, history, industry position and outlook, 4) the company's management, 5) the amount of control inherent in the transferred shares, 6) the restrictions on the transferability of the stock contained in the company's shareholder agreement, 7) the amount of time that a shareholder would probably have to wait before liquidating the shares, 8) the company's stock redemption policy, and 9) the costs that would be associated with making a public offering of the stock. The Court concluded, based on its analysis of the factors, that a 30% discount for lack of marketability was appropriate, which was somewhat below the typical range indicated by the published studies.
Mandelbaum was neither the first nor the last case in which the Tax Court placed little weight on the reports and testimony of appraisal experts. A 1992 study reported that in 65 percent of the cases surveyed, the Tax Court's decision in trials with experts did not coincide with the valuation opinions of any of the expert witnesses. Mandelbaum is simply one of the more prominent in a long line of cases that provide valuable lessons to attorneys who employ business appraisers for transfer tax valuations. Most of the lessons are also useful for attorneys who employ an appraiser for any purpose.
In every appraisal, there should be a clear and strong link between any published studies or other empirical evidence the appraiser relies upon, the facts and circumstances of the entity the appraiser is valuing, and the appraiser's opinion of value. The reason that the Mandelbaum court went to the trouble of performing its own analysis rather than relying on the opinion of either expert was that the Court did not believe that either expert established a strong enough nexus between the published marketability discount studies, the subject company, and the valuation conclusions. The Court analyzed the nine company-specific factors and their influence on the size of the discount in order to link the studies to the subject company and the valuation conclusion. Clearly, the results of studies or other empirical evidence will not be persuasive unless they are linked to the facts and circumstances of the case at hand.
Appraisal reports should not be abstract and theoretical. They should be persuasive. Appraisers are prohibited by their professional ethics from being advocates for their clients' interests. However, once an appraiser has independently and objectively reached a value opinion, he should present it in a report that leads the reader through the analysis and conclusions in a series of clear, logical and compelling steps. A report that contains excessive boilerplate, unintelligible jargon, leaps of faith and unsupported opinions will serve to confuse rather than convince its reader. If an attorney is not easily able to understand an appraiser's report, the appraiser needs to rewrite it.
An appraisal should not only be clear, but it should also be grounded in reality, because the standard of value for gift and estate taxes is "fair market value": the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of the relevant facts. In a speech to the American Society of Appraisers, The Honorable David Laro of the U.S. Tax Court stated that, in his opinion, the definition of fair market value is fluid and flexible, and that as standards in the financial and commercial markets change, courts will consider prevailing market conditions and practices when determining if the definition of fair market value has been satisfied in appraisals. For example, in Estate of Newhouse v. Commissioner, 94 T.C. 193,245 (1990), the Court criticized the use of one valuation method in part stating: "we believe that no willing buyer or willing seller being fully informed would have used such a method to determine the value of the common stock."
The professional qualifications of appraisers are also important to the courts. The Mandelbaum court described in some detail the professional qualifications of the IRS's and taxpayer’s experts and, because both experts were obviously very qualified to testify about business valuation, their relative qualifications were not an issue. However, in Estate of Berg v. Commissioner, T.C. Memo. 1991-279, affd. in part and revd. in part 976 F.2d 1163 (8th Cir. 1992), the court gave some weight to the fact that the taxpayer's experts "were not professional appraisers, had no formal education in the valuation of business enterprises, and were not members of any professional associations involved in the education and certification of appraisers."
The purpose of a business appraiser's work is to add clarity to a seemingly complex issue: the valuation of an interest in a closely held business entity. Courts are demanding that the work product of an appraiser be logical and clear, and grounded in reality. Attorneys would serve their clients well by demanding the same.
_____
John A. Kirby, J.D., A.S.A., is a Senior Manager at Singer Lewak Greenbaum & Goldstein LLP in the Business Valuation and Litigation Support Practice Group. He is a specialist in the valuation of business enterprises, closely held equity securities and intangible assets. John is engaged in the valuation of intangible assets, business enterprises, closely-held stock, partnership interests, debt securities, options and warrants for a variety of purposes, including transactions; strategic planning; financial reporting; corporate tax planning and compliance; gift and estate taxes; ESOPs; and litigation, including loss of business goodwill in eminent domain matters. John has two decades of experience in the valuation of closely held business entities and intangible assets as well as research and analysis for litigation support purposes.
|
Full Newsletter
