Financial Valuation€¦ · Michael G. Kaplan, CPA, CVA, CFFA Michael G. Kaplan Mark G. Kucik, CPA,...

Financial Valuation Litigation Expert

Editor’sOutlookJim Hitchner

As winter gives way to spring, wehope to “awaken” your thoughts to anissue that doesn’t always get the atten-tion it deserves. Our front-page articledelves into the data problems associat-ed with using control premium studies(MergerStat) as well as the many prob-lems that may be incurred whenapplying them.

Next up, Bill Quackenbushaddresses the ever-popular topic ofcost of capital. Bill believes the amountof discussion in the BV communityregarding this topic reflects the “grow-ing maturity of the BV profession asboth theoreticians and practitionersfind increasingly reliable, accurate andusable models to identify, or docu-ment, private company cost of capi-tal.”

Gil Matthews tackles the topic ofcalculating enterprise value. Heexplains that there are two differentapproaches for calculation used in theBV community, and he then explainswhich method he thinks is best andwhy.

Nearly two years after the pas-sage of the federal healthcare reformlegislation, Mark Dietrich believespeople remain confused about its pur-pose and impact on the economy aswell as the value of businesses. Marksays appraisers and valuation analystsneed to be aware of this increased

ViEWS anD TOOLS frOM LEaDinG ExPErTS On VaLuaTiOn, fOrEnSiC/frauD anD LiTiGaTiOn SErViCES

FVLE Issue 35 February/March 2012

and

Continued on page three

[email protected]

Continued on next page

“We made too many wrong mistakes.”Yogi Berra

While discounts for lack of marketabil-ity have received, by far, the mostattention in recent years, control pre-miums and discounts for lack of con-trol/minority discounts (DLOC) areback on the radar screen. The Apprais-al Foundation, which produces theUniform Standards of ProfessionalAppraisal Practice (USPAP), has creat-ed a “Working Group” that is studyingthis area. The American Institute ofCertified Public Accountants (AICPA)currently has two “Working Drafts”that also address this area. Later inthis article we will present short sum-maries of what the Appraisal Founda-tion and the AICPA have issued on thisimportant subject.

Before we get started, let’s take aquick test on control premiums andlack of control/minority discounts inoperating businesses.1

Control Premiums and Minority Discountsin Operating Businesses

• Is there a good source of data forminority discounts? No.

• Is a minority discount the oppositeof a control premium? No.

• Are control premium studies a goodsource of data for calculating aminority discount? No.

• Are control premiums derived fromcontrol premium studies useful andsupportable? No.

If the answer is no, then why dosome valuation analysts still applycontrol premiums in operating busi-nesses? Maybe it is because they have“made too many wrong mistakes.”Let’s take a closer look at why theanswer to these four questions is “no.”

The International Glossary of Busi-ness Valuation Terms2 includes the fol-lowing terms and definitions:“Discount for Lack of Control—anamount or percentage deducted fromthe pro rata share of value of 100% ofan equity interest in a business to

EXPERTS in this Issue

Jim HitchnerEditor’s Outlook..................................... 1

Bill Quackenbushon Cost of Capital............................... 15

Gil Matthewson Enterprise Value............................. 18

Mark Dietrich on Healthcare Valuation ...................... 20

Eva Langon Valuation Resources ....................... 22

Steve Babitsky and James Mangravition Expert Witness Testimony................ 24

John Waker and Chris Treharnewith a New Court Case......................... 25

Panel of Experts ................................. 28

Cost of Capital Corner ........................ 31

The Facts, the Fiction and the Figments


EdITOR’S OuTLOOk, continued

Although the information in this journal has been obtained from sources that Valuation Productsand Services, LLC, believes to be reliable, we do not guarantee its accuracy, and such informa-tion may be condensed or incomplete. This journal is intended for information purposes only, andit is not intended as financial, investment, legal, or consulting advice. Valuation Products andServices, LLC, disclaims all responsibility for its content.

Financial Valuation and Litigation Expert is published bi-monthly by Valuation Productsand Services, LLC, 10 South Buffalo Avenue, Ventnor City, NJ 08406. An annual sub-scription (6 issues) is $219, delivered in electronic (pdf) format. Individual issues arealso available for purchase.

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Editorial questions/comments or article submissions may be addressed to KarenWarner, managing editor, at [email protected] or (609) 289-8341.

While the authors have used their best efforts in preparing these articles, they make no repre-sentations or warranties with respect to their applications to a particular assignment. Eachfinancial analyst should analyze his/her own situation carefully in determining the appropriateuse of data and information. Each author’s views and opinions are his/her own, and the otherauthors may agree or disagree with the articles presented here.

© Copyright 2012, Valuation Products and Services (VPS). All rights reserved. This journal may not be reproduced in whole or in part without the express written permission of VPS.

Publisher Valuation Products & ServicesEditor in Chief James R. Hitchner, CPA/ABV/CFF, ASA

Valuation Products & ServicesManaging Editor Karen Warner, M.A., Valuation Products & ServicesDirector of Operations Janet Kern, B.A., Valuation Products & Services

Financial Valuation Litigation Expertand

Mel H. Abraham, CPA/ABV, CVA, ASA Mel H. Abraham

R. James Alerding, CPA/ABV, ASA, CVA Alerding Consulting, LLC

Steve Babitsky, JD SEAK, Inc.

Don Barbo, CPA/ABV Deloitte Financial Advisory Services, LLP

Neil Beaton, CPA/ABV, ASA, CFA Grant Thornton, LLP

Bruce B. Bingham, FRICS, FASA Capstone Valuation Services, LLC

Kristopher A. Boushie, CPA/ABV/CFF CVA Quantus Consulting LLC

Stephen J. Bravo, CPA/ABV, ASA, CBA, MST, CFP, PFS Apogee Business Valuations

Rod P. Burkert, CPA/ABV, CVA Burkert Valuation Advisors, LLC

Thomas F. Burrage, CPA/ABV/CFF, CVA, DABFA Burrage & Johnson, CPAs, LLC

Stacy P. Collins, CPA/ABV, CFF Financial Research Associates

Larry R. Cook, CPA/ABV, CBA, CDFA Larry R. Cook & Associates, PC

Michael A. Crain, CPA/ABV, ASA, CFA, CFE The Financial Valuation Group

Mark O. Dietrich, CPA/ABV, MBA, MST Mark O. Dietrich, CPA, PC

Darrell D. Dorrell, CPA/ABV, MBA, ASA, CVA, CMA, DABFA Financial Forensics

Robert E. Duffy, CPA/ABV, CFA, ASA Grant Thornton, LLP

Edward J. Dupke, CPA/ABV/CFF, ASA Clifton Larson Allen LLP

Nancy J. Fannon, CPA/ABV, ASA, MCBA Fannon Valuation Group

Jay E. Fishman, FASA Financial Research Associates

Carla G. Glass, CFA, FASA Hill Schwartz Spilker Keller, LLC

Robert P. Gray, CPA/ABV/CFF, CFE ParenteBeard LLC

Robert J. Grossman, CPA/ABV, ASA, CVA, CBA, MST Grossman Yanak & Ford, LLP

Chris Hamilton, CPA, CFE, CVA, DABFA Arxis Financial, Inc.

J. Michael Hill Sr., FASA, CBA Hill Schwartz Spilker Keller, LLC

J. Michael Hill Jr., ASA, CPA/ABV Hill Schwartz Spilker Keller, LLC

Thomas E. Hilton, MSF, CPA/ABV/CFF, ASA, CVA Anders Minkler & Diehl, LLP

James R. Hitchner, CPA/ABV/CFF, ASA Financial Valuation Advisors, LLC

Steven Hyden, CPA/ABV, ASA The Financial Valuation Group

Michael G. Kaplan, CPA, CVA, CFFA Michael G. Kaplan

Mark G. Kucik, CPA, CVA, CM&AA Kucik Valuation Group, LLC

Eva M. Lang, CPA/ABV, ASA The Financial Consulting Group

M. Mark Lee, CFA Eisner LLP

Howard J. Lewis, AVA, ABAR Institute of Business Appraisers

Derald L. Lyons, MT, CPA/PFS, CVA Lyons & Seacrest, PC

Michael J. Mard, CPA/ABV, ASA The Financial Valuation Group

L. Gail Markham, CPA/ABV/CFF, CFP Markham Norton Mosteller Wright & Co., PA

Harold Martin Jr., CPA/ABV, CFF, ASA, CFE, MBA Keiter, Stephens, Hurst, Gary & Shreaves, PC

Gilbert E. Matthews, CFA Sutter Securities Incorporated

Z. Christopher Mercer, ASA, CFA Mercer Capital

Dr. Shannon P. Pratt, FASA, MCBA, CFA, CM&AA Shannon Pratt Valuations

William C. Quackenbush, ASA, MCBA, ABAR Advent Advisors, LLC

Scott R. Saltzman, CPA, CVA, ASA, CFFA Saltzman, LLC

Ronald L. Seigneur, CPA/ABV, ASA, MBA, CVA Seigneur Gustafson, LLP

John J. Stockdale, ASA, CPA/ABV/CFF John J. Stockdale

Robin Taylor, CPA/ABV, CFE, CVA, CBA Dixon Hughes Goodman LLP

Chris D. Treharne, ASA, MCBA, BVAL Gibraltar Business Appraisals, Inc.

Gary R. Trugman, CPA/ABV, MCBA, ASA, MVS Trugman Valuation Associates

Linda B. Trugman, CPA/ABV, MCBA, ASA, MBA Trugman Valuation Associates

Stacey D. Udell, CPA/ABV/CFF, ASA, CVA Gold Gocial Gerstein, LLC

Daniel R. Van Vleet, ASA, CBA Stout Risius Ross

Richard M. Wise, FASA, MCBA, CVA, FCBV, CA•IFA, FCA Wise, Blackman LLP

Donald P. Wisehart, ASA, CPA/ABV, CVA, MST Wisehart, Inc.

Kevin Yeanoplos, CPA/ABV/CFF, ASA Brueggeman and Johnson Yeanoplos, P.C.

Panel of exPerts

uncertainty resulting from the reform legislation. He dis-cusses the reform’s impact on small and large businesses aswell as specific implications for the healthcare industry.

Internet research expert Eva Lang shares what shebelieves are some of the most useful “apps” for financialprofessionals. She says that iPads and smartphones can cer-tainly be of use in your business, but she also warns that itwill take some work on the user’s part to get the most out ofthem.

Steve Babitsky of SEAK, Inc., a leading provider ofexpert witness training, has shared a valuable checklistwith our readers. Steve brings us the “Expert Witness NewClient Interview Checklist,” a tool many of our readers willundoubtedly find useful.

John Walker and Chris Treharne provide us withanother thought-provoking court case. In the Estate of Liljes-trand v. Commissioner, a taxpayer fails to prevail as he relieson his own devices rather than those of a valuation profes-sional.

As always, we conclude the issue with Cost of Capi-tal Corner. c

SubScRIPTIOn InFORMaTIOn


FInancIaL VaLuaTIOn - Front page, continued

reflect the absence of some or all of thepowers of control.”“minority Discount—a discount forlack of control applicable to a minorityinterest.”“Control—the power to direct themanagement and policies of a businessenterprise.”“Control premium—an amount or apercentage by which the pro rata valueof a controlling interest exceeds the prorata value of a noncontrolling interestin a business enterprise to reflect thepower of control.”

The AICPA has the followingterm and definition:

Control adjustment. A valuationadjustment to financial statementsto reflect the effect of a controllinginterest in a business. An examplewould be an adjustment to own-ers’ compensation that is in excessof market compensation.3

As you can see control premi-ums, minority interest discounts anddiscounts for lack of control are allintertwined here. That is because con-trol premium data are often used as abasis to determine DLOCs.

mergerstat DataOkay, what do we do now? Go toMergerstat, correct.4 We’ll just use theinverse of a control premium by usingthe following formula:

DLOC = 1 - ______1______1 + premium

For example, a 40 percent control pre-mium would result in a 29 percentminority discount.

mergerstat CaveatsLet’s dig deeper into the Mergerstatdata. We will review information fromthe 2010 edition.

While we attempt to collect com-plete information on each transac-tion, this is not possible in manycases, particularly with privatecompanies. Therefore, the readershould use caution in drawingconclusions when the number of

data points is low relative to thetotal number of transactionsrecorded. Furthermore, while weattempt to point out certain trends,each transaction has specific fac-tors which affect its pricing.Therefore, the reader shouldexamine each transaction on itsown merit before drawing anyconclusions.5

The last two sentences are appli-cable to users of control premium dataand DLOCs. Each single transaction isdifferent and is based on the facts ofthe transaction and the individualmotivations of the buyer and seller.The publication also cautions the read-er to “…examine each transaction onits own merit before drawing any con-clusions.” It doesn’t say go to the aver-ages for the control premiums for allindustries or even to go to the averagesof an individual industry.

Important mergerstatInformatIonWhile Mergerstat is often used forlooking at control premiums, it alsopresents information on deals. • Transactions (1,777) disclosing a

purchase price (pp. 10-11)• Mean average transaction price is

$313.1 million (MM)• Median transaction price is $20.0

MM• 482 (27%) $5.0 MM or less• 464 (26%) over $5.0 MM through

$25.0 MM• 74% less than $100 MM • Median purchase price (p. 12)

- Public sellers $94.1 MM- Private sellers $10.0 MM

ControL premIum DataIn terms of control premiums, all thesellers were public companies as con-trol premiums are calculated by look-ing at the announced or closed dealprice and comparing it to the publiclytraded price of the company involvedin the transaction. Some importantinformation follows:• Control premiums (based on offer-

ing price) (p. 25)

- Base number of companies is 239- Calculations based on seller’s clos-ing market price five business daysbefore initial announcement- Excludes negative premiums- Average is 58.7%- Median is 39.8%- With negative premiums

(base is 269 transactions)• Average is 49.6%;

median is 34.8%• Median control premiums based on

size (p. 27)- $25 MM or less 53.4% (56)- Over $25 MM through $50 MM

41.8% (33)- Over $50 MM through $99.9MM

51.7% (29)- $100 MM or more

34.7% (121)- In some historical years the range is

closer or reversed (smaller companies with smaller premiums)

• There are 108 going private transac-tions which are acquisitions of pub-lic companies by private investmentgroups (p. 44)- Median price was $65.0 MM- Median premium was 36.1%- Median P/E was 11.9

• There are 50 industry classificationsfor control premiums (p. 81)- 2009 - Only 13 (26%) had more than

five transactions- 2008 – Only 12 (24%) had more

than five transactions- 2007 – Only 25 (50%) had more

than five transactions• Historically only four industries:

“Banking and Finance,” “Brokerage,Investment and Management Con-sulting,” “Computer Software, Sup-plies and Services,” and “Drugs,Medical Supplies and Equipment”account for a large percentage of thetransactions. (p. 81)- 2009 97/239 (41%)- 2008 152/294 (52%)- 2007 211/491 (43%)

Obviously this data reinforces thenotion of looking carefully at eachtransaction. With only 26 percent ofthe individual industry control premi-




um averages having more than fiveobservations in 2009, such a small sam-ple must be evaluated differently andwith caution. Also, for those who usecontrol premium averages across allindustries, the fact that over 40 percentof the transactions in the last threeyears are from four industries mustgive you pause and certainly make youthink twice about the supportability ofusing the data this way.

faCtset mergerstat/BvrControL premIum stuDyAnother similar source of control pre-mium data is from FactSet Merger-stat®/BVR Control Premium Study.™The FAQs6 include the following com-ments:

mergerstat Control premium• “Premium computed by comparing

the price ultimately paid to the unaf-fected stock price. [ = (Purchase Price Per Share inHome Currency / Unaffected Pricein Home Currency) - 1] (also knownas the Mergerstat UnaffectedControl Premium…)”

• Time before announcement- One day, one week, one month,

two months

mergerstat unaffected price• “Target company’s common stock

price per share unaffected by theacquisition announcement.”

• “Selected by Mergerstat® after ana-lyzing each transaction (see Transac-tion Information) (this price is in theHome Currency).”

• “The Mergerstat® Review™ coversa much broader spectrum of M&Adeals whereas the Mergerstat® /BVR Control Premium Study™focuses on premiums.”

• “…Mergerstat® Review includesboth closed and announced deals;FactSet Mergerstat®/BVR ControlPremium Study™ only includesclosed deals.”

• “The premiums in the Mergerstat®Review are only for US public tar-gets. The data for the year comesonly from deals announced during

that year that meet the criteria (ofbeing a US public company).

• The premium information from theCPS comes from worldwide publictargets where a controlling interestwas acquired, and the transactioncloses during the specific quarter inwhich it is tracked.”

Many of the same problems thatare in the Mergerstat Review data arealso in the FactSet Mergerstat®/BVRControl Premium Study data. As such,we will not repeat the same cautions.

Okay, with all this knowledge,what do we do now? Go to eitherMergerstat product? That is not whatis recommended in some of the leadingvaluation texts. Most endorse the con-cept that control and minority areadjusted (or not) in the cash flows ofthe business, i.e., control cash flowsresult in control value and minoritycash flows result in minority value.Most also strongly caution the use ofcontrol premium study data to deter-mine control value. They also cautionagainst adjusting the discount rate orcapitalization rate for minority or con-trol in an income approach. Also,most, if not all of the U.S. business val-uation committees/organizations teachthat control and minority valueemanates from the cash flows.

Financial Valuation Applications andModels, third edition, 20117

By choosing to make certainadjustments to the future econom-ic benefit (i.e., the numerator), theanalyst can develop a control ornoncontrol value. (p. 125)

The content of the numeratordrives the type of value (control orminority) produced. As such, if thenumerator includes adjustmentsrelated to control, the value con-clusion will be a control value. Byexcluding adjustments related tocontrol, the value conclusion is aminority value. If control adjust-ments are included in the normal-ization and the resulting value is acontrol value, a minority interest

discount may be used to adjustfrom control to minority value.There are often situations whereno control adjustments are neces-sary and the company’s controlowners run the company to thebenefit of all the owners. In this sit-uation, the value might be thesame for minority and control.However, some analysts still applya minority discount to reflect therisk of a potential change in thecontrol owner or his or her man-agement philosophy. (p. 125)

Adjustments to the income andcash flow of a company are the pri-mary determinants of whether thecapitalized value is minority orcontrol. (p. 126)

When there are controlling interestinfluences in the benefit stream oroperations of the entity and aminority interest is being valued, itmay be preferable to provide aminority value directly by notmaking adjustments. Doing thiswill avoid the problems related todetermining and defending theapplication of a more general levelof minority discount. (p. 127)

…it is important to note that manyanalysts now adjust for controland minority in the cash flows of abusiness as opposed to more sub-jective applications of control pre-miums and minority discounts.”(p. 366)

If there is no control premium,then the control value and the mar-ketable minority value may be thesame. Some analysts believe thatthe control standalone value andthe as-if-freely-traded minorityinterest value will often be close.(p. 368)

Control premiums quantify thevalue of controlling the destiny of thecompany and/or the ability to divertcash flows and value to the controlling




ownership. Acquisition or strategicpremiums quantify the incrementalvalue of a particular investment asviewed by a specific investor(s). Thereis empirical evidence of the size ofcombined control and strategicpremiums. However, these data donot separate the two types of pre-miums. (p. 370)

Far too often, control premiumshave been overstated by the use ofthese combined data (control andstrategic premiums) as a proxy forcontrol premiums only. (p. 371)

The quantification of the amountof the discount for lack of control(or the minority discount) is diffi-cult due to the lack of empiricalevidence in this area. (p. 377)

The Mergerstat data include syner-gistic and acquisition premiumsalong with the control premium,and segregation of these premi-ums is difficult. (p. 377)

While many analysts accept thatthe market approach using guide-line publicly traded companiesyields a minority value, manyother experts believe that theguideline public company methodmay, in fact, not result in just aminority interest value, that is,minority and control in a publiccompany are the same, even thoughthe market prices are those of minorityinterests. According to Eric Nath:I have concluded that demon-strable control premiums are rarein public companies, and that, forthe most part, statistics on con-trol premiums provide little orno useful information whenattempting to estimate the fairmarket value of a controllinginterest in a private company.Therefore, valuation of a privatecompany using a publicly tradedcomparative should result in amajority interest value. [EricNath, “Control Premiums andMinority Interest Discounts in

Private Companies,” BusinessValuation Review (June 1990).Emphasis added.] (p. 378)

It is the responsibility of the man-agement and board of directors ofa public company to run the com-pany to the benefit of all share-holders regardless of the size of theholding. As such, as the fortunes ofthe entire company go, so also gothe fortunes of minority share-holders. If the company does well,so does the minority interest. If thecompany does poorly, so does theminority interest. As such, underfair market value, minority andcontrolling interests in public com-panies may be so intertwined thatthey are essentially similar. (p. 378)

Many analysts also believe that theapplication of public company val-uation multiples to control cashflows results in a control value,while their application to non con-trol cash flows results in a minori-ty interest value. Since a multipleis really an inverted cap rate, thisposition may not be that differentfrom the same concept for theincome approach…which is gener-ally accepted. (p. 378)

The use of minority cash flows inthe income approach produces aminority interest value. …minoritycash flows are those cash flowswithout any adjustments due tocontrolling shareholders actionssuch as excess compensation, rentpayments, or perquisites. (p. 379)

When valuing a minority interest,it may be preferable to start workat the minority interest level ratherthan take on the additional workand risk of error involved in dis-counting back to a minority valuefrom a control value. Conversely,when valuing a controlling inter-est, it may be easier to start with acontrol value than to add a controlpremium. (p. 379)

Valuing a Business, the Analysis and Appraisal of Closely Held Companies, fifth edition, 20088

Does the Discounted EconomicIncome Model Produce a Controlor a Minority Value? (p. 228)

As noted earlier in the chapter, thediscounted economic incomemodel can produce either a controlvalue or a minority value, depend-ing on the model inputs involvingthe valuation variables. Generally,if the inputs in the valuation modelreflect changes that only a controlowner would (or could) make(e.g., changed capital structure,reduced owner’s compensation,and so on), then the model wouldbe expected to produce a controlvalue. (p. 228)

If the economic income projectionsmerely reflect the continuation ofpresent policies, then the modelwould be expected to produce aminority value. If every facet of thecompany is being so well opti-mized that a control owner couldnot improve on it, then there is lit-tle or no difference between a con-trol value and a minority value. (p. 228)

The argument is often made that,because discount rates typicallyare developed based on minoritytrades in publicly traded stocks,the discount rate is a minorityinterest discount rate, and there-fore the value indicated by a dis-counted economic income modelmust be a minority value. Thereare at least two problems with thisargument. First, most, if not all, ofthe difference between a control valueand a minority value in a discountedeconomic income model results fromdifferences in the projected economicincome (the numerator), not from dif-ferences in the discount rate. Second,while the cost of equity capital isestimated from trades of minority




ownership interests, the capitalstructure (i.e, the percentage ofdebt versus the percentage of equi-ty) of the subject company is clear-ly influenced by the controllingstockholder. And, the capital struc-ture mix is at least as important asthe cost of equity capital in the esti-mation of a company’s overallWACC—that is, the discount rateassociated with net cash flow. Inother words, the cost of equity cap-ital may be the same, or nearly thesame, whether a control or aminority interest is being calculat-ed. However, the controllingowner (and, generally, not theminority owner) influences theprojection of economic income (thenumerator in the model) and thecapital structure component of theWACC (the denominator in themodel). (p. 228)

While there is a great deal ofempirical evidence available toquantify the discount for lack ofmarketability, the empirical evi-dence to quantify the control pre-mium or, conversely, the minoritydiscount is, indeed, scant. The onlybody of empirical evidence that isavailable is from the public mar-ket. Of the several hundred publiccompanies that are taken over eachyear, most (about 85 percent) are atprices that represent a premiumover the previous public tradingprice. (pp. 384-385)

However, it is difficult, if notimpossible, to sort out how muchof this premium is for elements ofcontrol, and how much is for syn-ergies between the seller and thebuyer. (pp. 384-385)

In general, the only measure of acontrol premium is in the publicmarket, when a public company istaken over. But this measurementincludes the value of synergies aswell as the value of control. Mostanalysts tend to draw conclusionsfrom these data that exaggerate the

value of control, as analyzed in thischapter. (p. 393)

Also, it is important to emphasizethat what is called a “control pre-mium” in this book is in reality an“acquisition premium,” includingthe premium paid for synergies aswell as for the elements of control.Therefore, when using these datato estimate minority interest dis-counts, it is worthwhile to look atthe actual transactions and esti-mate what portion of the premiumactually represented synergies;they could be significant. (p. 405)

Understanding Business Valuation, APractical Guide to Valuing Small toMedium Sized Businesses, third edi-tion, 20089

The conventional wisdom in busi-ness valuation is that the valuationanalyst should not make adjust-ments to the financial statementsthat could not otherwise be madeby the interest being valued. Forexample, the minority intereststockholder cannot determine thelevel of compensation for the offi-cers of the company. However,with that being said, let’s be practi-cal when we consider the appro-priateness of the adjustments forthe assignment at hand. (p. 190)

… it may be necessary to make cer-tain adjustments to make the com-pany appear more comparable toguideline companies. If the con-trolling shareholder is taking toolittle salary out of the companyand chooses to take S corporationdistributions instead, a propercomparison to publicly traded Ccorporations may require a salaryadjustment even for a minorityvaluation. (p. 190)

What I am saying is use your head.Do not just blindly ignore adjust-ments because the valuation litera-ture indications [indicates] thatyou do not make adjustment for

the minority. There may be factsand circumstances that requirereasonable adjustments to bemade. [Note: See explanation onp. 8 on addressing value when thecash flows of the subject companyare zero.] (p. 190)

Another problem that exists inusing the control premium data isthat we cannot determine if thereis a true premium being paid forcontrol or if the acquiring compa-ny is paying for synergies that can-not be separately measured. Wealso do not know how many of theWall Street megadeals resulted inspin-offs after the acquisition. If acompany makes an acquisition for$100 million but intends to sell asubsidiary as soon after the acqui-sition as possible—for, let’s say, $10million—isn’t this really a $90 mil-lion net acquisition? However, thecontrol premium data used by thestudies would be based on the$100 million. Unfortunately, it isthe best that we have to work with.(p. 411)

In case you are not nervous aboutthis yet, one of the difficulties inproperly measuring the controlpremium that was paid is that itmust be a cash equivalent price tohelp the valuation analyst deter-mine the fair market value of theappraisal subject. Business transac-tions are frequently consummatedusing various payment options,including all cash, cash and non-cash, or all noncash consideration.(p. 411)

Putting this data into perspective,if a valuation analyst was to basethe control premium or discountfor lack of control merely on thedata included in the table that weare used to seeing, the premium ordiscount, or both, would be signif-icantly overstated. This means thatthe control premium that might beadded to the freely traded value




would be too high. Conversely, if adiscount for lack of control wascalculated from the normally useddata, the discount would be over-stated, and the minority interestwould be undervalued. So whatdoes all of this mean? It means thatwe have be aware of the data thatwe use and its impact on our con-clusions. Merely accepting datawithout understanding what isincluded is a bad practice. (p. 412)

morningstar Ibbotson SBBI, 2011 Valuation Yearbook10

Does the Equity Risk PremiumRepresent Minority or ControllingInterest? (pp. 61-62)

There is quite a bit of confusionamong valuation practitionersregarding the use of publicly trad-ed company data to derive theequity risk premium. Is a minoritydiscount implicit in this data? (pp. 61-62)

Both the S&P 500 and the NYSEinclude a preponderance of com-panies that are minority held.Does this imply that an equity riskpremium (or size premium)derived from these data representsa minority interest premium? (pp. 61-62)

Since most companies in the S&P500 and NYSE are minority held,some assume that the risk premiaderived from these return datarepresent minority returns andtherefore have a minority discountimplicit within them. However,this assumption is not correct. Thereturns that are generated by theS&P 500 and the NYSE representreturns to equity holders. Whilemost of these companies areminority held, there is no evidencethat higher rates of return could beearned if these companies weresuddenly acquired by majorityshareholders. The equity risk pre-mium represents expected premi-

ums that holders of securities of asimilar nature can expect toachieve on average into the future.There is no distinction betweenminority owners and controllingowners. (pp. 61-62)

When performing discounted cashflow analysis, adjustments forminority or controlling interestvalue may be more suitably madeto the projected cash flows than tothe discount rate. (pp. 61-62)

Appraisers need to note the dis-tinction between a publicly tradedvalue and a minority interestvalue. Most public companieshave no majority or controllingowner. There is thus no distinctionbetween owners in this setting.One cannot assume that publiclyheld companies with no control-ling owner have the same charac-teristics as privately held compa-nies with both a controlling inter-est owner and a minority interestowner. (pp. 61-62)

Well, as you can see, it’s in the cashflows. Minority cash flows are minori-ty value and control cash flows arecontrol value. Pretty simple, right?Not so fast. It’s not always that easy.First off, how does that concept fit val-uation approaches/methods?

Control and minority Issues Based onvaluation methodsDiscounted cash flow method – This fitsquite well in this income approachmethod as the projections that are dis-counted to present value can be adjust-ed to reflect either control or minoritycash flows.Capitalized cash flow method – This alsofits quite well in this income approachmethod as the amount of cash flowthat is to be capitalized can be adjustedto reflect either control or minoritycash flows.Guideline public company method – Manyvaluation analysts view a valuationmultiple, e.g., price to earnings, asnothing more than the inverse of a cap-

italization rate, albeit in this example,an earnings capitalization rate. Assuch, again, the economic benefit that amultiple is applied to can also beadjusted to reflect either control orminority cash flows.

Others argue that the subjectcompany must be normalized to bringit closer to publicly traded equivalentvalue. This is done by making all theadjustments necessary to make thesubject company and the guidelinepublic companies more comparable.This usually means making controladjustments. However, if a minorityvalue is desired, then an adjustmentmust be made to take the companyfrom control value to minority value.Since there is no reliable data to per-form such an analysis, we are essential-ly back to square one.Guideline company transaction method –Since the companies that make up thetransactions are mostly of the entirecompany, the multiples contain anyelements of control. This is okay whenthe subject company benefit stream ison a control basis. It is much morecomplicated when a minority value isdesired since you would be applyingcontrol multiples to minority benefitstreams.Net asset method – Assuming the assets,both tangible and intangible, are prop-erly valued, the resulting value wouldbe on a control basis. If a minority dis-count is warranted then an adjustmentmay be necessary. The adjustmentcould be made by referencing theminority values obtained by theincome approach and the marketapproach and making an economicadjustment. However, that just meansthat you are putting all the weight onthe income and market approachesand not really any weight on a pure netasset method.

Now that we have discussed potentialissues based on the valuationmethod/approach used, let’s look atpotential problem areas. Continued on next page



potentIaL proBLem areasWhat if the cash flows need no adjust-ments, i.e., minority and control are thesame. Is the value the same for minorityand control? The answer is yes assum-ing that the control owner(s) areexpected to continue running the com-pany to the benefit of all the ownersregardless of the size of the holding.

There is also some controversyabout whether the application ofthe market approach results in aminority value or a control value.Those who believe it is a minorityvalue argue that the underlyingpublic stocks are minority inter-ests, such that the application of avaluation multiple would result ina minority value. Others argue thatthe valuation multiples are noth-ing more than the inverse of capi-talization rates derived from thepublic market. Consequently, theybelieve that the underlying theoryabout minority/control being inthe cash flows for the incomeapproach should also apply to themarket approach. Also, the man-agement of a public company issupposed to do their best to maxi-mize earnings, cash flow, andvalue to all shareholders regard-less of the number of shares theyown.11

What if there is no one owner in control,e.g., three - 33 1/3 interests. Is the valuecontrol, minority or something inbetween? Assuming, again, that thecompany is run to the benefit of all theowners and that no one owner is usingthe company to their personal benefitto the detriment of the other owners,the value would be control if that isexpected to continue. Here, controlvalue and minority value would be thesame. This also assumes that the cashflows are on a control basis. If therewas a discount, it would be minimal.On the other hand, if one of the ownersis benefiting themselves to the detri-ment of the other owners that can bemodeled in the cash flows.

What if minority cash flows are zero? Is the value zero?

Would it be reasonable to ignorean adjustment for officer’s com-pensation in the following circum-stance? A parent owns and runs abusiness, takes $1 million out ofthe company as salary (when themarket rate of salary is $200,000 forthose services), reduces the profitsof the company to $0, and the pur-pose of the valuation is for a 10percent gift for the child of theowner. First of all, the answer isNO. It does not matter under fairmarket value whether the gift is tothe child or not. Under these cir-cumstances, a 10 percent owner,child or not, could probably bringan oppressed shareholder lawsuitin most jurisdictions against thecontrolling owner. Stripping thebusiness of any dividend-payingcapacity for the benefit of the con-trolling shareholder, and denyingthe minority of dividends, wouldconstitute oppression in my nonle-gal opinion. The legal remedy, atthat point, might be for the minor-ity shareholder to be bought out atfair value, providing a value basedon the control value of the interest,rather than the minority value.This would require the valuationanalyst to make the adjustment forcompensation and value the entitybased on its true profitability. 12

What if control cash flows are $500,000and minority cash flows are $100,000 andthe cap rate is 20 percent?• Control value = $2,500,000• Minority value = 500,000Is the minority discount 80 percent?Again, there could be some level ofshareholder oppression here and theminority shareholder would have toexercise their appraisal rights understate law. This can be a difficult analy-sis since you would have to estimatethe costs of litigation as well as theprobability of winning the lawsuit.

ControL premIum foCusIn the last few years several groups

have studied and reported on the useand sometimes abuse of control premi-ums and control premium studies anddata. The Appraisal Foundation,which issues USPAP, has formed aWorking Group on control premiumsand on Dec. 9, 2009, issued a requestfor comments. The American Instituteof Certified Public Accountants(AICPA) is also addressing controlinterests, control premiums andminority interests in two areas. First isthe AICPA, Working Draft, PracticeAid, Valuation of Privately Held Com-pany Equity Securities Issued as Com-pensation, released in draft form in2011. The second is the AICPA, Work-ing Draft, Accounting and ValuationGuide, Testing Goodwill for Impair-ment, released in draft form November4, 2011.

appraisal foundation, Workinggroup on Control premiums, Bestpractices in valuation for financialreportingCopyright © 2009 by The AppraisalFoundation. All rights reserved.

On December 9, 2009 a request forcomments was sent out that asked sixquestions. The first question, which isthe main focus of this article, was asfollows:

Discussion Question 1A matter of debate in the valuationfield relates to whether anobserved publicly traded marketshare price should be adjusted toreflect a control fair value. Someparties believe that a price multi-plied by quantity equation (PxQ)falls short of indicating the controlvalue of the business, when thebusiness as a whole is the unit ofmeasurement. Others posit that aPxQ analysis already captures con-trol features; thus it indicates acontrol value without requiringfurther adjustment.

view a: On its own, PxQ typicallydoes not indicate a control value.To determine a control value when




beginning with PxQ, a control pre-mium should typically be applied.As support for this traditionalview, proponents point to:• the premiums routinely paid incontrol acquisitions of public com-panies• the requirement to pay some-thing more than the current trad-ing price to acquire the number ofshares necessary to gain control• the value of the authority to setpolicy and make decisions for thebusiness• ASC Topic 350 and IAS 36 bothacknowledge the existence of acontrol premium

view B: On its own, PxQ typicallyindicates a control value. As sup-port for this view, proponentsargue that:• the vast majority of companiesare operating optimally which iswhy most companies are notacquired in a given year (i.e., formost public companies there areno incremental opportunities toenhance value)• empirical studies are unavoid-ably biased in that they includeonly companies that were acquired• companies may remain publicwhen the higher price required toentice the sale of enough shares togain control does not allow for areasonable return on the invest-ment to the market participant

Do you believe that view A or view Bis only applicable and the other is not?If so, which one and why?Do you believe that view A or view Bis applicable in the vast majority of sit-uations? If so, which one and why?Do you believe neither view is domi-nant and that facts and circumstanceswill dictate in every situation? Whatare the considerations for determiningthe applicability of the relevant view?

This working group received commentletters from different firms and indi-viduals. I would like to excerpt sever-al comments from the following valua-tion analysts:

• Eric Nath, ASA, Eric Nath & Associ-ates, comment letter dated January14, 2010

• Z. Christopher Mercer, ASA, CFA,ABAR, Mercer Capital, commentletter January 15, 2010

• Gilbert C. Matthews, CFA, SutterSecurities, comment letter datedJanuary 13, 2010

I picked these three individualsbecause they have been very active inwriting and speaking on the issue ofcontrol premiums well before theAppraisal Foundation decided toaddress this topic. It is also importantto note that there are other commentletters that disagree with the strongopinions of Mssrs. Nath, Mercer andMatthews.

erIC nath

Unfortunately, the control premi-um concept described in View A isplagued with fatal flaws that makeit totally useless for the purpose ofdeveloping a controlling interestvalue for almost any appraisalpurpose (or, by reciprocal, to use itto develop a lack of control dis-count for valuing a partial inter-est).

There are numerous problemswith the commonly accepted inter-pretation of the statistics generatedby the so-called ‘control premiumstudies.’ As with so many studiesin the business valuation field,they measure what is measurablebut not what is relevant and theresults are routinely misinterpret-ed. I will summarize why thisapproach for determining the con-trol value of the entire business orthe impairment of value for lack ofcontrol related to a minority inter-est does not work.

The traditional theory fails to rec-ognize that public investors actual-ly have a great deal of control overtheir investments because the liq-uidity of the public markets allows

them to sell at will. One of theunder-recognized benefits of asmoothly functioning and liquidpublic market is that shareholders’ability to sell at will eliminates vir-tually all risk associated with nothaving any control over the enter-prise.

Once it is realized that a sale of apublic company is simply a salefrom one control group to anothercontrol group, it becomes obviousthat an acquisition premium for apublic company cannot representthe value of control versus minori-ty value. Such an assertion simplyignores the true nature of the pub-lic shareholder’s position in thetransaction.

If a public company is acquired ata premium it is merely respondingto the laws of supply and demand,not some theory about a differen-tial in value between control andminority.

Public shareholders are no differ-ent than any other control group inthe sale of their company: all con-trol sellers hope to be paid a pre-mium. Sometimes this is possibleand sometimes not, as with anytransaction, but it doesn't require adifferential in value betweenminority and control to drive thisresult.

In looking at the premiums them-selves, the amount of the acquisi-tion premium, if any, will be afunction of many factors, includ-ing the skill with which the invest-ment banker manages the process.Hubris and stupidity on the part ofbuyers also play a well-document-ed role in driving up the price.These factors have nothing to dowith the difference in valuebetween control on the part of thebuyer and lack of control on thepart of the public shareholders.




It has been found that there is little,if any, difference in premiums paidby strategic buyers over financialbuyers of public companies.

Given the liquidity in the publicmarket, and the other factors men-tioned above which allow compa-nies to trade up to their intrinsiceconomic value, most public com-panies will tend to trade at or neartheir control value. Were this notsystematically true, given the hun-dreds of billions of buyout dollarswaiting for a good investment tomake itself known in the market,there would be far more acquisi-tions of public companies thanthere actually are.

Not that it is a compelling reasonto argue against the use of controlpremiums in financial reporting,but the SEC apparently takes avery dim view of the use of thistype of data to value the types ofassets and companies it reviews.As well they should – the use ofacquisition premiums will almostalways overvalue the assets atissue, which will misleadinvestors.

I believe that the issue of controlpremiums and what they don’t tellus is fairly settled at this pointamong the more experienced andsenior appraisal professionals.Nevertheless, the issue continuesto be debated by business apprais-ers who are either too young tohave researched the issues suffi-ciently or who do not have suffi-cient intellectual curiosity to movebeyond the superficial and rudi-mentary analysis that once charac-terized the discussion on this mat-ter.

ChrIs merCer

Control premiums neither do nordo they not measure control value.

Control premiums measure the

percentage difference between twoprices of a public company. Simplyput, control premiums measurethe difference between the price atwhich a public company isacquired (per share) and the priceat which it was trading before theannouncement of the acquisition(again, per share).

Assume that Company A isacquired for a price of $14.00 pershare. Assume further that theprice before the announcement ofacquisition (presumably the ‘unaf-fected price’) was $10.00 per share.The “control premium” is calculat-ed as follows:

CP = (Acquisition Price Per Share /Pre-Announcement Price PerShare) – 1.0CP = ($14.00 per share / $10.00 pershare) – 1.0CP = 1.4 – 1.0CP = 40%

So the control premium of Compa-ny A was equal to 40 percent. Whatdoes that tell you about the controlvalue of Company A? Absolutelynothing. You have to know thecomponents of the equation toknow what the control value ofCompany A was.

So the control premium of Compa-ny A was equal to 40 percent. Whatdoes that tell you about the ‘good-ness’ or ‘badness’ of that transac-tion price in relationship to othercompanies? Absolutely nothing.

If similar companies are tradingfreely at around 8x multiple ofEBITDA and the 40 percent controlpremium for Company A reflecteda 6x multiple of EBITDA, it mayhave been a ‘bad’ price. On theother hand, if the 40 percent con-trol premium reflected an 11.2xmultiple of EBITDA (with otherstrading at 8x), it may have been a‘good’ price.

It should be clear that the controlpremium from a single transactiontells you absolutely nothing aboutthe control value or the goodnessor badness (relatively) of the pric-ing of that transaction.

What about lots of control premi-ums? Mergerstat Review 2009 wasreviewed for a sample. Since Ithink I know something aboutfinancial institutions, I wrotedown all the control premiums forthree broad industry groups in2008, banking and finance, insur-ance, and brokerage/investmentbanking/management consulting.

So now, I tell you that of the 29banking transactions recorded inMergerstat Review 2009 had a medi-an control premium of 41.1 per-cent. What does that tell you aboutany bank transaction? Absolutelynothing.

The average control premium was62.7 percent, which should tell youthat there must have been somerelatively large premiums in 2008.The average premium excludingpremiums greater than 100 percentwas 33.6 percent. What does thattell you about any bank transac-tion? Absolutely nothing.

The standard deviation for the 29transactions was 86.7 percent,which is larger than the median orthe average. What does that tellyou about the control value of anybank? It tells me that the applica-tion of any of these numbers to anyother bank not in the group is anexercise in futility.

The remainder of the questionsposed in the ‘Request forResponse’ presuppose that oneplans to use control premiums andthen discuss potential guidance forhow to apply them. The ASBshould back away from these ques-tions. It is impossible to provide




credible guidance regarding howto apply something that doesn’tand cannot work.

The appropriate question is nothow to apply control premiums.Perhaps the appropriate questionrelates to how to develop values ona controlling interest basis. Thatquestion can be addressed in eco-nomic terms.

gIL mattheWs

I strongly believe in View B. Ispoke on this issue at the ASA con-ference in Boston with Prof. LarryHamermesh, discussing the issueas it relates to Delaware appraisals.

The default premise should be thatthe market price of an activelytraded stock (whether it be thesubject company or a guidelinecompany) represents a pro ratashare of control value.

I would never apply a control pre-mium based on average premi-ums, as discussed in my article. If acontrol premium is to be applied,it should be determined based onmultiples of guideline acquisitionscompared to multiples of the sub-ject company or guideline compa-nies.

Attached to Mr. Matthews com-ment letter is a copy of an article hewrote in the American Society ofAppraisers Business ValuationReview, Summer 2008, Volume 27,Number 2, “Misuse of Control Pre-miums in Delaware Appraisals.”Some excerpts follow which illus-trate some of the history of thecontrol premium issue and howseveral respected valuation expertseither rejected the prevailing per-spective or were brave enough tochange their positions.

Eric Nath, a San Francisco–basedvaluation expert, was the first toquestion the presumption of an

implied minority discount in pub-licly traded share prices. Nath pre-sented this view in a pioneering1990 Business Valuation Review arti-cle in which he argued that marketprices generally already reflectedcontrol value. He pointed out thatthe freely traded market prices of acompany already had incorporat-ed in them the company’s financialcontrol positives or negatives. [81 -Nath, ‘Control Premiums andMinority Interest Discounts in Pri-vate Companies,’ Business Valua-tion Review, June 1990. He reiterat-ed this position in ‘The Tale of TwoMarkets,’ Business Valuation Review,Sept. 1994 and in ‘How PublicGuideline Companies Represent“Control” Value for a PrivateCompany,’ Business ValuationReview, Dec. 1997.] Nath’s theorystimulated a great deal of debateand reconceptualization and,despite much initial resistance inpublications and seminars, hasbecome widely accepted by lead-ing valuation experts. Mark Lee,an experienced and well-respectedvaluation expert, pointed out in2001: ‘If there is no M&A marketavailable to sell a company at apremium to its stock market value,then there is little or no acquisitionpremium, much less a “theoreti-cal’’ premium based on an averageof acquisitions of dissimilar com-panies.’ [82 - M. Mark Lee, ‘Con-trol Premiums and Minority Dis-counts: the Need for EconomicAnalysis,’ Business ValuationUpdate, Aug. 2001, 4.]

Lee also pointed out in 2004 that‘the acquisition value of a compa-ny may be equal to or below itsmarket value,’ explaining, ‘While acompany may be viewed as veryattractive to a purchaser of aminority interest in the publicmarket, the company as a wholemay be perceived as too risky at itspublicly traded market price.’ [83 -M. Mark Lee, ‘The Discount forLack of Control and the Owner-

ship Control Premium,’ in TheHandbook of Business Valuation andIntellectual Property Analysis,Robert F. Reilly and Robert P.Schweihs, eds., (New York:McGraw-Hill, 2004), 37.]

In 1996, when Shannon Pratt wrotethat the guideline companymethod ‘usually requires someadjustment from the publicly trad-ed minority stock value equivalentto account for control,’ that was theaccepted view of the financialcommunity. [86 - Pratt, Reilly, andSchweihs, Valuing a Business, 3rded., p. 210.] At that time, theDelaware Court rightly reliedupon the financial community’saccepted view of an impliedminority discount since they werefollowing Weinberger’s injunctionto make their valuations in accor-dance with accepted financial the-ory.

Within three years, Pratt had cometo modify his view. In a 1999 articlehe stated, ‘Valuation analysts whouse the guideline public-companyvaluation method and then auto-matically tack on a percentage“control premium” . . . had betterreconsider their methodology.’ [87- Pratt, ‘Control Premiums?Maybe, Maybe Not— 34% of 3rdQuarter Buyouts at Discounts,’Business Valuation Update, Jan.1999, pp. 1-2. This article is cited inPratt, Reilly and Schweihs, Valuinga Business: The Analysis andAppraisal of Closely Held Companies,4th ed. (New York: McGraw-Hill2000), 357.] Pratt included thiscomment in the Fourth Edition ofValuing a Business in 2000…

In 2001, Pratt further clarified hisposition in Business Valuation Dis-counts and Premiums. After anextensive discussion of variousarticles and seminars regardingthe issue of whether market pricesreflect control value, Pratt quoted




extensively from Lee’s incisive2001 article and then concluded,‘In any case, it is obvious that,given the current state of thedebate, one must be extremelycautious about applying a controlpremium to public market valuesto determine a control level ofvalue ’[89 - Pratt, Business ValuationDiscounts and Premiums (2001), 40.]

Mercer was also coming to the con-clusion that market prices are oftenclose to control value. Headdressed the issue directly in2004 in the important 1st Edition ofThe Integrated Theory of BusinessValuation. [92 - Mercer, The Integrat-ed Theory of Business Valuation (Bal-timore: Peabody, 2004). This bookinnovatively showed the interrela-tion among various approaches tovaluation, discounts, and premi-ums.] After having disagreed withNath in the early 1990s, he conced-ed that Nath had been right, andthat the financial control premium(the difference between FinancialControl Value and MarketableMinority Value) could be zero.[93 -Id., p. 101.] Mercer’s 2004 bookincluded a modified levels-of-value diagram... that showed Mar-ketable Minority Value overlap-ping Financial Control Value. [94-Id., p. 110. This diagram is repro-duced in Pratt, Valuing a Business,5th ed., (2008), 387. ] He uses thatmodel to make the point that‘unless there are cash flow-drivendifferences between the enter-prise’s financial control value andits marketable minority value,there will be no (or very little)minority interest discount.’ [95 -Id., p. 108. ]

aICpa, Working Draft, practice aid,valuation of privately held Companyequity securities Issued as Compen-sationCopyright © 2011 by American Insti-tute of Certified Public Accountants,Inc., New York, NY. All rightsreserved.

The following caveats are from page 3.

This practice aid is nonauthorita-tive and has been developed byAICPA staff and the Equity Securi-ties Task Force.

This practice aid replaces the 2004edition of the practice aid Valuationof Privately-Held-Company EquitySecurities Issued as Compensation.

This publication does not repre-sent an official position of theAICPA, and it is distributed withthe understanding that the authorsand publisher are not renderinglegal, accounting, or other profes-sional services via this publication.

The issue of control vs. minority valueis addressed in Chapter 9, “Controland Marketability.” While we recom-mend that our readers read the entirechapter to gain the full context, somerelevant excerpts follow:

9.01 In the market approach, theguideline public company methodis typically regarded as indicatingthe enterprise or equity value on aminority, marketable basis (Foot-note 1: Note, however, that to theextent that the cash flows and costof capital for the enterprise undercurrent ownership are close tooptimal, the enterprise value on aminority basis may be similar orequal to the enterprise value on acontrolling basis.), and the guide-line transactions method is typical-ly regarded as indicating the enter-prise or equity value on a control-ling, marketable basis. The back-solve method indicates an equityvalue that is consistent with the

private equity or venture capitalinvestors’ expected rate of return,given the degree of control theyhave over the enterprise and thedegree of marketability of theirinvestment. (p. 78)

In the income approach, the dis-counted cash flow method is typi-cally regarded as indicating valueon a controlling, marketable basis,but it may be used to indicatevalue on a minority interest basis,if the cash flows reflect minorityinterest cash flows and the dis-count rate reflects the company-specific cost of capital. (p. 78)

9.04 In many cases, a control premi-um or acquisition premium is esti-mated based on the prices thatmarket participants may pay toacquire companies. Given the eco-nomics of supply and demand, abuyer who wishes to acquire con-trol of an enterprise may have topay a significant premium over theprevious equilibrium price toincentivize current interest holdersto sell. These premiums may bejustified by the expected improve-ments to the cash flows, reductionsin risk that buyers expect toachieve, or both. (Footnote 2: Theowners of an enterprise mayincrease enterprise value byimproving the cash flows directly;for example, by increasing rev-enues, reducing operating costs, orreducing nonoperating costs suchas taxes. The owners of the enter-prise may also increase enterprisevalue by reducing risk; for exam-ple, by diversifying the business,improving access to capital,increasing the certainty of cashflows, or optimizing the capitalstructure. Both of these approach-es may be used to justify the pre-miums paid in transactions.) Valu-ation specialists frequently esti-mate the control premium thatmight be paid for an enterprise byobserving the difference between




public company multiples and themultiples paid in transactions.(Footnote 3: For example, theMergerstat Review provides statis-tics and analysis of mergers andacquisitions for U.S. companiessegregated by industry. However,note that these statistics reflectaverages over a wide range, andthe actual premium paid in anygiven transaction depends uponthe negotiation dynamics. Whenestimating an acquisition premiumfor a specific company, it is impor-tant to consider the characteristicsof the likely market participantsand the level of improvements tothe cash flows and synergies avail-able to these market participants.Synergies available to only onepotential acquirer typically shouldnot be included in the estimatedcontrol premium, because it wouldbe difficult for the sellers to cap-ture the value of these synergies inthe negotiation process.) (p. 79)

9.06 In short, the task forcebelieves that it is not appropriateto include a control premium oracquisition premium in the enter-prise value used in valuing theminority interest securities withinthe enterprise, except to the extentthat such a premium reflectsimprovements to the business thata market participant would expectunder current ownership. (p. 80)

9.14 The most common method forestimating a discount for lack ofcontrol uses the inverse of theacquisition premium observed intransactions as discussed in para-graph 9.04. (Footnote 12: Usingthis method, the discount for lackof control would be measured as 1 – (1 / (1 + control premium)).However, the task force believesthat these premiums overstate the‘pure’ difference in value attributa-ble to the difference in the level ofinfluence between primaryinvestors’ securities and othersecurities, because the control pre-

miums measured in merger andacquisition studies include syner-gies and reflect transactiondynamics at the enterprise valuelevel. (p. 82)

9.15 In summary, as discussed inparagraphs 9.07–.12, when valuingminority interests in an enterprise(including investor securities thatlack control), the enterprise valuewould be measured consideringthe company’s cash flows undercurrent ownership, the company’splans for a future liquidity event (ifany), and the premium (if any) thatmarket participants would expectto be realized upon a liquidityevent (whether via a sale or anIPO). The enterprise value wouldnot include a significant control oracquisition premium, unless mar-ket participants would pay such apremium for an interest in theenterprise under current owner-ship. Therefore, in such case, itwould be unnecessary to back outa premium in estimating the fairvalue of the minority interests.(Footnote 13: If market partici-pants would pay a significant con-trol or acquisition premium for aninterest in the enterprise today,even though the expected liquidityevent is some time into the future,that premium should be consid-ered in estimating the fair value ofthe minority securities as well. Thediscount for lack of control thatmay apply to the minority securi-ties relative to the primary investorsecurities should capture only thedifferences in risk described inparagraph 9.13.) (p. 82)

aICpa, Working Draft, accountingand valuation guide, testing good-will for Impairment.Copyright © 2011 by American Insti-tute of Certified Public Accountants,Inc., New York, NY. All rightsreserved.

The following caveats are from pageiii.

This guide provides guidance andillustrations for valuation special-ists, preparers of financial state-ments, and independent auditorsregarding goodwill impairmenttesting. This guide is nonauthorita-tive and has been developed byAICPA staff and the AICPAImpairment Task Force.

This publication does not repre-sent an official position of theAICPA, and it is distributed withthe understanding that the authorsand publisher are not renderinglegal, accounting, or other profes-sional services via this publication.

The issue of control vs. minority valueis addressed in several places in theworking draft. While we recommendthat our readers read the entire work-ing draft to gain the full context, somerelevant excerpts follow:

3.02 FASB ASC 350-20-35-22 statesthat the fair value of a reportingunit is the price that would bereceived to sell the reporting unitas a whole in an orderly transac-tion between market participantsat the measurement date. It alsostates that quoted market prices inactive markets are the best evi-dence of fair value and should beused as the basis for the measure-ment, if available. (p. 43)

3.04 FASB ASC 350-20-35-23 fur-ther explains that substantial valuemay arise from the ability to takeadvantage of synergies and otherbenefits that flow from controlover another entity. Consequently,measuring the fair value of a col-lection of assets and liabilities thatoperate together in a controlledentity may be different from meas-uring the fair value of that entity’sindividual equity securities. Anacquiring entity often is willing topay more for equity securities thatgive it a controlling interest thanan investor would pay for a num-




ber of equity securities represent-ing less than a controlling interest.That control premium may causethe fair value of a reporting unit toexceed its market capitalization.The quoted market price of anindividual equity security, there-fore, need not be the sole measure-ment basis of the fair value of areporting unit. (p. 43)

The guidance in FASB ASC 350-20-35-23 (see paragraph 3.09) notesthat the underlying share priceused for impairment testing maybe higher than the observed pricebecause the basis for analysis instep 1 of the goodwill impairmenttest is that of a control buyer. Thiscontrol buyer may be able to real-ize synergistic benefits from theassumed transactions that mayinclude enhanced revenues andcost savings associated with itemsthat are redundant in nature. (p. 56)

3.79 Another consideration inapplying the market approach isthe basis of the valuation; that is,whether the resulting enterprisevalue would be considered con-trolling or minority. (Footnote 33:In a goodwill impairment test,using an income approach, cashflows are assumed to be on a con-trolling interest basis.)

1 This article does not address control premiums and lackof control/minority discounts in asset holding-type com-panies such as family limited partnerships.

2 As approved by the American Society of Appraisers, theAmerican Institute of Certified Public Accountants, theInstitute of Business Appraisers, the National Associa-tion of Certified Valuation Analysts and the CanadianInstitute of Chartered Business Valuators.

3 AICPA Statement on Standards for Valuation Services(SSVS) No. 1, Valuation of a Business, Business Own-ership Interest, Security, or Intangible Asset, AppendixC.

4 Mergerstat Review, FACTSET MERGERSTAT, GlobalMergers and Acquisitions Information, Newark, NewJersey, www.mergerstat.com or www.factset.com Note:The information for this article is primarily from the Mergerstat Review 2010 edition.

5 Mergerstat Review 2010, p. X.6 FactSet Mergerstat®/BVR Control Premium Study™,

Business Valuation Resources, www.bvresources.com 7 James R. Hitchner, editor and coauthor, Financial Valua-

tion Applications and Models, 3rd edition, 2011, Wiley &Sons.

8 Pratt, Shannon P. and Alina V. Niculita, Valuing a Busi-

ness, the Analysis and Appraisal of Closely Held Com-

panies, 5th ed., 2008, McGraw-Hill.9 Trugman, Gary, Understanding Business Valuation, A

Practical Guide to Valuing Small to Medium-Sized

Businesses, 3rd. ed., 2008, American Institute of Certified Public Accountants.

10 Morningstar Ibbottson SBBI, 2011 Valuation Yearbook,

Morningstar, Inc. 11 Hitchner, p.1258.12 Trugman, p. 190.

• The guideline public companymethod is typically regarded asindicating the enterprise or equityvalue on a minority basis.

• The guideline transaction methodis typically regarded as indicatingthe enterprise or equity value on acontrolling basis.” (p. 68)

3.80 Step 1 of the goodwill impair-ment test is considered to be a val-uation of the subject reporting uniton a controlling interest basis.Therefore, in some cases, a controlpremium may be applied to con-vert the guideline companyapproach to a controlling interestbasis. The magnitude of the con-trol premium is based on consider-ation of multiple qualitative andquantitative factors. In some cases,it may be determined that no con-trol premium would be applied.(p. 68)

3.88 The guideline transactionmethod is typically regarded asindicating the enterprise or equityvalue on a controlling, marketablebasis. Therefore, no premium forcontrol would be applied to theguideline transaction method. Ifcontrol premium data are availablefor the selected guideline transac-tions, however, these data may beused to help determine a reason-

able level of control premium to beapplied in the guideline publiccompany method. (pp. 69-70)

ConCLusIonMost, if not all of the U.S. business val-uation committees/organizations teachthat control and minority valueemanates from the cash flows. It is notbased on an arbitrary and unsupport-able acquisition premiums paid whena public company is acquired. Whythis use of control premiums from con-trol premium studies continues is puz-zling given the strong criticisms on theuse of such data. If a business is prop-erly valued and includes the applicableexpectations of future cash flow, tack-ing on a 15 percent or 25 percent or 40percent acquisition-based so-calledpremium for control will inappropri-ately inflate the value with no underly-ing economic or financial support.c


FInancIaL VaLuaTIOn - cost of capital

Over the past decade there have beenthree topics that have consumed thegreatest amount of BV ink: (1) valua-tion for financial reporting, (2) the tax-affecting (or not) of pass-through enti-ty profits, and (3) the cost of capital.Much of the conversation regardingthe first two has been driven, or at leastinstigated, primarily by third parties.In my opinion, however, the discussionof the cost of capital conversationreflects the growing maturity of the BVprofession as both theoreticians andpractitioners seek to find increasinglyreliable, accurate and usable models toidentify, or document, private compa-ny cost of capital.

Much has been contributed tothe BV profession on this topic over thelast several years. And no one articlecan do justice to any particular issue,let alone several, so consider the fol-lowing both a tease and an encourage-ment to you to dig further into the rel-evant professional literature, if youhaven’t already. In no particular orderand in no way exhaustive, some of thetheoretical advances regarding cost ofcapital that practitioners can add totheir practice arsenal include the fol-lowing:

a suppLy-sIDe erpUntil the past few years, practitionersunquestionably availed themselves ofIbbotson’s (now Morningstar) histori-cal equity risk premium (ERP) esti-mate, which was proffered with thebelief that a long-term average of his-torical actual returns would be a rea-sonable proxy for investors’ currentexpectations. In the 2011 edition of thedata, the Ibbotson historical ERP usesdata covering the period 1926 to 2010;its use implies the belief that the

extrapolated average of the past nearly85 years is reflective of the future.However, a few years ago some beganto question this assumption, notingthat it is a big leap to assume thatinvestors’ future expectations areequivalent to some (relatively arbi-trary) average of the past.1

Supply-side ERPs, on the otherhand, attempt to estimate long-termexpected equity returns by consideringfactors such as the expected growth incorporate earnings and dividends,arguing for a more reasonable assump-tion that investors cannot expect areturn in the long-run that is differentthan that which can be produced bybusinesses in the real economy. Thesupply-side ERP assumes that actualreturns to equity will track real earn-ings growth, and not the growthreflected in the price to earnings ratio.A recent Delaware Chancery Courtcase, Global GT LP v. Golden Telecom,Inc., C.A. No. 3698-VCS (Del. Ch. Apr.23, 2010), outlines the arguments onthis specific issue and is well worth thetime to read. Morningstar has pub-lished both a supply-side and histori-cal ERP for the past several years, andhas added some detailed explanationas to the supply-side ERP derivation inits annual SBBI books.2

sIze-aDjusteDpuBLIC Company erpFor several years Roger Grabrowskihas published a detailed study of equi-ty risk premiums (ERPs) of publiclytraded companies.3 The study is cur-rently published by Duff & Phelps andRoger has published and spoken wide-ly on the topic. As contrasted to Ibbot-son/Morningstar’s breakdown of ERPsby decile via market capitalization, the

study breaks down ERPs into 25 sizestratifications over eight criteria: sales,book value of equity, book value ofinvested capital, market value of equi-ty, market value of invested capital,assets, number of employees, fiveyear’s average net income, and fiveyear’s average EBITDA. The increasedgranularity of the data allows the prac-titioner to more closely “zero-in” on arepresentative size-adjusted ERP forthe subject ownership interest.

Many practitioners are using thisstudy to support size-related riskadjustments in their ERP estimates,either by selecting premium data fromthe percentile premia analysis tables orperforming a regression analysis basedon the specific metrics of the subjectcompany against the study data. TheContinued on next page

Current Issues in Developing the Cost of Capital

expertTIPNo matter how sophisticated a prac-

titioner’s analysis in developing a

cost of capital, the conclusion still

has to pass the “smell test.” At the

end of the day, after all the

research, number crunching and

documentation, the practitioner

must answer the question, does the

presumed cost of capital make

sense in the context of the subject

ownership interest and standard of

value?

WILLIam QuaCkenBush,ASA, CBA

Advent Valuation Advisors, LLCMontgomery, NY

[email protected]


FInancIaL VaLuaTIOn - cost of capital, continued

weighted against one another? Is thequality of management a moreweighty issue than geographic diversi-fication, or is it of equal importance orless important when estimating CSRP?How do any of these issues rank inimportance relative to financial liquid-ity? You may have a solid opinion, butit is likely not based on peer-reviewedempirical evidence from the market-place in general.

Enter Peter Butler and KeithPinkerton who, using total beta meas-urements of publicly traded compa-nies, developed (and market) amethodology for estimating total costof equity by considering marketreturns and, by inference, company-specific risk premiums.4 Essentiallythe model they proffer allows the prac-titioner to estimate the required equityreturn rate for private companies byidentifying comparable public compa-nies and analyzing market data to eval-uate the market’s perspective on boththe systematic and unsystematic risk ofthese companies to estimate the totalcost of capital, as opposed to buildingup a return rate by adding size premi-ums and a subjective, company-specif-ic risk premium.

This hotly debated modeling hasgained some traction of late and manyarticles have been published, both proand con.5 As with any of these models,make sure you understand the theory,computations, and issues underlyingthe model.

InternatIonaL Cost of CapItaLWhile most practitioners in the U.S. arenot valuing foreign companies, thosethat do suffer from a dearth of cost ofcapital data as contrasted with vol-umes of data generated from U.S. mar-kets. Nevertheless, with the implemen-tation of IFRS and the increasing glob-alization of the economy, the conversa-tion regarding country (political) riskpremiums, default risk premiums, andexchange rate risk issues is becomingmore relevant to a larger portion of theprofession. For those interested in

practitioner should be aware, however,of some of the underlying assumptionsand data content issues before blindlyapplying the ERP data. Here’s a littlequiz on the Duff & Phelps’ risk premi-um data to test your understanding ofRoger’s work (answers at end).1) Is the Duff & Phelps’ Equity Risk

Premium Study useful for develop-ing a cost of capital via a buildupmethod or a CAPM method?

2) Is the Duff & Phelps’ risk premiumdata levered or unlevered?

3) Are any types of companies exclud-ed from the study?

4) If the subject company is very small– say less than $1million in revenues– can one regress the Duff & Phelps’ERP data down to that small size todevelop an equity cost of capital?

5) Can the Duff & Phelps’ 2011 EquityRisk Premium Report data be usedto develop cost of capital estimatesfor banks or other financial servicescompanies?

6) Is the Hamada or the Harris-Pringleformula for unlevering applied tothe data?

sIze-aDjusteD puBLIC Company erp reDuxMany practitioners who rely primarilyon the Ibbotson/Morningstar ERPstudies also rely on the decile size pre-mia analysis that is part of the annualstudies, often looking at the 10th decile(the smallest 10 percent of companiesin the study) for representative size-based risk adjustments. Size is meas-ured by market capitalization in theIbbotson/Morningstar studies, and the10th decile in the current edition of thestudy includes companies with marketcapitalizations of between $1.2 millionand $236 million. Ibbotson/Morn-ingstar continues to segment the 10thdecile into “10a” and “10b,” and evenmore recently further segments thesetwo down to even smaller groups(“10y” and “10z”) within the “10b”segment. But even the “10z” segmentincludes companies with market capi-talizations as large as $86 million.

Practitioners should be askingwhether or not this segmentation at the

bottom end of the market capitaliza-tion spectrum provides sufficientlyuseful size premium information fordeveloping size adjustments to marketERPs relative to their smaller subjectcompanies. There are at least two con-siderations.

First, the bottom decile includescompanies that are much larger thanmany of the companies practitionersvalue. If one is valuing a small compa-ny, how does he or she connect the log-ical and analytical dots between thecompanies that are significantly largerin the data than the subject company?

In addition to the concern aboutrelative size comparison, the practi-tioner might want to be concernedregarding what companies are in theselowest percentile segments. After all,when size is measured only by marketcapitalization the data could includesome very large, but very poorly per-forming companies that have very lowmarket capitalization – particularly inthe current and recent economic envi-ronment. I am not proposing that thisdata is not good or useful, only that thepractitioner should use it with theunderstanding of what the data actual-ly represents.

totaL Cost of CapItaL moDeLIngWhile there have been decades ofresearch on various components ofequity returns, there is little direct evi-dence for the company-specific riskpremium (CSRP) component (or alphain CAPM) which generally requires amore qualitative approach to identifi-cation and measurement. In the pastsome have proffered methodologiesfor quantifying the qualitative issuesassociated with the CSRP, but the mod-els themselves tend to offer up a falseprecision that masks the underlyingsubjective analysis. For example, if onewere to build a factor rating model forvarious company-specific risk issues(depth and quality of management,internal systems and controls, geo-graphic or product diversification,etc.), on what empirical basis are theseand other relative factors chosen and Continued on next page


FInancIaL VaLuaTIOn - cost of capital, continued

delving into international cost of capi-tal, I offer the following two sources ofresearch, articles, and data.• Damodaran’s industry and country-

specific risk premia: New York Uni-versity’s Aswath Damodaran, whohas spoken at several BV confer-ences, is a widely published6 theo-retician and observer of market val-uation and has freely provided hisdata on international ERPs andindustry betas (both U.S. and in var-ious international markets) on hiswebsite, www.damodaran.com.

• Budyak’s articles and modeling of coun-try risk premia: Jim Budyak has writ-ten on international cost of capital,offering chapters on the subject inlarger BV works and in various jour-nals. His “Company, Country, Cur-rency, and Sector Method” attemptsto pick up where Professor Camp-bell Harvey’s “Country Risk RatingModel” ends.7

to Whom muCh Is gIven, muCh Is reQuIreDThe modeling of observed marketbehavior consists of complex computa-tions on significant amounts of data.For the practitioner, the potential dan-gers of this complexity are to (1) treatmajor components of the cost of capitalcomputation as black boxes, fromwhich the practitioner may not fullyunderstand how the output is derived,and (2) so over-analyze the develop-ment of each of the cost of capital com-ponents separately as to lose sight ofthe purpose of the calculations – toestimate the market’s required rate ofreturn for the subject business or intan-gible asset interest.

Conversely, the benefit of theseand other advances in our understand-ing of market evidence when develop-ing a cost of capital is that the practi-tioner has more tools to support his orher opinion of such. As a profession,BV has made great strides from thedays where the rationale for a cost ofcapital was based primarily upon adiscussion of bands of investmentreturns8 estimated on general descrip-tions of business risk without docu-

mented empirical evidence. Neverthe-less, the conversation regarding bandsof investment is still very useful andrevealing as to market behavior andperspective on risk. It is (perceived)future risk, after all, that drivesrequired market returns. The greaterthe perceived risk in a return notoccurring, the greater the return a mar-ket participant will want for makingthat investment, all other things heldconstant.

No matter how sophisticated apractitioner’s analysis in developing acost of capital, the conclusion still hasto pass the “smell test.” At the end ofthe day, after all the research, numbercrunching and documentation, thepractitioner must answer the question,does the presumed cost of capital makesense in the context of the subject own-ership interest and standard of value?

answers to Quiz:1) The data is presented in such a way

that it is useful for both a buildupmethod and a CAPM method. Thedata is analyzed and presented inmultiple formats, so that a size-adjusted ERP (over a riskless rate)can be derived for use in a buildupmethod, or a size premium overCAPM can be applied. The discus-sion starts on page 22 of the Duff &Phelps’ 2011 Equity Risk PremiumReport.

2) The Duff & Phelps’ 2011 Equity RiskPremium Report includes unleveredaverage risk premiums and sumbetas for each portfolio (see discus-sion on page 101 of the study).

3) Yes. ADRs, non-operating holdingcompanies, and financial servicescompanies are excluded (see page 10of the study). Additionally, high riskcompanies (as defined by Duff &Phelps) are also removed, but theirERPs are separately calculated andpresented for use when and whereappropriate. The discussion of highrisk companies starts on page 80 ofthe study.

4) Possibly not, and if so, only careful-ly. The company at the 5th percentile(95 percent of companies are larger)

in terms of net income reports $0.495million in five-year average netincome. Certainly it is not “good sta-tistics” to regress beyond the enddata point (beyond the minimum orthe maximum).

5) No. Since financial services compa-nies (defined as SIC Code 6) havebeen removed from the data, thedata is not useful for estimated costof equity capital for those entities(page 10 of the 2011 study).

6) Since 2008, the Harris-Pringle for-mula has been employed. Prior to2008, the Hamada formula had beenused. It is important to know whichformula is used and how it isemployed in order for you to consid-er unlevering and relevering yourdata to match the market evidence.c

1 Roger Grabrowski provides an introductory overview ofthe historical vs supply ERP issue in the August 2010Financial Valuation and Litigation Expert.

2 Starting on page 64 of the Ibbotson SBBI 2011 Valua-

tion Yearbook, the latest edition as of this writing.3 The January 2007 issue of Financial Valuation and Liti-

gation Expert provides an article by Rob Burkert on thetopic.

4 The July 2009 issue of Financial Valuation and Litigation

Expert provides an interview of Mr. Butler and Mr.Pinkerton on the topic.

5 Peter Butler’s website (www.valtrend.com) is a sourceof many of these articles. The ASA’s Business Valuation

Review published several articles which are availableon its website, www.bvappraisers.org. In addition BVResources, which hosts and markets the Butler/Pinker-ton model, provides many articles.

6 Some of Damodaran’s more resent books include,Damodaran on Valuation, New York (2006); Applied

Corporate Finance: A User's Manual (2005); Investment

Valuation (2002); The Dark Side of Valuation, (2001).His website, www.damodaran.com, provides access toarticles, research, and presentations.

7 Budyak, James T. “Getting Your Head Out of the Model:Due Diligence and Developing Cost of Capital,” Busi-

ness Valuation Update, Vol. 12, No. 5, May 2006, pp. 5-8.

8 The conversation regarding bands of investment docu-mented in BV literature was as early as (I can find) June1982 by James H. Schilt in an article, “Selection of Cap-italization Rates for Valuing a Closely Held Business”published by Business Valuation News (now Business

Valuation Review, by the American Society of Apprais-ers, www.bvappraisers.org). For those newer to the pro-fession, it is a good article to review.


FInancIaL VaLuaTIOn - Enterprise Value

Only one definition (not by an invest-ment banker) did not deduct cash, onedefinition deducted only “excesscash,”6 and a total of 208 (99 percent)of the definitions deducted all cash onthe balance sheet.7 The definitionscalled for the deduction of cash fromthe sum of debt and equity regardlessof whether cash exceeded the amountof debt.

Our review shows clearly thatthe practice of investment bankers is todeduct cash and cash equivalentswhen calculating multiples.

Why Cash shouLD Be DeDuCteD The investment banking practice ofusing net debt (interest-bearing debtminus cash) rather than gross interest-bearing debt reflects economic reality.The appropriateness of deducting cashin an EV calculation can be demon-strated by looking at the impact on EVof both a material debt repayment anda material debt issuance.

Consider a company with anequity market value of $200 million,debt of $200 million, and cash of $100million. Its EV net of cash would be$300 million, but its EV would be $400million if cash were not deducted. Ifwe assume that the company were touse half its cash to repay debt, bothdebt and cash would be reduced by$50 million and, when cash is deductedfrom debt, its EV would still be $300million. However, if cash were notdeducted, EV would be reduced from$400 million to $350 million.

Alternatively, if the companywere to borrow an additional $100 mil-lion, it would then have an incremental$100 million in debt and an incremen-tal $100 million in cash, so that its EVwould still be $300 million if cash werededucted; however, EV would increasefrom $400 million to $500 million ifcash were not deducted.

When cash is deducted, the com-pany’s EV stays at $300 million in boththe repurchase case and the debtissuance case. If the definition of EVwere to provide that cash should notbe deducted, the company’s calculatedEV would fall from $400 million to$350 million when it repays debt andwould rise to $500 million after a debtfinancing. Such disparities in the EVvalue of a company whose net debt isunchanged throws into question anycalculation of multiples based on EV. Ifa company’s calculated EV were tochange materially as a result of a debtretirement or of a financing, its EBIT-DA multiple would be materiallyaffected even though the economics ofthe company would remain substan-tially unchanged.

A company’s value is not reduced byretiring debt nor is its value increased byborrowing. Since cash is, in effect, neg-ative debt, the logical and accuratemethod is to deduct cash in the compu-tation of EV. Valuators who calculatemultiples for guideline companies andacquisitions with EV unadjusted for

shouLD Cash Be DeDuCteDWhen CaLCuLatIng enterprIse vaLue?The valuation community currentlyuses two different approaches to calcu-late Enterprise Value (EV) as thenumerator for multiples in the guide-line company and acquisition meth-ods. EV is sometimes defined as debtplus equity and sometimes as debtplus equity minus cash. We believe thatin calculating EV, cash should bededucted. The valuation literaturereflects this disorder: some writersexclude cash from the definition,1

while others (including the author)state that cash should be deducted.2

Pratt writes that both are acceptableapproaches.3 We set out to see whatinvestment bankers actually do inpractice. We then set forth our reason-ing as to why the valuation professionshould adopt what is the overwhelm-ing investment banking practice: todeduct cash when calculating EV. Wealso discuss other factors to be consid-ered in the determination of EV.

To determine how investmentbankers and others rendering fairnessopinions defined EV and, particularly,how they treated cash, we reviewedthe published descriptions of fairnessopinion methodologies used in cashacquisitions of U.S. companies. UnderS.E.C Rule 13e-3, summaries of fairnessopinion analyses must be included inthe proxy statements or tender offerdocuments sent to shareholders. Weexamined documents filed with theS.E.C. for 315 acquisitions that con-tained 351 fairness opinions.4

We reviewed the 351 opinions toidentify those which contained invest-ment bankers' definitions of EV. Of the351 opinions, 282 used multiples ofrevenues, EBITDA and/or EBIT withEV (by any name) in the numerator.5

Of these 282 opinions, 210 describedhow EV was defined while 72 did not.

expertTIPWhen calculating enterprise value,

cash should be deducted from the

sum of interest-bearing debt and

equity.


an investment Banking View of Enterprise Value

gILBert e. mattheWs, Cfa

Sutter Securities IncorporatedSan Francisco, [email protected]


FInancIaL VaLuaTIOn - Enterprise Value, continued

cash end up making invalid compar-isons that lead to questionable valua-tions.

other faCtors to ConsIDerIn CaLCuLatIng enterprIsevaLue Our review of the data shows thatinvestment bankers sometimes includeadditional data when calculating EV.The inclusion of minority interests andpreferred stock is customary whenthese items are on the balance sheet.Marketable securities are usually con-sidered to be cash equivalents and aretherefore deducted. Depending onfacts and circumstances, other itemsmay be considered; e.g., capital leasesmay be added and non-operatingassets and the present value of loss car-ryforwards may be deducted. We citeseveral examples of definitions:

[E]nterprise value … is the marketvalue of common equity plus thebook value of debt and minorityinterest less cash and the value ofunconsolidated assets.8

Firm value of a particular compa-ny was calculated as market valueof that company’s common stockbased on fully diluted shares usingthe treasury method … plus thevalue of that company’s indebted-ness, minority interest and pre-ferred stock, minus that company’scash and cash equivalents andmarketable securities.9

Enterprise value of a particularcompany was calculated as marketvalue of the company’s equity . . .plus the value of the company’sindebtedness, capital leases,minority interest and preferredstock minus the company’s cashand cash equivalents, and mar-ketable securities.10

[Firm value] … [is] equity value …plus straight debt, minority inter-est, straight preferred stock andout-of-the-money convertibles,less cash and long term equity

investments valued at the currentmarket price where available, andat book value where market priceis not available.11

The enterprise value of each com-pany was obtained by adding itsshort- and long-term debt to thesum of the market value of its com-mon equity, the value of any pre-ferred stock (at liquidation value)and the book value of any minori-ty interest, and subtracting its cashand cash equivalents and the pres-ent value of the net operating losscarryforwards, if any.12

Investment Bankers CommonLy InCLuDe DeBt at Book vaLueBased on a separate, ongoing review ofmore than 100 fairness opinion presen-tations, investment bankers includedebt in EV at book value rather than atmarket value, which is the academical-ly preferred but impractical approach.Book value is used because the differ-ence between the market value andbook value is seldom material andbecause it is often difficult to obtainprices of illiquid debt securities.

Because zero-coupon debt andany other debt issued at a discount arecarried on a company’s books at accret-ed value, market value is usually inline with accreted book value. Sinceaccounting rules require that zero-coupon debt and other debt issuedbelow par be carried at accreted value,the book value for reporting purposesshould be reasonably close to marketvalue.

If a company’s debt has an aver-age market value of 95 percent or 105percent of book and debt is 40 percentof EV, the impact on EV is only 2 per-cent. This is effectively a roundingerror when the EV/EBITDA ratio is cal-culated to two significant figures, sothat it is seldom worthwhile to expendthe time and effort necessary to mark acompany’s debt to market.

ConCLusIon: an InvestmentBanker’s vIeW1) When calculating EV, cash should bededucted from the sum of interest-bearing debt and equity. The valuationcommunity should adopt this practicefor two reasons. First, it is economical-ly realistic. Second, it should do sobecause having two or more conflict-ing definitions for the same measurenot only casts doubt on the validityand accuracy of valuations based onthat measure, but also may contributeto criticisms of valuations in general asuntrustworthy.2) When appropriate, EV should recog-nize other balance sheet items, such aspreferred stock, capitalized leases, andmarketable securities.3) Valuing debt at book value is a prag-matic approach that can be used inmost situations. c

1 E.g., James R. Hitchner, Financial Valuation Applica-tions and Models, 2nd. ed. (Wiley, 2006), p. 241; PhilipJ. Clements and Philip W. Wisler, The Standard &Poor’s Guide to Fairness Opinions (McGraw Hill, 2005),p. 40.

2 E.g., Patrick A. Gaughan, Mergers, Acquisitions, andCorporate Restructuring, 4th ed. (Wiley, 2007), p.12;Matthews, “Fairness Opinions: Common Errors andOmissions” in The Handbook of Business Valuation andIntellectual Property Analysis, Robert F. Reilly andRobert P. Schweihs, eds. (McGraw Hill, 2004), p. 212.

3 Shannon P. Pratt, Valuing a Business, 5th ed. (McGrawHill, 2008), p. 265.

4 This report is part of a larger study in which the 351 fair-ness opinions in cash acquisitions were reviewed toanalyze valuation methodologies used in fairness opin-ions. That study is still in progress.

5 The numerator was called “enterprise value” in 88% ofthe disclosures. "Firm value" or "company value" wasused in 8%, "aggregate value" in 3%, "market capital-ization" (which is also sometimes used as a synonymfor "market value of equity") in 1% and "total value ofinvested capital" once. It has been suggested in thepast that “enterprise value” might also mean “marketvalue of equity,” but this study shows that investmentbankers do not view the phrase to be ambiguous.

6 “Excess cash” was not defined. The same investmentbanker deducted all cash in 20 other opinions.

7 Most expressly deducted cash, while some used thephrase “net debt,” which in industry practice means debtminus cash.

8 California Pizza Kitchen, Inc. Form 14D-9 dated June 8,2011, p.31; fairness opinion by Moelis & Co.

9 EnergySouth, Inc. proxy statement dated August 20,2008, p. 22; fairness opinion by JP Morgan.

10 United Retail Group, Inc. Form 14D-9 dated September25, 2007, pp. 25-26; fairness opinion by Bear Stearns.

11 Anheuser-Busch Companies, Inc. preliminary proxystatement dated August 15, 2008, p. 39; fairness opin-ion by Citigroup Global Markets.

12 Mediacom Communications Corporation, p. 21; fairnessopinion by Barclays Capital.

Michelle Patterson, J.D., Ph.D., participated inthe preparation of this article.


FInancIaL VaLuaTIOn - Healthcare Valuation

More than 18 months after the passageof the federal healthcare reform legisla-tion, people remain confused aboutprecisely what it is supposed to accom-plish and what the effect of the legisla-tion will be on the economy and byextension, the value of businesses. Ifnothing else, appraisers and valuationanalysts should be aware of theincreased uncertainty resulting fromthe reform legislation.

ImpaCt on smaLL BusInessPerhaps the least understood of all thelegislation’s provisions are therequired changes in the manner inwhich health insurance premiums aredetermined in the small group andindividual market. The small groupmarket is where small businesses – andmost CPA and valuation firms – obtaintheir health insurance. Typically, thismarket consists of businesses of lessthan 50 employees, but the reform leg-islation raises that level to 100 employ-ees for reasons that will become clearlater herein.

The individual market, as thename would suggest, is where healthinsurance is obtained by those whocannot get it through their employer,along with the self-employed. This isthe market where the most problemsor outright abuses existed with respectto the practices of certain health insur-ers in certain states. This market alsocontains both the highest amount ofunderwriting risk as well as the high-est administrative costs for the insur-ance companies. Due to those two fac-tors in particular, it is also where pre-miums have been high and the extentof available coverage has been low.

The federal legislation requiresinsurers to “rate” or use the same fac-tors in setting premiums in both thesmall group and individual markets,and therein lies the rub for small busi-ness! The combined markets will have

the legislation, before the additionalcuts required as a result of the debtceiling deal in the summer of 2011.Expansion of Medicaid— the programfor the poor— to more than 20 millionadditional individuals2 is expected tocost nearly $500 billion of the $1 trillioncost of the legislation. Both Medicareand Medicaid pay hospitals and physi-cians poorly – Medicaid especially so –leading them to seek significantlyhigher payments from private insurersto make up for the shortfall. This willcreate yet another major upward pres-sure on premium increases.

It is important to understandthat the changes do not affect all partsof the country equally. Massachusetts,of course, had already dug its owngrave and will see comparatively littlechange as a result of the federalchanges. States like New York andNew Jersey had implemented reformssimilar to the federal legislation intheir small group markets, for exam-ple. States which had already imple-mented many of the federal reforms of

much higher premiums than the exist-ing small business market, so smallbusiness will experience a dramaticincrease in insurance premiums for agiven benefit level.

This is precisely what happenedin Massachusetts1 after the 2006Health Insurance Reform in that state,which served as the model for the fed-eral legislation. When the impact ofthe merger of the two markets is com-bined with the new rating rulesrequired by the federal legislation, theimpact is even more dramatic, particu-larly for businesses with fewer than 10employees. The two most significantrating rules that will impact the smallbusiness are the requirement that therebe no more than a three-to-one differ-ence in premiums based upon age(e.g., a 62-year-old cannot be chargedmore than 3 times what a 25-year-old ischarged for the same benefits), and therequirement that smokers cannot becharged more than 150 percent of whata nonsmoker is charged.

These maximum permitted dif-ferences bear no relationship whatso-ever to the relative cost of insuring theage groups or smokers, and thereforecreate an enormous cost shift fromyoung to old and smokers to nonsmok-ers in addition to the cost shift from theindividual market to the small groupmarket. Other significant cost factorsinclude the prohibition against annuallimits and lifetime limits on theamount of payments for certain cate-gories of benefits defined in the federallegislation and the prohibition againstexclusions for preexisting health con-ditions.

Other aspects of the legislationwill also increase the present cost-shift-ing to privately insured patients thattakes place as a result of the Medicareand Medicaid programs. There weresupposedly $500 billion in cuts to bemade to Medicare to pay for the cost of

Sizing Up Healthcare Reform’sImpact on Business

expertTIPAppraisers and valuation

analysts should be aware of the

increased uncertainty resulting

from the healthcare reform

legislation.


mark o. DIetrICh, CPA/ABV*

Mark O. Dietrich, CPA, PCFramingham, MA

[email protected]


FInancIaL VaLuaTIOn - Healthcare Valuation, continued

their own volition already had muchhigher premiums than states whichhad not. In contrast, many southernstates such as Texas and the largeststate, California, will see very signifi-cant impacts on their state’s insurancepractices and therefore the premiumscharged to small business will skyrock-et— unless benefits are cut ordeductibles increased.

ImpaCt on Larger BusInessIn the insurance area, larger businessesescape the dramatic cost-shift from theindividual market that small businessmust bear. Larger employers willeither be in the large-group insuredmarket or in the self-insured market.Self-insurance is yet another element ofhealth insurance not well known orunderstood outside the health insur-ance and healthcare consulting com-munities.

Many larger businesses actuallydo not purchase insurance from healthinsurers. Rather, they purchase accessto the insurer’s network of hospitals,physicians and other healthcareproviders along with administrativeservices like processing of claims andinsured (customer) relations servicesfrom the insurer and they pay theirown claims out of pocket; thus, theexpression “self-insured.” Nationally,nearly 60 percent of all businesses areself-insured and more than 90 percentof large businesses self-insure. Theself-insured business will pay a bud-geted “premium” to the insurer whichlooks like a real premium, but if theactual costs of caring for their employ-ees are greater than the budget, theemployer has to pay the difference.

Similarly, if the cost is less, theemployer gets the savings. From theemployee’s standpoint, it will all lookpretty much the same whether theiremployer is insured or self-insuredsince they will have an insurance cardand the same interaction with the sys-tem as an insured individual. Valua-tion analysts should consider under-standing whether the business they arevaluing is insured or self-insured andany outstanding obligations of a self-

insured employer for unexpectedclaims or perhaps a credit for lowerclaims than expected. These wouldlikely fall into the category of nonoper-ating assets and liabilities.

In short, the federal legislationpromises to drive the cost spiral inhealth insurance premiums ever high-er for small business as it absorbs thereduced costs of the individual marketand mandated benefit expansions.This can be a significant cashflow fore-casting issue for the appraiser andmanagement. Appraisers shouldascertain whether managementintends to pay the increased premiumsout of profits, cut benefits to maintainpremiums, shift the cost to employeesvia deductibles, co-pays and premiumshare or any other alternative thatcomes into play. Dropping the costbomb on employees could haveadverse employee retention conse-quences depending upon the responseof competitors.

Employers with 50 or moreemployees will also be subject to the“play or pay” penalty starting in 2014.The so-called 40 percent “Cadillacexcise tax” on “high cost” policies isnot effective until 2018 and appearsunlikely to survive. That said, if it doessurvive it will have a dramatic impacton health insurance costs in high coststates like Massachusetts where virtu-ally any standard policy presently onthe market would already be in theexcise tax range.

speCIfIC ImpLICatIons forthe heaLthCare InDustryPrimary care physicians (PCPs) werethe big winners in the reform legisla-tion, with Medicare paying a 10 per-cent bonus to primary care physicianswho earn 60 percent or more of theirrevenues from specified CPT©3 codes.Given Medicare’s already poor pay-ment levels as compared to privateinsurance payors in many markets andthe severe shortage of primary carephysicians, it is unclear how muchimpact this bonus will have on eitherincenting PCPs to see Medicarepatients or inducing new physicians to

go into primary care. That said, it rep-resents something appraisers shouldquantify.

More significantly, the opportu-nity for PCPs to change to so-called“concierge” or members-only practicescharging patients $1,500 to $2,000 perannum may further restrict the supplyof PCPs. It seems clear that financially,having a 600-member patient basewith a membership revenue stream of$900,000 or more per year in additionto insurance payments for coveredservices is preferable to 1,500 or 2,000patients with long hours required togenerate a revenue base of $500,000 +/-.These supply restrictions will drive upthe salary expectations of PCPs and asis already the case in many markets,drive up the payment for PCP services.

Hospitals were supposed to paymost of the $500 billion of Medicaresavings through limitations on annualincreases in their Medicare paymentsalong with new methodologies includ-ing quality-incented value-based pur-chasing and no payments for so-called“never events” where patients are hos-pitalized for medical errors. Medicarepayment mechanisms will reflect anincreasing emphasis on patient experi-ence measures as well.

Accountable Care Organizations(ACOs)— joint financial risk-bearingentities comprised of physicians andhospitals— are another major elementof the Obama reform package. TheACOs are supposed to voluntarilyagree to accept financial risk for fee-for-service Medicare beneficiaries in acomplex arrangement that includesscoring based upon 65 quality meas-ures. The proposed regulationsreleased in April of 2011 were widelypanned by the target audience ofphysicians and hospitals, leading to anadministrative decision by the Centersfor Medicare and Medicaid Services(CMS) to create something called thePioneer ACO, a by-application pro-gram limited to 30 participating enti-ties that closed in the summer of 2011.As such, appraisers are unlikely toencounter a pioneer— unless campingContinued on page 23


FInancIaL VaLuaTIOn - Resources

Financial professionals are increasing-ly looking to mobile devices to supple-ment or replace bulky laptop comput-ers. Can these new tools, which mayseem at first glance to be best suited forvideo games and texting, really workfor business?

The answer is yes— but be awareof limitations and understand that itmay take some work to outfit yourdevice as a business tool.

CreatIng DoCumentsIn most cases, any device with a hopeof replacing a laptop for business usewill need to be able to create and editdocuments. For a valuation engage-ment, that may mean bypassing theApple suite of office tools— Pages,Numbers, and Keynotes— for appsthat will allow you to manageMicrosoft Office documents. BecauseMicrosoft did not immediately offeroffice for the iPad, a number of appshave popped up to help users managethese documents.

Two such apps are Quickofficepro hD and Documents to go. Whileboth of these apps allow you to createand edit Office documents, their com-patibility with Office documents creat-ed on a Windows PC or a Mac isn’talways perfect.

In early 2012, the onLive Desk-top app was released. This app bringsthe full genuine Windows versions ofWord, Excel, and PowerPoint to theiPad, and they work the same way they

do on your desktop. While this is aleap over the other “Office Lite” typeproducts, there are some limitations.Because onLive is a cloud-based prod-uct, you must have a live (and reason-ably fast) connection to the Internet forit to work. And you have to save anydocuments emailed to you to theOnLive Cloud before you can openthem.

Mobile device keyboards arenotoriously tedious to use for creatinglong documents, so it is a good idea toadd a wireless keyboard to your iPad ifyou’re planning to use it as a laptopreplacement. Another option is to usea voice recognition app like DragonDictation. This will allow you tobypass the keyboard altogether.

other appsOnce you have these basic documentediting tools, what other apps will helpmake your iPad or smartphone into avaluable business tool? Here are 20apps that will get you on your way:

• omnifocus – A task-managementprogram that allows you to keep upwith appointments and lists.

• scan2pDf mobile – Use yourphone’s built-in camera to scan doc-uments and convert them to PDFfiles. Similar to Genius Scan.

• my eyes only – This app uses 512-bit AEX encryption to protect per-

sonal and business data such ascredit card numbers, passwords andfinancial information.

• Dropbox – Store and sync your files.

• filemaker go – Allows you toaccess databases on the go.

• evernote – Allows you to save andorganize everything in your life.

• Citrix gotomypC – Get remoteaccess to your desktop computerfrom the same company who makesGoToMeeting which will allow youto attend online meetings on youriPad.

• skype – Make free voice and videocalls on your device.

• fastcase – Research legal cases andstatutes on your mobile device forfree.

apps


eva Lang, CPA/ABV, ASA

Financial Consulting Group Germantown, TN [email protected]

It’s all about the

• Is an ipad a toy or a tool?• how much more than a phone is a smartphone? • how can you make these devices work for you?

It’s all about the apps!

expertTIPIPads and smartphones can

work for your business, but it

will take some work to outfit

your device as a business tool!


LanG, continued dIETRIcH, continued

• CamCard – Scans and organizes allyour business cards.

• redLaser – Barcode scanner thatallows you to check prices on thespot.

• expensify – Allows you to keeptrack of expenses by loggingmileage, filing expense reports, anduploading receipts using yourphone's camera .

• tripit – Allows you to track yourtravel. Keep up with multipleflights, car rentals, and hotelreservations.

• omnigraffle – Create a quick dia-gram, process chart, page layout orgraphic design on your iPad2.

• ithoughtshD – Mind mappingapp.

• print Central – Allows you to printto most WiFi/wireless printers with-out additional software.

• time master+Billing – This is aneasy-to-use timekeeping app.

• iannotate pDf – Allows you to editand mark up your PDF files. You cansign a contract and return it withouthaving to print it out and scan itback in.

• yousendit – Allows you to securelysend files, share folders, synchronizedevices and digitally signdocuments with mobileapplications.

• audionote – Allows you to recordthe conversation while simultane-ously taking notes. Great for record-ing meetings.

Many of the apps listed here are free oravailable at a nominal cost. Apple hasdedicated a section of its website tousing the iPad in business,www.apple.com/ipad/business. Here youwill find examples of how businessesare using Apple devices, how to inte-grate the devices into your workflowand information on how to use encryp-tion and maintain security on yourdevices.

The move to mobile devices willonly accelerate in the coming year.This is especially true in small to medi-um size businesses. According to astudy by the NPD Group published inDecember 2011, nearly three quartersof U.S. businesses with fewer than1,000 employees have plans to pur-chase tablets over the next 12 months.

With this list of apps, you will beset to make the most of the move tomobile computing in 2012.

in the wilderness – or too many regu-lar ACOs for that matter, but they willhave a significant impact on the cash-flows of physicians and hospitals whoparticipate in them.

summIng It upThere are numerous other provisionsin the reform legislation that affect vir-tually every segment of the healthcareindustry. Professionals engaged invaluing healthcare entities should besure to study the changes for a particu-lar segment in forecasting cashflowand establishing risk premiums. Forgeneral valuation engagements, healthinsurance costs represent a significantelement of many employee fringe ben-efits and a significant element of cash-flow forecasts. Based upon the experi-ence in Massachusetts, small businesswill be severely, negatively impactedby the various reform provisionswhich disproportionately shift costsonto the small employer community.c

1 Where the author resides and whose small businesspremium increased 64 percent in 2010.

2 More than 20 percent of the U.S. population will be cov-ered by Medicaid post-Reform!

3 CPT or Current Procedural Terminology is copyrightedby the American Medical Association.


LITIGaTIOn SERVIcES - Expert Witness Testimony

expert Witness New clientInterview checklist

1. What kind of a case is this?Practice point: Just obtain a generaldescription, i.e., product liability defectiveladder and do not accept confidential infor-mation that could potentially conflict youout if the other side calls to retain you.

2. Who are the parties?Practice point: This will enable you to doa conflict check to make sure you do nothave a conflict of interest.

3. Where is or where will the case befiled?

Practice point: You will want to know ifthe case will be filed in state or federalcourt. In addition, you will want to knowin which state the litigation will take place.

4. What deadlines should you beaware of?

Practice point: You will want to know thedeadline for designation of expert witness-es and for submission of the experts report.

5. What is the issue(s) that you will beasked to address?

Practice point: You will want to deter-mine if you are qualified to opine on theseissues and are comfortable that your quali-fications, experience and expertise are agood match for the issue(s) at hand.

6. how much is in dispute?Practice point: This will enable you toget a rough idea of the overall litigationbudget and resources counsel will be utiliz-ing to litigate the case.

© 2012 seak, Inc.www.testifyingtraining.com

www.seakexperts.com

reprinted with permissionfrom seak, Inc.

steven Babitsky, esq.and

james j. mangraviti, jr., esq.

Expert witnesses can expect to be “interviewed” by an attorney during his or herinitial call about a new potential case. The experts who are prepared to ask keyquestions of the attorney will:• Stand a better chance of being retained and• Obtain crucial information they can use to determine if they should accept

the new assignment

cHecklISt

expertTIPExpert witnesses will want to

ask counsel precise, informed

questions during their initial

call interview.

7. how many pages of documents willyou be sent for your review?

Practice point: This will enable you toestimate your retainer. The more volumi-nous the materials you will be sent, thehigher your retainer will likely be.

8. have the other experts been selected yet and if so, who are they?

Practice point: Knowing who you mightbe working with and the experts retainedby opposing counsel may be helpful for youin determining if you are a good fit for thecase at hand.

9. Will a report and/or a depositionlikely to be requested?

Practice point: You will want to know ifcounsel will ask for a report, a rebuttalreport or no report at all. Knowing whetheryour deposition will likely be taken is help-ful as well.

10. What has counsel's experiencebeen with these types of cases?

Practice point: You will want to “gently”determine how much experience counselhas had litigating and trying this particu-lar type of case. Counsel with little or norelevant experience will likely require moreassistance.

11. Where did you get my name?Practice point: Tracking referrals helpsexperts determine which marketing tech-

niques are working. c

SEAK, Inc. provides on-site training,seminars, publications, consulting, 1-1 training and professional directoriesfor expert witnesses, physicians, attor-neys, independent medical examiners,and workers' compensation profession-als.

SEAK is the world's leading provider ofExpert Witness training and texts andsponsors the nation's longest runningWorkers’ Compensation and Occupa-tional Medicine conference. SEAK spon-sors writing seminars for physiciansand lawyers and publishes directoriesfor Expert Witnesses, IME Doctors, andFile Review Consultants. SEAK is alsothe leading provider of Non-ClinicalCareer training for physicians as well asconsulting and expertise in negotiating.

This article, along with other free, helpful expert witness resources, can be found athttp://www.seak.com/seakpubs.html


In THE cOuRTROOM

overvIeWIn yet another bad facts case (from thetaxpayer’s perspective), the value ofassets contributed to an FLP wereincludable in the Decedent’s estateunder IRC § 2036(a). In particular, theDecedent failed to provide a non-taxreason for the FLP’s formation, ignoredpartnership formalities, commingledfunds, did not maintain sufficientassets outside the FLP for personal use,and made disproportionate distribu-tions of Partnership assets to himself.

the faCtsPaul H. Liljestrand (“Dr. Liljestrand”or the “Decedent”) formed Paul H. Lil-jestrand Partners Limited Partnership(“PLP” or the “Partnership”) on May30, 1997. The Decedent, through atrust, transferred more than $5.9 mil-lion of real estate to PLP in December1997. Of particular note:• Dr. Liljestrand was both trustee and

beneficiary of the trust, and he hadaccess to all trust income and corpusduring his life.

• The mortgage associated with oneproperty was not transferred to PLP.

• Leases associated with the trans-ferred properties were not trans-ferred to the Partnership.

The Decedent – through his trust– received a 99.98-percent interest inthe Partnership (all of the general part-ner units, all of the Class A limitedpartner units, and 5,545 out of 5,546Class B limited partner units), whilehis son, Robert, received one Class Blimited partnership unit. No record ofRobert’s contribution of capital to PLPwas found.

Class A limited partners weregranted a preferred return. Interesting-ly, the preferred return – along withthe total number of PLP partnershipunits, the number of partnership units

each partner would receive, and therequired contribution of each partner –was left blank on the PartnershipAgreement when it was initiallysigned by the Partners.

Dr. Liljestrand formed the Part-nership on the advice of his attorney,who believed the entity was the onlyway for Dr. Liljestrand to protectagainst the restrictions of two Hawaiistatutes (one permits certain propertyowners to seek partition; the otherallows beneficiaries of trusts to voidthe actions of interested trustees). TheDecedent further wished to gift inter-ests of PLP to his four children,although only Robert was involvedwith the formation or running of thePartnership. Finally, Dr. Liljestrandwished to ensure Robert’s continuedmanagement of the real estate proper-ties owned by the Decedent throughhis trust.

During 1998, the Decedent’strust gifted Class B units to four irrev-ocable trusts for the benefit of theDecedent’s children. The children’strusts each received an additional 33Class B units during 1999. Althoughgift tax returns were required, nonewere filed until after Dr. Liljestrand’sdeath in 2004.

No bank account was opened forPLP until August 1999, even thoughthe Partnership was formed in 1997.Additionally, Dr. Liljestrand reportedPLP’s income and expenses on his per-

sonal tax return. As a result, there wassignificant commingling of trust andPartnership funds. The Decedent’saccountant (rather than Dr. Liljestrandor Robert) noticed that PLP had noemployer identification number or aseparate bank account. Instead ofamending the Decedent’s 1997 and1998 tax returns, the Decedent’s advi-sors agreed to treat the Partnership ashaving begun on January 1, 1999, eventhough property titles were transferredin December 1997.

Although Dr. Liljestrand main-tained some assets outside of PLP, theretained assets were insufficient tomaintain the Decedent’s lifestyle. As aresult, Dr. Liljestrand received dispro-portionate distributions and the Part-nership frequently paid personalexpenses directly. Included in the per-sonal expenses paid by PLP were Dr.Liljestrand’s housekeeping staff, per-sonal assistant, grandchildren’s tuition,personal line of credit, and personalmortgage. Additionally, the Decedent’schildren used PLP’s funds to pay per-sonal expenses but did not executepromissory notes for repayment of thepurported loans.

Further, the preferred returnportion of the Partnership Agreementwas filled in at some point and allowedfor a 14-percent return. Based on a$310,000 value for the preferred ClassA limited partner units (a value deter-

T.C. Memo. 2011-259, Docket No. 29397-08

Estate of Liljestrand v. Commissionerby

John Walker and Chris D. Treharne, ASA, MCBA, BVAL

Gibraltar Business Appraisals, Inc.

e-fLash takeaWayamong the many reasons the taxpayer failed to prevail was his reluctance torely on a business appraisal prepared by an independent business apprais-er. Instead, he chose to rely on his own estimate of fair market value toestablish the rate of return on his Class a limited partnership units. thecourt viewed his actions as self serving and not what would transpire in anarm’s-length transaction.



In THE cOuRTROOM , continued

mined by the Decedent and not by anindependent outside expert), the$43,400 annual preferred return wasalmost exactly the amount of incomegenerated by the Partnership’s proper-ty, which inferred the two were drivenby the Decedent’s personal incomerequirements and not an arm’s-lengthmarketplace.

When she began separatelytracking business activities in 1999(again, two years after the Partnershipwas formed), PLP’s accountant set upcapital accounts for each partner. How-ever, according to the statement ofpartners’ capital, there was only$24,203 of capital as of December 31,1999, even though more than $5.9 mil-lion of real property had been con-tributed.

After Dr. Liljestrand’s death, thePartnership’s accountant was informedthat disproportionate distributions andpersonal expense payments werebeing accounted for incorrectly. Thedistributions and expenses shouldhave been treated as receivables for thePartnership rather than draws againstcapital accounts. However, there wasno evidence any of the partners madeany attempt to pay the allegedly bor-rowed amounts.

After Dr. Liljestrand passedaway in 2004, his estate filed an estatetax return. To pay the federal and statetax obligations of $2.37 million and$130,000, respectively, his estate refi-nanced property owned by PLP andused the proceeds from the refinancingto fund the tax liabilities.

The IRS determined a federalestate tax deficiency of $2.57 million inAugust 2008 and included in its noticeof deficiency the assets transferred toPLP.

DIsCussIonAlthough the estate attempted to shiftthe burden of proof to the IRS under § 7491, the Tax Court decided that itsruling would be based on the prepon-derance of evidence. Therefore, thecourt did not address the burden ofproof argument.

seCtIon 2036(a) – Bona fide sales§ 2036(a) does not apply if the transfermeets the bona fide sale exception; thatis, the transfer must be an arm’s-lengthtransaction, for full and adequate con-sideration. Accordingly, the bona fidesale portion of the requirement wasconsidered by the court.

non-tax reasons for partnershIp formatIon

the estateThe estate argued that PLP had beenformed for several non-tax reasons (asoutlined in the Court Analysis below).

Court analysisThe tax court considered the estate’sreasons for forming the Partnership:A) Ensure Robert would continue to

manage the real estateThe court determined that

Robert’s role as manager was not acentral reason for the formation ofthe Partnership.

Robert’s roles as trustee of thetrust and manager of the real estatecreated a conflict of interest thatcould potentially allow a benefici-ary of the trust (i.e., one of Dr. Lil-jestrand’s other children) to invokea state statute voiding his actions astrustee. The estate argued thatresolving this conflict was a pri-mary reason for the formation ofPLP.

The court disagreed, determin-ing that the formation of the Part-nership merely changed the assetsin the trust but did not changeRobert’s roles. After the formationof PLP, Robert was still trustee ofthe trust and manager of the prop-erty. Because the conflict still exist-ed, the court determined Robert’scontinued management of theproperty was not a non-tax reasonfor the formation of PLP.

B) Ensure real estate was not subject topartition

The court decided that a parti-tioning action was not a significantnon-tax reason for the formation ofthe Partnership.

In particular, the court notedmost of the real estate in questionwas outside of Hawaii and thus notsubject to the state’s partitioninglaw. Because the Decedent’s attor-ney made no effort to research par-titioning laws in the states in whichthe real estate sets, the court deter-mined a partitioning action was nota primary reason for the Partner-ship’s formation.

The court further noted that thetrusts to which the LP interestswere gifted (and those whichwould be created upon the Dece-dent’s death for the benefit of hischildren) would never allow hischildren to be joint tenants nor ten-ants in common.

Finally, no partitioning actionwas considered on the date of Dr.Liljestrand’s death nor had parti-tioning come up before his death.Although the estate attempted torely on precedent set in Estate ofShurtz v. Commissioner, T.C. Memo2010-21 (see FCG E-Flash 12-2), thecourt determined Shurtz was inap-plicable. More specifically, the liti-gation environment in Hawaii wasdifferent than that of Mississippi.Furthermore, the estate’s attorneyhad never been involved in a parti-tioning action and had neveradvised other clients to form anFLP to avoid a partitioning action.

C) Protection from creditorsAlthough the estate claimed

creditor protection was a reason forthe Partnership’s formation, it pro-vided no evidence any of the part-ners were worried about creditorclaims. The court faulted the estatefor failing to name a single creditorand for failing to determine howthe protections provided by the for-mation of a partnership were differ-ent from a trust. Accordingly, thecourt found creditor protection wasnot a significant non-tax reason forPLP’s formation.



In THE cOuRTROOM , continued

The court also determined therewere factors indicating the transferswere not bona fide sales.

DIsregarD of partnershIp formaLItIesThe court faulted the Partnership forfailing to open a bank account duringits first two years of existence and forcommingling funds. PLP held only onepartnership meeting, failed to keepmeeting minutes, and had no other for-mal meetings between partners. Thepartners used Partnership funds forpersonal expenses, made dispropor-tionate distributions to Dr. Liljestrand,and failed to execute loan documentswith partners for purported loans.More emphatically, the final two char-acteristics violated the PartnershipAgreement, which required pro ratadistributions.

stanDIng on Both sIDes ofthe transaCtIonDr. Liljestrand contributed all of thecapital to the Partnership, received5,545 out of 5,546 units of Class B lim-ited partnership interests, all of theClass A limited partner units, and all ofthe general partner interests. WhileRobert did receive a limited partnerinterest, he failed to receive outsidecounsel independent of his father. Fur-ther, the Decedent did not consult withthree of his children – although heindicated he wanted them to be part-ners – before forming the Partnership.As a result, the court determined thetransfers were not arm’s-length.

As a result of the preceding, thecourt determined that the transfers ofassets to the Partnership failed the bonafide sale prong of the bona fide saleexception.

The court further determinedthat the transactions were not for fulland adequate consideration. In partic-ular, the interests credited to the part-ners were not proportionate to capital

contributed because Robert neverproved he contributed capital. It alsofaulted the Partnership for a valuationof its interests with a value muchgreater than the value of the assets con-tributed and then ignoring that value(as determined by an outside, inde-pendent appraiser) and determining avalue (in a manner not reflected in thecourt record) much less than the valueof the property contributed. Addition-ally, the court found that the assetscontributed by each partner were notproperly credited to their capitalaccounts.

Finally, the court determinedthat Dr. Liljestrand retained possessionof, enjoyment of, or the right to incomefrom the property he transferred toPLP. The court noted that the Dece-dent failed to maintain enough assetsoutside the Partnership to maintain hislifestyle. PLP’s payment of many of Dr.Liljestrand’s personal expenses(including his estate tax obligations),the Decedent’s commingling of trust

and Partnership funds, and PLP pro-viding Dr. Liljestrand with dispropor-tionate distributions were the majordeterminative factors for the court.

The court ultimately decidedthat the Decedent’s motivation forforming PLP was primarily testamen-tary and that his relationship with theassets did not change as a result of thePartnership’s formation. As a result,the assets were includable in his estateunder § 2036(a).

ConCLusIonPoor estate planning advice coupledwith inattention to partnership formal-ities doomed the use of the FLP as anestate planning vehicle in the presentcase. Because the Decedent’s relation-ship with the assets did not change asa result of PLP’s formation and becausethe partners failed to follow throughwith partnership formalities, the Part-nership’s assets were includable in Dr.Liljestrand’s estate. c


FInancIaL VaLuaTIOn and LITIGaTIOn EXPERT - Panel of Experts

mel h. abraham, CPa/abV/CFF, CVa, asais founder/director of Mel H. Abraham in Simi Valley, CA. He providesstrategies in financial risk management and personal/physical, threatmanagement. His is author of Valuation Issues and Case Law Update-AReference Guide and co-author of Financial Valuation Applications andModels, A Healthier You and Masters on Success.

r. james alerding, CPa/abVis the owner of Alerding Consulting, LLC (Valuation and Forensic Con-sultation) in Indianapolis, IN. He has over30 years of experience in val-uation and litigation. Alerding is a member of the AICPA Business Valu-ation Hall of Fame and was a member of the AICPA Task Force thatdeveloped the AICPA Business Valuation Standards (SSVS #1).

steVe babitsky, jdfounded SEAK, sponsor of the nation’s largest Workers’ Compensationand Occupational Medicine conference, in 1980. SEAK is the world’sleading provider of expert witness training and texts, writing seminars fordoctors and lawyers, and publisher of national directories for Expert Wit-nesses and IME Doctors. Steve is also the founder and president ofCustomized Forensic Consulting.

don barbo, CPa/abVis a director for Deloitte Financial Advisory Services in Dallas, TX. Hehas extensive experience in healthcare valuation involving mergers andacquisitions, divestitures, partnership transactions, leasing arrange-ments, divorces, and commercial damages. He speaks to variousorganizations, has published articles regarding BV issues, and servesas an expert witness.

neil beaton, CPa/abV, CFa, asa is partner-in-charge of the Valuation Services Group, Grant Thornton,LLP. A former member of the AICPA BV Subcommittee, the AICPA Valu-ation of Private Equity Securities Task Force, and FASB’s ValuationResource Group, Neil is a prolific presenter, teacher and writer andmember of the AICPA BV Hall of Fame.

bruCe b. bingham, FriCs, Fasais executive director of Capstone Valuation Services, LLC. He is cur-rently chair of the RICS-Americas Valuation Council and past chair ofthe ASA BV Committee. Bruce graduated from Rutgers and also has amasters degree from the Yale School of Management. He is a retiredbrigadier general, US Army Reserve.

kristoPher a. boushie, CPa/abV/CFF, CVa is the president and managing member of Quantus Consulting LLC inJericho, VT. He has over 28 years of experience in financial and litiga-tion consulting, with over 21 years focused on intellectual property mat-ters. He is co-author/co-editor of Calculating and Proving Damages,Law Journal Press.

stePhen j. braVo, CPa/abV, asa, Cba, mst, CFP, PFs is founder of Apogee Business Valuations, Inc. and has a regional officeaffiliation with The Financial Valuation Group. Steve serves on the edi-torial boards of Business Valuation Review and Business AppraisalPractice and is a technical editor of BV books. He performs businessappraisals for a variety of purposes.

rod P. burkert, CPa/abV, CVa, mbais the founder of Burkert Valuation Advisors, LLC. His assignmentsfocus on income/gift/estate situations, divorce proceedings, partner/shareholder disputes, and commercial damage/economic loss matters.He also provides independent report review and project consulting serv-ices to assist other practitioners with their engagements. Rod is a pastchairman of NACVA’s Executive and Education Advisory boards.

thomas F. burrage, CPa/abV, CVa is a principal in Burrage & Johnson, CPAs, LLC, The Forensic Firm inAlbuquerque, NM. His fields of expertise include litigation, forensicaccounting, business valuation and taxation. He is co-author of Divorceand Domestic Relations Litigation: Financial Advisor's Guide,a contribut-ing editor to the Guide to Divorce Taxation and the Guide to Tax Plan-ning for High Income Individuals, and has been published in both theJournal of Accountancy and the Family Advocate.

staCy Preston Collins, CPa/abV/CFF is a managing director at Financial Research Associates, specializing inbusiness valuation, forensic accounting and litigation support services.She has provided expert witness testimony in New York, New Jersey,Pennsylvania and Florida. She is chair of the AICPA’s Family Law TaskForce and a member of its Forensic and Litigation Services Committee.

larry r. Cook, CPa/abV/CFF, Cba, CdFabrings 33 years of financial advisory experience to clients. He hasattained local, state and national recognition for his contribution to theaccounting profession. He has made presentations and is a speaker atconferences, closed circuit television productions and internet web-casts. He is a co-author and author of technical books on valuation.

miChael a. Crain, CPa/abV, asa, CFa, CFeis a managing director of The Financial Valuation Group in Ft. Laud-erdale, FL. He currently serves on the ASA Board of Governors and isa past chair of the ASA BV committee. Mike is a contributing author toThe Portable MBA in Finance and Accounting, 3rd edition and the 4thedition of Litigation Services Handbook; he is a co-author of FinancialValuation Applications and Models.

mark o. dietriCh, CPa/abV, mba, mstis editor, technical editor and contributing author to the American HealthLawyers Association/Business Valuation Resources Guide to Health-care Valuation, 3rd ed.; editor and principal author of Business ValuationResources Guide to Physician Practice Valuation; and co-author withGregory Anderson, CPA/ABV of The Financial Professionals Guide toHealthcare Reform, published by John Wiley and Sons.

DarrELL D. DOrrELL CPa/aBV, MBa, aSa, CVa, CMa, DaBfa is co-founder of financialforensics®. He delivered 120+ forensicaccounting training sessions during the last 5 years and has publishedover 70+ articles in technical journals. He co-authored three forensicaccounting publications for the US Dept. of Justice (USDOJ) and co-authored Financial Forensics Body of Knowledge. His civil/criminalpractice transcends all aspects of civil and criminal financial forensics.

edward j. duPke, CPa/abV/CFF, asa is a senior consultant in the valuation and forensics division of CliftonLarson Allen LLP. He is former chair of the AICPA BV committee andpast chair of the Michigan Association of CPAs. With over 35 years ofexperience, he is a qualified expert witness in state and federal courtsand a BV instructor at the state and national level.

nanCy Fannon, CPa, asa, mCba, abVis owner of Fannon Valuation Group, a BV and litigation services firm inPortland, ME. With 20+ years of valuation experience as an appraiser andexpert witness, Nancy has lectured extensively on valuation and dam-ages and is an author and technical reviewer on valuation textbooks andjournals. The second edition of The Comprehensive Guide to Lost ProfitsDamages for Experts and Attorneys was published in January 2011.

jay e. Fishman, Fasais a managing director of Financial Research Associates. He has co-authored several books, including Standards of Value: Theory and Appli-cations and Guide to Business Valuations. He is an expert witness andhas taught courses to the IRS, the National Judicial College, the HongKong Society of Accountants and World Bank in Russia.

Carla g. glass, CFa, Fasais a managing director in the valuation and litigation consulting firm ofHill Schwartz Spilker Keller LLC and is former chair of the Business Val-uation Committee of the American Society of Appraisers and of theAppraisal Standards Board of The Appraisal Foundation. She serves onFASB’s Valuation Resource Group and has been a course developer of,and teaches, ASA courses.

robert P. gray, CPa/abV/CFF, CFe is a partner in the National Forensic Litigation & Valuation Services Groupand heads its Texas practice. He is chair of AICPA’s Forensic & Litiga-tion Services Committee and a member of the Texas Society of CPA’s BVand Litigation Services Committee. He specializes in corporate/specialinvestigations, stakeholder disputes, and defense professional malprac-tice cases and has authored numerous articles for various professionalpublications.


FInancIaL VaLuaTIOn and LITIGaTIOn EXPERT - Panel of Experts

robert j. grossman, CPa/abV, asa, CVa, Cba, mst heads the BV and valuation services group at Grossman Yanak & FordLLP in Pittsburgh. A nationally recognized speaker and instructor ofbusiness valuation matters, he has extensive experience in valuationand litigation issues in a broad variety of applications and venues. He ispast chair of the NACVA Executive Advisory Board and a contributor toFinancial Valuation Applications and Models.

Chris hamilton, CPa, CFe, CVa, dabFais a partner with The Arxis Group in Simi Valley, CA, and most of his pro-fessional time is spent in the areas of business valuations, fraud, foren-sic accounting and litigation-related engagements. He has publishedarticles and spoken around the country on issues related to valuationand forensic accounting. He is a co-author of Financial Valuation Appli-cations and Models.

j. miChael hill sr., Fasa, Cbais a shareholder in the valuation/litigation consulting firm of Hill SchwartzSpilker Keller, LLC and is former chairman of the BV Committee of theASA. He also served as chair of the Appraisal Foundation and was acourse developer and instructor for the ASA.

j. miChael hill jr., asa, CPa/abVis a shareholder in the valuation and litigation consulting firm of HillSchwartz Spilker Keller, LLC. He is past chair of the ASA BV committee.He earned a BBA in accounting and finance from the University ofTexas.

thomas e. hilton, msF, CPa/abV/CFF, asa, CVais director of the Forensic & Valuation Services Group at Anders Minkler& Diehl LLP in St. Louis, MO. He is an adjunct professor at the JohnCook School of Business, St. Louis University. An experienced forensicaccountant and expert witness, he is past chair of the AICPA Forensic &Valuation Services Executive Committee, a board member for theAICPA, and a member of AICPA Governing Council.

james r. hitChner, CPa/abV/CFF, asais managing director of Financial Valuation Advisors, Ventnor City, NJ, afounding member and president of The Financial Consulting Group, andCEO of Valuation Products and Services. He is editor/co-author ofFinancial Valuation Applications and Models; co-author of Financial Val-uation Workbook; co-author of Valuation for Financial Reporting; andeditor of Financial Valuation and Litigation Expert.

steVen d. hyden, CPa/abV, asais managing director of The Financial Valuation Group, Tampa, FL andpresident of Hyden Capital, Inc. With over 20 years of BV experience,he was a guest expert for the AICPA video course series, “Valuation ofIntellectual Property,” and co-author of Valuation for Financial Report-ing: Intangible Assets, Goodwill, and Impairment Analysis-SFAS 141and 142, volumes 1-3.

miChael g. kaPlan, CPa, CVa, CFFa has more than 30 years experience in the areas of forensic accounting,business valuation and litigation consulting. He has served on the facul-ty of the University of Southern California and teaches continuing edu-cation programs for the AICPA, NACVA and other organizations. He isdirector of the NACVA Forensic Institute.

mark g. kuCik, CPa, CVa, Cm&aa was named “Instructor of the Year” by NACVA. Mark teaches exten-sively and is a member of NACVA’s Training and Development Team.He co-authored training materials for the CVA certification program,represented NACVA on the CLARENCE committee, and developed a4-day seminar on business valuation for the IRS. He is a sought-afterspeaker and media resource for expert information on valuation ofclosely held businesses.

eVa m. lang, CPa/abV, asais the executive director of The Financial Consulting Group, LC, andpresident of Valuation Products and Services, LLC. She is a nationallyrecognized expert on internet research, a frequent contributor to valua-tion industry publications, and a co-author /contributing author to sixbooks, including The Best Websites for Financial Professionals, Busi-ness Appraisers, and Accountants.

m. mark lee, CFais a valuation principal of Eisner LLP. His responsibilities have includ-ed serving as principal-in-charge of the Valuation Services Practice ofKPMG LLP’s Northeastern Region and as vice chairman of Bear,Stearns & Co. Inc.’s Valuation Committee, as well testifying in court. Heteaches BV at the New York University School of Continuing and Profes-sional Studies.

howard j. lewis, aVa, abar is the executive director of the Institute of Business Appraisers in Plan-tation, FL. Howard is the former National Program Manager for the Val-uation Program at the Internal Revenue Service. He holds the AVA andABAR designation from the National Association of Certified ValuationAnalysts.

dERaLd LyOnS, MT, cPa/PFS, cVa is president of Lyons & Seacrest, P.C., CPAs in Denver, CO. He is anationally recognized author and presenter on valuation matters. He isa co-author of Financial Valuation Applications and Models. He hasbeen qualified as an expert witness and provided testimony regardingvaluations and other financial matters on numerous occasions.

miChael j. mard, CPa/abV, asa is managing director of the Financial Valuation Group of Florida, Inc. Hewas founding president of The Financial Consulting Group (FCG) andlead author of Driving Your Company's Value: Strategic Benchmarkingfor Value. He is co-author of Valuation for Financial Reporting: Intangi-ble Assets, Goodwill, and Impairment Analysis-SFAS 141 and 142, andco-author of Financial Valuation Workbook.

l. gail markham, CPa/abV/CFF, CFP is president of Markham Norton Mosteller Wright & Co., P.A. She is thefounding partner of that firm and head of its litigation, forensic and valu-ation services team. Gail has extensive experience in litigation services,mediation, business valuations, and forensic accounting. She has beenrecognized as an outstanding community leader.

harold g. martin jr., CPa/abV, CFF, asa, CFe, mba is principal in charge of BV, forensic, and litigation services for Keiter,Stephens, Hurst, Gary & Shreaves. He is an AICPA instructor andadjunct professor for The College of William and Mary Graduate Schoolof Business. He is co-author of Financial Valuation Applications andModels and contributing author to Cost of Capital: Estimation and Appli-cations.

gilbert e. matthews, CFais chairman of Sutter Securities Incorporated in San Francisco. He hasmore than 50 years of experience as an investment banker. At BearStearns in New York, he was responsible for all fairness opinions andvaluations for 25 years. He has written several book chapters and arti-cles on fairness opinions and corporate valuations and has testified innumerous federal and state courts.

Z. ChristoPher merCer, asa, CFa is founder/chief executive officer of Mercer Capital, one of the country’sleading independent business appraisal firms. He has prepared, over-seen, or contributed to valuations for purposes related to M&A, litigation,and tax, among others. Chris is a prolific author (four textbooks andscores of articles) and a frequent speaker on valuation topics.

dr. shannon P. Pratt, Fasa, mCba, CFa, Cm&aa is chairman/chief executive officer of Shannon Pratt Valuations, LLC;Publisher Emeritus for BV Resources, LLC; and a board member ofPaulson Capital Corp. He is the best-known authority in the field of BVand the author of many books, including Guide to Business Valuations,now in its 16th edition and Valuing a Business, 5th edition.

william C. quaCkenbush, mba, asa, mCba, abar is the founder of Advent Valuation Advisors. Bill provides valuation fortax and financial statement compliance and litigation support in dam-age/economic loss matters. He is the past chair of the ASA’s BusinessValuation Committee, former editor of the ASA’s weekly BV E-Letter, andvice chair of IIBV. He teaches for both the ASA and the IBA and writesand speaks on BV issues.


FInancIaL VaLuaTIOn and LITIGaTIOn EXPERT - Panel of ExpertssCott r. saltZman, CPa, CVa, asa, CFFapractices BV, lost profits and earnings, forensic accounting, profession-al malpractice, marital dissolution and financial damages. He is a rec-ognized expert and has testified on various financial and BV matters.He is president of NACVA, past chairman of NACVA's executive adviso-ry and certification boards, and past member/president of the ColoradoState Board of Accountancy.

ronald r. seigneur, CPa/abV, asa, mba, CVais a partner in Seigneur Gustafson LLP, Lakewood, CO. Ron has over25 years of experience working with complex valuation and litigationsupport matters. He is co-author of Financial Valuation Applications andModels and an adjunct professor at the University of Denver College ofLaw.

john j. stoCkdale, asa, CPa/abV/CFFhas been involved in business valuation since 1979. He heads up a firmin the Detroit area. His practice is concentrated in the valuation of smalland mid-market firms and in performing lost profit and damage claimanalysis.

robin e. taylor, CPa/abV, CFe, CVa, Cbais a partner in Dixon Hughes Goodman LLP. A founding member/pastpresident of The Financial Consulting Group, he is an instructor for theAICPA valuation curriculum and the Association of Certified FraudExaminers. He has provided expert witness testimony and has writtenand spoken on a number of valuation, litigation support, and financialfraud issues.

Chris d. treharne, asa, mCba, bValis president of Gibraltar Business Appraisals, Inc. Combined with 20+years of BV experience, Chris’s engineering, production and financialmanagement experience in public and closely held businesses bringunique perspectives to valuation topics. He is a faculty member for ASAand IBA, member of ASA’s Education Subcommittee, chair of ASA’sCenter for Advanced Valuation Studies, and member of The S Corpora-tion Association’s Advisory Board.

gary r. trugman, CPa/abV, mCba, asa, mVs is president of Trugman Valuation Associates, Inc., a BV/economic dam-ages firm in Plantation, FL and Parsippany, NJ. Gary is chair of the IBAEthics Committee of ASA and serves on the AICPA’s ABV ExaminationCommittee. He is authorof Understanding Business Valuation and hascoauthored several other textbooks and articles in various publications.

linda b. trugman, CPa/abV, mCba, asa, mbais vice president of Trugman Valuation Associates, Inc. and serves asco-chair of the ASA BV Education Subcommittee. She is a member ofthe AICPA BV/Forensic and Litigation Services Executive Committee.Linda is co-author of Financial Valuation Applications and Models.

staCey d. udell, CPa/abV/CFF, asa, CVa is a partner in the Moorestown, NJ office of Gold Gocial Gerstein LLC,specializing in valuation and litigation support services. She serves onthe NACVA Litigation Forensics Board, the NJ State NACVA ChapterExecutive Board, and the AICPA’s CFF Exam Development Committee.Ms. Udell was a contributing author to the AHLA/BVR Guide to Health-care Valuation and John Wiley and Sons, Inc. Family Law ServicesHandbook: The Role of the Financial Expert .

daniel r. Van Vleet, asa, Cba is a managing director at Stout Risus Ross, Chicago. He serves on theBV Committee and Board of Governors of the ASA. He has taught grad-uate BV courses at DePaul and Northwestern universities and is a fre-quent lecturer and author. His practice includes BV, financial advisoryservices and economic analysis for litigation, taxation and transactionmatters.

riChard m. wise, Fasa, mCba, CVa, FCa, FCbV, Ca/iFa, CFeis partner of MNP LLP. Past president of The Canadian Institute of Char-tered Business Valuators and former Governor of ASA, he is a Fellow ofthe Ontario Institute of Chartered Accountants, author of Financial Liti-gation - Quantifying Business Damages and Values, co-author of Inves-tigative and Forensic Accounting Practice Issues (CICA), and a memberof the ASA BV Committee and Standards Subcommittee and NACVA’sLitigation Services Board.

donald P. wisehart, asa, CPa/abV, CVa, mst is owner of Wisehart, Inc., a Rhode Island CPA and consulting firm andmember of The Financial Consulting Group. With 30 years of profession-al experience, he has given numerous BV presentations and has devel-oped several courses for NACVA, where he chaired the EducationBoard. Don was also founding president of the Rhode Island BusinessAppraisal Group.

keVin r. yeanoPlos, CPa/abV/CFF, asa is director of valuation services for Brueggeman and Johnson Yeanop-los, P.C., and a former member of the ASA’s International Board ofExaminers and the AICPA’s National Accreditation Commission. Kevin isa past chair of the AICPA’s ABV Credential Committee and a member ofthe AICPA Business Valuation Hall of Fame. He is a frequent author, pre-senter and instructor on many business valuation topics.

GUIDE TO ABBREVIATIONSABV Accredited in Business Valuation, American Institute of Certified Public

Accountants (AICPA)ASA Accredited Senior Appraiser, American Society of Appraisers (ASA)BV Business ValuationCBA Certified Business Appraiser, Institute of Business Appraisers (IBA)CDFA Certified Divorce Financial Analyst, Institute for Divorce Financial AnalystsCFA Chartered Financial Analyst , CFA InstituteCFE Certified Fraud Examiner, Association of Certified Fraud ExaminersCFF Certified in Financial Forensics, AICPACFFA Certified Forensic Financial Analyst, NACVACFP Certified Financial Planner, Certified Financial Planner Board of Standards, Inc.CIRA Certified Insolvency and Restructuring AdvisorCM&AA Certified Merger & Acquisition Advisor, Alliance of Merger & Acquisition

AdvisorsCPA Certified Public AccountantCVA Certified Valuation Analyst, National Association of Certified Valuation Analysts

(NACVA)DABFA Diplomate of the American Board of Forensic AccountingFASA Fellow of the American Society of AppraisersJD Juris DoctorMBA Masters of Business AdministrationMCBA Master Certified Business Appraiser, IBAMST Masters of Science in TaxationMVS Masters in Valuation Sciences

*CPA licensure designation regulated by the State of Florida •State of Maine


cOST OF caPITaL cORnER

Corneribbotson decile (1)

10 10

rf(3) 2.8% 2.8%

rPm(4) 6.7% 6.0%

rPs (5) 6.4% 6.4%

Cost of equity (6) 15.9% 15.2%

duff & Phelps 25th portfolio (2)

equity invested Capital sales

rf(3) 2.8% 2.8% 2.8%

risk Premium (7) 14.1% 13.9% 12.4%

erP adjustment (8) 1.1% 1.1% 1.1%

Cost of equity (9) 18.0% 17.8% 16.3%

gross domesticinflation Product

historical (1926-2010)(10) 3.0% 3.2%

10 yr. forecast (11) 2.5% 2.6%(1) Source: Ibbottson SBBI 2011 Valuation Yearbook. © 2011

Morningstar, Inc. All rights reserved. Used with permission. To purchase copies of the Valuation Edition, or for more information on other Morningstar publications, please visit global.morningstar.com/DataPublications.

(2) Source: Duff & Phelps (D&P) 2011 Risk Premium Report, average premiums over risk-free rate©Duff & Phelps LLC. All rights reserved. Used with permission. Available through Morningstar: http://corporate.morningstar.com/ib and Business Valuation Resources, www.bvresources.com, and ValuSource: www.valusource.com.

(3) Risk-free rate, 20-year Treasury Bond Yield, Federal Reserve Statistical Release, 2/13/12(not adjusted).

(4) “Risk Premium in the Market,” SBBI, inside back cover historical and supply side.(5) “Size Premium,” SBBI, inside back cover.(6) Build up method illustration only; excludes industry risk premium and specific company risk,

if any. Uses unadjusted data for ERPs.(7) Report includes premiums where size is measured by market value of equity, market value of

invested capital, 5-year average EBITDA, 5-year average net income, total assets, sales, book value of equity, and number of employees. Each measure for size organized by D&P, gain to 25 portfolio ranks, with portfolio rank 1 being the largest and portfolio 25 being the smallest. Smoothed average premiums are presented here because they are considered a better indicator than actual historical observation for most portfolio groups. Exhibits A-1, A-4 and A-7.

(8 )(9) Adjustment for difference in historic equity (market) risk premium from 1963-2010 of 4.39% andforward estimate of ERP as of early 2012 equal to 5.5%. Source: Duff & Phelps Client Alert, January 27, 2012. Also see Roger J. Grabowski, “Developing the Cost of Equity Capital: Risk-Free Rate and ERP During Periods of ‘Flight to Quality,’” http://www.duffandphelps.com/ expertise/publications/pages/ArticleDetail.aspx?id= 214&list=Articles and presentations by Jim Harrington of Duff & Phelps.

(10) Lawrence H. Officer and Samuel H. Williamson, “Annualized Growth Rate of Various Historical Economic Series,” www.measuringworth.com, 2010. Inflation as of 2010; GDP as of 2010.

(11) Consensus Median Average, The Livingston Survey, Federal Reserve Bank of Philadelphia, December 2011.

Editor’s Note: I highly recommend that all financial experts who rely on Morningstar andDuff & Phelps data purchase these books/studies and thoroughly understand how the dataare compiled and the data choices available.

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