Katz, Sapper & MillerCertified Public Accountants

valuation services bulletin

Court Case Summaries

Summer/Fall 2014

IN THIS ISSUE

3 Help Clients Squeeze the Most Value Out of M&A Synergy

4 How to Value a Holding Company and Discount for BICG Liability

5 U.S. Tax Court Judge Laro Discusses Valuation and Expert Testimony Issues

6 Pratt’s Stats Analysis Reveals Significant Trends

COURT CASE SUMMARIES

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Help Clients Squeeze the Most Value Out of M&A Synergy As the economy improves, M&A activity increases. Companies buy other companies because they expect an increase in value triggered by the combination of two firms into a new entity. One way valuation analysts can help ensure that buyers get the value they expect is to analyze the various synergies a deal is expected to generate. One may ask, what is the point of splitting out and valuing all of the potential synergies? After all, the buyer is not interested in paying the seller for anything that the buyer is bringing to the table. Why not simply value the target company on a fair market value stand-alone basis?

The best way to answer this question is to go through an example. Jeff Litvak and Brent Miller, both with FTI Consulting, a global business advisory firm, provide a hypothetical case study that demonstrates the key concepts and benefits of this approach. Litvak is a senior managing director and Miller is a senior director, both with FTI’s practice in Chicago. First, there are three different types of synergies: cost, growth and financial. Each needs to be examined and valued separately because they have different risk characteristics. Also, some of the changes that will come about with a merger are not really synergies at all, but instead relate to control, which is examined separately. The case study example focuses on the identification and valuation of actual synergies.

Proposed acquisition: Buyer Co. and Seller Co. are both U.S.-based auto parts manufacturers, but one of the attractions for Buyer Co. is that Seller Co. happens to have a distribution network in South America. Buyer Co. has determined that Seller Co. is worth $40 million on a stand-alone basis, that is, without regard to any changes the buyer may make or synergies that may be triggered. If it makes the acquisition, Buyer Co. envisions a few different steps that could be taken to create value: • Write up the seller’s assets to achieve some benefit from increased depreciation expense; • Eliminate a portion of the seller’s G&A by absorbing some of the back-office tasks; • Renegotiate some of the seller’s supplier contracts to get more favorable terms; • Expand the seller’s marketing efforts; and • Use the seller’s distribution network in South America to launch a new product in that market.

Break out ‘control’ changes: The first step is to outline what changes Buyer Co. is looking to make that would represent a synergistic value versus a control value. A synergistic value is one created by the integration of the two firms, that is, the value can only be realized by an actual combination of the two entities. A control value is one that can be achieved without having to actually combine the two entities.

Continued on page 7.See “M&A Synergy”

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How to Value a Holding Company and Discount for BICG LiabilityJust as film critics predict that a movie they see today will be a contender in next year’s Oscar race, many believe the Tax Court’s recent Estate of Richmond opinion will be one of the most important valuation decisions of 2014. It deals with a number of hot topics: dividend capitalization versus net asset value (NAV) approach, discounting for the built-in capital gain (BICG) tax and how to avoid an undervaluation penalty.

The scenario: At the time of her death in December 2005, the decedent owned a 23.44 percent interest in a family-owned investment holding company (C corp) most of whose assets were publicly traded securities. The total assets then were worth nearly $52.16 million, of which $45 million—or 87.5 percent of the portfolio’s value—was unrealized appreciation. The BICG tax on the unrealized appreciation was over $18.1 million.

The executors retained an accounting firm to value the company stock for purposes of reporting estate tax. The certified public accountant who performed the initial appraisal was a member of various professional groups and the author of numerous valuation reports, but he was not a certified appraiser. The estate used his unsigned draft report to declare on Form 706 that the decedent’s interest was valued at $3.15 million. In sharp contrast, an auditor for the Internal Revenue Service (IRS) determined the interest was worth over

$9.2 million. This assessment prompted a deficiency notice and the estate’s petitioning the Tax Court for review. At trial, both sides gave expert testimony as to the fair market value of the decedent’s interest.

The IRS expert used a discounted NAV approach. Broadly speaking, he began with the stipulated net asset value of $52.16 million to calculate that the decedent’s interest was worth $12.2 million. He then applied a 6 percent discount of lack of control (DLOC) and a 36 percent “marketability” discount that included a 15 percent discount for the BICG tax. He concluded the decedent’s interest was worth approximately $7.3 million—about 20 percent less than the value in the deficiency notice. The estate’s trial expert was different from the valuator doing the first appraisal. He was a certified business appraiser and valuation analyst, who used the capitalization-of-dividends method. Based on historical data, he assumed an annual 5 percent increase in dividend payments, which would continue indefinitely. He found the market rate of return for a company with a similar profile was about 10.25 percent, resulting in a capitalization rate of 5.25 percent. Dividing the decedent’s expected dividend return for the following year by the cap rate, he arrived at a present value of about $5 million for future dividends. Continued on page 9.See “BICG Liability”

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U.S. Tax Court Judge Laro Discusses Valuation and Expert Testimony IssuesIt is not every day that one has an opportunity to hear the insights of a U.S. Tax Court judge on issues of interest to valuation analysts. At a recent luncheon sponsored by the Business Valuation Association, Judge David Laro spoke on a number of interesting topics. Judge Laro is the author of the seminal Mandelbaum decision. Valuation professionals Robert Reilly and Dan Van Vleet moderated the luncheon.

Tax Court facts: Reilly and Van Vleet asked Judge Laro to situate the Tax Court in the U.S. legal system. The judge obliged and pointed out that there is one Tax Court, in Washington, D.C., that is composed of 19 federal judges, all of whom have their own jurisdiction. Most tax-related cases settle rather than proceed to the U.S. Tax Court. In cases where the parties do not come to a resolution, they can litigate in federal district court, the U.S. Court of Federal Claims or the U.S. Tax Court. Consequently, financial experts cannot assume that every tax decision is a Tax Court decision. Litigants may appeal a U.S. Tax Court decision at the U.S. Court of Appeals of the appropriate regional circuit; but the appeals court decision only serves as precedent in that circuit—it does not bind Tax Court judges in other circuits. Also, the appeals court affirms 94 percent of the time. Judge Laro’s affirmation rate is even higher—97 percent.

Tax Court memos are fact-intensive and do not serve as precedent, but they can serve as persuasive authority. Reilly

pointed out that some opinions can assume landmark status. Judge Laro’s Mandelbaum decision is a case in point. By now, it has become the quintessential job aid for the Internal Revenue Service (IRS) and valuation analysts when it comes to conceptualizing and computing a discount for lack of marketability (DLOM).

More on Mandelbaum: Reilly wants to know: Why don’t all judges do what Judge Laro did in Mandelbaum? That is, provide a thorough description of how they arrived at their valuation conclusions. Different judges prefer different approaches, Judge Laro explained. It is a matter of transparency, and not every judge wants to set out his or her thought process. The judge’s approach to Mandelbaum was to research the DLOM legal landscape and provide a methodology that valuators and future litigants could use to create their valuations. When he discovered that many of the earlier memo cases broaching the subject lacked explanations as to how the court arrived at its decision, he made a deliberate effort to develop a decision that could guide the appraisal industry.

Tailor approach to presiding judge? Should knowledge about the presiding judge influence the way an expert performs a valuation, Reilly and Van Vleet wanted to know. No, said Judge Laro. He allowed that he would question the Continued on page 9.See “Judge Laro”

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Pratt’s Stats Analysis Reveals Significant Trends Recent analysis of 2013 data from Pratt’s Stats, the leading private M&A transaction database, reveals several notable trends. Business values are on the rise: The median selling price-to-EBITDA ratio for all major sectors was 2.96x in 2013, up slightly from 2.88x in 2012, but down from a 10-year high of 6.16x in 2006. In 2013, the major sector with the greatest median selling price-to-EBITDA ratio was manufacturing, at 5.69x, and the sector with the lowest was retail trade, at 2.01x. The tech sector, which Pratt’s Stats classifies as a subsector under the major industry sector “services,” had a median selling price-to-EBITDA ratio of 12.98x in 2013.

Companies pay more: The median selling price-to-EBITDA ratio in 2013 for public companies acquiring private companies was 9.55x, significantly more than that of individuals buying companies, which was 2.78x.

Size does matter: The median selling price-to-EBITDA ratio in 2013 corresponds positively with firm size. When transactions are sorted by those with the largest revenues to those with the smallest and are then divided into five equal-sized quintiles, there is a general decline from 6.02x to 3.13x to 2.63x to 2.45x to 2.00x, respectively. This shows that companies with the highest net sales tend to have a larger median selling price to EBITDA ratio than the companies with lower net sales. Stay tuned for more: As business intermediaries continue to submit deal information, additional data will be made available.

Pratt’s Stats contains transactions submitted by business intermediaries and M&A advisors where a person buys a private business, as well as transactions that have been researched at the U.S. Securities and Exchange Commission website where a public company buys a private business. Unless otherwise noted, this analysis contains all transactions.

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M&A Synergy(Continued from page 3) In this case, the first change—writing up the seller’s assets—is a synergy based on the fact that you have to actually integrate the firms to really get the benefit of the increased depreciation expense. The second change (eliminating some G&A) is also a synergy based on the fact that it requires integration.

Renegotiating the seller’s supply contracts is more of a control change because there is no indication that the firms would need to integrate to accomplish this. Likewise, expanding the seller’s marketing efforts is a control change because it does not require integration. On the other hand, using the seller’s distribution network in South America to launch a new product is a synergy—it is necessary to integrate that network into the existing operation to carry out this strategy.

The issue of synergy versus control is not always so clearly defined. It depends on the facts and circumstances of the particular situation. Some changes that appear to be a synergy may really be related to control. For example, a buyer does not always have to integrate the seller firm to reduce G&A costs. There simply could be waste and inefficiency such that a streamlining of the seller’s existing back-office operations could suffice without having to combine the seller’s departments with the buyer’s. This would be an example of something that could potentially be a control change instead of being a synergy.

Similarly, if it is possible to renegotiate the supplier contracts because the integration of the two companies will provide additional buying power and leverage in negotiations, it could be more of a synergy change than a control change.

One needs to look closely at the specifics of what he or she is trying to change about the company that is going to generate value. The question

to ask is whether the target company can generate the change on its own or whether it is a change in which the buying company plays an essential role. That is really what is going to make the determination of whether it is a control change or a synergy change.

So what does one do with the changes that are determined to be related to control value? Those changes and the capital associated with them are discounted based on the seller’s weighted average cost of capital. This, however, assumes that the risk associated with it is not particularly higher or lower than the seller’s overall risk. The reason this is done is because those changes relate to improving the target company as it stands rather than integrating it together. Because it is the target as it stands, that is where one would look to determine what the risk of achieving that control improvement would be. Different risk levels: Once the different types of changes and benefits determined as synergies are identified, the next step is to figure out the level of risk associated with each synergy. In this case, there are the three different types of synergies: cost, growth and financial. As a general rule, financial synergies (such as the tax benefit in this case) are going to be something that is a lower risk proposition. Cost-saving synergies are going to have a slightly higher risk. On the other hand, growth synergies can represent a very high risk. In this case, putting out a completely new product in a completely new market is something that can be very risky for the buying company.

Because there are different levels of risk, one cannot simply go to the basic synergy valuation method, but must go through and separately conduct a valuation of each synergy. For the purposes of this case study, assume that the weighted average cost of capital (WACC) for the buyer and seller is 10 percent and 16 percent, respectively. When the companies are integrated

together, the combined WACC of the integrated firm will be 12 percent.

Financial synergy: The first benefit to examine in this case is the tax synergy. The asset write-up will increase depreciation expense by $6 million a year for the next three years. Examine the likelihood of being able to actually utilize that increase in that depreciation to determine the level of risk associated with the synergy.

In this case, the buyer has had pre-tax income that has consistently been more than $15 million, which is greater than the $6 million per year expected as increased depreciation. This indicates that the risk of achieving the tax savings is relatively low. However, it is not a virtual certainty. It would be different if the buyer consistently had $100 million in pre-tax income and there was no expectation that acquiring the selling company was going to lower that income. In that case, the pre-tax income is so much greater than the $6 million in extra depreciation that it would be safe to say it is an absolute certainty that the tax benefit would be realized.

But, in this case, there is some level of risk because the pre-tax income is not dramatically higher. Therefore, the determination made in this situation is that the risk is relatively comparable to the risk associated with the buyer’s ability to make its debt payments. Based on that fact, the discount rate that should be applied to the cash flows from the tax synergy should be the integrated firm’s cost of debt. Notice that the integrated firm’s cost of debt is used rather than the buyer’s cost of debt because the synergy relates to the combination of the two businesses. Look at the risk associated with the two businesses together at those different levels to determine the risk associated with these cash flows.

Continued on page 8.See “M&A Synergy”

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M&A Synergy(Continued from page 7) Cost-reduction synergy: The next synergy to analyze is the cost reduction the buyer is planning by eliminating some of the seller’s back-office operations (accounting, HR, and purchasing). The buyer expects that it will take two years to see any savings associated with this change. Again, the question is: How risky is the achievement of this synergy?

In this situation, these particular cost-cutting efforts are relatively comparable to any other cost-cutting measures that the integrated firm might make. There is nothing particularly complex about them. As a result, one would expect that the risk associated with achieving these cost-cutting measures is comparable to the level of risk associated with the firm’s cash flow to invested capital. Therefore, one would look at the integrated firm’s WACC to determine the discount rate to use for the projected cash flows from the G&A cost savings.

In this case, because the buyer expects it will take two years to achieve the G&A cost reductions, no synergies are projected in those first two years (see Exhibit 1). Also, the discount rate that is being applied is the 12 percent WACC of the integrated firm and not the buyer’s 10 percent WACC or the seller’s 16 percent rate. Focus on the integrated firm when examining the risk associated with a change that relates to the integrated firm as a whole.

New product/market synergy: The final synergy in this case is the idea of using the existing distribution network that the target company has in order for the buying company to launch a new product in a new market.

The buyer has conducted some market research and learned that customers who purchase auto parts also happen to be mountain-bike enthusiasts. So the buyer thinks there is an opportunity to sell mountain bikes to the same customers that purchase their auto parts. With this particular acquisition, the buyer sees the chance to sell mountain bikes in some mountainous regions of South America. How risky is this synergy? First of all, this is a completely new product—not a variation of its existing product line (auto parts). It is a completely new line of business for the buyer, and, at the same time, it is also in a completely different market location (the buyer primarily operates in the U.S.). These two factors together suggest that this is a rather high-risk venture. Therefore, it would be appropriate to use a relatively high discount rate—30 percent or more—which would be comparable to a venture capital-type rate. This is appropriate because a venture involving a new product in a new market has so much risk associated with it.

Exhibit 1 demonstrates how to value the projected synergy cash flows from this new venture. The free cash flow to invested capital and the amount of growth that is projected for those cash

flows are discounted at a 30 percent rate. Because this venture is so high risk and different from the existing operations of the buyer, the seller, or the integrated company, do not look at the WACC or the cost of equity related to any of those separate entities or the integrated firm. Go beyond that to a higher level of risk because it is so different from their existing lines of business.

Now that the analysis of valuing the different synergies has been completed, the buyer can use this information at the negotiating table.

Negotiating power: Armed with the knowledge of the value of the synergies, the buyer is better equipped to negotiate. This information has an impact on whether the buyer is able to take the hard line and extract the full value of its expected synergies or whether it would potentially need to give something back to the seller in order to make the deal happen. There are certain situations involving these changes the buyer wants to make where the seller may have more negotiating power. In this case, this can certainly be true with regard to the two different control-related changes related to renegotiating the contracts that the seller has with its suppliers and increasing and changing the marketing efforts. Again, in theory, any buyer could come in, acquire the company, make

Continued on page 9.See “M&A Synergy”

Exhibit 1. Case Study — Cost Reduction Synergy

COST SAVINGS SYNERGY PROJECTION

Year 1 Year 2 Year 3 Year 4 Year 5 Terminal Value

Projected Cost Savings $ - $ - $ 1.0 $ 1.1 $ 1.1

Cash-Flow Impact $ - $ - $ 0.6 $ 0.6 $ 0.7 $ 7.6

Discounted Cash Flow (at 12%) $ - $ - $ 0.5 $ 0.4 $ 0.4 $ 4.5

Company Value $ 5.8

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BICG Liability(Continued from page 4) Alternatively, the expert provided a valuation based on the NAV method; it essentially critiqued and modified elements of the IRS expert’s valuation. For example, he proposed a 100 percent BICG tax discount.

‘Standing on firm ground’: At the start of its analysis, the Tax Court noted that dividend capitalization was one legitimate way to value a business and “may be entirely appropriate where a company’s assets are difficult to value.” But this approach rests “entirely on estimates about the future.” And, the court continued, “even small variations in those estimates can have substantial effects on the value to be determined.” By relying on dividend capitalization, the estate’s expert “ignored the most concrete and reliable data of value … the actual market prices of the publicly traded securities” in the company’s portfolio, said the Tax Court. By contrast, the NAV method begins “by standing on firm ground—with stock values one can simply look up.” A potential investor would have known that the company held assets whose value was easily attainable and would take those values as a starting point.

Next, the court dove into the “difficulties and uncertainties” going along with the NAV—determining the applicable discounts, including one for the BICG liability. It agreed that a BICG discount was appropriate, but rejected the estate’s proposed dollar-for-dollar reduction as “plainly wrong in a case like the present one.” Also, the estate cited circuit case law that was not controlling. The IRS expert’s calculation method was equally “problematic,” said the court, but his $7.8 million bottom line was “reasonable.” It adopted a 7.75 percent discount for lack of control and a 32.1 percent discount for lack of marketability. A secondary issue—but one that resonates

with valuation professionals—was what type of appraisal may excuse an undervaluation and exempt the taxpayer from any accuracy-related penalty. The short answer: one prepared by a certified appraiser.

M&A Synergy(Continued from page 8) those changes and generate that value. Because of this, it makes it a little harder for the buyer to really extract the full value of the control changes.

Also, think about whether any particular synergy is specific to the buyer itself or whether it is really a synergy that any number of buyers could achieve. If many buyers have the potential to achieve those same synergies, it gives a little more negotiating power to the seller. The seller will try to take some of that value for itself and for its shareholders because it can essentially pit more of the buyers against each other to try to drive up the price.

In this case, assume that the tax benefits could potentially be achieved by a large number of buyers. If that is the case, then the seller may have a great deal of negotiating power related to maintaining the value or grabbing onto the value associated with those tax benefits.

By contrast, some of these other potential changes could result in the buyer having more negotiating power. This is especially true if the cost savings related to incorporating the seller’s operations into its existing infrastructure is something that the buyer is particularly well suited to do. In this case, it is more likely that the buyer will be able to extract that value from this acquisition. By the same token, if the particular buyer is the only one who has the chance to generate some synergistic value from launching a new product in a new market, then the buyer is going to be able to retain that value. In summary, exploring the different synergies associated with a potential acquisition can definitely play a role in the negotiations and help the buyer obtain the most value.

Judge Laro(Continued from page 5) thoroughness of a report in which an expert appearing in front of him failed to discuss the Mandelbaum factors. He also thought it was good practice for an expert to read the cases in which a presiding judge discussed valuation issues to get a picture of where the judge is coming from, but it would be a mistake to tailor a valuation to the judge. What matters is the expert’s independent, unbiased opinion. How did he or she arrive at it? Can he or she back it up?

There are so many variables, Judge Laro said, that go into a judge’s decision-making: the facts specific to a case, the experts, the witnesses, documentary evidence, and the judge’s own views and preferences. For an expert to assume he or she can influence the outcome of a case by studying the judge’s prior decisions would be a big mistake. Tax affecting: Judge Laro was hesitant to answer technical questions. When Van Vleet and Reilly tried to ask about specific issues, he reminded them that the judges look to the experts for the right answer to those questions, but he did allow that the issue of tax affecting was not a closed matter in his court. The Delaware Court of Chancery allows it, he noted. “The door is wide open,” he said. He was waiting for the right set of facts to walk through it.

Continued on page 10.See “Judge Laro”

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Judge Laro(Continued from page 9) ‘Hot tubbing’: What’s the future of expert testimony? “Hot tubbing,” responded Judge Laro to chuckles in the audience. Hot tubbing is an alternate way to handle cross-examination of expert witnesses. In our system, he explained, the parties retain experts to teach the fact-finder and the court (sometimes the same) about valuation and other issues that require specialized knowledge; but, the judge points out, think of what the expert’s testimony looks like to a judge after the opposing counsel has put the expert through cross-examination, as our adversarial model requires. The testimony is fragmented because of the sustained attack on the expert’s credibility.

The solution to a more equitable outcome, he said, is a technique practiced in a number of other countries known as hot tubbing or, more formally, “concurrent witness testimony.” Judge Laro, who has used it in a few cases, says he usually sits at a table with the two experts flanking him and the attorneys relegated to the periphery. The judge opens a conversation, asks questions of the experts, and invites them to pursue their own dialogue. Without having to worry about attacks on their credibility, the experts are able to have a collegial discussion about their work on the case. Reilly, who had experience with this approach involving cases in Australia, Ireland and England (countries that trace their legal system to England), says it is “radically different” from the U.S. approach. In many ways, it is better for fact-finding. When you sit next to someone you know or whose work you know, he says, you do not attack the person just because you feel on the defensive. You talk about the case and air honest disagreements.

All three speakers agreed it requires a certain sophistication by the presiding judge because the judge has to get the conversation started. Reilly wanted to know what the reception of this approach has been in the legal community. When he proposed adopting it in a case, Judge Laro said, the parties at first were reticent, but ultimately the IRS and the petitioning taxpayer agreed and seemed satisfied. In a second case, the taxpayer asked for it. Judge Laro thinks this approach is the way forward: It provides the judge with coherent expert testimony and as such aids the decision-making.

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About Katz, Sapper & Miller

Andy Manchir is a director in KSM’s Valuation and ESOP Services Groups. Andy provides valuation and business advisory services for various purposes, with a particular emphasis on Employee Stock Ownership Plan (ESOP) services. He has testified as an expert witness on business valuation matters.

Katz, Sapper & Miller’s Valuation Services Group provides you with the information you require; whether creating or updating a buy/sell agreement, developing an estate plan or gift program, or implementing a corporate merger or acquisition, our professionals can provide the valuation expertise needed. We value many types of businesses, including partnerships, LLCs, corporations, not-for-profit organizations and governmental entities.

When a valuation is conducted, all relevant approaches are considered, including asset, income and market approaches. Our professionals follow a comprehensive due diligence process which includes conducting onsite interviews, performing industry and competitor research, and examining company specific and other relevant factors. Learn more at ksmcpa.com/valuations.

Dan Rosio is the partner-in-charge of KSM’s Valuation Services Group. Dan has extensive experience in project management, financial statement analysis, report writing and other due diligence services related to business valuation services. He has completed hundreds of valuation and litigation engagements.

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