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Valuing a Business


									Valuing a Business
The Analysis and Appraisal
of Closely Held Companies

Fifth Edition

Shannon P. Pratt, CFA, FASA, MCBA, MCBC,
Chairman and CEO
Shannon Pratt Valuations, Inc.

Alina V Niculita, CFA, MBA
President and COO
Shannon Pratt Valuations, Inc.

                             Hill. >
     New York • Chicago • San Francisco • Lisbon • London
      Madrid • Mexico City • Milan • New Delhi • San Juan
             Seoul • Singapore • Sydney • Toronto

PART I       State of the Profession, the Engagement,
             and the Basic Theory                                      .       1
1. Business Valuation Standards and Credentials                                 3
   Growing Consensus on Business Valuation Standards. The Appraisal
   Foundation. Background and Organization. Uniform Standards of
   Professional Appraisal Practice. Standards Published by Business Valuation
   Professional Organizations. Other Organizations That Have Offered
   Guidance on Business Valuation Issues. Internal Revenue Service.
   Department of Labor. Association for Investment Management and
   Research. The ESOP Association. Recognition of Professional Standards
   by Courts. International Acceptance of U.S. Standards and Practices.
   Professional Organizations Offering Accreditation in Business Valuation.
   American Society ofAppraisers. Institute of Business Appraisers. National
   Association of Certified Valuation Analysts. American Institute of Certified
   Public Accountants. The Canadian Institute of Chartered Business Valuators.
   Summary. Bibliography.
2.   Defining the Assignment                                                   29
     Basic Elements of the Valuation Assignment. Definition of Who Offered and
     Who Accepted the Assignment. Description of the Legal Interest or Interests
     to Be Appraised. Description of the Business Entity. Description of the
     Specific Business Interest. Interests Other than Direct Fee Simple
     Ownership. Description of the Specific Ownership Interest Characteristics.
     Control versus Minority. Degree of Marketability. Valuation Date. Purpose
     of the Appraisal. Standards of Value. Fair Market Value. Investment Value.
     Intrinsic or Fundamental Value. Fair Value under State Statutes. Fair
      Value for Financial Reporting. Going-Concern versus Liquidation Premise
     of Value. Sources of Guidance as to Applicable Standards and Premises of
     Value. Form of the Work Product. Scheduling. Fee Arrangements. Summary.
3.   Business Valuation Theory and Principles                                55
     Generally Accepted Theory. Reliance on Projected versus Historical
     Benefits. Basic Variables Affecting Value. Impact of Risk on Value.
     Accepted Business Valuation Approaches and Methods. Background and
     Structure. Interrelationship of the Three Broad Approaches. Impact of
     Controlling versus Noncontrolling Ownership Interest. Impact of
     Marketability. Distinction between Discount for Lack of Control and
     Discount for Lack of Marketability. Other Qualitative Factors Affecting
     Value. Matching the Valuation Methodology with the Standard and Premises
     of Value. Sum of Parts Not Necessarily Equal to Whole. Summary of
     Business Valuation Principles. Bibliography.

PART II       Gathering and Analyzing Data                                      73
4.   Gathering Company Data                                                    75
     Generalized Company Information Checklist. Financial Statements.
     Relevant Time Period. Levels of Financial Statement Preparation. Impact
     of Enterprise Legal Structure. Federal Tax Returns. Interim Statements.
     Other Financial Schedules. Current Assets and Liabilities. Plant and
     Equipment. Officers' and Directors' Compensation Schedule. Distribution
     of Ownership. Dividend or Partnership Withdrawal Schedule. Schedule of
     Key Person Life Insurance. Off-Balance Sheet Assets or Liabilities. Related
     Party Transaction Information. Operating Information. Company History.
     Brochures, Catalogs, Web Sites, and Price Lists. Key Personnel. Customer
     and Supplier Base. Contractual Agreements and Obligations. Industry and
     Trade Association Information. List of Past Transactions in the Stock or
     Offers to Buy. Budgets and Forecasts. Capital Requirements. Capital
     Expenditures. Deferred Maintenance. Working Capital Requirements.
     Company Documents Relating to the Rights of Owners. Corporate or
     Partnership Records. Buy-Sell and Employee Stock Ownership Plan
     Agreements. Employment and Noncompete Agreements. Summary.
5.   Site Visits and Interviews                                                  91
     History. Description of the Business. Management and Management
     Compensation. Operations. Materials and Supplies. Labor and Government
     Relations. Plant and Equipment. Inventory. Markets and Marketing. Finance.
     Current Assets. Fixed Assets. Intangible Assets. Current Liabilities. Capital
     Structure. Off-Balance Sheet Items. Profitability and Budgeting. Insurance.
     Dividends. Prior Arm's-Length Transactions or Offers. Catch-All Question.
     Interviews of Outsiders. Professionals Related to the Company. Other
     Possible Outside Interviews. Summary.
6.   Researching Economic and Industry Information                           103
     National Economic Information. The Federal Statistical System.
     Banks. Business Periodicals and Statistical Services. Regional Economic
     Information. Industry Information. General Industry Information.
     Composite Company Data. Information on Management Compensation.
     Online Information. Indexes to Economic and Industry Information.
     Summary. Bibliography.
7. Analyzing Financial Statements                                          129
   Normalizing versus Controlling Adjustments. Adequacy of Allowance and
   Reserve Accounts. Allowance for Doubtful Accounts—Accounts Receivable.
   Allowance for Doubtful Accounts—Notes Receivable. Inventory Accounting
   Methods. FIFO, LIFO, and Other Methods. Write-Down and Write-Off
   Policies. Depreciation Methods and Schedules. Declining-Balance Method.
   Sum-of-the- Years '-Digits Method. ACRS and MACRS. Analytical
   Implications. Depletion. Treatment of Intangibles. Leasehold Interests.
   Other Intangible Assets. Capitalization versus Expensing of Various Costs.
   Timing of Recognition of Revenues and Expenses. Contract Work.
   Installment Sales. Sales Involving Actual or Contingent Liabilities.
   Prior-Period Adjustments. Accounting for Leases. Net Operating Loss
   Carryforwards. Treatment of Interests in Affiliates. Extraordinary or
   Nonrecurring Items. Ordinary versus Extraordinary Items. Other
   Nonrecurring Items. Discontinued Operations. Operating versus
Contents                                                                      ix

     Nonoperating Items. Management Compensation and Perquisites.
     Transactions Involving Company Insiders. Contingent Assets and Liabilities.
     Adjustments to Asset Valuations. Marketable Securities. Other Assets.
     Computation of Earnings per Share. Weighted Average Basis. Basic versus
     Diluted Earnings. Computation of Book Value per Share. An Example of the
     Effect of Alternative Accounting Methods. Adjusting the Balance Sheet to
     Current Values. Summary. Bibliography.
8.   Financial Statement Ratio Analysis                                      153
     Use and Interpretation of Ratio Analysis. Common-Size Statements.
     Short-Term Liquidity Measures. Current Ratio. Quick (Acid-Test) Ratio.
     Activity Ratios. Accounts Receivable Turnover. Inventory Turnover. Sales to
     Net Working Capital. Sales to Fixed Assets and Total Assets. Risk Analysis.
     Business Risk. Financial Risk. Balance Sheet Leverage Ratios. Total Debt to
     Total Assets. Equity to Total Assets. Long-Term Debt to Total Capital.
     Equity to Total Capital. Fixed Assets to Equity. Debt to Equity. Income
     Statement Coverage Ratios. Times Interest Earned. Coverage of Fixed
     Charges. Income Statement Profitability Ratios. Return on Investment
     Ratios. Return on Equity. Return on Investment. Return on Total Assets.
     Asset Utilization Ratios. Summary.

PART III       Business Valuation Approaches and Methods                    171
9.   Income Approach: Discounted Future Economic Income Method               173
     Introduction: Theoretical and Practical Soundness of the Approach.
     The Basic Discounted Economic Income Framework. The Numerator:
     Expected Prospective Economic Income. The Denominator: The Discount
     Rate. Estimating the Discount Rate. Return and Rate of Return Defined.
     Components of the Discount Rate. The Risk-Free Rate. The Equity Risk
     Premium. The Capital Asset Pricing Model. Systematic and Unsystematic
     Risk. Beta: The Measure of Systematic Risk. Using Beta to Estimate
     Expected Rate of Return. Levered and Unlevered Betas. Assumptions
     Underlying the Capital Asset Pricing Model. The Size Premium.
     The Build-Up Model. Formula for the Build-Up Model. Company-Specific
     Risk Premium. Industry Risk Premia. The Discounted Cash Flow or the
     Implied Method of Estimating the Cost of Capital. Arbitrage Pricing Theory.
     Sources of Data to Estimate the Cost of Equity Capital. Risk-Free Rate.
     Equity Risk Premium. Beta. Size Premium. Industry Risk Premia.
     Investment-Specific Risk. Arbitrage Pricing Theory Factors. Rate of Return
     Allowed to Regulated Companies. Cost of Capital Yearbook. Discounting
     Economic Income Available to Overall Capital. Defining the Capital
     Structure. Weighted-Average Cost of Capital Formula. Should an Actual or
     a Hypothetical Capital Structure Be Used? Specific Projection Period plus a
     Terminal Value. The "Midyear Discounting Convention." Example of
     Application of Discounted Economic Income Methods. Estimating an Equity
     Discount Rate. Discounting Net Cash Flow to Equity. Estimating a
     Weighted-Average Cost of Capital. Discounting Net Cash Flow to Invested
     Capital. Caveats in Using Discounted Economic Income Methods. Converting
     a Discount Rate Applicable to Net Cash Flow to a Discount Rate Applicable
     to Net Income. Does the Discounted Economic Income Model Produce a
     Control or a Minority Value? What Standard of Value Does a Discounted

   Economic Income Model Produce? Common Errors. Mismatching the
   Discount Rate with the Economic Income Measure. Confusing Discount
   Rates with Capitalization Rates. Projecting Growth Beyond What the Capital
   Being Valued Will Support. Projecting That Extrapolation of the Recent Past
   Represents the Best Estimate of Future Results. Discounting a Terminal
   Value for an Incorrect Number of Periods. Internally Inconsistent Capital
   Structure Projection. Assumptions That Produce a Standard or Premise of
   Value Other Than That Called for in the Valuation Engagement. Summary.
10. Income Approach: Capitalized Economic Income Method                     237
    Essential Difference between the Discounting Model and the Capitalization
    Model. The Perpetual Economic Income Stream Model. Converting a
    Discount Rate to a Capitalization Rate—The Constant Growth Model.
    The Gordon Growth Model, Sensitivity to Growth Rate Assumptions. When
    to Use the Discounting versus the Capitalization Method. Equivalence of the
    Discounting and Capitalization Methods. Implementing the Capitalized
    Economic Income Method. Projecting the Basic Economic Income Level
    and the Growth Rate. Start with Sustainable Expected Economic Income.
    The Projected Long-Term Growth Rate. Defining the Components in the
    Capitalization Method. Valuing Equity versus Invested Capital. Selecting the
    Appropriate Measure of Economic Income. Modification of the Capitalized
    Economic Income Method to Reflect the Midyear Discounting Convention.
    Using the Capitalized Economic Income Method to Develop a Terminal
    Value for the Discounted Economic Income Method. Why the Capitalized
    Economic Income Method Is Preferable. Implementation of the Capitalized
    Economic Income Method to Estimate the Terminal Value. Does the
    Capitalized Economic Income Method Produce a Control Value or a
    Minority Value? What Standard of Value Does the Capitalized Economic
    Income Model Produce? Relationship between the Capitalized Economic
    Income Method and the Market Approach. Derivation of Income Approach
    Capitalization Rates versus Market Approach Multiples. Economic Income
    Variables Used in the Income Approach versus the Market Approach.
    Summary. Bibliography.
11. Market Approach: Guideline Publicly Traded Company Method              261
    Overview of the Guideline Publicly Traded Company Method. When Is the
    Guideline Publicly Traded Company Method Most Useful? Standard of
    Value. Ownership Characteristics. Going-Concern versus Liquidation Value.
    Quantity and Quality ofAvailable Data. Criteria for Guideline Company
    Selection. How Many Guideline Companies? Time Period to Consider.
    Deciding Which Valuation Multiples to Use. Influence of the Ownership
    Characteristics. Going-Concern versus Liquidation Value. Type of Company.
    Availability of Data. Compiling Guideline Company Tables. Developing a
    List of Guideline Companies. Financial Statement Adjustments to Guideline
    Companies. Adjusting for Operating Leases. Comparative Ratio Analysis.
    Obtaining the Guideline Companies' Market Value Data. Presenting
    Guideline Company Tables. Selecting and Weighting Multiples for the
    Subject Company Based on Guideline Companies. Impact of Guideline
    Company Data Evaluation. Measures of Central Tendency and Dispersion.
    Multiples of Economic Income Variables. Capitalization of Dividends or

    Dividend-Paying Capacity. Multiples of Revenue. Multiple of Stock Value
     to Asset Value. Treating Nonoperating Assets, Excess Assets, and Asset
     Deficiencies. Nonoperating Assets. Marginal Operating Real Estate. Excess
    Assets or Asset Deficiencies. Beware of Recent Acquisitions . Multiline
     Companies. Procedures for Valuation. "Portfolio Effect." Typical Adjustments
     to Reach a Value Conclusion. Valuation Multiples Using Market Value of
     Invested Capital. Common Errors. Failure to Conduct an Adequate Search
    for Guideline Company Data. Failure to Make Appropriate Financial
     Statement Adjustments to Guideline Companies. Multiples that Mismatch
    Numerator and Denominator. Simple Reliance on Average of Guideline
     Company Multiples without Comparative Analysis. Summary. Bibliography.
12. Market Approach: Guideline Merged and Acquired
        Company Method                                                      309
     Overview of the Merged and Acquired Company Method. When Is the
     Guideline Merged and Acquired Company Method Most Useful? Standard
     of Value. Going-Concern versus Liquidation Value. Quantity and Quality of
     Data Available. Control Transaction (Acquisition) Valuation Multiples.
    Announcement versus Closing Date Value. Caveat: Check the Deal Structure.
     Deal Terms. Exactly What Was Transacted? Noncompete and Employment or
     Consulting Agreements. Sources of Merger and Acquisition Data. Sources
    for Large Company Transactions. Sources for Middle-Market and Smaller
     Company Transactions. Past Subject Company Transactions. Past Subject
     Company Changes of Control. Bona Fide Offers. Past Acquisitions by the
     Subject Company. Formulas or Rules of Thumb. Nonoperating Assets,
     Excess Assets, and Asset Deficiencies. Selecting and Weighting Multiples
     for the Subject Company Based on Guideline Transactions. Impact of
     Guideline Transactional Data Evaluation. Multiple of Stock Value to Asset
     Value. Reaching the Value Conclusion. Summary. Bibliography.
13. The Capitalized Excess Earnings Method                                   331
    The History of the Capitalized Excess Earnings Method. The Capitalized
    Excess Earnings Valuation Method. Practical Application of This Method.
    The Seeming Simplicity of This Method. An Illustration. Analysis of the
    Capitalized Excess Earnings Method. Estimation of the "Net Tangible Asset
    Value." Estimation of the "Normalized Level of Earnings." Appropriate Rate
    of Return on Tangible Assets. Appropriate Direct Capitalization Rate for
    Excess Earnings. Comprehensive Example. The Treatment of Negative
    Goodwill. Common Errors in Applying the Capitalized Excess Earnings
    Method. Failure to Allow for Shareholder/Employee Salary. Failure to Use
    Realistic Estimate of Future Normalized Earnings. Errors in Developing
    the Appropriate Direct Capitalization Rates. Summary. Bibliography.
14. Asset-Based Approach: Asset Accumulation Method                           349
    Fundamentals of the Asset Accumulation Method. Asset-Based Approach
    versus Book Value. Asset Accumulation Method and Capitalized Excess
    Earnings Method. Asset Accumulation Method—Individual Revaluation.
    Combining Elements of Asset Accumulation Method and Capitalized Excess
    Earnings Method. Asset Accumulation Method Procedures. Obtain or
    Develop a Cost-Basis Balance Sheet. Identify Assets and Liabilities to Be
    Revalued. Identify Off-Balance Sheet Assets. Identify Off-Balance Sheet and
    Contingent Liabilities. Value the Accounts Identified Above. Construct a

     Value-Basis Balance Sheet. Individual Asset Valuation Procedures. Financial
    Assets. Real Estate. Tangible Personal Property. Intangible Real Property.
    Intangible Personal Property. Categorization of Intangible Assets. Valuation
    of Intangible Assets. Remaining Useful Life Analysis of Intangible Assets.
    Example. Advantages of the Asset Accumulation Method. Disadvantages of
    the Asset Accumulation Method. Summary. Bibliography.

PART IV       Discounts, Premiums, and the Value Conclusion                   381
15. Control and Acquisition Premiums                                        383
    Levels of Value. Elements of Control. Control or Lack of Control Covers
    a Spectrum. How the Standard of Value Affects the Control Premium. Fair
    Market Value. Fair Value. Fair Value for Financial Reporting. Investment
    Value. Market Evidence Regarding Control and Acquisition Premiums.
    The Mergerstat Review. The Mergerstat/Shannon Pratt s Control Premium
    Study. Negative Control Premiums. Means, Medians, and Effect of Negative
    Premiums. Robinson, Rumsey, and White Study. Summary. Bibliography.
16. Discount for Lack of Control                                              397
    Lack of Control Covers a Spectrum. Factors That Influence the Lack of
    Control Discount. Effect of State Statutes. Articles of Incorporation and
    Bylaws. Potential Dilution. Preemptive Rights. Cumulative versus
    Noncumulative Voting. Contractual Restrictions. Financial Condition of
    Business. Highly Regulated Industries. Buy-Sell and Other Shareholder
    Agreements. Fiduciary Duties. Private Company with Public Securities.
    Private Company That Operates Like a Public Company. Control Has
    Already Been Dissipated. Nonoperating Assets. Empirical Evidence to
    Quantify Lack of Control Discounts. Discounts from Net Asset Value.
    Holding Companies. Limited Partnerships. Built-in Gains Discount.
    Trust and Estate Sales Study. Discounts for Direct Undivided Ownership
    Interests in Real Estate. Procedures for the Valuation of Noncontrolling
    Ownership Interests. The Discount Approach. The Direct Comparison
    Approach. The Bottom-Up Approach (Income Approach). Adjustments to
    Income Statement. Summary. Bibliography.
17. Discounts for Illiquidity and Lack of Marketability                        415
    Concept and Importance of Marketability. Adjustment for Lack of
    Marketability for Noncontrolling Ownership Interests. Evidence for the
    Quantification of Discount for Lack of Marketability. Marketability
    Discounts Extracted from Prices of Restricted Stocks. SEC Institutional
    Investor Study. Gelman Study. Trout Study. Moroney Study. Maher Study.
    Standard Research Consultants Study. Willamette Management Associates
    Study. Silber Study. FMV Opinions, Inc., Study. Management Planning, Inc.,
    Study. Johnson Study. Columbia Financial Advisor Study. LiquiStat
    Database. Summary of Empirical Studies on Restricted Stock Transactions.
    Studies of Private Transactions before Initial Public Offerings. Robert W.
    Baird & Company Studies. Willamette Management Associates Studies.
    Criticisms of Willamette Management Associates Studies. Valuation Advisor
    Studies. Summary of Conclusions from Private Transaction Studies. Other
    Analysis of Discounts for Lack of Marketability for Minority Ownership
    Interests. Discounts for Lack of Marketability for Controlling Ownership
Contents                                                                        xiii

    Interests. Illiquidity Factors Affecting Controlling Ownership Interests.
    Benchmark for the Illiquidity Discount for Controlling Ownership Interests.
    Differences between Private and Public Company Acquisition Price/
    Earnings Multiples. Factors That Affect the Discounts for Illiquidity and
    Lack of Marketability. "Put" Rights. Dividend Payments. Potential Buyers.
    Size of Interest. Prospect of Public Offering or Sale of the Business.
    Information Access and Reliability. Restrictive Transfer Provisions.
    Company Characteristics: Size, Performance, and Risk. Court Decisions
    on Discounts for Illiquidity and Lack of Marketability. Mandelbaum v.
    Commissioner Reviews Lack of Marketability Factors. Estate of Barge v.
    Commissioner Considers Lack of Marketability Factors. Okerlund v. United
    States Approves Pre-IPO Studies. McCord v. Commissioner Lacks Rebuttal.
    Howard v. Shay Upholds 50 Percent DLOM. Summary. Bibliography.
18. Other Valuation Discounts                                               459
    Entity Level Discounts. Key Person Discounts. Discounts for Trapped-In
    Capital Gains Taxes. "Portfolio " (Nonhomogeneous Assets) Discount.
    Discount for Contingent Liabilities. Other Shareholder Level Discounts.
    Nonvoting versus Voting Stock. Blockage. Summary. Bibliography.
19. Valuation Synthesis and Conclusion                                        471
    The Reconciliation Process. Criteria for the Selection of Valuation
    Approaches and Methods. Quantity and Quality of Available Data.
    Type of Business, Nature of Business Assets, and Type of Industry Subject
    to Valuation. Nature of the Business Interest Subject to Valuation. Statutory,
    Judicial, and Administrative Considerations. Informational Needs of the
    Valuation Audience. Purpose and Objective of the Analysis. Professional
    Judgment and Expertise of the Analyst. Reconciling Divergent Indications
    among Valuation Methods. Weighting of Valuation Method Results. At What
    Point Are Valuation Discounts and Premiums Applied? Concluding the Value
    Estimate. Explicit Weighting. Implicit Weighting. Final Value Estimate.

PART V       Writing and Reviewing Business Valuation Reports                  483
20. Writing the Business Valuation Report                                       485
    Overview of the Business Valuation Report. USPAP Reporting Standards.
    Written Business Valuation Reporting Standards. Oral Business Valuation
    Reporting Standards. USPAP Ethics Provisions. Retention of Valuation
    Reports and Work Paper Files. Confidentiality Provision. Internal Revenue
    Service Business Valuation Guidelines. Valuation Industry Reporting
    Standards. American Society of Appraisers. The Canadian Institute of
    Chartered Business Valuators. National Association of Certified Valuation
    Analysts. Institute of Business Appraisers. American Institute of Certified
    Public Accountants. Guidelines for Effective Report Writing. What Causes
    Ineffective Report Writing? Make the Report "Incisive." Summary.
21. Sample Report                                                           501
    Introduction. Description of the Assignment. Summary Description of the
    Company. Capitalization and Ownership. Sources of Information. Analysis
    of the U.S. Economy. Overview. Outlook. Analysis of the Poultry Processing

    Industry. Overview. The Current Market. Exports. Identification of Guideline
    Companies. Overview. Descriptions of Selected Guideline Companies.
    Financial Statement Analysis. Overview. Balance Sheets. Income Statements.
    Cash Flow Statements. Adjustments. Financial and Operating Ratios.
    Valuation of Common Stock. Overview. The Guideline Publicly Traded
    Company Method. The Discounted Cash Flow Method. Overall Valuation
    Conclusion. Discount for Lack of Marketability. Summary and Conclusion
    of Empirical Research. Selection of the Applicable Lack of Marketability
    Discount for a Warm Chicken Noncontrolling Ownership Interest.
22. Reviewing a Business Valuation Report                                     535
    Identification of the Subject Property. Relevant Dates. Definition of Value.
    Standard of Value. Reason for the Selected Standard of Value. Purpose of
    the Valuation. Actual or Assumed Ownership Characteristics. Degree of
    Marketability. Degree of Ownership Control. Basic Company Information.
    Economic and Industry Outlook. Sources of Information. Site Visits.
    Management Interviews. Economic and Industry Data. Company Financial
    Statements. Income Approach Data. Market Approach Data. Asset-Based
    Approach Data. Financial Statement Analysis. Financial Statement
    Adjustments. Comparative Financial Statement Analysis. Valuation
    Methodology. Income Approach. Market Approach. Asset-Based Approach—
    Asset Accumulation Method. Asset-Based Approach—Capitalized Excess
    Earnings Method. Are the Data Used Appropriate for the Valuation Date?
    Cost of Capital Data. Market Approach Data. Asset-Based Approach Data.
    Valuation Synthesis and Conclusion. Analyst's Qualifications. Professional
    Accreditations. Education. Professional Association Memberships.
    Experience and Professional Involvement. Appraisal Certification.
    Statement of Contingent and Limiting Conditions. Overall Evaluation.

PART VI       Valuing Specific Securities and Interests                      545
23. Valuing Debt Securities                                                   547
    Common Situations Requiring Valuation of Debt Securities. Purchase or
    Sale for Cash. Exchange of Equity for Debt. Gift and Estate Taxes. Allocation
    of Total Enterprise Value among Classes of Securities. Adjusting a Balance
    Sheet for Debt Securities Owned or Owed. Lease Financing. Method of
    Valuation. Amount and Timing of Future Payments. Estimation of Yield to
    Maturity. Marketability Aspects of Closely Held Debt Securities. Special
    Characteristics of Various Debt Securities. Call Provisions. Sinking Fund
    Provisions. Collateral Provisions. Income Tax Status. Zero Coupon Debt.
    Convertible Debt. Summary. Bibliography.
24. Valuing Preferred Stock                                                 563
    Common Situations Requiring Valuation of Preferred Stock. Purchase or
    Sale for Cash. Exchange of Common Equity or Debt for Preferred Stock.
    Gift and Estate Taxes. Allocating Total Enterprise Value among Classes of
    Securities. Adjusting a Balance Sheet for Preferred Stock Owned or
    Outstanding. Income Taxes—Code Section 409A. Special Characteristics
    of Closely Held Preferred Stocks. Dividend Rate. Liquidation Preference.
    Cumulative versus Noncumulative Dividends. Redeemable versus
  r Nonredeemable. Put Option. Voting versus Nonvoting. Participating versus

    Nonparticipating. Convertible versus Nonconvertible. Method of Valuation.
    Assessing Dividend and Liquidation Payment Risk. Comparison with
    Publicly Traded Preferred Stocks. Capitalizing the Income Stream.
    Marketability Aspects of Closely Held Preferred Stock. Revenue Ruling
    83-120. Summary. Bibliography.
25. Introduction to Valuing Stock Options                                  585
    Common Situations Requiring Valuation of Options. Terminology.
    The Basic Call Option Equation. The Black-Scholes Option Model.
    European Options on Non-dividend-Paying Stocks. European Options on
    Dividend-Paying Stocks—The Merton Model. American Call Options—The
    Pseudo-American Call Option Model. Empirical Tests of Black-Scholes
    Options Models. Valuing Options on the Stock of Closely Held Companies.
    The Binomial Model for American Call Options. Introduction. Methodology.
    Employee Incentive Stock Options. Using Option Pricing to Value the
    Built-in Gains (BiG) Tax Liability. Real Options. Summary. Bibliography.
26. Valuing S Corporation Stock and Interests in Other
       Pass-Through Entities                                                613
    Case Law History. Gross v. Commissioner. Wall v. Commissioner.
    Estate of Heck v. Commissioner. Estate of Adams v. Commissioner.
    Empirical Research on Sales of Controlling Interests. Erickson-Wang
    Study. Mattson, Shannon, and Upton Study. Summary of Empirical
    Research. Models for Valuation of S Corporation Minority Interests.
    Summary. Bibliography.

PART VII       Valuations for Specific Purposes                             625
27. Valuations for Gift and Estate Tax Purposes                              627
    Introduction. Current Tax Rates and Penalties. Appraiser Penalty and
    Potential for Blacklisting. Guidelines for Federal Gift and Estate Tax
    Valuations. Weight to Be Accorded Various Factors. Capitalization Rates.
    Average of Factors. Restrictive Agreements. Summary of Guidelines.
    Chapter 14 Special Valuation Guidelines. Valuing Recapitalizations and
    Senior Equity Interests under Section 2701. Valuation Issues under Section
    2702. Buy-Sell Agreements and Leases (Including Operating Agreements of
    LLCs) or Sale of Options under Section 2703. Valuation Rules for Lapsing
    Rights and Other Restrictions under Section 2704. Locking in the
    Three-Year Gift Tax Statute of Limitations. Shifting the Burden of Proof
    from the Taxpayer to the IRS. Valuation Issues in Estate and Gift Tax
    Planning. Placing Family Assets in Corporate, Limited Liability Company,
    or Partnership Form. Minimizing Taxes through a Series of Timely Minority
    Ownership Interest Transfers. Loss of Key Person. Trapped-In Capital Gains
    Discounts. Other Estate Planning Situations Requiring Valuations.
    Other Gift and Estate Valuation Issues. Summary. Bibliography.
28. Estate and Gift Tax Court Cases                                         661
    Standard of Value. Approaches to Value. Burden of Proof. Selection of
    Guideline Companies. Buy-Sell Agreements. Covenants Not to Compete.
    Reliance on Subsequent Sales. Subsequent Events and Data. Discount for Lack
    of Marketability (DLOM). Discounts for Lack of Marketability—Controlling
    Ownership Interests. Discount for Lack of Control (DLOC). Blockage

    Discounts. Key Person Discount. Contingent Liability Discounts.
    Combined Discounts. Premiums. Trapped-In Capital Gains Taxes.
    S Corporations. Family Limited Partnerships. FLP Valuation Issues.
    Validity Issues. Focus on Willing Seller as Well as on Willing Buyer.
    Inadequacy of the Valuation. Must Use Empirical Data to Quantify
    Variables. Sufficiency of Data. Summary. References.
29. Buy-Sell Agreements                                                  707
    Types of Buy-Sell Agreements. Valuation Provisions of the Buy-Sell
    Agreement. Need for Clear Direction. Formula Approaches. Negotiation
    Among the Parties. Independent Outside Appraisal. Understanding an
    Agreement's Pricing Philosophy. Terms and Funding. Term Payment
    Provisions. Funding the Buy-Sell Agreement with Life Insurance.
    Restrictions on Transfer. Buy-Sell Agreement Values for Estate and
    Gift Tax Valuation under Chapter 14. Valuation Requirements under
    Section 2703. Bibliography.
30. Valuation for Income Tax Purposes                                         723
    Introduction. Federal Income Tax Reasons to Conduct an Appraisal.
    Valuation of Property Received in a Transaction. Determining Basis in a
    Property. Joint Ownership of Property. Property Acquired from a Decedent.
 - Valuation Requirements for Charitable Contribution Deductions.
    Documentation Requirements—Contributions of Property. Noncash Property
    Contributions. Appraisals for Noncash Contributions. Year^End Charitable
    Gifting Considerations. Limitations on Charitable Contribution Deductions.
    Valuation of Compensation. Multifactor Tests. Independent Investor Test.
    Valuation of Worthless and Abandoned Property. Worthless Securities.
    Valuation Aspects of Section 165. Abandonment Loss for Nondepreciable
    Business Assets. Worthless Stock Deduction. Summary of Worthless and
    Abandoned Property Valuation. Valuation Aspects of Cancellation of
    Indebtedness Income. Unfavorable Tax Consequences of Debt Restructuring.
    Insolvency Provisions of Code Section 108. Insolvency Test Illustrative
    Example. The "Costs" of Code Section 108. Valuation-Related Income
    Tax Penalties. The Section 6695A Appraiser Penalties. The Section 6662
    Accuracy-Related Penalties. Negligence Penalty. Substantial Valuation
    Overstatement Penalty. Substantial Overstatement of Pension Liabilities
    Penalty. Definitions and Special Rules under Section 6664. Tax Return
    Preparer Penalties. Summary of Valuation-Related Income Tax Penalties.
    Valuation Aspects of Intercompany Transfer Pricing. Key Features of the
    Final Section 482 Regulations. Special Circumstances. Multiple Year Data.
    Purposes and Roles of Valuation and Economic Analysis Experts. Types of
    Experts. Summary of Transfer Pricing Valuation Issues. Valuation of
    Intellectual Properties for State Income Taxation Purposes. Trademarks and
    Trade Names. Transfer of Intellectual Properties. Creation of the Intellectual
    Property Holding Company. Valuation of the Transferred Intellectual
    Properties. Summary. Bibliography.
31. Income Tax Court Cases                                                753
    Introduction. General Valuation Methodology Issues. Pabst Brewing
    Company v. Commissioner. Nathan and Geraldine Morton v. Commissioner.
    Caracci v. Commissioner. Gow v. Commissioner. BTR Dunlop Holdings, Inc.
    v. Commissioner. Charitable Contribution Issues. John T. and Linda L.

    Hewitt v. Commissioner. John C. Todd v. Commissioner. Gerald D. and
    Catherine Leibowitz v. Commissioner. Koblick v. Commissioner. Reasonable
    Compensation Issues. Multifactor Tests. LabelGraphics, Inc. v.
    Commissioner—9th Circuit. B&D Foundations, Inc. v. Commissioner—10th
    Circuit. Brewer Quality Homes, Inc. v. Commissioner. O.S.C. & Associates,
    Inc. v. Commissioner. Law Offices—Richard Ashare, PC. v. Commissioner.
    Alpha Medical, Inc. v. Commissioner. Beiner, Inc. v. Commissioner.
    E.J. Harrison and Sons, Inc. v. Commissioner. Independent Investor Test.
    Exacto Spring Corporation v. Commissioner—7th Circuit. Menard, Inc. v.
    Commissioner. Intangible Asset Valuation Issues. Nestle Holdings, Inc. v.
    Commissioner. Bemidji Distribution Company v. Commissioner. Frontier
    Chevrolet Co. v. Commissioner. DHL Corporation and Subsidiaries v.
    Commissioner. Other Income Tax Issues. Purchase Price Allocation. Indeck
    Energy Services, Inc. v. Commissioner. Present Value as Indicator of
     "For Profit" Status. Walford v. Commissioner. Stock Warrant Valuation.
    Kimberlin v. Commissioner. Valuation as Accounting Method. In re Heilig
    Meyers Company. Summary.
32. Valuations for Employee Stock Ownership Plans                              809
    General ESOP Framework. Types of ESOPs. Nonleveraged ESOPs.
    Leveraged ESOPs. All Parties to a Leveraged ESOP Transaction Benefit.
    Valuation of a Company for ESOP Purposes. Adequate Consideration.
    Independence of the Appraiser and the Appraiser's Role. Reporting
    Requirements. Valuation Approaches and Methods. ESOP-Specific
    Adjustments. ESOP Contributions. Normalized Employee Benefit Costs.
    Compensation Adjustments. ESOP Compensation Adjustment. Control
    Premiums. Discount for Lack of Marketability. Put Option and Repurchase
    Liability. Current Controversies. Posttransaction Value in Leveraged ESOPs.
    Legislative and Regulatory Issues in ESOPs. Section 1042 Rollover. 409(1)
    Employer Securities. Principal Deductibility and Code Section 415. Code
    Section 133 Interest Exclusion. The IRS Audit Guidelines. ESOP Specific
    Plan Administration Issues. Allocations to Participant Accounts. Distribution
    Policy. Diversification. Finance Issues in Leveraged ESOPs. Repurchase
    Liability. Repurchase or Recycling. Redemption. Managing the Repurchase
    Liability. Methods of Funding. Fiduciary Issues in ESOPs. Voting Issues.
    Trustee's Voting Rights. Circularity of Control. Independent, Directed, or
    Internal Trustee. Accounting for ESOPs. Nuances of S Corporation ESOPs.
    Limitations on S Corporation Tax Benefits. Voting Issues. Form of
    Distribution. S Corporation Distributions. Steps to Implementing an ESOP.
    Summary. Bibliography.
33. ESOP Court Cases                                                         837
    Introduction. Sommers Drug Stores. Introduction. The Facts of the District
    Court Case. The Facts of the Appeal. The Plaintiff's Position. The
    Defendants' Position. Commentary and Conclusion. U.S. News & World
    Report. Introduction. The Facts of the Case. The Valuation Issues. The
    District Court's Decision. The Appeals Court's Decision. Commentary and
    Conclusion. Andrade v. Parsons. Introduction. The Facts of the Case. The
    District Court's Decision. The Appeals Court's Decision. Commentary
    and Conclusion. Reich v. Valley National Bank of Arizona. Introduction.
    The District Court's Findings. Commentary and Conclusion. Howard v.

    Shay. Introduction. The Facts of the Case. The District Court's Decision.
    The District Court's Decision—Commentary and Conclusion. The Appeals
    Court's Decision. The District Court Retrial. The District Court Retrial—
    Commentary and Conclusion. Eyler v. Commissioner. Introduction.
    The Issues of the Case. The Facts of the Case. The Issues before the Court.
    The Petitioner's Position. The Appeals Court Decision—The Valuation
    Issues. The Appeals Court Decision—The Fiduciary Issues. Commentary
    and Conclusion. Davis v. Torvick. Introduction. The Facts of the Case.
    The Issues of the Case. The Plaintiffs' Position. The Defendants' Position.
    The District Court's Decision. Commentary and Conclusion. Henry v.
    Champlain Enterprises. Introduction. The Facts of the Case. The Issues of
    the Case. The District Court's Decision. Commentary and Conclusion.
    Eckelkamp v. Beste. Introduction. The Facts of the Case. The District Court's
    Decision. The Appeals Court's Decision. Commentary and Conclusion.
    Horn v. McQueen. Introduction. The Facts of the Case. The District Court's
    Decision. Commentary and Conclusion. Chao v. Hall Holding Co., Inc.
    Introduction. The Facts of the Case. The District Court's Decision. The
    Appeals Court's Decision. Commentary and Conclusion. Keach v. U.S.
    Trust Co. Introduction. The Facts of the Case. The Issues before the District
    Court. The District Court's Decision. The Issues before the Appeals Court.
    The Appeals Court's Decision. Commentary and Conclusion. Armstrong v.
    LaSalle Bank National Ass 'n. Introduction. The Facts of the Case. The
    District Court's Decision. The Appeals Court's Decision. Commentary
    and Conclusion. Kennedy v. Trustmark National Bank. Introduction.
    The Facts of the Case. The District Court's Decision. Commentary and
    Conclusion. Summary.
34. Valuations for Ad Valorem Taxation                                        873
    Introduction. Definitions of Ad Valorem Taxation Terminology. Market
    Value as the General Basis of Property Assessment. The Property Tax
    Valuation Process. The Property Tax Equalization Process. Assessment Ratio
    Studies. Use of Assessment Ratio Studies in Administrative Appeals and
    Litigation. The Property Tax Unitary Valuation Process. The Property Tax
    Appeal Process. Steps in the Ad Valorem Taxation Valuation Process: The
    Assessing Authoritys Objective. The Property Owner's Objective. The
    Independent Valuation Analyst s Objective. Special Topics. Identification and
    Quantification of Functional Obsolescence. Identification and Quantification
    of the Economic Component of External Obsolescence. Issues in Unit
    Valuation for Ad Valorem Purposes. Jurisdictional Differences. Value
    Excluded from the Taxable Unit. Identification and Valuation of Intangible
    Assets in the Unit Method of Assessment. Alternatives to Use of Stock Market
"' Data. Problems with the Use of Stock Market Data in Property Tax
    Valuations. Introduction. Income Approach Valuation Issues. Resolving
    Circularity Due to Property Tax Expenses. Differences in the Risk and
    Expected Return Investment Characteristics between Operating Property and
    Negotiable Securities. Capitalization of Leased Equipment Rental Expense.
    Introduction. Operating Lease Rental Expense. Summary. Bibliography.
35. Dissenting Stockholder and Minority Oppression Actions                   905
    Dissenting Stockholder Actions. Interpretation of the Fair Value Standard in
    Dissent Cases. "That Which Has Been Taken." The Delaware Block Method.
Contents                                                                          xix

    Should Consider All Relevant Factors. Requirement for Entire Fairness.
    Fair Consideration. Procedural Fairness. Consequences of Lack of Entire
    Fairness. Minority Interest Dissolution Actions. Interpretation of the Fair
    Value Standard in Dissolution Cases. Summary. Bibliography.
36. Dissenting Stockholder and Minority Oppression Court Cases               915
    Readers Must Interpret Cases Carefully. Fair Value Is Not Fair Market Value.
    Premise of Value. Breach of Fiduciary Duty Expands Plaintiffs' Potential
    Damages. Approaches to Value. Should Consider Market Value, Asset Value,
    and Investment Value. Market Approach. Guideline Merged and Acquired
    Company (Transaction) Method. Discounted Cash Flow Method. Net Asset
    Value. Excess Earnings Method. Weighting of Methods. Discounts and
    Premiums. Lack of Control Discounts Rejected. Lack of Control Discounts
    Accepted. Ownership Control Premium Accepted. Lack of Marketability
    Discounts Rejected. Lack of Marketability Discounts Accepted. Lack of
    Combinatorial Value Discount Rejected. Discounts for Trapped-In Capital
    Gains. Discounts Left to Court's Discretion. Sufficiency of Valuation
    Evidence. "Dr. Pangloss and Mr. Scrooge." Summary.
37. Valuations for Marital Dissolution Purposes                             943
    The Marital Estate. Community Property. Equitable Distribution. Active or
    Passive Appreciation During Marriage. Active or Passive Post-Valuation
    Date Appreciation. Standard of Value. Investment Value. Fair Market Value.
    Intrinsic Value. Fair Value. Internal Contradictions in the Case Law.
    Valuation Date. Discovery. Goodwill. Valuation Methods. Income Approach.
    Market Approach. Asset-Based Approach. The Capitalized Excess Earnings
    Method. Usually Employ More Than One Method. Compensation.
    Noncompete Covenants. Buy-Sell Agreements. Treatment of Trapped-In
    Capital Gains Taxes. Valuation Discounts and Premiums. The Role of the
    Analyst. "Jointly Retained" Assignments. Adequacy of Evidence. Summary.
38. Marital Dissolution Court Cases                                         963
    Standards of Value. Fair Market Value. Fair Value. Investment Value.
    Premise of Value. Active versus Passive Appreciation. "Active" Appreciation
    as a Marital Asset. "Active" Appreciation Must Be Proven. Valuation Date.
    Goodwill. The "Market Value of Goodwill" Paradox. Personal Goodwill Not
    a Marital Asset in Many States. Personal Goodwill Is a Marital Asset in
    Many States. Other Goodwill Issues. The "Double Dipping" Issue. Valuation
    Methods in the Family Law Courts. The Size Argument. The Liquidity
    Argument. The Risk Argument. The Cost of Flotation Argument. Noncompete
    Covenants. Buy-Sell Agreements. Cases Rejecting Buy-Sell Agreements.
    Cases Finding Buy-Sell Price Controlling. Buy-Sell Agreement May Be
    Considered. Discounts for Lack of Control and Lack of Marketability.
    Discount for Lack of Control. Discount for Lack of Marketability. Adequacy
    of Evidence. The Need for a Solid Record. Preserving the Record.
    Inadequate Evidence. Greater Weight Given to Valuation Professionals.
    Rejection of Unqualified Experts and Unaccepted Methodolgies. Appraiser s
    Due Diligence Duties. Treatment of Tax Liabilities. Summary.
39. Fair Value for Financial Reporting                                       1005
    Definition of Fair Value. Differences from Fair Market Value.

PART VIII       Litigation and Dispute Resolution                           1009
40. Litigation Support Services                                               1011
    Valuation-Related Controversy Matters. Types of Litigation. Contract
    Disputes. Commercial Torts. Business Interruption Claims. Antitrust Claims.
    Shareholder Disputes and Securities Litigation. Marital Dissolution.
    Personal Injury or Wrongful Termination Cases. Estate, Gift, and Income
    Taxes. State and Local Property Taxes. Bankruptcy/Insolvency/
    Reorganization. Intellectual Property Rights Infringement. Engaging the
    Appraiser. Qualifications. Conflicts of Interest. Engagement Agreement.
    Discovery. Assessing the Case. Business Appraisal Discovery. Permanent
    Files. Accountant's Files. Bank Files. Invoices. Interrogatories. Depositions.
    Research. Calculating the Amount of Damages. The Before-and-After
    Method. The Yardstick (Comparable) Method. Sales Projections ("But For ")
    Method. Mitigation. Summary of Damages. Work Product. Affidavits.
    Written Reports. Critique of the Opposition. Expert Testimony. Rebuttal.
    Assistance in Preparing Briefs. Summary.
41. Expert Testimony                                                        1031
    Background Preparation. Basic Preparation and Documentation. Federal
    Rules of Civil Procedure. State Rules Are Often Less Stringent. Discovery.
    Reading Prior Cases and Articles. Federal Rules of Evidence Regarding
    Expert Testimony. Use of Hearsay Evidence. Challenges to Testimony per
    Daubert/Kumho. Daubert. General Electric v. Joiner. Kumho Tire Company.
    Other Cases Rely on Daubert Factors. Depositions. What to Bring to the
    Deposition. Deposition Testimony. After the Deposition. Outlining
    Courtroom Testimony. Qualifying the Witness. Description of the
    Assignment. Summary of Conclusion. Description of Steps Taken. Findings.
    Final Conclusion. Exhibits. Preparation with the Attorney. In the Courtroom.
    General Guidelines for Testimony. Direct Examination. Cross-Examination.
    Redirect Examination. Rebuttal Testimony. Exclusion of Witnesses. Courts'
    Expectations Regarding Expert Testimony. Summary. Bibliography.
42. Arbitration and Mediation                                               1053
    Advantages of ADR over Court Trial. Situations Suitable for Arbitration.
    Corporate and Partnership Dissolutions and Buyouts of Minority Interests.
    Dissenting Stockholder Actions. Damage Cases. Divorces. The Arbitration
    Agreement. Factors Specified in the Arbitration Agreement. Factors Left to
    the Arbitrators' Discretion. Other Factors to Address. Selection of
    Arbitrators. Criteria for Selection. Procedure for Selection. American
    Arbitration Association Procedure. Engagement and Compensation of
    Arbitrators. The Arbitration Process. Review of Arbitration Document. Initial
    Communication among Arbitrators. Field Visit. Hearings. The Valuation
    Meeting. Reporting the Results of the Arbitration. Mediation. How
    Mediation Differs from Arbitration and Litigation. Self-Determination Is the
    Fundamental Principle. Role of the Business Valuation Expert in Mediation.
    Mediation in Family Law. Mediation in Federal Tax Disputes. Summary.
    Bibliography. Professional Arbitration and Mediation Organizations.
Appendix A     International Glossary of Business Valuation Terms           1069
Index                                                                       1077

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