16 Mistakes to Avoid in Valuations, Part 1

According to Tax Court decisions

Part 1 of this article examines eight of the 16 most common mistakes made in business valuation reports according to U.S. Tax Court decisions. Business valuation textbooks, training manuals, and conference presentations may do a good job of teaching the right ways to conduct valuations. But in some respects, the most authoritative teacher of what is right and, just as importantly, what is wrong is the decision of the court in a dispute over the value of a privately held business or shares thereof.

U.S. Tax Court

Business valuation textbooks, training manuals, and conference presentations may do a good job of teaching the right ways to conduct valuations.  But in some respects the most authoritative teacher of what is right and, just as importantly, what is wrong is the decision of the court in a dispute over the value of a privately held business or shares thereof.

In this article, we have collected 16 examples of mistakes made by valuation experts, as reported in federal courts in tax decisions.  In this first installment, we’ll be covering the first eight.  It is important to note that there are two sides to every story, and courts do not always get it right.  For this reason, we do not name any valuators in this collection of mistakes to avoid.

1. Lacking Explanation Needed to Replicate.  No matter how “correct” your conclusion of value is, the court may not accept it if you do not provide sufficient details and explanations about how you arrived at that conclusion.  Another valuator should be able to replicate your work after reviewing your report or work-papers. In Winkler Estate v. Commissioner (T.C. Memo 1989-231.  See also Former IBA Business Appraisal Standards Sec. 1.8. See also True Est. v. Comr., T.C. Memo 2001-167, aff’d., 390 F. 3d 1210 [10th Cir. 2004], the Tax Court provided perhaps one of the best arguments for a free-standing, comprehensive appraisal report:

Respondent’s expert appears to be extremely well qualified but he favored us with too little of his thought processes in his report.  In another area, for example, his report briefly referred to the projected earnings approach, but the discussion was too abbreviated to be helpful.  His testimony on the computer models he used, while unfortunately never developed by counsel, suggested that a lot of work had been done but simply not spelled out in his report.  That may also be the case in his price-to-earnings computations, but the Court cannot simply accept his conclusions without some guide as to how he reached [them].

2. Pure Reliance on Case Law for Discount.  What constitutes the proper valuation discount is essentially case-by-case factual issue. Valuation discounts can be factored in as an element of the discount rate (sometimes characterized as implicit treatment) or applied as direct adjustment(s) to value after the enterprise level value has been determined. As such, pure reliance on case law for determination of valuation discounts is inadvisable, particularly when the economics, facts, and circumstances of the precedent cases do not reasonably parallel those of the subject interest.  Nevertheless, some valuators have resorted to reliance on case law for determination of valuation discounts. In Berg Estate v. Commissioner (T.C. Memo 1991-279), the Tax Court was unimpressed with this practice: 

The fact that petitioner found several cases which approve discounts approximately equal to those claimed in the instant case is irrelevant.

3. Failure to Find Available Information. Very few things look worse for a valuator than when he or she cannot find information that the opposing valuator finds.  This happened in Barnes v. Commissioner (T.C. Memo 1998-413):

[Valuator A] used the market or guideline company approach to estimate the value of Home and Rock Hill stock, but he excluded three companies that [Valuator B] used as comparables because he did not have their market trading prices as of the valuation date.  In contrast, [Valuator B] apparently easily obtained the stock prices by contacting the companies.

4. Insufficient Explanation of Assumptions.  It is important to explain any assumptions that you make in a valuation report.  In Bailey Estate v. Commissioner (T.C. Memo 2002-152.  See also, for example, NACVA/IBA Professional Standards Secs. IV[G][9] and V[C][11]), the Tax Court criticized the appraiser for failing to do so: 

[He] offered no explanation or support for any of the many assumptions that he utilized in the just-described analysis.  Nor did he offer any explanation or support for his conclusion that the discount related to stock sale costs should be 6 percent.  An expert report that is based on estimates and assumptions not supported by independent evidence or verification is of little probative value or assistance to the Court. 

5. Failure to Explain Weightings.  It is essential that you include a significant discussion in the valuation report of how you weighted products of various multiples in your conclusion of value. This did not happen in True Estate v. Commissioner (T.C. Memo 2001-167, aff’d., 390 F. 3d 1210 [10th Cir. 2004]), as the Tax Court pointed out:

[The valuator’s] report’s guideline company analysis was even more questionable. It provided no data to support the calculations of … pretax earnings and book value for either the comparable companies or True Oil. Further, [he] did not explain the relative weight placed on each factor….Without more data and explanations, we cannot rely on [his] report’s valuation conclusions using the guideline company method. 

Where different valuation methods yield differing indications of value, you must be very clear about how you use them to arrive at a conclusion of value.

It sometimes is tempting to simply weight the indications equally.  What is more important, however, is to have an explanation for the weighting of the indications of value, whatever they might be. In Hendrickson Estate v. Commissioner (T.C. Memo 1999-278.  See also Pratt with Niculita, Valuing a Business, 5th ed. [New York: McGraw-Hill, 2008], 477-482.), the Tax Court criticized the work of a valuator who simply gave the indications of value equal weight without bothering to explain why. (Editor’s note: Some valuation books include complete chapters on reconciling the three approaches (Market, Asset, and Income). An example is Chapter 15 of The Market Approach to Valuing Businesses, 2nd ed., by Shannon P. Pratt and Alina V. Niculita, [New Jersey: Wiley,  2006].)

6. Failing to Justify Capitalization or Discount Rates.  You cannot simply pull a capitalization or discount rate out of thin air; you must justify it. This seems to have been an issue in Morton v. Commissioner (T.C. Memo 1997-166):

[The valuator] testified that venture capitalists generally require between 30- and 60 percent return, and that his 35 percent discount rate was “conservative.” However, [he] did not provide any objective support, either at trial or in his expert report, for selecting a discount rate in this range.

7. Inadequate Guideline Company Data.  You are usually required to include the names of guideline companies in the valuation report.  This was not done in Jann Estate v. Commissioner (T.C. Memo 1990-333.  See also AICPA Statement on Standards for Business Valuation, Paragraph 61), where the Tax Court pointed out:

[The valuator’s] report referred to comparable companies but did not identify them; did not state whether [he] used average earnings or a weighted average earnings in his analysis; referred to a standard industrial classification number but did not identify it; and did not explain how he arrived the price-earnings ratio of 9.8.

In True Estate v. Commissioner (T.C. Memo 2001-167, aff’d., 390 F. 3d 1210 [10th Cir. 2004]), the Tax Court criticized one of the taxpayer’s valuators, stating:

[He] provided no data showing: (1) How he computed the guideline company multiples or the Belle Fourche financial fundamentals, (2) which of three multiples he applied to Belle Fourche’s fundamentals, or (3) how he weighed each resulting product.  Without more information we cannot evaluate the reliability of [his] results.

8. Failure to Think Like an Investor.  In Newhouse Estate v. Commissioner (94 T.C. 193 (1990)), the Tax Court concluded:

None of respondent’s expert witnesses testified that they would have advised a willing buyer to use the subtraction method in deciding the value of the stock.  None could testify that they had ever advised the use of the subtraction method in advising buyers or sellers of closely held stock in any comparable situation.

Conclusion

In this article, we presented the first eight of 16 kinds of mistakes made by valuation experts, as reported in federal courts in tax decisions. Just because one judge in one case calls something a mistake doesn’t make it a mistake in all cases.  But we think the above examples are indeed instructive in most valuation situations.

This article originally appeared in the July/August 2013 issue of The Value Examiner.  It was adapted from Chapters 17-18 of A Reviewer’s Handbook to Business Valuation by L. Paul Hood, Jr., and Timothy R. Lee, (New Jersey: John Wiley & Sons,  2011).

L. Paul Hood, Jr., Esq. is currently on staff with The University of Toledo Foundation.  He can be reached at  paul@acadiacom.net. 

Timothy R. Lee, ASA, is managing director of corporate valuation with Mercer Capital.  He can be reached at  leet@mercercapital.com.