Complex Valuation Engagements

How to Account for Current or Proposed Legislation in the Business Valuation Engagement

Oftentimes a valuation engagement presents a unique set of challenges for the appraiser. For instance, a particular engagement may be the first look at how companies in a particular industry operate. Other times, it may be a look at a company experiencing a downturn, and the appraiser must determine how to properly determine its value, so as not to overemphasize the downturn, while not overvaluing the company at the particular date of valuation. Other times, particular engagements present the issue of how to adequately account for current or proposed legislation. The focus of this article is how to account for current or proposed legislation in an appraisal.

Oftentimes a valuation engagement presents a unique set of challenges for the appraiser.  For instance, a particular engagement may be the first look at how companies in a particular industry operate.  Other times, it may be a look at a company experiencing a downturn, and the appraiser must determine how to properly determine its value, so as not to overemphasize the downturn, while not overvaluing the company at the particular date of valuation.  Other times, particular engagements present the issue of how to adequately account for current or proposed legislation.  The focus of this article is how to account for current or proposed legislation in an appraisal.

My point in exemplifying unique challenges presented in various valuation scenarios is to illustrate that the answer oftentimes lies in going back to the basics—reviewing our fundamental theories and considering all approaches and methods in each valuation we prepare, no matter the perceived simplicity of the engagement.

Oftentimes we perceive an engagement as simple or complex, without laying eyes on the information required to complete a valuation.  By way of example, consider the following:  The engagement requires the valuation of a holding company, a family limited partnership (FLP) that holds several parcels of commercial property.  When pricing such an engagement, most appraisers view this as a “simple” valuation, a “discount study” that is an aberration from a typical full conclusion of valuation report.  Many times, the only approach given any consideration is the asset approach—adjusted net asset value method.  This is not to say that this is not the approach/method combination that will be chosen as the final indicator of value in the overwhelming majority of cases; the point is, it should not be the only method considered.

When speaking on valuation issues to valuation practitioners and advisors alike, I tend to relate the simplicity of the valuation process to the participants.  While each valuation presents unique technical challenges, and valuation professionals must be credentialed and highly-skilled in their particular practice, the valuation report is relatively simple.  Simple in the fact that it serves a singular purpose—to walk the reader through the thought processes and assumptions on which the analyst utilized to develop their ultimate conclusion of value.  In short, it is the road map that guides the reader through the valuation report.

As such, the report should detail each and every approach considered in developing a representative value estimate.  Oftentimes, newly credentialed analysts look at a potential valuation engagement with confusion in terms of how to adequately consider each valuation method in their report.  It is much simpler to take a step back to the valuation approach level, consider the relevant approaches, then a relevant method or two under each of the approaches.

Another word of caution lies with what to do with valuation approaches that are rejected.  The key is detail.  The analyst must provide a detailed account of why the particular approach was rejected.  A particular pet peeve, is when I review a report and the author states an approach or method was considered but rejected and provides language similar to the following as their reasoning: “This (approach/method) was considered but rejected based on the analyst’s opinion in light of the unique nature of the subject company.”  That provides the reader with no insight as to why the analyst rejected the approach or method.  The analyst should spend adequate time in their report detailing why a particular method or approach was not utilized.  Maybe the engagement required the analyst to estimate the fair market value of a holding company that held only vacant land which did not generate any distributable income.  In the aforementioned instance, it is completely justifiable that the analyst would not utilize the income approach.  But if the report doesn’t walk the reader through the analyst’s thought process, the reader is left to guess as to why the analyst simply “considered but rejected” the approach/method combination.

Justification of assumptions is also critical when walking the reader through normalization adjustments, and the magnitude of such adjustments.  While each normalization adjustment, and the magnitude and direction of each adjustment, may be completely justified, if it is not detailed in the report, the reader may surmise that the analyst is making each normalization adjustment to advocate for their client.  This example is common when valuations are prepared for litigation.  A recent case that went before the United States Tax Court, Gallagher v. Commissioner (T.C. Memo 2011-148) highlighted the importance of this issue.  The Gallagher court did not allow several normalization adjustments made by the petitioner’s expert because the expert did not justify their assumptions.  It should be noted that the Gallagher Court did not state that the petitioner’s expert’s normalization adjustments were incorrect in any way shape or form.  What they said is that the expert did not provide enough explanation into why each adjustment was made and, as such, the court was unable to determine if each adjustment was justified.

We now consider our original example of an engagement that requires a conclusion of value as to the fair market value of a limited partnership interest in an FLP that holds several commercial properties.  Also, consider the IRS has proposed legislation that would do away with all discounts for intra-family transfers of such interests.  Bear in mind that this is proposed legislation.  This has been the topic of more than one discussions with practitioners caught in the crosshairs of this real world issue.

At this point, the answer to such a question should be relatively clear.  The answer lies in careful consideration of the various methods and approaches available to the practitioner, as well as a well thought out and detailed account of the practitioner’s thought process as they developed their ultimate conclusion of value.  Let’s look at the issue on a step-by-step basis.

The first thing to be considered is the fact that this legislation is merely proposed.  In early fall of 2015, many felt the issue would be formally passed by Congress in September of 2015.  Then September came and went and Congressional interest in the issue waned.  At the time of this article’s writing the issue is still in the proposed or planning stage.  There has been nothing passed by Congress at this point.  As such, valuations will not be affected—yet.

Remember my earlier statement, that when most analysts look at an FLP valuation, they instantly assume it is a simple report, a “discount study,” or some sort of hybrid valuation.  Not the case; each valuation method should be considered in each FLP report, just as they are in any other valuation analysis.  Further, the report should be detailed enough to walk the reader through the appraiser’s thought process as they developed their ultimate conclusion of value.  The analysis contained in the report should also be rigorous enough to convince the reader of the analyst’s positions.

A recent U.S. Tax Court decision in Richmond v. Commissioner (T.C. Memo 2014-26) is an illustration of the importance of justifying your assumptions in your valuation report.  The petitioner’s analyst that prepared the valuation for the decedent’s Form 706 estate tax return solely used the income approach when developing his conclusion of value of the decedent’s interest.  The subject company in Richmond was a holding company that held a portfolio of marketable securities.  At first blush it seems rather odd that the analyst would have used the income approach at all, and to use it as his only approach seems even odder.  However, after we familiarize ourselves more fully with the subject company, it doesn’t seem odd at all.  The subject company had a long history of making significant and consistent dividends.  As such, it seems completely justifiable and within reason to use the income approach to produce a value estimate.  The Tax Court did not agree.

The Tax Court noted the most direct method to produce a value estimate of a company, such as the subject company in Richmond was to simply look up the market quotations of the assets held by the subject company at the date of valuation.  In essence, to mark the cost basis balance sheet up to market value.  True, very true, in fact.  This would be the go-to method to produce a value estimate.  However, given the fact that the subject pays out very consistent dividends would also point to utilizing the income approach.  Care must be taken in the valuation report to provide the analyst’s reasoning as to why the subject company is a viable candidate on which to provide a value estimate under the income approach.  The Tax Court opinion is silent on this issue.  It does not state whether or not the analyst provided detail as to why this valuation approach should have been used.

It is the author’s opinion that the analyst should have produced a value estimate under the asset approach as a matter of default, then also produced a value estimate under the income approach, either as a stand-alone valuation estimate, or as a justification to the value produced under the income approach.  The report should then contain the necessary detail so as to convince the reader why the case at hand justified the use of the income approach.  It is always better to produce as many relevant value estimates as possible.  This will assist the analyst in identifying any flaws in any of the other value estimates or, more importantly, identifying any of the other value estimates as outliers.  This is impossible if the analyst produces only one value estimate.  It can also serve as a crippling blow to the valuation analyst if new legislation renders the use of a particular valuation approach obsolete.

Back to our example, if such proposed legislation is enacted and discounts are no longer applicable, is the analyst adequately valuing the subject holding company under the asset approach alone?  Consider the level of value produced by the undiscounted asset approach.  The value estimate will produce a value at the marketable control level of value.  Now, consider the value estimate produced under the income approach.  Most generally, this will produce a value estimate at the marketable minority level of value.  As such, even if discounts are not applicable to intra-family transfers, the value estimate produced under the income approach would seem like the logical fair market value of the subject interest.

If analysts have been adequately considering, and producing value estimates, under the various approaches all along, then the proposed legislation would not serve to greatly alter their current valuation practice.  This is a stark contrast to the analyst that only produces value estimates under the asset approach and such legislation presents a reinvent-the-wheel situation.

In the case at hand, the analyst would want to consider several factors when weighting the value estimates under the two approaches.  First and foremost, in regards to the value estimate produced under the asset approach—does the value estimate reflect the risk-adjusted benefits the limited partner could expect to receive?  Probably not.  Looking into the transaction marketplace (Partnership Profiles) we can see sales of non-controlling interests in limited partnerships holding land reflect a significant discount from the undiscounted market value of equity.  As such, the value estimate produced under the income approach may be a better indicator of the fair market value of the subject interest since it has a discount for lack of control imbedded in the capitalization or discount rate, since that rate is derived from returns of minority stocks in the public marketplace.  In essence, it is the return that an investor could expect to receive when holding a minority interest in a representative public-company security with a similar investment and risk profile as the subject company.

Keep in mind, it is not the intent to “smuggle” risk assumptions into the capitalization or discount rate of the subject company, so as to take into account lack of control and marketability considerations.  It is just that the risk rate reflects a minority rate of return.  This holds true, when using the build-up or CAPM approaches to developing a representative risk rate.

The point of the example provided throughout this article is to illustrate the fact that even new or proposed legislation does not have the effect of greatly altering valuation methodologies.  In this case, the new legislation has the most impact on the weighting of the value estimates produced under each valuation approach.  It is a far departure of the effect that many in the valuation community viewed the legislation would have—being the elimination of valuations of closely-held family holding companies.  In essence, the proposed legislation just ensures we do our jobs properly and carefully consider all valuation approaches, normalization adjustments, and then take the time to carefully document our findings and positions in our valuation reports.

In closing, it is worthwhile to reiterate the point that no matter the obstacle faced by a particular engagement, it is incumbent on the analyst to look at the engagement from the proper vantage.  Just because a particular engagement has always been handled in the same manner, or because engagements of that manner are generally handled in that way, it does not mean the engagement on the desk of the analyst will be an exact carbon copy.  Many times, typical problems facing analysts can be solved when analysts change their focus and look at different methods to produce value estimates from those commonly used or those we would expect to use given the valuation at hand.

Peter H. Agrapides, MBA, CVA, is with the Salt Lake City, Utah, and Las Vegas, Nevada, offices of Western Valuation Advisors. Mr. Agrapides’ practice focuses primarily on valuations for gift and estate tax reporting. Mr. Agrapides has experience valuing companies in a diverse array of industries. These engagements have ranged from small, family owned businesses to companies over $1 billion. Mr. Agarapides can be reached at: (801) 273-1000 ext. 2, or by e-mail to: panayotiagra@yahoo.com.