How advanced valuation practices help businesses and investments

How advanced valuation practices help businesses and investment

Business valuation can seem to be as simple as a multiple paid against your last year’s earnings.

But the truth is, valuation is an ever-evolving field, and recent advances continue to affect how valuations are performed. The goals are still to determine “What is the right multiple?” and “What discounts or premiums apply?”

Recent changes in the “how of getting there” are going to have a direct effect on business owners and investors.

For those actively involved in acquiring companies, significant advances are being discussed and taught regarding the way that acquired intangible assets are valued and tested for impairment. The impact of these changes on financial statements cannot be ignored.

How much amortization expense is recordable, how financial ratios that are relied on by investors and other third parties are computed – all are affected by these changes. Even how much time is expected of CFOs and audit teams focusing on what is often the last set of entries before accounting books can be closed is changing.

The interaction of debt at a parent/holding company and its acquired subsidiary is also changing, introducing new uncertainty over how inventive, highly structured deals will play out on the financial statements prepared for outside parties.

There is some good news, however. A recent announcement gives a break to small nonpublic companies concerning the level of initial testing to check for impairment of certain intangibles.

For those more concerned about using stock and options as compensation and as sweeteners in financing arrangements, the analysis is becoming more advanced and complex. This isn’t as terrible as it first sounds. One benefit comes from the standardization of the models and techniques that are being taught. The uncertainty over how much difference in opinion might arise between your valuation expert and an adversarial expert (from the IRS, for example) should diminish as the tools to value complex securities become more commonly applied.

In the past, the lack of clarity over how much the securities were worth created a barrier to their utilization. As analysis of them becomes more consistent, complex securities become a more viable tool to better match the incentives and payoffs for executives to reach for the hurdles and thresholds that make businesses succeed.

 Also, as the understanding improves of how volatility affects complex securities’ values, so does the judgment and advice of when to use them and how to structure them.

 In the world of valuations for wealth transfer, the age-old debate over marketability and control discounts continues, but more emphasis than ever is being placed on tying the analysis to specific, relevant data.

Tax Court cases, and the experts testifying in them, generally have moved beyond qualitative judgments over discounts and have embraced thinking about shareholder-level returns and considering the kinds of information that real investors find relevant in buying and selling securities.

New studies and databases are cropping up that specifically address issues that, in the past, were purely the realm of “appraisal judgment,” and in which the older and more experienced appraiser was given more deference and credibility. These new stores of information are altering the arguments, much like new weaponry changes how battles are fought.

What used to pass for good enough – even a few years ago – is unlikely to stand up to the rigor expected nowadays. This doesn’t necessarily mean that valuation discounts or results have changed drastically, but it does mean that – if challenged – an analysis submitted to audit and headed for Tax Court had better be prepared to reconcile against this new wealth of information that the court is aware of and expects to hear about.

At the same time, a well-prepared analysis, relying on good information, improves its intangible value of “That report looks thorough and well done. Find a weaker one to challenge.”

Like many professions, valuation continues to evolve, creating the need for more specialized knowledge to properly help clients meet their needs. Advances in valuation theory and practice are increasing the complexity of the valuation models and analyses routinely performed, which does create concern over how many new ways errors can find their way into such analyses.

On the other hand, improved valuation models and better data are helping fine-tune value estimates. This will lead to more tailored solutions for business owners and for investors in all types of securities.

Be sure to ask how your valuation adviser is staying up to speed with these changes.

Real estate has become major market for fraud

Real estate has become major market for fraud

Real estate fraud is one of the fastest growing white collar crimes in the United States. Some fraud has been perpetrated by lenders themselves, who made bad loans and then sold them to investors.

However, lenders are also increasingly becoming victims of fraud. Mortgage fraud has increased by staggering proportions.

In 2002, banks filed 5,623 reports of mortgage fraud according to FBI statistics. Five years later, the number of mortgage fraud cases reported was nearly 48,000.

Despite the depressed real estate market and the glut of foreclosed properties, mortgage fraud continues to climb. According to the mortgage fraud index on www.mortgagedaily.com, the dollar amount of loans involved in mortgage fraud exceeded $5 billion in 2009 and was already at more than $4.1 billion for the first two quarters of 2010.

Fraud for profit

Mortgage fraud can be divided into two categories: fraud for property and fraud for profit.

In fraud for property, the borrower makes misrepresentations with the goal of obtaining a loan to buy a home. Fraud for property is only a small percentage of mortgage fraud and involves less risk to the lender because the fraud perpetrator intends to pay the mortgage.

The vast majority of mortgage fraud is fraud for profit. Here, the goal is money. Fraud for profit may involve corrupt industry insiders or fabricated documents. The two primary methods of fraud used are false identities and phony or dishonest appraisals.

One of the top mortgage fraud schemes is the practice of acquiring property, having it appraised for far more than it is worth and then selling it for the inflated price and pocketing the profit. The sale often is made to a “straw buyer,” an accomplice who will simply walk away from the mortgage and let the bank foreclose.

Documents may be fabricated to create the appearance that the straw buyer is creditworthy. Sometimes the sale is to an innocent buyer who later learns that what he or she bought isn’t worth what the appraisal said.

A fraud perpetrator may pose as someone who owns property and hire others to impersonate employers, appraisers, etc., when the lender phones to verify employment, income and credit. Fraud perpetrators also may use identity theft techniques to acquire personal information sufficient to submit loan applications in the names of persons who own property or have credit.

Fraud perpetrators may attempt to sell property twice by scheduling closings with two different lenders so closely timed that the transactions do not appear in the property records in time to tip off title-search companies.

Flipping and short sales

Lenders are under severe pressure because the number of foreclosures and the drop in property values make their collateral worth less than the loan. This has led to an increase in the number of “short sales” – sales for less than the amount owed on the mortgage. This situation has created a new opportunity for fraud. Perpetrators may negotiate a short sale using dishonest appraisals.

Also, burdened with too many distressed properties and desperate to cut costs, banks may use computer programs to estimate values or turn to real estate agents who provide what are known as “broker price opinions,” or BPOs, at a relatively inexpensive price. The real estate agent hired to estimate the property’s value may also end up being the listing agent on the sale of the house when it is flipped for a higher price. Obviously, this can create a conflict of interest and a motive to underestimate the property’s value for purposes of the short sale.

Parties negotiating the short sale may already have a buyer lined up at a higher price and immediately flip the property and pocket the profit.

Fighting fraud

The Financial Fraud Enforcement Task Force, established by the Obama administration to combat financial crimes, announced in June 2010 the results of a nationwide takedown, Operation Stolen Dreams, which targeted mortgage fraud perpetrators throughout the country and is the largest collective enforcement effort ever brought to bear in confronting mortgage fraud.

In only a few short months, Operation Stolen Dreams had involved 1,215 criminal defendants nationwide – with 485 arrests – who are allegedly responsible for more than $2.3 billion in losses. As of June 2010, the operation has resulted in 191 civil enforcement actions, which have resulted in the recovery of more than $147 million.

Court Rules Appraisal Must Be Reliable, Relevant

In a case involving the donation of a conservation easement, the Tax Court ruled that the charitable contribution deduction was 100 times less than estimated by the appraiser.

Although the $3.245 million contribution deduction was supported by an appraisal conducted by a qualified appraiser, the court refused to accept the appraisal report, calling it unreliable and irrelevant. Instead, the court accepted the appraisal conducted by the IRS’s experts, which valued the charitable contribution at $31,280. (See Boltar LLC v. Commissioner (136 TC No. 14, April 5, 2011).

In 2003, Boltar granted an easement to a land trust restricting the use of approximately eight acres of land in Indiana. In addition to the property that was the subject of the tax litigation, Boltar also owned a number of contiguous parcels of land, much of which was forested wetlands. The parcel affected by the easement was zoned for single-family residences.

In determining the fair market value of a qualified conservation easement, the regulations generally look to the value of comparable easements. If there are an insufficient number of comparable easements, then the regulations state that the value of the ­contributed easement is equal to the difference between the fair market ­value of the property it encumbers, ­before the granting of the restriction, and the fair market value of the ­encumbered property after the granting the restriction.

In other words, when there are insufficient sales to determine the value of the easement, then a before-and-after valuation approach must be used.

Boltar engaged the services of an appraiser who valued the ­unencumbered property at $3.27 million. The appraiser determined that the highest and best use for the eight acres would be a 174-unit condominium development, consisting of 29 hypothetical buildings, each containing six units. The appraiser reduced this amount by the enhancement in value of Boltar’s adjacent properties as a result of the donation of the easement.

The IRS’s appraiser determined the highest and best use of the property was development of eight to 16 single-family homes, making the unencumbered property worth $100,600.

The IRS argued that condominiums could not be built on the property, which was zoned for single-family homes. The IRS further argued that the hypothetical 29-building condominium project cited by Boltar’s appraiser was designed for a 10-acre site, while the land that was the subject of the easement was no more than eight acres.

Before the trial commenced, the IRS filed a motion to exclude Boltar’s appraisal report on the basis that the report was neither reliable nor relevant. The IRS argued that Boltar’s appraiser failed to:

• · Properly apply the before-and-after methodology
• · Value all of Boltar’s contiguous landholdings
• · Take into consideration zoning restraints and density limitations
• · Consider pre-existing conservation easements

As a result, the IRS contended that Boltar’s appraiser valued the land by reference to a hypothetical development project that could not fit on the land, was not economically feasible to construct and would not be legally permissible to be built in the foreseeable future.

The IRS argued that Boltar’s appraiser departed from the legal standard to be applied in determining the highest and best use of property and instead determined a value “based on whatever use generates the largest profit, apparently without regard to whether such use is needed or likely to be needed in the reasonably foreseeable future.”

The Tax Court concluded that the valuation submitted by Boltar’s appraiser was not sufficiently based on facts or data, and the report did not state the facts or data as support for the conclusions. The court found that the report was too speculative and unreliable to be useful. As a result, the court ruled that the report was inadmissible.

Without Boltar’s valuation report, the court had only the report of the IRS’s appraiser in evidence. Boltar offered no defense against the IRS’s appraiser. As a result, the court upheld the valuation as determined by the IRS.

CPA objectivity important when valuing a business

As cliché as it may sound, one of the pillars of the accounting profession is integrity.

The role of the accountant is so crucial for the successful operations of a business that CPAs have always been looked to with respect for their ability to advise business owners on a myriad of topics. It has long been established that the CPA must meet certain standards of independence, objectivity and integrity when performing attest services such as financial statement audits or reviews. Similarly, certain standards are called into play when a CPA performs a business valuation.

Clearly, it is the objectivity and integrity of the CPA that attorneys seek when hiring a valuation analyst. Even more, these qualities must be beyond reproach when considering the fact that often the CPA is an expert who may be called upon to testify at trial or even to assist in mediating the case between all parties.

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Court must unravel complicated real estate transfers

On the surface, a recent Tax Court case appears unremarkable, but it involved application of the Internal Revenue Code to a rather unusual set of facts.

In 1962, Adelina Van immigrated to the United States from China, as a single mother with her four children. In the 1970s, Van struck up a romantic relationship with a gentleman who purchased a home for her that became the subject of her estate’s tax issue.

In 1997, Adelina Van gifted title to her residence to her daughter and three granddaughters. Van continued to live in the house rent free until her death in 2000. The estate excluded the value of the residence, and the IRS disagreed.

The IRS viewed the situation as a classic gift with a retained life interest of the type that includes the property in the estate under §2036(a). But the estate had a different view of the situation.

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How to manage goodwill during a sale

The time has come. You’ve decided to sell your business.

You know that a great deal of your business’s value comes from your existing client base. The potential buyer, whoever he may be, may not want your building, your processes or your company name, but he will want the revenue stream that your customers generate.

This should be a serious consideration during the search for a potential buyer and throughout the transition. You’ll maximize your company’s value if you can demonstrate that your clients are loyal and will likely remain so.

To increase the chances that your clients will stay, here are a few things they will want to know:

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Family Limited Partnerships

There has been a great deal of interest in estate planning lately. As a result, a lot of valuations are coming along dealing with family limited partnerships (FLPs), the apparent investment entity of choice for gift and estate planning. One area that doesn’t always receive as much attention as other mainstream valuation issues is that of liquidity inside the FLP. What follows is a summary of current research on the topic and some notions on applicability of the question: “How much cash is reasonable – and ‘discountable’ – inside a family limited partnership?” One area that doesn’t always receive as much attention as other mainstream valuation issues is that of liquidity inside the family limited partnership

In the valuation analysis of FLPs, whether they are invested in portfolios of marketable securities, real estate, or other interesting investments sometimes found in FLPs, the core market data that is typically analyzed for comparative pricing purposes consists of closed-end funds and publicly traded limited partnerships. Closed-end funds (CEFs) are like open-end mutual funds, which allow investors the opportunity to buy into portfolios run by professional managers. However, closed-end funds have no obligation to redeem their own investors’ shares upon demand but behave instead like ordinary publicly traded companies. In that regard, publicly traded real estate limited partnerships (RELPs) behave like closed-end funds. This allows their professional managers to focus on maximizing portfolio returns without the concern of carrying cash, or unexpectedly liquidating positions, to redeem upon demand. Investors are free to buy and sell their shares through stock brokers, and in effect, “vote with their feet” if they disapprove of management or simply wish to reallocate their own portfolios to other investments. Perhaps not surprisingly, the market data shows that CEFs hold very little in the way of cash. This is consistently true for almost all of the several hundred CEFs researched, covering all of the major asset classes and investment styles for stocks and bonds. The typical range for cash positions was less than five percent. Only a few closed-end funds have held a larger portion of their portfolio in cash at any point in the past couple of years (some, seemingly in response to stock market conditions, reduced their equity exposure for one or two quarters and then reinvested). The only closed-end funds that seem to consistently maintain a higher cash position than a few percent are those that have an investment policy that allows them to invest a substantial portion of their portfolio in nontraded securities (such as private companies, venture capital investments, etc.).  Publicly traded real-estate limited partnerships, based on records found on SEC.gov and other valuation databases show more diversity. In looking at a published database of the more than 100 RELPs that are still operating, a majority show cash ranges between 5 percent and 10 percent of assets.

More interestingly, many show substantially larger cash positions, upward of 30 percent to 40 percent of their balance sheet invested in cash, at different points and for substantial periods in their recent history. While in some instances, the jump in cash is due to a recent sale of a property or a refinancing, there is no consistent pattern. In at least a few of the examples, the cash position has resulted purely from the retention of earnings over several years.

So what does this mean as far as family limited partnerships are concerned? What difference does it make to you? Well, it depends, of course. Much like private companies that have different motivations and reasons than public companies for holding cash and retaining earnings, private FLPs have different reasons and investment rationales for holding cash and retained earnings than their publicly traded parallels, CEFs and RELPs. That said, the market data typically used in analyzing FLPs for valuation purposes strongly support large proportions of cash.

While this does not preclude such a situation from existing in an FLP, it does highlight the need to emphasize those differences when documenting rationale in the valuation process. Such situations, which are not unusual in FLP settings, require a more thoughtful analysis of how all the assets in the FLP, including the cash, work together to accomplish the bona fide business goals set out for the FLP. Simply applying a median pricing multiple (sometimes still referred to as the “implied lack of control discount”) derived from CEFs or RELPs, without a corresponding analysis, opens the door to a challenge of the quality and conclusions of the valuation exercise.

That reason alone is worth understanding how your valuation adviser is handling the analysis of your FLP, particularly if it is one holding substantial amounts of cash at the time the analysis is made.

Expert Witness qualification has dramatic effect on Tax Court case

A recent Tax Court case demonstrates how the quality of Expert Witness testimony earned a favorable result for a client. It might be said that the IRS appraiser, a former ski instructor, missed several gates on his downhill run. The court noted that, once the IRS appraiser was qualified as an expert, the former ski instructor’s performance “went downhill fast.”

The taxpayers in this case were a series of entities owned or controlled by Kevin Kimberlin. For simplicity, these entities are collectively referred to as “Kimberlin.” Kimberlin was in the investment banking business and specialized in obtaining early-stage financing for technology companies.

The court noted that, once the IRS appraiser was qualified as an expert, the former ski instructor’s performance “went downhill fast.” He inaccurately stated his credentials, repeatedly contradicted himself, inappropriately relied on a colleague not identified in his report, insisted that multiple errors in his report were the fault of his “editor,” and cited as an authority a textbook that was two editions out of date.  When the court asked whether he was trying to determine fair market value, he replied that fair market value could not be determined because, as a certified financial analyst, he was required to follow a “higher standard” and determine the “intrinsic value” of the warrants.

In contrast, the court found Kimberlin’s expert credible, consistent and highly qualified. He determined the fair market value of the warrants on the date of grant was 90 cents per share. This case is another example of how an ill-prepared, inexperienced expert witness can undermine a client’s entire case.

Matrimonial dissolution: The value of a valuation

In a marital dissolution matter, the starting point for a business valuation is the company’s prior five years of tax returns and financial statements.

We research the industry, acquire benchmarking and market data on the industry for comparison and analyze the company’s financial performance, as well as its assets and debt structure. These, along with our forensic analyses, help to identify, examine and, if necessary, make adjustments to the reported income stream upon which our valuation is based.

Typical Findings

Unreported income. There are frequently allegations of unreported or “cash” income and/or personal expenditures being paid by the business. In looking at closely held companies, these allegations often prove true. When considering an allegation of unreported income, you must look at the company’s income sources and determine if there is an opportunity for this to occur. Certain industries lend themselves to a greater possibility of this situation. If opportunity is there, it is often difficult to quantify the exact amount. An analysis of the company’s bank records and the business owner’s personal bank accounts, personal assets and lifestyle should be performed to ascertain if the reported income is consistent with these items.

Non-operating assets. After examining the cash activity, the next step is to look for non-operating assets.  An examination of the detail cash transactions may reveal that large amounts had been transferred between business accounts.  For example, from the operating account of the business into a business savings account.  Further inquiry may determine that the funds were not reserved for capital purchases. One could  conclude that the savings account is a non-operating asset of the business, which must added to the value of the business in addition to the value determined by a capitalization of income approach.

Change of company accountant. If a business changes accountants frequently, this could be a red flag. 

Non-business expenses. When analyzing the company’s expenses from a forensic viewpoint, there are some common non-business or personal expense categories that lend themselves to abuse possibilities.  Examples of such include personal  auto expenses, entertainment, travel, telephone, utilities, as well as legal and professional fees associated with the litigation. It is important to determine how these types of expenses are being categorized in the company’s financial records. If these expenses are incorrectly categorized as business expenses, the true earnings stream of the business is being distorted, and therefore expenses must be “normalized” to prepare a proper valuation.

Each case has nuances that require the keen analytical skills of the business valuation analyst. Careful planning and procedures can help assure that you have captured all the relevant data needed to issue a proper business valuation report.

Effective January 1, 2012 South Carolina Employers Must Verify All New Hires through E-Verify

Amendments to the “South Carolina Illegal Immigration and Reform Act” were signed into law by Governor Nikki Haley on June 27, 2011. The amended law requires all employers to enroll in the U.S. Department of Homeland Security’s E-Verify system beginning January 1, 2012 and to verify the legal status of all new employees through E-Verify within three business days. Failure to enroll in and use E-Verify to verify new hires will result in probation for the employer or suspension/revocation of the employer’s business licenses.

E-Verify is a free Internet-based system maintained by the U.S. Department of Homeland Security. E-Verify compares the information an employee provides on Form I-9, Employment Eligibility Verification, against millions of government records maintained by the Department of Homeland Security and the Social Security Administration. The database generally provides results in three to five seconds. If the information matches, the employee is eligible to work in the United States. If there’s a mismatch, E-Verify will alert the employer and the employee will be allowed to work while he or she resolves the problem. To enroll in E-Verify, go to www.dhs.gov/e-verify.

If you have not already enrolled in this system and would like our assistance, please contact us at (803) 771-0077.