So much wealth in this country consists of shares in closely held companies that it pays to know exactly how to value those assets. Yet no one method suffices, nor is there any set formula for how to combine a variety of methods. That is the clear message sent by the Tax Court in its Aug. 8 opinion on Johann T. and Johanna Hess v. Commissioner.1 The decision is a powerful reminder that appraisals must be based on good financial information and correctly reflect the status of a company as of the valuation date. More importantly, though, the Tax Court offered an overview of some of the methods now in use, insisted that multiple approaches should be considered when determining fair market value — and made the task more difficult by demonstrating that not all methods should be given equal weight. Unfortunately, the court didn't fully explain the basis for how it reached its own valuation of the Hess shares in question. But careful examination of the case does provide clues as to how the court might weigh such techniques in the future.
In 1995, Johann and Johanna Hess gifted 10 shares of the common stock of Hess Industries, Inc. to their daughter. The company is a closely held C Corporation comprised of “a group of companies that provides a spectrum of metalforming, metal processing, manufacturing and factory automation solutions to the global market” for the automotive industry, according to its web site.2 At the time of the gift, the company's accountant and tax advisor valued the shares at $120,000 each. In contrast, the Internal Revenue Service determined that each share had a fair market value of $253,000. According to the IRS, this discrepancy in value resulted in Johann and Johanna underpaying by about $262,000 the taxes on this present to their daughter. Before trial, the Hesses and the IRS each retained a professional appraiser to determine the value of the common stock gifted to the daughter. These new appraisals supported each side's original valuation, with the Hesses' expert finding a value per share of $128,000 and the Service's consultant actually upping the value to $269,000 per share. The Hesses' expert utilized a comparative analysis of public companies and a discounted cash-flow analysis. The IRS's expert, on the other hand, considered five methodologies — the net asset value, the stockholder agreement, the prior stock transaction, the public company guidelines and the discounted cash flow — assigning a weight to the value indicated by each to derive a fair market value. Then it was up to the Tax Court to decide what exactly the shares' fair market value was under Internal Revenue Code Section 2501.
THE COURT'S ANALYSIS
The court reviewed the methodologies utilized by both experts. The Hesses' expert made a significant adjustment to the company's income statement to account for an understated expense reserve that had not been quantified as of the date of valuation, the court noted. This adjustment affected both methods this expert used, allegedly causing the shares to be significantly undervalued. The court concluded that such an adjustment should not have been made for a number of reasons: First, at the time of the expert's appraisal in 1997, he received a memo from some Hess employees concerning a potential overstatement of income that had occurred two years prior. The company's financial statements were never adjusted to account for the overstatement, a result of an underestimation of reserves for expenses related to construction projects. When the Hesses' accountant initially valued the shares, he had not considered this issue. The Hesses said that the overstatement had not been quantified at the time of their gift. The court agreed.
Furthermore, the court determined that the Hesses' expert had placed too much weight on the discounted cash flow analysis, because the company's “sales and earnings are erratic and not readily predictable.”3 Nevertheless, the court concluded that the resulting indication of value should be accorded some consideration in determining the fair market value of the shares. The court also stated that the expert erroneously applied “a minority interest discount to the market comparable analysis, which already reflects transactions involving minority interests.”
The court reviewed the analysis of the IRS's expert, which employed five methodologies:
Net Asset Value — In defense of the net asset value method, the Hesses argued that the indication of value from this method supported the value reported on their gift-tax returns and should be given more weight. The court concluded, however, that because the company is an operating entity and not simply an asset holding company, “the net asset value method should be accorded less weight,” as it “is not particularly reflective of the fair market value of [the company's] stock.” This conclusion was based upon the court's stated belief that, as an operating business, the company possessed intangible assets, such as goodwill, the value of which was not accurately reflected in the net asset value. Nevertheless, the court agreed that this method should be accorded some consideration in determining the final value.
Stockholders' Agreement — Next, the court reviewed the IRS expert's conclusions based upon the company's stockholders' agreement dated Sept. 1, 1989. This method is based upon the existence of a formula contained in the stockholders' agreement, which the court found overvalued the stock and shouldn't be relied upon heavily. For one thing, the agreement was not in place when the Hesses made the gift in 1995, and no transactions ever occurred under the agreement when it was in effect. Also, the agreement between certain shareholders and the company accounted for specific rights and obligations that would not be considered by a hypothetical buyer. Moreover, “the shareholders were not bound to the value per share derived under the formula provision, since they could agree in writing among themselves to a specified value per share.” Lastly, the court was unclear about whether the stockholders' agreement applied to voluntary sales of the company's stock. (The court appears to have interpreted the stockholders' agreement to apply in situations where the sale of the stock is forced.)
Prior Transactions — The IRS's expert considered a transaction in the company's stock that occurred on Feb. 26, 1995, involving the purchase of 12 shares from a former employee. Given the proximity of the transaction to the date of valuation, the IRS's expert concluded it was a reliable indication of fair market value as of the date of the gift: $329,500 per share. But the expert deemed immaterial the value of the selling employee's eight-year non-compete agreement and three-year employment agreement, which accompanied the stock sale. The court disagreed, saying that the purchase price likely included the value of the employee's non-compete agreement.
Still, the court said, the Hesses' expert didn't get it right either. His initial report did not quantify the value of the non-compete agreement. Although his initial analysis did not utilize the prior transaction method, in a supplemental report he attempted to quantify the value of the agreement and then determine a value for the shares using this method. In doing so, he estimated the opportunity losses that would result if the employee were to compete against the company. These losses were projected over an eight-year period after the completion of the three-year employment contract and were discounted back to the present. His analysis determined that the non-compete agreement had a value of $2 million, which was subtracted from the $3.95 million purchase price of the 12 shares of stock, resulting in a value of $104,000 for the shares.
The IRS expert protested, observing that this value suggested the company was willing to pay the employee substantially more than his normal salary not to work. The court also found the methodology employed by the Hesses' expert to be “flawed,” stating that “potential opportunity losses [do not] provide an acceptable measure of value for a covenant not to compete.”4 The value of the shares was “much greater,” the court said, than that derived by the Hesses' expert using this methodology.
Pricing Data — The IRS expert's guideline companies analysis applied a price-to-earnings ratio to the company's earnings for the fiscal year that ended July 31, 1995. The court said that, although this methodology “would have been more complete if it had employed additional measures of comparison…it is clear that P/E ratios bear a well-recognized relationship in the valuation of companies.” However, the P/E ratios selected by the IRS expert were based upon comparable companies' earnings for the two most recent quarters and forecast earnings for next two “cycles,” and were applied only to the Hess Industries' historical earnings using the four quarters leading up to July 31, 1995. The court noted that although “the preferable comparison to historical and/or projected earnings should be made using consistent time periods,” this error is not likely to materially change the expert's conclusion.
The Hesses noted that the IRS expert relied upon the July 31, 1995 financials to derive the value of the company. But, they argued, these earnings were the result of a banner year and not representative of the company's operations. The court agreed, noting that a potential buyer of an interest in a growth company would likely consider not just the most recent year of operations, and the use of “longer periods of time or averages over ‘a peak to trough sort of cycle’ would seem preferable.” Even so, the court did not determine that the use of financial metrics from only 1995 necessarily resulted in a conclusion that was overstated or not meaningful.
Future Earnings Stream — The IRS expert concluded that the discounted cash flow analysis did not provide a meaningful indication of value, as it was extremely sensitive to small changes made to the model. These small changes resulted in large fluctuations in the indicated value. The court disagreed, finding these variations were not reason enough to completely write off the indication of value provided by this methodology. The court added, “Generally, in valuing the shares of an operating company…primary consideration should be given to earnings.”5 The court noted that variations of this nature occur in other valuation methodologies and may be more significant than those found in the discounted cash flow analysis. The court believed that the indication of value from the discounted cash flow model should be considered in the final conclusion of value, although it should be accorded less weight.
And For Good Measure — On top of the valuation methodologies employed by the experts, the court also considered the indication of value provided through a letter of intent to purchase all of the outstanding shares of the company, dated Sept. 28, 1999. The court determined that this indication was not representative of the fair market value of the company's shares, as the letter was not binding on the parties and the acquiring company decided against purchasing the company.6 The letter was more of a negotiating ploy than evaluative tool.
Discounting — Both experts concurred that the appropriate discount for lack of control should be 15 percent. But they differed in the amount of the discount that should be applied to account for the shares' lack of marketability. The Hesses' expert testified in favor of a 30 percent discount, while the IRS expert applied a 25 percent adjustment. The court said the Hesses' expert did not properly account for just those factors affecting marketability and incorrectly included some factors considered in the lack-of-control discount. Therefore, the court relied solely upon the IRS expert's determination of the illiquidity discount.
In the final analysis, the court found that that value per share was actually $200,000 — right in the middle of the range of all the experts' values.
The court did not provide any insight into the weighting used for each of the valuation methods. Instead it gave each method some consideration and decided that the value of the shares would fall somewhere in the middle of the experts' range of valuation indications. This default to the average of a range is contrary to instructions given by the U.S. Court of Appeals for the Ninth Circuit in both Leonard Pipeline v. Commissioner7 and Estate of Paul Mitchell v. Commissioner.8 In these cases, the federal appeals court told the Tax Court to provide the reasoning behind the concluded value, as opposed to merely relying upon a value that falls within the range of values opined by the experts. In Leonard, the appellate judges said they “can see the pieces of the puzzle,” but “can only guess how the trial judge put them together.”9
The methodologies employed by an analyst should depend upon the operating status of the company and the assets it holds. Without question, though, one lesson from this decision is that the methodologies employed should be consistent with the company's circumstances as of the date of valuation. The court made it clear that an analyst should consider as many methods as possible when determining fair market value. This decision affords analysts valuable insight concerning the court's thought process in applying the individual methodologies. Unfortunately, the court neglected to provide thorough reasoning about how it reconciled the various methods to reach a conclusion. But it's not only the Tax Court that need explain itself; valuation analysts also must clearly show how the indications of value factored into their final figure.
The second outstanding lesson is to avoid overweighting the asset approach when the company's operations are not asset-intensive. Use of this method here would have undervalued the company, because the value of intangible assets such as goodwill were not reported on the balance sheet. Likewise, companies with significant variations in their earnings streams may not be valued accurately using income-based methods like the discounted cash flow model.
The third lesson is to be very careful when adjusting financial statements or projecting future financial performance. It is equally important to include the company's situation as of the date of valuation, as well as what then was known, or knowable, about the future. If the company's present or anticipated future financial situation is not consistent with the facts and expectations as of the date of valuation, the analyst must work to understand what caused this disparity.
The fourth lesson is to remember that not all valuation methods are equally appropriate in all situations. Although the court instructs that multiple approaches must be considered when determining fair market value, not all methods will give equally meaningful results. Here the court considered several methods, but established that indications from each do not necessarily result in an equally weighted indication of the fair market value of the shares in question. When factoring the results of different valuation methodologies into a conclusion, an analyst should consider the company's characteristics and whether the result from a given method accurately reflects its operations, financial performance or asset base as of the date of valuation. An analyst also must consider whether outside factors are influencing the product developed through a given method. The indication of value can be affected by the valid inclusion of a non-compete agreement or through the invalid use of stock pricing from a transaction that was never completed.
Finally, if a court is to accept an analyst's conclusions, those conclusions and the underlying analysis must be well-supported. This ruling demonstrates that any adjustments made to financial statements and valuation methods used need to be consistent with the circumstances surrounding the company as of the date of valuation. Also, while it is apparent that the final conclusion of value must consider multiple indications, the Tax Court has shown that not all methods should be given equal weight.
- T.C. Memo. 2003-251.
- Hess v. Commissioner, p. 22.
- Supra, p. 36.
- Supra, p. 21.
- Supra, p. 46.
- Leonard Pipeline Contractors v. Commissioner of Internal Revenue, 142 F.3d 1133 (9th Cir. 1998).
- Estate of Paul Mitchell v. Commissioner of Internal Revenue, 250 F.3d 696 (9th Cir. 2001).