The Handbook of Business Valuation and Intellectual Property Analysis
Robert F. Reilly Managing Director Willamette Management Associates
Robert P. Schweihs Managing Director Willamette Management Associates
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We dedicate this book to our families. As we devote inordinate amounts of time to our professional endeavors (including this book), we recognize that our wives and children are the most important—and most precious—parts of our lives.
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Mary Katherine
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Ann Marie Bridget
Robert F. Reilly
Robert P. Schweihs
Contents List of Exhibits About the Editors About the Contributors Preface Acknowledgments Introduction PART I
xiii xix xxiii xxix xxxiii xxxv
Business Valuation Technical Topics
1
1. The Equity Risk Premium
3
ROGER J. GRABOWSKI and DAVID W. KING
Introduction. Realized Return or Ex Post Approach. The Selection of the Observation Period. Which Average: Arithmetic or Geometric? Expected ERP versus Realized Equity Return Premiums. Noncontrolling Ownership or Controlling Ownership Interest Returns? Forward-Looking Methods. Bottom-Up Methods. Projected Real Equity Returns. Surveys. Other Sources. Realized Returns and the Size Effect. Criticisms of the Small Stock Effect. The January Effect. Bid/Ask Bounce Bias. Geometric versus Arithmetic Averages. Infrequent Trading and Small Stock Betas. Delisting Bias. Transaction Costs. No Small Stock Premium Since 1982. Summary and Conclusion. 2. The Discount for Lack of Control and the Ownership Control Premium—A Matter of Economics, Not Averages
31
M. MARK LEE
Introduction. Determinants of the Discount for Lack of Control. Suboptimal Management of the Firm. Treatment of Passive Equity Holders. Valuing Ownership Control and Passive Ownership Interests in Operating Companies. Ownership Control Premium Procedures. Direct Procedures. Discount for Lack of Control in Investment Companies. Valuing Passive Ownership Interests in Family Investment Companies. Public Closed-End Fund Data. The Partnership Spectrum Data. Conclusion. 3. Valuation of C Corporations Having Built-in Gains
45
JACOB P. ROOSMA
Introduction. Base Case. Discussion of Methodology. Financial Model of the Investment Alternatives. Sensitivity Analyses. Spread between the Investment Rate of Return and the Debt Interest Rate. Investment Rate of Return. Corporate Income Tax Rate. Individual Income Tax Rate. Inside Tax Basis. Preliminary Conclusions of Sensitivity Analyses. Some Real-World Assumptions. Assumptions Regarding Expected Rates of Return. Using Put Options to Address the Contingencies of Direct Asset Purchase. Reasonableness Check Using the Price of the Put Option. Investment Holding Period Adjustment.
v
vi
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Dividends. Potential Value of the S Status Election. Financial Model of the S Corporation Election Strategy. Sensitivity Analyses—S Corporation Election Analysis. Debt Interest Rate. Spread between Investment Rate of Return and Debt Interest Rate. Corporate Income Tax Rate. Individual Income Tax Rate. Inside Tax Basis. Conclusion of Sensitivity Analyses. Amortizable/Depreciable Appreciating Assets. Short-Cuts Taken and Other Potential Criticisms. Summary and Conclusion. Other Implications for Business Valuations Involving the BIG Tax. 4. The S Corporation Economic Adjustment
71
DANIEL R. VAN VLEET
Introduction. Basic Premises. Business Valuation Approaches. Income-Based Approaches. Asset-Based Approach. Conceptual Mismatch between S Corporations and C Corporations. The S Corporation Economic Adjustment. S Corporation Equity Adjustment Multiple. Application of the SEAM. Primary Assumptions and Potential Adjustments. S Corporation Perpetuity Assumption. Cash Investment Returns and Unrealized Capital Gains. Recognition of Capital Gains Taxes. Tax Status of Buyers and Sellers. Current Income Tax Law. Profitability Assumption. Summary and Conclusion. 5. Applying the Income Approach to S Corporation and Other Pass-Through Entity Valuations
89
ROGER J. GRABOWSKI and WILLIAM P. MCFADDEN
Introduction. Pass-Through Entities. General Advantages of Pass-Through Entities. Restrictions and Benefits of an S Corporation. Economic Basis for Considering Income Taxes. Considerations in the Valuation of Pass-Through Entities. Fair Market Value and the Pool of Likely Buyers for S Corporation Shares. Controlling Ownership Interest Valuation Considerations. Noncontrolling Ownership Interest Valuation Considerations. How Should S Corporations Be Valued Using the DCF Method? Three Suggested Methods of S Corporation Valuation. Applying the Three Methods to Value an S Corporation. Traditional Method. The Gross Method. Valuing a Controlling Ownership Interest. The Modified Gross Method. C Corporation Equivalent Method. The Pretax Discount Rate Method. Valuing a Noncontrolling Ownership Interest. Summary of Before Lack of Marketability Discount Example. Summary of Example with 5 Percent Long-Term Growth Rate Assumed. Effect of Jobs and Growth Tax Relief Reconciliation Act of 2003. Proposals to Simplify Subchapter S. Conclusion. 6. S Corporation ESOP Valuation Issues
127
DAVID ACKERMAN and SUSAN E. GOULD
Introduction. The Current Tax Laws. Authorization of S Corporation ESOPs. Repeal of Unrelated Business Income Tax. New Distribution Rules. Exemption from Prohibited Transaction Rules. Denial of Special ESOP Tax Incentives. No Section 1042 Tax-Deferred Sales. Limit on Contributions. No Deduction for Dividends. New Antiabuse Rules for S Corporation ESOPs. Perceived Abuses. Disqualified Persons. Nonallocation Year. Penalties for Violation of the Nonallocation Rules. Regulations. Effective Dates. The S Corporation Election. Taxation of S Corporations and Their Shareholders. Eligibility to Make the S Election. Advantages of the S Corporation Election.
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Avoidance of Double Tax. Tax Savings on the Sale or Liquidation of a Business. Pass-Through of Losses. Other Benefits. Disadvantages of the S Corporation Election. Shareholder Limitations. One-Class-of-Stock Limitation. Limitation on Other Benefits. Fiscal Year. State Income Tax Considerations. Advantages of an S Corporation ESOP. Disadvantages of an S Corporation ESOP. Valuation Issues for S Corporation ESOPs. Fair Market Value. S Corporation Valuations versus C Corporation Valuations—The Conventional Method. Recent Judicial Precedent. Range of Value. 100 Percent S Corporation ESOPs. Valuation Conclusion. Planning Opportunities. Should ESOP Companies Make the S Election? Tax-Deferred Sales to ESOPs. Limits on Plan Contributions. Corporate-Level Income Tax. Should S Corporations Adopt ESOPs? Unresolved Issues. Use of S Corporation Distributions to Pay Off an ESOP Loan. Distribution of S Corporation Earnings to Plan Participants. Special Issues for S Corporation ESOPs. Lack of Marketability Discount. Repurchases from Plan Participants. ESOP Income Tax Shield. Sale of an S Corporation ESOP. S Corporation ESOPs and Step Transactions. S Corporation ESOPs in Distress Situations. S Corporation ESOPs and Acquisitions. Managing Repurchase Obligation in an S Corporation ESOP. Conclusion. PART II
Business Valuation Special Applications
7. The Valuation of Family Limited Partnerships
169 171
ALEX W. HOWARD and WILLIAM H. FRAZIER
Introduction. The Partnership Structure. Rationale Behind FLPs. Internal Revenue Code Chapter 14. Adequate Disclosure. The IRS and Valuation Discounts. Valuation Parameters. FLPs That Own Primarily Marketable Securities. FLPs That Own Primarily Real Estate. Lack of Marketability. Summary. Understanding and Interpreting the Partnership Agreement. Business Purpose. Contributions. Management Prerogatives. Distributions to the Partners. Control and Lack of Control. Transferability of Family Limited Partnership Interests. Section 754. Dissolution/Liquidation. Recent Tax Court Cases. Strangi v. Commissioner. McCord v. Commissioner. Other Relevant Cases. Estate of Thompson v. Commissioner. Estate of Morton B. Harper v. Commissioner. Estate of Kimbell v. United States. Church v. United States. Knight v. Commissioner. Kerr v. Commissioner. 8. Fairness Opinions: Common Errors and Omissions
209
GILBERT E. MATTHEWS
Introduction. Calculation and Miscalculation of Aggregate Market Value. Diluted Shares. Long-Term and Short-Term Debt. Preferred Stock and Minority Interests. Cash. Selection and Use of Guideline Companies and Guideline Acquisitions. Acquisition Price Premiums. Overstating Averages by Using the Arithmetic Mean. Irrational Pricing Multiples. Limitations of the Application of the Discounted Cash Flow Method. Unreliability of Financial Projections. Sensitivity to the Present Value Discount Rate. Sensitivity to Terminal Value. Depreciation and Capital Expenditures. Asset Value. Proper Standards of Value. Stock-for-Stock. Consideration to Other Class Members. High-Vote versus Low-Vote Shares. Structural Fairness. Presentation of Fairness Opinions. Updating Fairness Opinions. Conclusion.
viii
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9. Valuing a Canadian Business for a U.S. Purchaser: Canadian Laws to Be Considered
233
RICHARD M. WISE and SHERI-ANNE DOYLE
Introduction. Foreign Ownership Considerations. Acquisition of a Canadian Corporation—Income Tax Considerations. Acquisition of a Small Business. Canadian Withholding Taxes. Other. Business Corporations Acts— Shareholder Rights. Dissent and Oppression Remedies. Take-Over Bids and Follow-Up Offers. Canadian Publicly Traded Securities. Formal Valuations— Ontario Securities Commission. Environmental Laws. Intellectual Property. Conclusion. 10. Sports Team Valuation and Sports Venue Feasibility
253
ROGER J. GRABOWSKI, JACK HUBER, and ROBERT CANTON
Introduction. The State of the Major Professional Sports Leagues. Economics of the Four Major Sports Leagues. National Broadcasting Revenue. Local Broadcasting Revenue. Ticket Revenue. Stadium Leases. Naming Rights. Sponsorships. Collective Bargaining Agreement. Buyers of Professional Sports Teams. Sports Team Values. National Football League. Major League Baseball. National Basketball Association. National Hockey League. Income Tax Consequences of Professional Sports Team Acquisitions. Acquired Assets. Player Contracts. Stadium Lease/Premium Seat Agreements. Season Ticket Holders. Broadcasting Agreements. Sponsorship Agreements. Nonplayer Contracts and Noncontractual Employees. Draft Picks. Other Intangible Assets. Venue Feasibility Analysis. The Study Process for the Franchise Owner Considering a New Market. Income from Operations. Venue Financing Alternatives. Economic Impact on the State and/or Local Community. Conclusion. 11. Health Care Entity Valuation
279
CHARLES A. WILHOITE
Introduction. Health Care Entity Valuation Methodology. Valuation Approaches. Asset-Based Approach. Income Approach. Market Approach. Significant Valuation Issues. Managing Expectations. Identifying and Rationalizing Value Trade-Offs. Issues of Management/ Operational Control. Complying with Regulatory Constraints. Impact of Market Activity on Current Practice Values. Shift toward Gainsharing. Summary and Conclusion. PART III
Advanced Business Valuation Issues
12. Three Peas in the Business Valuation Pod: The Resource-Based View of the Firm, Value Creation, and Strategy
303 305
WARREN D. MILLER
Introduction. Michael Porter. Edith Penrose. People. The Resource-Based View of the Firm, Value Creation, and Strategy. External Sources of Investment-Specific Risk. Macroenvironmental Analysis. Industry Dynamics. Competitive Analysis. Internal Sources of Investment-Specific Risk. Ratio Analysis. Tool #1: The Resource-Based View of the Firm. Tool #2: The Value Chain. Tool #3: The VRIO Framework. Tool #4: Generic Competitive Strategy. Tool #5: The Star Framework. Summary and Conclusion. Afterword: Competitive Analysis.
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13. Differences between Economic Damages Analysis and Business Valuation
329
MICHAEL K. DUNBAR and MICHAEL JOSEPH WAGNER
Introduction. Value the Whole or Just a Part? Use All Valuation Approaches? Damages Before or After Taxes? The Income Tax–Affect Procedure. Complications to the Tax-Affect Procedure. Typical Lost Profits Claim. Value Only the Future? Know Only the Past? Background for the Ex Ante and Ex Post Discussion. Expectancy versus Outcome Damages. Advantages and Disadvantages of the Ex Ante Analysis. Advantages and Disadvantages of the Ex Post Analysis. Hybrid Analysis. Projected or Expected Cash Flow. Differences in Reporting Requirements. Use of Legal Precedent. Conclusion. PART IV
Intellectual Property Valuation Issues
353
14. Intellectual Property Income Projections: Approaches and Methods 355 JACQUELYN DAL SANTO
Objective of Intellectual Property Income Projection. Reliability of Income Projections. Alternative “Scenario” Income Projections. Extrapolation Methods. Linear Extrapolation Method. Multicollinearity. Curvilinear Extrapolation Method. Multiple Regression-Based Extrapolation Method. Tabula Rasa Methods. Life Cycle Analyses. Product Life Cycle Stages. Product Life Cycles Vary in Length. Sensitivity Analyses. Simulation Analyses. Judgmental Methods. Summary and Conclusion. 15. Intellectual Property Discount Rates and Capitalization Rates
385
TIMOTHY J. MEINHART
Introduction and Overview. Discount Rate versus Capitalization Rate. Valuation of an Intellectual Property Using a Discount Rate. Valuation of an Intellectual Property Using a Capitalization Rate. Sensitivity Analysis Using Alternative Discount Rates and Growth Rates. Using Discount Rates to Quantify Economic Damages and Transfer Prices. Economic Damages Example. Transfer Price Example. Estimating Discount Rates and Capitalization Rates for Intellectual Property. Capital Asset Pricing Model. The Build-Up Model. The Discounted Cash Flow Model. Arbitrage Pricing Theory Model. Weighted Average Cost of Capital. Using the WACC to Estimate Discount Rates for Intellectual Properties. Summary. Suggested Reading. 16. Intellectual Property Life Estimation Approaches and Methods
421
PAMELA J. GARLAND
Introduction. Importance of Life Estimation. Performing a Life Estimation Analysis. Topics Covered in This Chapter. Reasons to Perform a Life Estimation Analysis. Valuation. Economic Damages. Transfer Price/Licensing. Intellectual Property Life Measurements. Statutory Life. Contract Life. Judicial Life. Economic Life. Technological Life. Analytical Life. Other Life Measurements. Data Used in Intellectual Property Life Estimation. Registration Documents. Contracts. Judicial Decisions/Orders. Financial Statements. Usage Data. Operational Documents. Technology Data. Age/Life Data Summary. Definitions and Analytical Methods. Age. Average Life. Total Life. Probable Life. Average Remaining Useful Life. Survivor Curve. Probable Life Curve. Survivor Curve and Probable Life
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Curve Example. Turnover or Retirement Rate. Expected Decay or Depreciation. Iowa-Type Curves. Weibull Curves. Technology Forecasting. Illustrative Examples. Patent Infringement Example. Trade Secret Valuation Example. Trademark Licensing Example. Copyrighted Software Example. Summary and Conclusion. Suggested Reading and Resources. 17. Intellectual Property Residual Value Analysis
447
ROBERT F. REILLY
Introduction. Importance of Residual Value Analyses. Valuation Analysis. Intellectual Property Liquidation Value. Alternative Types of Liquidation Analyses. Intellectual Properties within a Bankruptcy Context. Summary and Conclusion. 18. Intellectual Property Ad Valorem Case Study
471
PAMELA J. GARLAND
Introduction. The Case Study Problem. Purpose and Objective of the Analysis. Description of the Subject Intellectual Property. Data and Data Sources. Analytical Approaches and Methods. Cost Approach. Income Approach. Market Approach. Analytical Approaches and Methods Considered and Selected. Analytical Variables. Analyses and Results. Cost per Person-Month. COCOMO Analyses. KnowledgePLAN Analyses. Synthesis and Conclusion. Analysis Work Product. Purpose and Objective. Description of the Subject Property and of the Subject Data Sources. Valuation Methods and Procedures. Valuation Synthesis and Conclusion. Appendixes. Illustrative Narrative Valuation Opinion Report Outline. Schedules and Exhibits. 19. Licensing of Intellectual Property Case Study
503
JAMES G. RABE
Introduction. The Case Problem. Overview of the Licensee. Overview of the Licensor. Importance of the Appropriate Royalty Rate. Objective of the Analysis. Description of Subject Intellectual Property. Data and Data Sources. Alternative Analytical Methods Considered. Comparable Uncontrolled Transaction Method. Comparable Profits Method. Profit Split Method. Summary of Royalty Rate Estimation Methods. Discounted Cash Flow Method. Base Case Analysis Discounted Cash Flow Method. Alternative Case Analysis Discounted Cash Flow Method. Synthesis and Conclusion. PART V
Intellectual Property Transfer Price Analysis Issues
20. Transfer Pricing Considerations in Estimating Fair Market Value
535 537
KENNETH R. BUTTON and JERRIE V. MIRGA
Introduction: When Are Transfer Prices Likely to Be a Valuation Issue? The Regulatory Framework. Fair Market Value. Financial Reporting and FASB Statement No. 57. Federal and State Tax Reporting. OECD Guidelines. How Do Non-Arm’s-Length Transactions Distort an Entity’s Financial Statements? The Identification of the Subject Company Related-Party Transfer Prices. Methods of Determining Arm’s-Length Transaction Prices. The Comparable Uncontrolled Price Method. The Comparable Uncontrolled Transaction Method. Resale Price Method. Cost Plus Method. The Comparable Profits Method. Profit Split Methods. Use of “Comparable” Companies in Determining the Arm’s-Length Price. Adjusting the Financial Statements to Reflect Arm’s-Length Prices. Sales of Product A and the CUP Method. Sales of Product B and the RPM. Sales of Product C and the
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CPM. Administrative Overhead Charge and Cost Plus Method. Intercompany Loan. Use of Parent Manufacturing Technology with the CUT Method and the CPM. Overall Impact on Financial Statements. Conclusion. 21. Intangible Asset Intercompany Transfer Pricing Analyses
563
THOMAS J. MILLON JR.
Introduction. The Nature of Intercompany Transfer Pricing. Income Tax Consequences. Key Features of Section 482 Regulations. Reporting “Taxable Income.” The Arm’s-Length Standard. The Best Method Rule. The Arm’sLength Range. Determining Comparable Circumstances. Summary of the Section 482 Regulations. Two Major Types of Intercompany Transfers. Intangible Asset Transfer Pricing Methods. Comparable Uncontrolled Transaction Method. The Comparable Profits Method. Other Methods. Transfer Pricing for Domestic Taxation Purposes. Transfer Pricing–Related Valuation Misstatement Penalties. Valuation Misstatement. Transfer Pricing Penalty Safe Harbor Provisions. The Role of Transfer Pricing Analysts. Exposure Analysis and Defense. Planning and Compliance. 22. Transfer Pricing Case Study
583
THOMAS J. MILLON JR.
Introduction. Membership. Leadership Division. Publications. Events. Endorsed Vendors. IGTMA Services. Endorsed Vendor Royalty Income. Purpose and Objective of the Analysis. Premise of the Analysis. Financial Statement Analysis. Consolidated Balance Sheets. Consolidated Income Statements. Adjusted Financial Fundamentals. Analytical Procedures. Description of the Intellectual Property Subject to Analysis. Definition of Trademarks. Attributes to Consider in the Economic Assessment of Trademarks. Trademark Analysis. Company-Specific Analyses. IndustrySpecific and Guideline Company–Specific Royalty Rate Analysis. MarketDerived Royalty Rate Analysis. Economic Analysis Synthesis and Conclusion. PART VI
Intellectual Property Economic Damages Issues
23. Research Techniques for an Intellectual Property Economic Analysis
611 613
VICTORIA A. PLATT
Introduction. Data Categories. Owner/Operator Financial Statements. Comparative Companies, Transactions, and Empirical Market Data. Industry Statistics and Economic Indicators. Securities Analyst Research Reports. Remaining Useful Life Data. Prospectuses and Other SEC Documents. Trade Association Publications and Materials. Guideline/Subject Company Public Relations Information. Information Requirements by Purpose. 24. Intellectual Property Economic Damages Case Study
627
TERRY G. WHITEHEAD and DENNIS M. MANDELL
Introduction. Background. The Case Problem. Purpose and Objective of the Analysis. Description of the Subject Intellectual Property. Data and Data Sources. Alternative Analytical Methods Considered. Analyses and Conclusions. Comparison of Operating Results “with” and “without” Infringement. Historical Lost Profits Method. Discounted Cash Flow Method. Reasonable Royalty Method. Synthesis and Conclusion. Analysis Work Product. Bibliography
649
Index
653
List of Exhibits 1.1 1.2 1.3 1.4
1.5 1.6 1.7 1.8 2.1 2.2 2.3 3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8
Historical Realized Return Premiums (Stock Market Returns vs. Treasury Bond Returns) Disaggregated Ibbotson Associates Return Premium Data Summary of Forward-Looking Implied ERP Estimates Long-Term Returns in Excess of CAPM for Decile Portfolios of the NYSE/AMEX/ Nasdaq (1926–2002) with Annual Beta Premium over CAPM for Size-Ranked Portfolios (Historical Data 1926–2002) Actual Observed Rates of Return for the 25 Portfolios Compared to Those Predicted by CAPM Alternative Stock Index Data: 1982–2002, Return Premiums over Treasury Bonds Small Stock Premium 1982–2002 Relationship of Stock Market and M&A Market Levels of Value The Partnership Spectrum (2001 Discount from Net Asset Value Studies) Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for Debt Interest Rate Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for Investment Rate of Return Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for Corporate Income Tax Rate Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for Individual Income Tax Rates Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for Inside Tax Basis Analysis of Comparative Returns, Value of C Corporations with Built-In Gains, Base Case Scenario Adjusted for “Normal” Spread Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Put Analysis—Base Case Scenario
3.9
3.10
3.11
3.12
3.13
3.14
3.15
4.1 4.2 4.3 4.4 4.5 4.6 5.1
5.2 5.3
5.4
5.5
5.6
Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Put Analysis—Stress Testing Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Calculation of Maximum Price of Put—Direct Investor Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Subchapter S Election Adjusted for Rates Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Subchapter S Election Adjusted for Investment Return Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Subchapter S Election Adjusted for Corporate Tax Rate Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Subchapter S Election Adjusted for Individual Tax Rate Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Subchapter S Election Adjusted for Inside Basis Net Economic Benefit to Shareholders S Corporation Economic Adjustment S Corporation Equity Adjustment Multiples Application of the SEAM: Market Approach Application of the SEAM: Income Approach Application of the SEAM: Asset-Based Approach Value of a Debt-Free S Corporation with No Expected Growth: The Traditional Method (as if C Corporation) Value of a Debt-Free S Corporation with No Expected Growth: The Gross Method Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with No Expected Growth: The Modified Gross Method Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with No Expected Growth: The C Corporation Equivalent Method Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with No Expected Growth: The Pretax Discount Rate Method Value of a Debt-Free S Corporation (Noncontrolling Ownership Interest Basis) with No Expected Growth: The Modified Gross Method
xiii
xiv
List of Exhibits
5.7
Value of a Debt-Free S Corporation (Noncontrolling Ownership Interest Basis) with No Expected Growth: The C Corporation Equivalent Method
5.8
Value of a Debt-Free S Corporation (Noncontrolling Ownership Interest Basis) with No Expected Growth: The Pretax Discount Rate Method
5.9
Value of a Debt-Free S Corporation with 5 Percent Expected Growth Rate: The Traditional Method (as if a C Corporation)
5.10
Value of a Debt-Free S Corporation with 5 Percent Expected Growth Rate: The Gross Method
5.11
Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with 5 Percent Expected Growth Rate: The Modified Gross Method
5.12
Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with 5 Percent Expected Growth Rate: The C Corporation Equivalent Method
5.13
Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with 5 Percent Expected Growth Rate: The Pretax Discount Rate Method
5.14
Value of a Debt-Free S Corporation (Noncontrolling Ownership Interest Basis) with 5 Percent Expected Growth Rate: The Modified Gross Method
5.15
Value of a Debt-Free S Corporation (Noncontrolling Ownership Interest Basis) with 5 Percent Expected Growth Rate: The C Corporation Equivalent Method
5.16
Value of a Debt-Free S Corporation (Noncontrolling Ownership Basis) with 5 Percent Growth Rate: The Pretax Discount Rate Method
6.1
Tax on the Sale of Appreciated Property and Liquidation, Assumes a $100,000 Taxable Gain
6.2
Sample S Corporation—No ESOP Ownership ($ in 000s)
6.3
Sample S Corporation—100 Percent ESOP Owned ($ in 000s)
6.4
Sample S Corporation—30 Percent ESOP Owned
7.1
Closed-End Funds—Domestic Equity Portfolios as of June 28, 2002, Ranked by Percentage Premium/(Discount)
7.2
Closed-End Funds—Corporate Bond Portfolios as of June 28, 2002, Ranked by Percentage Premium/(Discount)
7.3
Equity Real Estate Partnerships—Distributing as of May/June 2002, Ranked by Discount From NAV 7.4 Equity Real Estate Partnerships—Undeveloped Land Partnerships as of May/June 2002, Ranked by Percentage Discount 7.5 Summary of Partnership Resale Discounts 7.6 SEC Institutional Investor Study 7.7 The Silber Study Sample Characteristics 7.8 Columbia Financial Advisors, Inc., Restricted Stock Study 7.9 Summary of Restricted Stock Studies 7.10 Willamette Management Associates Studies, Summary of Discounts for Private Transaction P/E Multiples 7.11 FLP Document Checklist 8.1 Cable Acquisitions, October 1998–March 1999 8.2 Multiples of Comparable Companies, Supermarket Chain Example 8.3 Range of Calculated AMVs and Equity Values for Hypothetical Company 8.4 Range of Calculated AMVs and Equity Values Using Gordon Growth Model for Hypothetical Company 8.5 Three Percent Growth, 10-Year Straight-Line Depreciation 8.6 Excess of Capital Expenditures over Depreciation 8.7 Depreciation as Percent of Capital Expenditures 9.1 Cross-Border Transactions 10.1 State of the Major Sports Leagues ($ in 000s, Except Ticket Prices) 10.2 Major League Sports Largest Naming Rights Contracts ($ in millions) 10.3 Recent NFL Team Sale Transactions ($ in millions) 10.4 Recent MLB Team Sale Transactions ($ in millions) 10.5 Recent NBA Team Sale Transactions ($ in millions) 10.6 Recent NHL Team Sale Transactions ($ in millions) 10.7 Typical Major League Sports Franchise Purchase Price Allocation 10.8 Annual Attendance Change in New MLB Stadiums Since 1990 10.9 Sports Venue Development, Public versus Private Funding Sources 10.10 MLB Ballpark Development Costs, Source of Funding
List of Exhibits
10.11 Typical Range of Sources of Private Funding 11.1 Multispecialty Discounted Cash Flow Analysis, Medical Clinic, Inc. 11.2 Estimated Required Return on Equity 11.3 Weighted Average Cost of Capital 11.4 Multispecialty Guideline Merged and Acquired Company Analysis, Medical Clinic, Inc. 12.1 Organizational Theory and Industrial Organization 12.2 The Six Dimensions of the Macroenvironment 12.3 Porter’s Five-Forces Framework 12.4 Examples of Financial Capital 12.5 Examples of Physical Capital 12.6 Examples of Human Capital 12.7 Examples of Organizational Capital 12.8 The Value Chain 12.9 The Star Framework 13.1 Differences between Economic Damages Analysis and Business Valuation Analysis 13.2 Excerpts from Case Law 13.3 Before-Tax vs. After-Tax Economic Damages Analysis 13.4 General Case of Before-Tax vs. After-Tax Economic Damages Analysis 13.5 13.6 13.7
Lost Project Economic Damages Example Present Value of Future Lost Profits Alternative Definitions of Cash Flow and Cost of Capital 13.8 Past and Future Economic Damages, Ex Ante and Ex Post Damages 13.9 Differences between Ex Ante and Ex Post Analyses 13.10 Risk Parity, Expected Cash Flow, Expected Rate of Return, and Time, Ex Post Economic Damages 14.1 Creative Patent Company Income Statement ($000s) Alternative Income Scenarios for Very Important Patent #501 14.2 Description of a Simple Linear Relationship— Supply Curve for ABC Software 14.3 Scatter Diagram 14.4 Alternative Values of Y for a Given Value of X When the Relationship Is Y + 10 + 2X + u and u Is a Random Variable 14.5 Curvilinear Graphs 14.6 Number of Units Sold and Product Price for 35 Sales of Program F 14.7 Scatter Diagram, Number of Sales and Product Price for Soft ’n Bake Software
xv
14.8 14.9 14.10 14.11 14.12
15.1 15.2 15.3 15.4 15.5 15.6
15.7
15.8
15.9
15.10
15.11 15.12
15.13
15.14 15.15
15.16
Multiple Regression Analysis, Primo Pet Care Company, Patent Royalty Rate Example Product Life Cycle Income Projections Monte Carlo Analysis, Income Projection for a Software Valuation Valuation Financial Model Based on “Best Case’’ Scenario Valuation Variables from a Monte Carlo Analysis Discounted Cash Flow Analysis, Trademark Valuation Example Direct Capitalization Method, Trademark Valuation Example Discounted Cash Flow Analysis, Increase in Discount Rate, Trademark Valuation Example Discounted Cash Flow Analysis, Decrease in Discount Rate, Trademark Valuation Example Direct Capitalization Method, Increase in the Capitalization Rate, Trademark Valuation Example Direct Capitalization Method, Decrease in the Capitalization Rate, Trademark Valuation Example Discounted Cash Flow Analysis, Increase in Expected Long-Term Growth Rate, Trademark Valuation Example Discounted Cash Flow Analysis, Decrease in Expected Long-Term Growth Rate, Trademark Valuation Example Direct Capitalization Method, Increase in Expected Long-Term Growth Rate, Trademark Valuation Example Direct Capitalization Method, Decrease in Expected Long-Term Growth Rate, Trademark Valuation Example Discounted Cash Flow Analysis, Varying the Discount Rate, Trade Secret Valuation Example Discounted Cash Flow Analysis, Valuation of Wonder Club Patent, Economic Damages Analysis Example Discounted Cash Flow Analysis, Valuation of Proprietary Computer Software, Transfer Pricing Analysis Example Beta Measurement Characteristics of Common Financial Reporting Services Fair Market Value of Trademark, Present Value Discount Rate Estimation, Extraction of Discount Rate from Guideline Sale/License Transactions Differences between Intellectual Property and Publicly Traded Company Stock, Comparison of Discount Rate/Capitalization Rate
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16.1 16.2
Illustrative Survivor Curve and Probable Life Curve Turnover/Retirement Rate and RUL, Based on Retirement Rate 16.3 Survivor Decay Rate, Based on Constant Retirement Rate 16.4 Weibull Analysis 16.5 Owner Company Patent Infringement Example, Illustrative Survivor Curve Construction 16.6 Owner Company Patent Infringement Example, Illustrative Survivor Curve and Best-Fitting IowaType Curve 16.7 Goodfood Corporation Trade Secrets Valuation Weighted Average Remaining Useful Life Calculation 16.8 Goodfood Corporation Trade Secrets Valuation Calculation of Composite Decay 16.9 Electronics Company Trademark License 3-DVD Market Share Figures 16.10 Electronics Company Trademark License 3-DVD Market Share Graph 17.1 Expected Income During Discrete Projection Period 17.2 Residuum Income Flow, Negative Constant Rate of Change 17.3 Zero vs. Negative Growth Rate 17.4 Residuum Income Flow, Positive Constant Rate of Change 17.5 Zero vs. Positive Growth Rate 17.6 Illustrative Intellectual Property Maintenance Expenditures 17.7 Economic Income Projection, Measured by Expected License Royalty Income 17.8 Residual Value Maintenance Expenditures, Net Present Value Analysis 17.9 Residual Value Maintenance Expenditures, Net Present Value Analysis, Incremental Economic Income Basis, Incremental Operating Expense Scenario 17.10 Residual Value Maintenance Expenditures, Net Present Value Analysis, Incremental Economic Income Basis, Incremental Capital Expenditure Scenario 18.1 Illustrative Example of Overtaxation of Centrally Assessed Taxpayers 18.2 On Track Railways, Cost per Person-Month, as of January 1, 2003 18.3 On Track Railways, COCOMO Variables by System Group, as of January 1, 2003 18.4 On Track Railways Valuation Analysis, COCOMO Mainframe Software, as of January 1, 2003
List of Exhibits
18.5 18.6 18.7
18.8
18.9
18.10 18.11 19.1 19.2 19.3 19.4 19.5 19.6 19.7 19.8 19.9 19.10 19.11 19.12 19.13 19.14 19.15
19.16 19.17
19.18
On Track Railways Valuation Analysis, COCOMO 4GL Software, as of January 1, 2003 On Track Railways Valuation Analysis, COCOMO Client/Server Software, as of January 1, 2003 On Track Railways Valuation Analysis, KnowledgePLAN Mainframe Software, as of January 1, 2003 On Track Railways Valuation Analysis, KnowledgePLAN 4GL Software, as of January 1, 2003 On Track Railways Valuation Analysis, KnowledgePLAN Client/Server Software, as of January 1, 2003 On Track Railways Internally Developed Software, Fair Market Value Synthesis, as of January 1, 2003 Sample Table of Contents for a Software-Related Intellectual Property Valuation Report North American Market Share Jackpot, Inc., Comparable Uncontrolled Transaction Method Jackpot, Inc., Historical Balance Sheets Jackpot, Inc., Historical Common-Size Balance Sheets Jackpot, Inc., Historical Income Statements Jackpot, Inc., Historical Common-Size Income Statements Jackpot, Inc., Historical Ratio Analysis Jackpot, Inc., Comparable Profits Method Jackpot, Inc., Base Case Analysis, Projected Income Statements Jackpot, Inc., Base Case Analysis, Common-Size Income Statements Jackpot, Inc., Alternative Case Analysis, Projected Income Statements Jackpot, Inc., Alternative Case Analysis, Common-Size Income Statements Jackpot, Inc., Profit Split Method Jackpot, Inc., Base Case Analysis, Discounted Cash Flow Method, Value Summary Jackpot, Inc., Base Case Analysis, Discounted Cash Flow Method, Weighted Average Cost of Capital Jackpot, Inc., Alternative Case Analysis, Discounted Cash Flow Analysis, Value Summary Jackpot, Inc., Alternative Case Analysis, Discounted Cash Flow Method, Weighted Average Cost of Capital Jackpot, Inc., Impact on Equity Value of Various Alternative Royalty Rates
List of Exhibits
20.1 20.2
Transactions among Related and Unrelated Parties Acquisition Cost of Products A and B for Domestic Sales Subsidiary 20.3 Acquisition Cost of Product C for Foreign Subsidiary 20.4 Administrative Services Charge Paid by Domestic Sales Subsidiary 20.5 Loan from Parent to Domestic Sales Subsidiary 20.6 Royalty Payment by Foreign Subsidiary for Use of Parent’s Manufacturing Technology 20.7 Sales Subsidiary before Adjusting Transfer Prices to Arm’s Length ($ Values, Unless Otherwise Indicated) 20.8 Sales Subsidiary after Adjusting Transfer Prices to Arm’s Length ($ Values, Unless Otherwise Indicated) 20.9 Foreign Subsidiary before Adjusting Transfer Prices to Arm’s Length ($ Values, Unless Otherwise Indicated) 20.10 Foreign Subsidiary after Adjusting Transfer Prices to Arm’s Length ($ Values, Unless Otherwise Indicated) 22.1A Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Consolidated Historical Balance Sheets—Assets (in $) 22.1B Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Consolidated Historical Balance Sheets—Liabilities & Stockholders’ Equity (in $) 22.2 Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Consolidated Historical Income Statements (in $) 22.3 Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Adjusted Financial Fundamentals (in $) 22.4 Attributes That Affect the Economic Analysis of Trademarks and Trade Names 22.5 Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Profit Split Method 22.6 Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Weighted Average Cost of Capital 22.7 Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Excess Earnings Method—Asset Basis (in $) 22.8A Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Guideline Company Analysis, Market Value of Invested Capital
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22.8B Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Guideline Company Analysis, Earnings before Interest and Taxes 22.8C Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Guideline Company Analysis, Earnings before Interest, Taxes, Depreciation, and Amortization 22.8D Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Guideline Company Analysis, Revenues 22.8E Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Guideline Company Analysis, Revenue Performance Ratios 22.8F Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Guideline Company Analysis, Definitions, Footnotes, and Sources to Exhibits 22.9 Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Excess Earnings Method—Industry-Specific and Guideline Company–Specific (in $) 22.10 Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Third-Party License Agreements 22.11 Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Summary 24.1 Dead Dried Meats, Inc., Product Sales Volume and Pricing 24.2 Dead Dried Meats, Inc., Projected Income Statements 24.3 Dead Dried Meats, Inc., Historical Lost Profits Method Summary 24.4 Dead Dried Meats, Inc., Business Enterprise Value Method, “without” Infringement Scenario Summary 24.5 Dead Dried Meats, Inc., Business Enterprise Value Method, “with” Continued Infringement Scenario Summary 24.6 Dead Dried Meats, Inc., Reasonable Royalty Rate Analysis Summary 24.7 Dead Dried Meats, Inc., Reasonable Royalty Rate Analysis, Royalty Rate Transaction Data 24.8 Dead Dried Meats, Inc., Economic Damages Summary
About the Editors Robert F. Reilly Robert Reilly is a managing director of Willamette Management Associates and Willamette Capital. He performs valuation consulting, economic analysis, and financial advisory services including event analyses, merger and acquisition valuations, divestiture and spin-off valuations, solvency analyses, fairness opinions, ESOP feasibility and formation analyses, purchase price allocations, business and stock valuations, restructuring and workout analyses, litigation support analyses, tangible/ intangible asset transfer pricing studies, and lost profit/economic damages analyses. Robert has valued the following types of business entities and securities: close corporations, public corporation restricted stock, public corporation subsidiaries/ divisions, portfolios of nonmarketable securities, complex capital structures (various classes of common/preferred stock; options, warrants, grants, rights), general and limited partnership interests, joint ventures proprietorships, professional service corporations, professional practices, LLPs, and LLCs. He has performed economic damages, valuation, remaining useful life, and transfer price analyses of numerous intangible assets and intellectual properties. He has prepared financial advisory/economic analyses for merger and acquisition purposes including identification of merger and acquisition targets, valuation of synergistic/strategic benefits, identification and assessment of divestiture and spin-off opportunities, analysis of alterative deal structures, transaction negotiation and consummation, fairness of proposed transactions, initial public offering (IPO) alternative pricing strategies, and design/valuation of alternative equity and debt instruments in a multi-investor environment. Prior to Willamette, Robert was a partner and national director of the Deloitte & Touche valuation practice. Prior to Deloitte & Touche, he was vice president of Arthur D. Little Valuation, Inc., a national appraisal firm. Prior to that, he was associated with Huffy Corporation, a diversified manufacturing firm in various financial management positions. Prior to that, he was a senior consultant for Booz, Allen & Hamilton, an international management consulting firm. Robert holds a master of business administration degree in finance from Columbia University Graduate School of Business and a bachelor of arts degree in economics from Columbia University. Robert is a certified public accountant/accredited in business valuation, a certified management accountant, and an enrolled agent before the Internal Revenue Service. He is an accredited tax advisor, a chartered financial analyst, a certified business appraiser, and an accredited senior appraiser (certified in business valuation). He is also a certified real estate appraiser, a certified review appraiser, and a state certified general appraiser in numerous states from New York to California. He is a state certified affiliate member of the Appraisal Institute.
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Robert is the coauthor with Robert Schweihs of four other books and the coauthor with Robert Schweihs and Shannon Pratt of two other books. He has contributed chapters to over a dozen anthology textbooks, and he has had over 300 articles published in technical journals. Robert currently serves on the editorial boards of several journals, including the American Bankruptcy Institute Journal, the Journal of Property Taxation, and Valuation Strategies.
Robert P. Schweihs Bob Schweihs is a managing director of Willamette Management Associates and Willamette Capital. Bob provides valuation consulting and economic analysis services relating to business valuation, intangible asset/intellectual property analysis, security analysis, forensic accounting and special investigations, and lost profits/economic damages analysis. Bob has testified as an expert witness on numerous occasions in various federal and state courts. He regularly provides industrial, commercial, institutional, and governmental clients with transactional fairness opinions, solvency/ insolvency opinions, economic analyses, financial advisory services, and litigation support services. He is an accredited senior appraiser (designated in business valuation) and a certified business appraiser. He is a member of numerous professional organizations, including The ESOP Association, the Institute for Professionals in Taxation, the Association for Corporate Growth, the American Society of Appraisers, and the Institute of Business Appraisers. He recently served for two consecutive 3-year terms as a trustee of The Appraisal Foundation. He is the coauthor of Valuing a Business: The Analysis and Appraisal of Closely held Companies, 4th edition (McGraw-Hill, 2000), Valuing Small Businesses and Professional Practices, 3rd edition (McGraw-Hill, 1998), Valuing Intangible Assets (McGraw-Hill, 1999), The Handbook of Advanced Business Valuation (McGrawHill, 2000), and Valuing Accounting Practices (John Wiley & Sons, 1997). He has also written numerous articles on valuation and economic analysis topics that have been published in various professional and technical journals. Bob is often called upon to speak at seminars and conferences of professional and industry associations. He has taught courses in business valuation and intangible asset valuation both in the United States and abroad. Prior to joining Willamette, Bob was a partner and national director of Deloitte & Touche valuation group. Before that, he was a manager of Arthur D. Little Valuation, Inc., a national appraisal firm. He holds a master of business administration degree in economics and finance from the University of Chicago Graduate School of Business and a bachelor of science degree in mechanical engineering from the University of Notre Dame. Willamette Management Associates and Willamette Capital. Willamette Management Associates is a premier valuation consulting, economic analysis, and financial advisory firm. Firm services include business valuation and security analysis, intangible asset valuation and remaining life analysis, intellectual property valuation and royalty rate analysis, intercompany transfer price analysis, forensic accounting, strategic investment analysis, merger and acquisition transaction fairness/solvency analysis, economic damages/lost profits analysis, economic event studies, and financial advisory and due diligence services.
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Willamette Management Associates provides these client services for purposes of transaction pricing and structuring, taxation planning and compliance, financing securitization and collateralization, litigation support and dispute resolution, bankruptcy and reorganization analysis, and management information and planning. The firm’s board advisory services and corporate governance services include fairness opinions, solvency opinions, and special forensic investigations related to fraud and other allegations. Willamette Capital is a private company investment banking firm affiliate of Willamette Management Associates. Willamette Capital specializes in middle-market business brokerage, capital formation (through the private placement of debt and equity securities), debt restructuring and capital structure reorganization, and leveraged employee/management buyouts, both with and without an ESOP structure. The firm’s clients include publicly owned and closely held businesses, industrial and commercial corporations, professional service firms, financial institutions and financial intermediaries, governmental and regulatory agencies, fiduciaries and financial advisors, the accounting profession, and the legal profession. The firm’s clients include the largest multinational corporations and professional service firms— as well as substantial family-owned businesses and professional practices.
About the Contributors David Ackerman is a shareholder in the Chicago office of Jenkens & Gilchrist, a national law firm. Mr. Ackerman cochairs the Jenkens & Gilchrist ESOP Team, which is one of the largest ESOP practice groups in the country. He is one of the most experienced ESOP attorneys in the country, and he is the immediate-past chair of the Legislative & Regulatory Advisory Committee of The ESOP Association. Mr. Ackerman is general counsel to numerous ESOP companies and also regularly represents ESOP trustees and ESOP lenders. He has written and lectured extensively on the subject of ESOPs. Mr. Ackerman is a graduate of Princeton University and of Harvard Law School. Kenneth R. Button is senior vice president of Economic Consulting Services, LLC, in Washington, DC. He specializes in international corporate valuation assignments. He has testified as an expert witness before the U.S. Tax Court, the Inter-American Commercial Arbitration Commission, and the Indiana State Board of Tax Review. He also practices extensively on international trade matters before the U.S. International Trade Commission. He received his MBA in finance from George Washington University and his Ph.D. in international economic development studies from the Fletcher School at Tufts University. Robert V. Canton serves as director of PricewaterhouseCoopers’ Sports, Convention, and Tourism practice. He has consulted on hundreds of economic and strategic studies related to professional and amateur sports teams and their venues, as well as other areas of the entertainment industry. Mr. Canton has served as a guest lecturer at the University of Tampa and is a frequent speaker at industry events. He serves on the advisory board of the Management of Sports Industries program at the University of New Haven and is on the editorial board of the Journal of Leisure Property. Jacquelyn Dal Santo is a principal of Willamette Management Associates. She specializes in the appraisal of business entities and business interests, in the appraisal of fractional business interests, and in the valuation, transfer price, and remaining life analysis of intangible assets. Ms. Dal Santo holds a master of business administration degree in finance from Loyola University and a bachelor of arts degree in management from Purdue University. She is an accredited senior appraiser of the American Society of Appraisers, certified in business valuation. Sheri-Anne Doyle, graduate of McGill University, is a senior manager at Wise, Blackman, Business Valuators, Montreal, where she has been involved in business valuation and the quantification of economic damages since joining the firm in 1998, prior to which she was a senior auditor at KPMG, Chartered Accountants. Ms. Doyle has valued a wide array of Canadian and U.S. businesses and has been involved extensively in international transfer pricing. She holds the chartered accountant and chartered business valuator designations. At McGill, she was recipient of the James McGill Scholarship and the Schwartz Levitsky Feldman Scholarship.
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Michael Dunbar is a vice president in the Silicon Valley office of Charles River Associates. He has extensive experience in the calculation of damages for infringement of intellectual property rights, including valuing trade secrets, trademarks, copyrights, and patents. He has also assessed damages for a wide variety of other commercial disputes. Mr. Dunbar has published in the areas of valuation of emerging technology and calculation of damages. He holds bachelor’s and master’s degrees in mechanical engineering and an MBA from the Wharton School at the University of Pennsylvania with a concentration in finance. William H. Frazier, a principal in the firm of Howard Frazier Barker Elliott, Inc., has 28 years of experience in business valuation and corporate finance. His articles on the subject of business valuation have been published by the Philip E. Heckerling Institute of Estate Planning (1999), The Journal of Business Valuation (1999), Valuation (1997), Shannon Pratt’s Business Valuation Update (1997), Estate Planning (1996), and Business Valuation Review (1989). He also wrote and produced “The Deal,” a multidisciplined valuation program presented at Valuation 2000 and the 2001 Advanced Business Valuation Conference. An accredited senior appraiser since 1987, Mr. Frazier is a member of the Business Valuation Committee of the American Society of Appraisers. Pamela J. Garland is a senior manager with Willamette Management Associates. She specializes in the identification, valuation, and remaining useful life analysis of intangible assets. Ms. Garland holds a master of business administration degree in accounting and information systems from the J.L. Kellogg Graduate School of Management at Northwestern University, and a bachelor of arts degree in mathematics from DePauw University. She is a member of the Institute of Electrical and Electronics Engineers and the International Society of Parametric Analysts. Susan E. Gould is a senior manager of Willamette Management Associates. Ms. Gould specializes in the valuation of business entities and equity security interests. In particular, she has extensive experience in structuring transactions and designing special equity securities for ESOPs. She holds a master of business administration degree in finance and economics from J.L. Kellogg Graduate School of Management, Northwestern University, and a bachelor of arts degree in political science from Northwestern University. Ms. Gould is a chartered financial analyst of the Association for Investment Management and Research and a candidate member of the American Society of Appraisers in business valuation. She is a member of The ESOP Association and the Finance Committee of The ESOP Association. Roger J. Grabowski is a managing director in Standard & Poor’s Corporate Value Consulting practice. He is formerly a partner of PricewaterhouseCoopers LLP and one of its predecessor firms, Price Waterhouse (where he founded its U.S. Valuation Services practice and managed the real estate appraisal practice). He has directed valuations of businesses, intellectual property, real property, and other assets. Mr. Grabowski has testified as an expert witness on numerous valuation issues. His testimony in U.S. District Court was quoted in the U.S. Supreme Court opinion in the landmark Newark Morning Ledger case. He coauthors the annual S&P Corporate Value Consulting Risk Premium Report, published at www.ibbotson.com. He is an accredited senior appraiser and teaches Cost of Capital for the American Society of Appraiser’s Center for Advanced Valuation Studies, a course he codeveloped.
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Alex W. Howard is a founding principal in Howard Frazier Barker Elliott, Inc. (HFBE ). Prior to founding HFBE, Mr. Howard was employed in the corporate finance departments of major regional investment banking firms in Houston. He has over 30 years of experience in financial valuations. Mr. Howard holds B.S. and MBA degrees from New York University. He is a chartered financial analyst of the Association for Investment Management and Research and is a member of the Houston Society of Financial Analysts. He is an accredited senior appraiser of the America Society of Appraisers. Mr. Howard has been a speaker at a variety of seminars on business valuation issues and mergers and acquisitions. He has also published articles on these subjects. Jack Huber is a senior associate at Casas, Benjamin & White, LLC. Prior to joining the firm, he was a manager at Standard & Poor’s Corporate Value Consulting. Mr. Huber has managed valuation studies of businesses, interests in businesses, and intangible assets. He has valued businesses and assets in various industries including professional sports, entertainment and media, publishing, mining, consumer products, leasing, railroads, information and communications, and financial services. Mr. Huber graduated from Miami University where he majored in finance and accountancy. He holds an MBA from the University of Notre Dame with a concentration in finance and is a CPA. Mr. Huber’s sports clients have included the Atlanta Falcons, the Boston Celtics, the Jacksonville Jaguars, and the Vancouver and the Memphis Grizzlies, among others. David W. King is a director in the Standard & Poor’s Corporate Value Consulting practice in their Chicago office. He formerly worked in the valuation consulting practice at PricewaterhouseCoopers LLP and one of its predecessors, Price Waterhouse LLP. He has conducted extensive research into the theory and practical application of discount rates for domestic and international companies. Mr. King is a chartered financial analyst. He coauthors the annual Standard & Poor’s Corporate Value Consulting Risk Premium Report, published at www.ibbotson.com. M. Mark Lee is senior managing director in charge of the New York office of Sutter Securities Incorporated and has more than 30 years of experience in business valuations, intangible asset valuations, corporate finance, and fairness opinions. For many years he was principal in charge of the Valuation Services Practice of KPMG LLP’s Northeastern Region and vice-chairman of Bear, Stearns & Co. Inc.’s Valuation Committee. Mr. Lee has lectured and published extensively and testified in court. He also teaches business valuation at New York University’s School of Continuing and Professional Studies. Mr. Lee is a chartered financial analyst and received his BSE in economics from the Wharton School of Finance and Commerce of the University of Pennsylvania and his MBA from New York University. Dennis M. Mandell is a principal of Willamette Management Associates and the director of the firm’s San Francisco office. His practice includes forensic accounting, litigation support, fraud investigations, business valuations, and corporate financial advisory services. Mr. Mandell holds a master of science degree in taxation from Golden Gate University—Los Angeles and a bachelor of arts degree in accounting from California State University—Fullerton. Gilbert E. Matthews is chairman of the board and senior managing director of Sutter Securities Incorporated in San Francisco. From 1960 through 1995, he was with Bear, Stearns & Co. Inc. in New York where he had been senior managing director and a general partner of its predecessor partnership. From 1970 through 1995,
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he was chairman of Bear Stearns’Valuation Committee, which was responsible for all opinions and valuations issued by the firm. Mr. Matthews received an A.B. from Harvard in 1951 and an MBA from Columbia in 1953. He is a member of the New York Society of Security Analysts and is a chartered financial analyst. William P. McFadden is a director in the Chicago office of Standard & Poor’s Corporate Value Consulting practice. He was formerly a director of PricewaterhouseCoopers LLP. Mr. McFadden has managed a wide range of valuation engagements including business equity, intangible assets, real estate, and machinery and equipment related matters. He has testified as an expert witness in the state and federal court systems. His experience covers a broad spectrum of industries. His previous professional experience includes commercial lending and the administration of closely held business interests held in estates and trusts. Mr. McFadden has an MBA degree and is a graduate industrial engineer. Timothy J. Meinhart is a senior manager of Willamette Management Associates. He specializes in the financial valuation of business enterprises, fractional business interests, and equity and debt securities. Mr. Meinhart holds a master of business administration from Kellstadt Graduate School of Business, DePaul University, and a bachelor of science degree in finance from Northern Illinois University. He is an accredited senior appraiser of the American Society of Appraisers, certified in business valuation. Warren D. Miller, with his wife, Dorothy Beckert, founded Beckmill Research in 1991. Their home base is Lexington, Virginia. The firm restricts its work to three domains: strategic management, market research (B2B only), and valuation-related activities. Mr. Miller’s research has appeared in Harvard Business Review, Academy of Management Executive, American Fly Fisher, CPA Expert, CPA Consultant, and, most recently, Business Valuation Review. He is a former CFO and ex-strategy academic. He is also a Level II candidate for the chartered financial analyst designation. He is a certified management accountant and a CPA/ABV. Mr. Miller has conducted in-house training for law, valuation, and CPA firms in 29 states and Puerto Rico. He is a frequent presenter at state and national valuation conferences. Thomas J. Millon Jr. is a principal of Willamette Management Associates and director of the firm’s Washington, DC, office. He has substantial experience in the appraisal of business entities and business interests, in the appraisal of fractional business interests, and in the valuation and remaining life analysis of intangible assets. Mr. Millon holds a master of business administration degree in finance from Loyola University, a master of science degree in economics from the University of Illinois, and a bachelor of arts degree in economics from Ripon College. He is an accredited senior appraiser of the American Society of Appraisers, certified in business valuation, and a chartered financial analyst of the Association for Investment Management and Research. Jerrie Varrone Mirga is a vice president of Economic Consulting Services, LLC, in Washington, DC. Her work focuses on the transfer pricing issues associated with intercompany transactions involving tangible property, intangibles, and services. Ms. Mirga received her undergraduate degree from the College of William & Mary, and her MBA (with a concentration in international business) from George Washington University. She also completed post-MBA courses, specializing in international taxation. Victoria A. Platt is director of research of Willamette Management Associates. For the last 6 years, Mrs. Platt has coordinated research services for six regional offices
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and managed the library collection in the national headquarters office. She is also the author of several articles and book chapters in various valuation-related publications. Mrs. Platt is the current editor of the Special Libraries Association Business & Finance Division Bulletin and has been a member of that association for 10 years. In addition to speaking at library conferences on Internet searching techniques, Mrs. Platt has spoken at local and national valuation conferences. Prior to Willamette Management Associates, Mrs. Platt worked for the Chicago law firm Kirkland & Ellis and the Main Library at Michigan State University. James G. Rabe is a principal of Willamette Management Associates and a director of the firm’s Portland, Oregon, office. His practice includes valuation consulting, economic analysis, and financial advisory services. Mr. Rabe holds a master of business administration degree in finance from Washington University, Graduate School of Business, and a bachelor of science degree in business administration and finance from the University of Missouri at Columbia. He is a chartered financial analyst of the Association for Investment Management and Research and an accredited senior appraiser of the American Society of Appraisers, certified in business valuation. Jacob P. Roosma is a principal of Willamette Management Associates and director of the firm’s New York office. He has extensive experience in all aspects of domestic and international financial valuation involving taxation, dispute resolution and expert witness testimony, allocation of purchase price, accounting and reporting, corporate finance, and mergers and acquisitions. Mr. Roosma holds a bachelor of science degree in business administration and finance from the College of Business Administration, University of Connecticut, and a bachelor of arts degree in economics from the University of Connecticut. Daniel R. Van Vleet is a principal of Willamette Management Associates and director of the firm’s Chicago office. Mr. Van Vleet holds a master of business administration degree from the Graduate School of Business of the University of Chicago. He is an accredited senior appraiser (ASA) of the American Society of Appraisers, certified in business valuation, and a certified business appraiser (CBA) of the Institute of Business Appraisers. Mr. Van Vleet currently serves on the International Business Valuation Committee of the American Society of Appraisers. He has served as president of the board of directors of the Chicago Chapter of the American Society of Appraisers and as an adjunct professor of finance at DePaul University in Chicago. Michael J. Wagner is a senior advisor in the Silicon Valley office of Charles River Associates. Mr. Wagner has testified more than 75 times in both federal court and state court trials. He is frequently called upon to provide expert testimony as to commercial damages and business valuation. During his 26-year career, Mr. Wagner’s consulting experience has covered most of the major industries in the United States. He has particular expertise in high technology and biotechnology. A principle focus has been to determine the economic value of intellectual property including patents, copyrights, trademarks, and trade secrets. Terry G. Whitehead is a founding member of American Financial Investments, LLC, whose primary business is purchasing seller financed real estate mortgage notes and trust deeds. He was formerly a senior manager with Willamette Management Associates where his practice included valuation consulting, economic analysis, and financial advisory services. Mr. Whitehead holds a bachelor of science
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degree in business administration from Warner Pacific College. He is a certified public accountant and is a member of the American Institute of Certified Public Accountants and the Oregon Society of Certified Public Accountants. Charles A. Wilhoite is a principal of Willamette Management Associates and a director of the firm’s Portland, Oregon, office. His practice includes valuation consulting, economic analysis, and financial advisory services. Mr. Wilhoite holds a bachelor of science degree in accounting and a bachelor of science degree in finance, both from Arizona State University. He is a certified public accountant and is accredited in business valuation by the American Institute of Certified Public Accountants. He is a certified management accountant and certified in financial management, designated by the Institute of Management Accountants. He is also an accredited senior appraiser of the American Society of Appraisers, certified in business valuation. Mr. Wilhoite serves on the board of directors of Oregon Health Sciences University, the Portland Business Alliance, and the Urban League of Portland. Richard M. Wise is partner of Wise, Blackman, Business Valuators, Montreal. A graduate of McGill University, he was president of the Canadian Institute of Chartered Business Valuators; fellow of the Institutes of Chartered Accountants of Quebec and Ontario; and former international governor of the American Society of Appraisers. He holds the accredited senior appraiser and master certified business appraiser designations and is a fellow of the Canadian Institute of Chartered Business Valuators. Author of Financial Litigation—Quantifying Business Damages and Values (Canadian Institute of Chartered Accountants) and coauthor of Guide to Canadian Business Valuations (Carswell), Mr. Wise is a frequent speaker at professional conferences across North America, and he has been valuation consultant to various Departments of the Canadian Government.
Preface Intent of This Book This book is intended to effectively serve as an updated companion to the Handbook of Advanced Business Valuation (McGraw-Hill, 2000). Most chapters in that book are still relevant and timely. However, a few chapters have been updated. And, it is important for several new chapters related to the topical issues in business and intangible asset valuation to be added. Instead of simply updating the Handbook of Advanced Business Valuation, this text expands the scope of our previous work by focusing on intellectual property economics. In particular, this expanded scope includes the topics of intellectual property valuation, economic damages analysis, and intercompany transfer price analysis. Accordingly, the title of this text reflects its dual focus on (1) business valuation and (2) intellectual property analysis. As business structures become more complicated, business valuations become more complicated. As transparency in corporate financial reporting becomes more desirable and less attainable, business valuations become more complicated. And, as securities market cycles become more exaggerated and less predictable, business valuations become more complicated. However, the complexities and controversies surrounding business valuation theory and practice pale in comparison to the sea of change related to the economy’s reliance on intellectual capital in this twentyfirst century information age. In the last 5 or so years, there has been a quantum level increase in the amount of licenses, joint ventures, financings, litigation, and business formations related to intellectual property. Personal and institutional fortunes were made—and lost— related to the formation, financing, and failure of Internet, dot-com, and other technology companies. The corporate strategies of most of these companies involved the development, exploitation, and commercialization of intellectual property. As with the intellectual properties themselves, intellectual property licenses, contracts, and agreements have become more complicated—and more common. Transfers of various intellectual property ownership rights often involve valuation and economic analysis issues. In particular, the intercompany transfer (especially cross-border) of intellectual properties involves both complex taxation issues and elegant economic analyses. More than any other effect, the proliferation of intellectual property development and commercialization has caused a proliferation in intellectual property litigation. This includes litigation claims related to infringement, breach of contract, fraud, lender liability, tortuous interference with business, expropriation, bankruptcy, and income/transfer/property taxation. And, litigation matters require the most rigorous valuation, lost profits, and economic damages analyses. Nonetheless, litigation matters attract the most imaginative and unsubstantial valuation, lost profits, and economic damages analyses. xxix
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Preface
Accordingly, the intent of this book is to both (1) update and expand the professional discussion on current business valuation conceptual theories and practical applications and (2) recognize the commercial importance of intellectual property with a professional discourse on the topical issues in intellectual property valuation, economic damages, and transfer price analyses.
Content of This Book This book may be divided conceptually into six sections. The first three sections relate to various advanced business valuation topics. The second three sections relate to intellectual property analysis issues. Of course, the reader is encouraged to read all of the chapters in this book. However, it is possible that some readers may focus on one section only. Some readers may even focus on a few individual chapters within a section. And, the detailed index in the back of the book will enable readers to zero in on a specific topic of interest. This book is written and edited to allow the reader to do just that. While there are many common themes and conclusions, each chapter is intended to stand independently. And, there are relatively few instances where latter chapters rely on material presented in earlier chapters. However, the more general chapters are presented earlier in each section, and the more specific chapters are presented later in each section. All topics and all chapters are presented at a fairly technical level, though. This is intended to be an advanced level book written for the use of an experienced practitioner audience. Readers of this book are expected to be familiar with the concepts and principles presented in intermediate college level finance, accounting, and economics texts. Also, readers of this book are expected to be familiar with the concepts and principles presented in more introductory level valuation texts, such as Valuing a Business, 4th edition (McGraw-Hill, 2000) and Valuing Intangible Assets (McGraw-Hill, 2000). Each chapter is written by one or more recognized experts in their respective disciplines, including law, finance, economics, and valuation. All are experienced practitioners. Many advanced concepts are researched and presented with academic thoroughness. But, the authors’ conclusions and insights are intended to be from practitioners to practitioners. Therefore, the objective of the editing process was not to conform the chapter conclusions to a predetermined consensus. In fact, just the opposite is true. The authors were encouraged to (and many did) express original analytical approaches, methods, and procedures. The objectives of the editing process were (1) to apply a uniform vocabulary throughout the book and (2) to present a uniform narrative style throughout the book. Accordingly, the authors’ experience and expertise shine through the stylistic editing. Throughout this book, all present value/future value calculations were made using the financial calculation feature of Microsoft Excel spreadsheet software. If the reader performs the same present value/future value calculations (1) using different software or (2) using a handheld financial calculator, the reader may obtain slightly different present value/future value factors. This slight difference is due to the various rounding conventions used in the different software packages and financial calculators. Such slight differences will not materially affect the results of the calculations. And, such slight differences will not affect the intellectual rigor of the analytical procedures presented in this book.
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Audience for the Book As mentioned above, this book is written by practitioners for practitioners. However, this book is intended to serve the needs of a wide variety of practitioners. First, this text is intended to expand the professional literature in the valuation community. This audience includes both business valuation analysts and intellectual property valuation analysts. And, this audience includes analysts involved in both transactional valuations and notational valuations. For this audience in particular, this book will refresh and expand (but not replace) The Handbook of Advanced Business Valuation. Second, this text is intended to supplement the professional literature in the intellectual property development and licensing communities. This audience includes creative and development personnel, licensors and licensees, licensing intermediaries, corporate executives responsible for commercializing intellectual property, and corporate executives and counsel responsible for protecting intellectual property. Third, this text is intended to serve the reference needs of the commercial litigation community, including litigants, lawyers, and judges. Intellectual property attorneys are a particular audience for this book. This includes attorneys responsible (1) for the safeguarding and corporate governance of owner/operator interests and (2) for the litigation of intellectual property claims. As intellectual property represents an increasing percentage of total corporate value, intellectual property litigation represents a correspondingly increasing percentage of total commercial litigation. Fourth, transaction intermediaries are an intended audience of this book. This audience includes corporate, securities, and intellectual property intermediates. Both business brokers and private company investment bankers should benefit from the first half of this text. Full-service investment bankers, venture capitalists, and security analysts should benefit from the entire book. And, intellectual property brokers/ intermediaries and joint venture/venture capital investors should benefit from the second half of this book. Fifth, taxation, financial planning, and estate planning professionals should find this book a useful discussion of current valuation/investment analysis issues. This audience includes corporate taxation representatives specializing in income, property, or international taxation. This audience includes tax administrators on the federal, state, and local levels. This audience includes tax advisors to closely held business owners. And, this audience includes financial planners and estate planners advising business owners, high net worth individuals, and intellectual property owners/developers. This book strives to serve all of these audiences by including both (1) an academic discourse on relevant valuation, economic damages, and transfer pricing concepts and theories and (2) a practical explanation of the related analytical approaches, methods, and procedures. Robert F. Reilly and Robert P. Schweihs Willamette Management Associates 8600 West Bryn Mawr Avenue, Suite 950 Chicago, Illinois 60631 (773) 399-4300 (773) 399-4310 (fax)
[email protected],
[email protected]
Acknowledgments First, we would like to thank each of the chapter authors. We were able to assemble a remarkable group of nationally recognized valuation analysts, lawyers, economists, and intellectual property practitioners to contribute to this book. All of the chapter authors are recognized for their experience and expertise in their respective areas of scholarship. And, all of the chapter authors enjoy individual prominence and eminence in their respective professional community. These authors did not expend their valuable time and considerable effort for personal financial gain. Rather, each author wanted to make a significant contribution to the professional literature related to valuation, economic damages, and transfer price analyses. The editors are extremely appreciative of each author’s significant contribution. As is often the case with leading authorities in any profession, the positions espoused by the chapter authors are not necessarily universally adopted by professional societies and organizations. In fact, sometimes, the chapter authors do not agree with one another (or with opinions expressed elsewhere by the editors). As with leading-edge anthologies in most professions, the chapter authors have presented advanced discussions of the current thinking in their respective disciplines. In particular, we would like to thank Charlene M. Blalock, a research associate in our Portland, Oregon, office. Charlene served as the project manager for this undertaking. Charlene coordinated all aspects of the writing, editing, and publication of this book. She was responsible for obtaining permission to use material reprinted in this book from other sources. Charlene also prepared the index and edited and proofread the entire manuscript. Jeffrey Tarbell, a principal of Willamette Management Associates, also edited and proofread the entire manuscript. Ashley Reilly, an intern of the firm, checked all of the mathematical expressions and calculations in the manuscript. Mary McCallister, our administrative assistant, typed and formatted much of the manuscript. We also wish to thank Kelli Christiansen, our editor at McGraw-Hill, for guidance and assistance during the preparation of this book. For permission to use material, we especially wish to thank: Association for Investment Management and Research Business Valuation Resources Crosbie & Company Ibbotson Associates
John Wiley & Sons Kagan World Media Partnership Profiles, Inc. Random House
Robert F. Reilly and Robert P. Schweihs Chicago, Illinois
xxxiii
Introduction As the title implies, this book focuses on the economics of both business valuation and intellectual property analysis. In particular, this book focuses on valuation, economic damages, and transfer price analysis with regard to business entities and intellectual properties. In the 4 years since the publication of The Handbook of Advanced Business Valuation (the de facto predecessor of this book), the business valuation discipline has advanced as a profession. Various professional organizations continue to develop and promulgate professional standards. Many more analysts have obtained professional training and earned certifications and designations. Many more empirical databases and automated data sources have become available to valuation practitioners. And, there is a greater consensus in the professional community with regard to generally accepted approaches, methods, and procedures. Nonetheless, numerous conceptual controversies still remain, even among the most prominent practitioners. And, “new and improved” data sources gradually replace traditional data sources. In fact, these factors are among the primary reasons to write this book. In addition, over time, both (1) governmental and regulatory changes and (2) judicial precedent affect business valuation practitioners. This book attempts to reflect the current overall effect of these cumulative changes. The last several years have seen an exponentially increased interest in intellectual properties, particularly as they relate to transactions, taxation, financial reporting, bankruptcies, financings, and litigation. Intellectual properties are a specifically identified subset of general commercial intangible assets. Intellectual properties encompass a specifically identified bundle of legal rights. As a result of this bundle of legal rights, intellectual properties have commercial value. Intellectual properties have commercial value to their owners, and intellectual properties have commercial value to their users. This book explores the economic attributes—and the economic influences—that (1) create value, (2) destroy value, and (3) transfer value in intellectual properties. In the case of a general intangible asset, value is often created only when the owner is also the user of the asset. However, this is not the case with an intellectual property where the owner can be (and often is) a different party than the user. In this way, an intellectual property is analogous to a parcel of industrial or commercial real estate. That is, the owner of the real estate can be (and often is) a different party than the user of the real estate. This ability to separate ownership (i.e., the lessor position) from use (i.e., the lessee position) is one of the important attributes that creates value in real estate. This ability to separate ownership (i.e., the licensor position) from use (i.e., the license position) is also one of the important attributes that creates value in intellectual properties. To continue with the real estate analogy, it is not uncommon for the commercialization process to involve at least three parties: (1) the property developer (who specs out the site and builds the mall, office building, etc.), (2) the property
xxxv
xxxvi
Introduction
owner/landlord (who buys the building from the developer and then manages the property), and (3) the property tenants (who lease the building from the owner/ landlord and use the property as just one element of production in their own industrial or commercial enterprises). With an intellectual property, it is not uncommon for the commercialization process to also have at least three parties: (1) the property developer (who creates the material, device, or design and applies for the patent, copyright, or trademark), (2) the property owner/manager (who protects, coordinates, and commercially exploits the property), and (3) the property user (who incorporates the property as just one element of production in their own industrial or commercial enterprises). Another party—the funding/financing source—is also common to the commercialization of real estate and intellectual property. In addition to its discussion of business valuation, this book also explores the factors that create value in an intellectual property. These factors include the bundle of legal rights associated with the creation and ownership of the property. In addition, there are elements internal to the property (albeit intangible elements) that create value. And, there are elements external to the property that create value. How these elements are different for each type of intellectual property is explored. Since supply and demand ultimately affect the value of any asset, the factors of supply and demand that influence intellectual property are considered. This book presents a process for the analysis of intellectual properties. This process includes the following components: 1. A description of the specific intellectual property and definition of the specific legal rights subject to analysis. 2. An assemblage of the descriptive and quantitative data that relate to (a) the development, (b) the historical use, (c) the current use, (d) the expected future use, and (e) the potential future use(s) of the subject. 3. A catalog of the factors that may influence the supply and demand for the subject, including legal, technological, functional, economic, financial, and competitive factors. 4. A model for the qualitative assessment of the subject both (a) in absolute terms and (b) in comparison to current alternative or potential competitive properties. 5. A model for the quantitative assessment of the specific influences that affect the value of the subject, including (a) historical creation costs and current recreation costs, (b) historical income generation and future income-generating capacity, and (c) independent market-extracted transaction pricing of alternative, competitive, and comparative properties. 6. A framework to synthesize all of these qualitative and quantitative analyses into either (a) a defined value conclusion, (b) a transaction assessment, or (c) a recommendation regarding an investment, financing, taxation, commercialization, or legal decision. This process emulates the economic decision making of intellectual property developers, owners, and users. This book also explores the factors that diminish value in an intellectual property. Numerous actions can cause damage to an intellectual property and/or lost profits to the property owner. Some of these actions are under the control of the property owner. Sometimes, intellectual property owners will deliberately cause or allow their property to degenerate. These actions are usually taken in order to benefit the owner’s newer and/or more valuable intellectual properties. Sometimes, intellectual property owners simply let the value of their property diminish over time.
Introduction
xxxvii
Such value diminution is often due to technological or economic neglect, such as a lack of research or promotional investments. These actions (or inactions) are usually taken when the owner has superior alternative investment opportunities and is faced with a capital rationing decision. Many actions that cause damage to an intellectual property are outside of the control of the property owner. When (1) the party responsible for causing the damage and (2) the action(s) responsible for causing the damage are identified, the property owner may initiate a legal claim. That legal claim will typically request a judicial ruling that the responsible party (1) stop the damage-causing action and (2) pay compensation to the property owner. The requested compensation is usually related to the amount of economic damages to the intellectual property and/or lost profits (or other lost economic rents) to the property owner. The party causing the damages could have any number of relationships with the intellectual property owner, including the following: 1. 2. 3. 4. 5. 6.
A current or potential competitor A customer or supplier (or similar trade relationship) A joint venturer or partner (or similar contractual relationship) A current (or past) employee or agent A creditor or other banking relationship A local, federal, or foreign governmental agency
In such controversial matters, the analysis of intellectual property lost profits/ economic damages is important (1) to the plaintiff/claimant, (2) to the defendant/ respondent, and (3) to the finder of fact. The plaintiff/claimant wants a well-reasoned and well-supported analysis in order to prove liability and damages. The defendant/ respondent wants a rigorous and comprehensive analysis in order to (1) prepare and present an appropriate defense and (2) negotiate a reasonable settlement of the claims. And, the finder of fact wants an unbiased and fully documented analysis in order to (1) assign culpability to the appropriate party and (2) order a compensatory and/or punitive award. This book describes approaches, methods, and procedures for intellectual property economic damages analyses. These procedures can be used as a touchstone by the parties involved in a dispute. Such a touchstone can be used to assess the amount of reliance that lawyers and judges should place on the analyses that come before them. This book also explores the factors that affect the transfer pricing for intellectual property. The two most common types of intellectual property transactions that involve a transfer price are (1) a license of a specified bundle of property rights for a specified period of time and (2) an outright sale of the fee simple interest (typically) in the property. In such transactions, a price has to be determined for the payment by the licensor to the licensee or by the buyer to the seller. In addition, there are less common types of intellectual property transactions, including gifts, contributions, abandonments, and like-kind exchanges. A transfer price may have to be assigned to these latter types of transactions even if no money is exchanged between the parties. This assignment of a transfer or transaction price is often necessitated by financial accounting or a taxation requirement. Intellectual property transactions take place between related parties and unrelated parties. Transfer prices between unrelated parties are usually set by the marketplace. That is, the independent licensor and licensee each negotiate in their own best interests. The license price agreed to by independent parties negotiating at arm’s length generally indicates a fair license price for the subject transfer. Likewise, the sale price
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Introduction
agreed to by an independent buyer and seller negotiating at arm’s length generally indicates a fair sale price for the subject transfer. However, transfer prices between related parties are not set by the marketplace. In fact, the forces of supply and demand may have no effect at all on the transfer price. Examples of related parties include the following: 1. Brother/sister corporations (under common parent corporation ownership) 2. A parent corporation and its wholly owned subsidiary 3. A domestic corporation and its foreign affiliate corporation (e.g., domestic parent/foreign subsidiary or foreign parent/domestic subsidiary) 4. An individual intellectual property developer and his or her closely held corporation 5. Two divisions or departments within the same corporation With such related parties, intellectual property transfer (license or sale) prices do not necessarily reflect market influences. And, such related party transfer prices typically are not based on arm’s-length negotiations. Such related party transfer prices may be more influenced by a motivation to achieve a desired accounting or taxation objective than by a motivation to reflect the impact of market forces on arm’s-length bargaining. However, related party transfer prices may be set so as to equate to arm’s-length prices. Related parties may elect to use arm’s-length prices in intercompany or interparty license/sale transfers. The parties may decide to use arm’s-length transfer prices because they more accurately allocate the true level of economic income between brother/sister companies, parent/subsidiary corporations, and so on. Or, the parties use arm’s-length transfer prices because they are required to (1) under generally accepted accounting principles (GAAP) or (2) under state, federal, or international taxation laws. This book presents a framework that may be used by related parties to emulate the arm’s-length price negotiation process of independent third parties. This book presents practical procedures that may be used to estimate what a fair, arm’s-length transfer price would be for the license or sale of an intellectual property. The intellectual property transfer price conceptual framework and analytical procedures discussed in this book generally reflect the applicable requirements of Internal Revenue Code Section 482. In the new millennium, the market value of many industrial and commercial companies is comprised principally of the value of their intellectual property capital. And, in this information age, the market value of many companies is based primarily on the value of their intellectual property. Domestic and international businesses, large and small, rely on their intellectual property to allow them to be first to the marketplace, to have a competitive advantage, and to earn above-normal levels of profitability. And, both businesses and individuals are much more inclined than ever before to protect and defend their intellectual property rights through all legal means. Intellectual property transfers (through either license or sale) are now a common component of the commercial landscape. Historically, intellectual properties were commercially exploited by owner/developers. In the last few years, the global economy has provided many more opportunities to commercialize intellectual property. The ability to divide and transfer (through license or sale) intellectual property rights allows for the realization of greater value by the intellectual property owner. And, that realization allows for the creation of greater wealth to be shared by the intellectual property owner and users.
Introduction
xxxix
From an economic history perspective, we can identify the types of property (and property rights) that have created wealth in the last few centuries. We can track when—and why—the types of properties that create wealth have changed over time. When we consider the major source of capital formation at the turn of the millennium, we can see that the type of property that has created the most wealth in the last few decades is intellectual property. The history of what we would recognize as modern economics in the western world begins in the seventeenth century. At that time, the economies of Europe and the United States were changing from principally agricultural to industrial. The primary economic school of thought of the day was the mercantilist school. Mercantilists concluded that the primary source of wealth during the sixteenth and seventeenth centuries was gold and silver (and, to a lesser extent, other metals such as copper and iron). This conclusion could be empirically proved on a national basis; the wealthiest countries in the western world had large stockpiles of gold and silver. And, this conclusion was also true, directly and indirectly, on a personal level. Wealth for individuals could be measured directly by a family’s holdings of gold and silver. And, individual wealth was created indirectly by the ownership of businesses that owned, mined, or traded in gold and silver. Accordingly, at this point in economic history, capital formation was primarily associated with the ownership of mines. And, mines and mining are one form of real estate ownership rights. In the eighteenth century, the physiocratic school of economics was the contemporary wisdom. This school of thought, originating in France, believed that land in general and agricultural land in particular was the principal source of national and individual wealth. By the eighteenth century, it was easy for any country to acquire stocks of gold and silver, even if they had no mines. All they had to do was trade their agricultural production for the precious metals. And, this national source of wealth creation was also the primary source of individual wealth accumulation. Families that owned the source of agricultural production (i.e., land) were the wealthiest in contemporary society. So, during the eighteenth century, agricultural land was recognized as the primary source of capital formation. In 1776, The Wealth of Nations, Adam Smith’s monumental work, was published. Many economic historians credit Adam Smith with being the father of modern economics. Unquestionably, he was the father of the classical school of economics. Smith accepted some of the physiocrats’ theories. For example, the concept of laissez-faire, a national economic policy that calls for minimal government regulation of economic activities, is often attributed to Smith. Actually, the laissez-faire policy was originated by the French physiocrats. In any event, Smith’s classical school identified three sources of wealth creation: land, labor, and capital. These are the three factors of production that contribute to national wealth as well as to individual wealth. So, by the end of the eighteenth century, it was widely recognized that the sources of income (and the associated accumulation of wealth) were landowners’ ownership of both industrial and agricultural land, workers’ ownership of their own labor, and capitalists’ ownership of industrial factories and equipment. In the early nineteenth century, several classical school economists expanded on Smith’s theories. David Ricardo studied the distribution of income between landowners, workers, and industrialists. In particular, Ricardo identified that, ultimately, returns to land, labor, and capital would have to be out of balance. This is because, over time, there is (1) a fixed supply of land and (2) an expanding supply of labor and capital.
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Robert Malthus studied the expanding population trends in the early nineteenth century. He concluded that lower income returns (and lower wealth generation) would be associated with the labor component of production. This was because labor (i.e., the western world’s total workforce) was expanding (1) at a faster pace than capital was expanding and (2) at a faster pace than the remaining supply of land was decreasing. John Stuart Mill is recognized as a conceptual leader at the closing stages of the classical school. By the second half of the nineteenth century, Mill agreed with the classical theory that the three factors of production (and, therefore, wealth) were land, labor, and capital. However, his study of historical data convinced him that returns to these three factors were always out of balance. Moreover, Mill concluded that the distribution of income (both national and personal) would always be out of balance and, therefore, unfair. So, by the 1850s, Mill concluded that governments would have to intervene in the economic system in order to more rationally allocate income among the three sources of wealth. During the second half of the nineteenth century, Karl Marx also studied this same inefficiency in the allocation of national and personal income (wealth) among the three factors of production. From the 1840s, landmark Marx publications advocated the labor theory of economics. Marx believed that landowners and capitalists (the owners of industrial factories and machinery) exploited workers by not giving them a fair return on their labor. Marx predicted that capitalism was only an evolutionary phase of economic development, soon to be replaced by a labor-based economic system. In 1936, John Maynard Keynes, authored the landmark General Theory of Employment, Interest, and Money. This textbook is critically important to even the most cursory review of modern economic theory. As a result of Keynes’ theories, the Keynesian school replaced the classical school as the accepted explanation for changes in wages and prices in the mid-twentieth century. However, the Keynes’ text does not specifically focus on the creation and allocation of wealth (personal or societal). On the other hand, first published around the same time, a finance textbook does focus on the creation of wealth in the twentieth century. In 1934, Benjamin Graham and David Dodd authored Security Analysis. This groundbreaking finance text explained the creation of wealth through the investment analysis of securities. Securities, of course, represent indirect ownership interests in capital—that is, the means of production. However, in the twentieth century, most of the wealth creation (and certainly virtually all of the personal wealth creation) related to the ownership of securities. Business institutions became successful through the management of land, labor, and capital (still the three components of income production). And, individuals created wealth through the ownership of the securities of these business institutions. The Graham and Dodd model still works at the beginning of the twenty-first century. However, in the last several decades, one component of capital has become increasingly important in the wealth creation process: intellectual capital. The end of the twentieth century has been called the information age, the computer age, the communications age, and the technology age. When one considers all of these names collectively, it is easy to conclude that the last few decades can be considered the intellectual property age. In addition to controlling land, labor, and traditional capital (factories and equipment), the most successful business institutions today also control great stores of intellectual capital. Intellectual capital includes copyrights, patents, trademarks, and related intellectual property.
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xli
The Graham and Dodd Security Analysis methodology has evolved in recent years. This is because the traditional Graham and Dodd fundamental analysis of business institution financial statements does not always capture all of that institution’s intellectual capital. However, security prices do seem to capture (and, some may say over-reward) the value of intellectual capital. Wealth creation relates to both (1) the indirect ownership of intellectual property (through the securities of institutions that successfully profit from their intellectual capital) and (2) the direct ownership of intellectual property (by individual intellectual property creators). In summary, the analysis of intellectual capital is an essential element in a business enterprise valuation. That analysis may be explicit or implicit. However, the two analytical disciplines are conceptually (and professionally) linked. This book focuses on the common quantitative and qualitative analyses of business valuation and intellectual property analysis, particularly with regard to valuation, economic damages, and transfer price analyses.
Part I
Business Valuation Technical Topics
Chapter 1 The Equity Risk Premium Roger J. Grabowski and David W. King
Introduction Realized Return or Ex Post Approach The Selection of the Observation Period Which Average: Arithmetic or Geometric? Expected ERP versus Realized Equity Return Premiums Noncontrolling Ownership or Controlling Ownership Interest Returns? Forward-Looking Methods Bottom-Up Methods Projected Real Equity Returns Surveys Other Sources Realized Returns and the Size Effect Criticisms of the Small Stock Effect The January Effect Bid/Ask Bounce Bias Geometric versus Arithmetic Averages Infrequent Trading and Small Stock Betas Delisting Bias Transaction Costs No Small Stock Premium Since 1982 Summary and Conclusion
4
I / Business Valuation Technical Topics
Introduction Common stocks are riskier investments than government securities. Financial theory holds that investors in common stocks expect a superior return over the expected yield on government securities as a reward for incurring the extra risk. The equity risk premium (ERP) (sometimes referred to as the market risk premium) is defined as the extra return (over the expected yield on government securities) that investors expect to receive from an investment in a diversified portfolio of common stocks. The ERP is defined as ERP = Rm – Rf where Rm is the expected rate of return on a fully diversified portfolio of common equity securities and Rf is the rate of return expected on an investment free of default risk, or the risk-free rate. The ERP is a forward-looking concept. The ERP is an expectation, as of the valuation date, of a rate of return for which no “market quotes” are observable. While one can observe return premiums realized over time by referring to historical data (i.e., the realized return approach or the ex post approach), such calculated return premiums are only estimates for the expected ERP. Alternatively, one can directly derive implied forward-looking estimates for the ERP (1) from data on the underlying expectations of growth in corporate earnings and dividends or (2) from projections by equity analysts (i.e., the ex ante approach). The goal of either the ex post approach or ex ante approach is to estimate the true expected ERP as of the valuation date. Even then, the expected ERP can be thought of in terms of (1) a normal or unconditional ERP and (2) a conditional ERP based on current prospects.1 The ERP is an important component in applying the income approach to valuation. It is one component of most models for estimating the equity discount rate (i.e., rate of return on equity capital or cost of equity capital) including (1) the capital asset pricing model (CAPM), (2) the build-up model, (3) some versions of arbitrage pricing theory (APT), and (4) the Fama-French three-factor model. Estimating the ERP may be more important than many other decisions analysts make in applying these theories. For example, the effect of a decision that the appropriate ERP in the CAPM is 4 percent instead of 8 percent will generally have a greater impact on the concluded discount rate than alternative theories of the proper measure of other components—for example, beta. One academic study looked at sources of error in estimating expected rates of return over time and concluded: We find that the great majority of the error in estimating the cost of capital is found in the risk premium estimate, and relatively small errors are due to the risk measure, or beta. This suggests that analysts should improve estimation procedures for market risk premiums, which are commonly based on historical averages.2
1 Robert Arnott,
“Equity Risk Premium Forum,” AIMR, November 8, 2001, p. 27.
2 Wayne Ferson and Dennis Locke, “Estimating the Cost of Capital Through Time: An Analysis of the Sources of Error,” Management
Science, April 1998, pp. 485–500.
1 / The Equity Risk Premium
5
There is no one universally accepted standard for estimating the ERP. A wide variety of return premiums are used in practice and recommended by academics and financial advisors.
Realized Return or Ex Post Approach Practitioners agree that ERP is a forward-looking concept. However, many practitioners use historical data to measure it, under the assumption that historical data are a valid proxy for current investor expectations. The realized return approach employs the return premium that investors have, on the average, realized over some historical holding period (i.e., the historical realized premium). The justification for using the historical realized premium is based on two propositions: (1) that the past provides an indicator of how the market will behave in the future and (2) that investors’ expectations are influenced by the historical performance of the market. If period (say, monthly) returns are serially independent (i.e., not correlated) and if expected returns are stable through time, then the arithmetic average of historical returns provides an unbiased estimate of expected future returns. A more indirect justification for use of the historical approach is the proposition that, for whatever reason, securities in the past have been priced in such a way as to earn the returns observed. By using the historical realized premium in applying the income approach to valuation, one may, to some extent, replicate this level of pricing. The selection of an appropriate government security for the risk-free rate is a function of the expected holding period for the investment to which the discount rate (i.e., the rate of return) will apply. For example, if the analyst is estimating the equity return on a highly liquid investment and the expected holding period is potentially short-term, then the yield on a Treasury bill may be an appropriate instrument to use in measuring the historical realized premium. In this book, we are directing our observations principally to the valuation of closely held businesses/securities and intangible assets/intellectual properties. These investments are generally thought of as being long-term investments. Therefore, there is general consensus in the valuation community that the return on a longterm government bond should be used as the benchmark in calculating the historical realized premium. The measure of the risk-free rate is not controversial once the proper term (i.e., long-term versus short-term) of the investment is determined. This is because the expected yield-to-maturity on Treasury securities is directly observable in the marketplace.3 Accordingly, the differences in approach to estimating the ERP effectively hinge on the measure of expected return on stocks. In applying the realized return method, the analyst selects the number of years of historical return data to include in the average. One school of thought holds that the future is best estimated using a very long horizon of past returns. Another school of thought holds that the future is best measured by the (relatively) recent past.
3 In
applying the ERP in, say, the CAPM, one must use the return on a risk-free security with a term (maturity) that is consistent with the benchmark security used in developing the ERP. For example, in this book, we are measuring ERP in terms of the premium over that of long-term government bonds. In CAPM, ke = Rf + (Beta × ERP). The Rf used as of the valuation date should be the yield on a long-term government bond, because the data cited herein have been developed comparing equity returns to the income return (i.e., the yield promised at issue date) of long-term government bonds.
6
I / Business Valuation Technical Topics
Exhibit 1.1
Historical Realized Return Premiums (Stock Market Returns vs. Treasury Bond Returns) Time Period 20 years (1983–2002) 30 years (1973–2002) 40 years (1963–2002) 50 years (1953–2002) 77 years (1926–2002) 131 years (1872–2002) 205 years (1798–2002)
Arithmetic Return Premiums (%)
Geometric Return Premiums (%)
6.2 4.1 4.4 5.9 7.0 5.8 5.0
5.00 2.60 3.10 4.50 5.00 4.10 3.50
SOURCE: Roger Ibbotson and Gary Brinson, Global Investing (New York: McGraw-Hill, 1993); G. William Schwert, “Indexes of U.S. Stock Prices from 1802 to 1987,” Journal of Business, July 1990; Sidney Homer, Richard Sylla, A History of Interest Rates, 3d ed. (Piscataway, NJ: Rutgers University Press, 1991); and Stocks, Bonds, Bills, and Inflation, 2003 Yearbook (Chicago: Ibbotson Associates, 2003).
These differences in opinion result in disagreement as to the appropriate number of years to include in the average. The highest quality data are available for periods beginning in 1926 at the Center for Research in Security Prices (CRSP) at the University of Chicago. Ibbotson Associates publishes summaries of returns on U.S. stocks and bonds derived from that data.4 The year 1926 was selected as the starting point in the data in order to capture one complete business cycle prior to the Great Crash. However, good stock market data are available back to 1871, and less reliable stock market data are available from various sources back to the end of the eighteenth century. In the earliest period, the stock market consisted almost entirely of bank stocks. By the mid-nineteenth century, the stock market was dominated by railroad stocks.5 Data for government bonds are also available for these periods. Exhibit 1.1 presents the realized average annual premium for common equities for alternative periods through 2002. We measure the historical realized premium by comparing the stock market returns realized during the period to the income return on bonds (or to the yield-tomaturity, for the years before 1926). While investors do not know the actual stock market return at the beginning of a period when they invest, they do know the rate of interest promised on long-term government bonds. Therefore, we measure the actual stock market returns realized over the expected return on bonds. An investor makes a decision to invest in the stock market today by comparing the expected return from that investment to the return on a benchmark security. In this case, the benchmark security is the long-term government bond. The realized return method is based on the expectations that history will repeat itself and that such a premium return will be realized (on the average) in the future. 4 Stocks,
Bonds, Bills, and Inflation, Valuation Edition 2003 Yearbook (Chicago: Ibbotson Associates, 2003).
5 See Lawrence Fisher and James H. Lorie, “Rates of Return on Investments in Common Stocks,” Journal of Business, January 1964;
Jack W. Wilson, and Charles P. Jones, “A Comparison of Annual Stock Market Returns: 1871–1925 with 1926–1985,” Journal of Business, April 1987; G. William Schwert, “Indexes of Common Stock Returns from 1802 to 1987,” Journal of Business, July 1990; Roger Ibbotson and Gary Brinson, Global Investing (New York: McGraw-Hill, 1993); Jack W. Wilson and Charles P. Jones, “An Analysis of the S&P 500 Index and Cowles’s Extensions: Price Indexes and Stock Returns, 1870–1999,” Journal of Business, July 2002; Stephen Wright, “Measures of Stock Market Value and Returns for the U.S. Nonfinancial Corporate Sector, 1900–2000,” Working Paper, February 1, 2002.
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The Selection of the Observation Period The historical average realized premium is sensitive to the period selected to calculate the average. The selection of 1926 as a data starting point is a happenstance of the selection process used by the founders of the CRSP database. The average calculated using 1926 return data as a starting point may be heavily influenced by the unusually low interest rates during the 1930s to mid-1950s. For example, the average yield on longterm government bonds was only 2.3 percent during the 1940s (the lowest decade on record). Moreover, the yield on long-term government bonds was under 3 percent in each year from 1934 through 1955. The yields on long-term government bonds exceeded 4 percent for most of the nineteenth century and have been generally higher since the 1960s. Some observers have suggested that the period that includes the 1930s, 1940s, and the immediate post–World War II boom period may have exhibited an unusually high average realized return premium. The period of the 1930s exhibited extreme volatility. The period of the 1940s and early 1950s experienced a combination of record low interest rates and rapid economic growth. That combination of economic factors caused the stock market to outperform Treasury bonds by a wide margin. The low real rates on bonds may have contributed to higher equity returns in the immediate postwar period. Since firms finance a large part of their capital investment with bonds, the real cost of obtaining such funds increased returns to shareholders. It may not be a coincidence that the highest 30year average equity return occurred in a period marked by very low real returns on bonds. As real returns on fixed-income assets have risen in the last decade, the equity premium appears to be returning to the 2 percent to 3 percent norm that existed before the postwar surge.6 For comparative purposes, let us disaggregate the 77 years reported by Ibbotson Associates into two periods: the first period covering before the mid-1950s and the second period covering after the mid-1950s. After this disaggregation of the data, we arrive at the comparative figures for stock and bond returns presented in Exhibit 1.2. The period since the mid-1950s is characterized by a more stable stock market relative to a more volatile bond market (as compared to the earlier period). Interest rates, as reflected in the Ibbotson Associates long-term Treasury bond income return statistics, are relatively more volatile in the later period. This effect is amplified in the volatility of the Ibbotson Associates long-term Treasury bond total returns. This is because the total bond returns include the capital gains and losses associated with interest rate fluctuations. Empirical evidence since 1871 supports the conclusion that the difference between stock yields and bond yields is a function of the long-run difference in volatility between stocks and bonds.7 An examination of the volatility in stock returns (as measured by rolling 10-year average standard deviation of real stock returns) indicates (1) that the volatility beginning in 1929 dramatically increased and (2) that the volatility since the mid-1950s has returned to prior levels.8 This conclusion suggests that the arithmetic average historical realized return reported 6 Jeremy
Siegel, Stocks for the Long Run (New York: McGraw-Hill, 1994), p. 20.
7 Clifford S. Asness, “Stocks versus Bonds: Explaining the Equity Risk Premium,” Financial Analysts Journal, March/April 2000,
pp. 96–113. 8 Laurence Booth, “The Capital Asset Pricing Model: Equity Risk Premiums and the Privately-Held Business,” The Journal of Business Valuation (Toronto: The Canadian Institute of Chartered Business Valuators, 1999), p. 98.
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Exhibit 1.2
Disaggregated Ibbotson Associates Return Premium Data 1926–1956
1957–2002
Nominal (i.e., without inflation removed) Arithmetic average Geometric average
10.3% 7.4%
4.7% 3.4%
Standard Deviations Stock market annual returns Long-term Treasury bond income returns Long-term Treasury bond total returns
24.9% 0.5% 4.9%
17.4% 2.4% 11.4%
Realized Equity Return Premiums over Treasury Bond Income Returns
SOURCE: Compiled from data in Stocks, Bonds, Bills, and Inflation, 2003 Yearbook (Chicago: Ibbotson Associates, 2003).
by Ibbotson Associates (i.e., the realized return measured from 1926) may overstate expected returns. Using historical data may also overstate expected returns given the increasing opportunities for international diversification. International diversification lowers the volatility of returns in investors’ portfolios. This lower volatility, in theory, should lower the required return on the average asset in the portfolio. This lower return on globally diversified portfolios should lower the expected return on U.S. securities generally. The lower expected return should suggest a lower ERP on a forwardlooking basis than indicated by historical data. One analyst has suggested that the increased globalization of financial markets has lowered the expected ERP to about two-thirds of the post-1926 average realized return premium.9 If the average expected return on stocks has changed through time, then the use of average realized returns derived from the longest available data is questionable. A short-run horizon may give a better estimate. This is true if changes in economic conditions have created a different expected return environment than that of more remote past periods. For example, why not use the average realized return over the past 20-year period? A drawback of using averages over shorter periods is that they are susceptible to large errors in measuring the true ERP. This error is due to high volatility of annual stock returns. Also, the average of the realized return premiums over the past 20 years may be biased high due to the general downward movement of interest rates since 1981. While we can only observe historical realized returns in the stock market, we can observe both expected returns (i.e., yield-to-maturity) and realized returns in the bond market. Prior to the mid-1950s, the difference between the yield at issue and the realized returns was small. This is because bond yields did not fluctuate very much. Beginning in the mid-1950s and until 1981, bond yields trended upward, causing bond prices to decrease in general. Realized returns were generally lower than returns expected when the bonds were issued. Beginning in 1981, bond yields trended downward, causing bond prices to increase in general. Realized returns
9
Rene Stulz, “Globalization of Capital Markets and the Cost of Capital: The Case of Nestle,” Journal of Applied Corporate Finance, 1995.
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were generally higher than returns expected when the bonds were issued. If an analyst selects the period during which to measure realized premiums beginning from the late 1950s/early 1960s to today, the data include a complete interest cycle.10 Even if an analyst wants to use long-term observations, the high volatility of annual stock returns makes any estimate unreliable. For example, the standard deviation of the realized average return for the entire period 1926–2002 is approximately 21 percent. Even if we assume that the 77-year average provides an unbiased estimate, we still must recognize that a 95 percent confidence interval for the unobserved true ERP spans a range of approximately 3.3–11.7 percent.
Which Average: Arithmetic or Geometric? Realized return premiums measured using the geometric, or compound, averages are always lower than those using the arithmetic average. The selection of which average to use is a matter of debate among practitioners. The use of arithmetic average receives the most support in the professional valuation literature.11 However, some authors recommend the use of a geometric average.12 The use of the arithmetic average relies upon two key assumptions: (1) market returns are serially independent (i.e., not correlated) and (2) the distribution of market returns is stable (i.e., not time-varying). Under these assumptions, an arithmetic average gives an unbiased estimate of expected future returns. Moreover, the more observations one has, the more accurate the estimate will be. However, a number of academic studies have suggested that U.S.-stock returns are not serially independent. Rather, these studies indicate that U.S.-stock returns have exhibited negative serial correlation.13 One recent study suggests that if stock returns have negative serial correlation, then the best estimate of expected returns would lie somewhere between the arithmetic and geometric averages. The best estimate would move closer to the geometric average as (1) the degree of negative correlation increases and (2) the projection period lengthens.14 However, these empirical studies indicate a fairly low degree of serial correlation, supporting the use of the arithmetic average.
Expected ERP versus Realized Equity Return Premiums Recent studies have compared the realized returns as reported in sources such as Ibbotson Associates and the ERP that must have been expected by investors. These ERP investor expectations are based on (1) the underlying economics of publicly traded companies (i.e., expected growth in earnings or expected growth in dividends) 10 See
Booth, “The Capital Asset Pricing Model: Equity Risk Premiums and the Privately-Held Business,” p. 113.
11 For examples: Paul Kaplan, “Why the Expected Rate of Return is an Arithmetic Average,” Business Valuation Review, September
1995; Stocks, Bonds, Bills, and Inflation Valuation Edition 2002 Yearbook, pp. 71–73; Mark Kritzman, “What Practitioners Need to Know about Future Value,” Financial Analysts Journal, May/June 1994; Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments (New York: McGraw-Hill, 1989), pp. 720–723. 12 For example: Aswath Damodaran, Investment Valuation, 2d ed. (New York: John Wiley & Sons, 2002), pp. 161–162. 13 Eugene Fama and Kenneth French, “Dividend Yields and Expected Stock Returns,” Journal of Financial Economics, 1986; Andrew Lo and Craig McKinlay, “Stock Market Prices Do Not Follow Random Walks,” Review of Financial Studies, 1988; James Poterba and Lawrence Summers, “Mean Reversion in Stock Prices: Evidence and Implications,” Journal of Financial Economics, 1988. 14 Daniel Indro and Wayne Lee, “Biases in Arithmetic and Geometric Averages as Estimates of Long-Run Expected Returns and Risk Premia,” Financial Management, 1997.
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and (2) the underlying economics of the economy (i.e., expected growth in gross domestic product). Such studies conclude that investors could not have expected as large an ERP as the equity premiums actually realized. Robert Arnott and Peter Bernstein concluded that the long-run normal ERP is approximately 2.4 percent on a geometric average basis. This conclusion translates into an arithmetic premium of approximately 4.5 percent.15 Arnott and Bernstein concluded that the historical realized return premium exceeded the expected return premium for two reasons: (1) the expected ERP in 1926 was above the long-term average (making 1926 a higher-than-average starting point for the realized returns) and (2) important nonrecurring developments occurred that were not anticipated by investors (such as rising valuation pricing multiples, survivor bias of the U.S. economy, and regulatory reform).16 Eugene Fama and Kenneth French examined the unconditional expected stock returns from fundamentals (derived from studying historical observed relationships for 1872–2000). These expected stock returns are estimated as the sum of the average dividend yield and the average growth rate of dividends or earnings. Fama and French concluded that, during the period 1951–2000, investors should have expected an ERP lower than the subsequent actual realized premium over Treasury bills. Their calculations indicate an expected ERP on a geometric basis of 2.6 or 4.3 percent, depending on the methodology used. These return premiums over Treasury bills can be converted into arithmetic average premiums over long-term government bonds of approximately 2.9 and 4.6 percent.17 Fama and French concluded that the greater return premium actually realized during those years was due to an unanticipated decline in the discount rate. “[T]he bias-adjusted expected return estimates for 1951 to 2000 from fundamentals are a lot (more than 2.6 percent per year) lower than bias-adjusted estimates from realized returns. . . . Based on this and other evidence, our main message is that the unconditional expected equity premium of the last 50 years is probably far below the realized premium.”18 Finally, Roger Ibbotson and Peng Chen performed a study that estimated forward-looking, long-term sustainable equity returns and expected ERPs. First, Ibbotson and Chen analyzed historical equity returns by decomposing returns into factors including inflation, earnings, dividends, price/earnings ratio, dividendpayout ratio, book value, return on equity, and gross domestic product per capita. Second, they forecast the ERP through supply-side models derived from the historical data. Ibbotson and Chen determined that the long-term ERP that could have been
15 Robert Arnott and Peter Bernstein, “What Risk Premium is Normal?” Financial Analysts Journal, March/April 2002. Arnott and
Bernstein estimate that a “normal” equity risk premium equals 2.4 percent (geometric average). One method of converting the geometric average into an arithmetic average is to assume the returns are independently log-normally distributed over time. Then the arithmetic and geometric averages approximately follow the relationship: arithmetic average of returns for the period = geometric average of returns for the period + (variance of returns for the period/2). In this case, one obtains the following conclusion: 2.4% + (0.0412/2) = 4.5% approximately. During the period 1926–2001, the arithmetic average realized premium (relative to Treasury bonds) was 7.4 percent. The difference is, therefore, 7.4 minus 4.5 percent, or approximately 3 percent. 16 Ibid. 17 Fama and French estimate that the expected ERP using dividend growth rates was approximately 2.55 percent and using earnings growth rates was approximately 4.32 percent (geometric averages compared to Treasury bills). These are approximately equivalent to arithmetic average realized premium of 4.1 and 5.8 percent, compared to Treasury bills. Subtracting the horizon premium of 1.2 percent prevailing over the period of the study indicates premiums over long-term Treasury bonds of 2.9 and 4.6 percent. 18 Eugene F. Fama and Kenneth R. French, “The Equity Premium,” The Journal of Finance, April 2002, pp. 637–659.
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expected from the underlying economics was approximately 4.1 percent on a geometric basis and 5.9 percent on an arithmetic basis.19 The greater than expected historical realized equity returns were again caused by an unexpected increase in market multiples relative to economic fundamentals (i.e., decline in the discount rates). What caused the decline in discount rates that led to the unexpected capital gain? McGrattan and Prescott found that the value of the stock market relative to the gross domestic product in 2000 was nearly twice as large as in 1962.20 They determined that the marginal income tax rate declined (the marginal tax rate on corporate distributions averaged 43 percent in the 1955–1962 period and averaged only 17 percent in the 1987–2000 period). The regulatory environment also changed. Equity investments could not be held “tax free” in 1962. But, by 2000, equity investment could be held “tax deferred” in defined benefit and contribution pension plans and in individual retirement accounts. The decrease in income tax rates on corporate distributions and the inflow of retirement plan investment capital into equity investments combined to lower discount rates and increase market multiples relative to economic fundamentals. Assuming that investors did not expect such changes, the true ERP during this period has been less than the historical realized premium calculated as the arithmetic average of excess returns realized since 1926. Further, assuming that the likelihood of changes in such factors being repeated are remote and investors do not expect another such decline in discount rates, the true ERP as of today can also be expected to be less than the historical realized premium.
Noncontrolling Ownership or Controlling Ownership Interest Returns? Do the realized return data result in ERP estimates reflecting noncontrolling ownership interest or controlling ownership interest positions? Some practitioners conclude that the data reflect the realized risk premium for noncontrolling interest positions. This is because the data cited above have, as their source, stock market returns. These valuation analysts conclude that a present value discount rate derived from stock market data is appropriate for valuing noncontrolling ownership interest positions. They conclude that a different discount rate should be used for valuing a controlling ownership interest position. The historical realized returns are measurements of returns from all stockholders. These returns include the results of sales of 100-share blocks of stock by one noncontrolling shareholder and purchases of a 100-share block by another noncontrolling shareholder. And, these returns include the results of purchases in tender offer acquisitions of entire companies. Accordingly, these historical returns are the result of all stock purchases and sales. Calculating the equity discount rate using CAPM results in the minimum rate of return necessary for investors to earn a return commensurate with the risk incurred. It is well accepted in corporate finance that the rate of return so calculated is the 19 Roger G. Ibbotson and Peng Chen, “Long-Run Stock Returns: Participating in the Real Economy,” Financial Analysts Journal, January/February 2003, pp. 88–98. 20 Ellen R. McGrattan and Edward C. Prescott, “Is the Market Overvalued?” Federal Reserve Bank of Minneapolis Quarterly Review, Fall 2000, and “Taxes, Regulations and Asset Prices,” Federal Reserve Bank of Minneapolis Working Paper 610, July 2001.
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minimum rate of return a corporation must earn on its investments in order to maintain a company’s share price. If investments are made at less than this rate of return, shareholder value will erode because expectations of investors as to the rate of return the corporation must earn have not been met. For example, in assessing the price one corporation would be willing to pay to acquire control of another corporation, the acquiring corporation must set its minimum hurdle rate based on its cost of capital. Does the aggregate market value of a publicly traded company reflect the aggregation of noncontrolling values or a control value? Why, then, does the market experience price premiums paid for acquisitions of controlling ownership interests? Do these price premiums reflect the fact that the corporations making acquisitions are willing to accept lower rates of return than their cost of capital? In assessing the value of a company’s stock using the income approach, the analyst measures the expected cash flow in the numerator and the cost of capital in the denominator. The owner of a noncontrolling interest in a company is the acceptor of the expected cash flows, given the existing management of the corporation. To the extent that corporate management compensation is tied to increases in the share price of the company (i.e., options, shareholdings, etc.), shareholder and management interests are wed to each other. In that case, the stockholders’ returns may closely reflect the value of ownership control of that corporation (at least as the corporation exists today).21 In assessing the value of an acquisition using the income approach, company management should pay no greater price than the price that will allow the corporation to earn its cost of capital. The cost of capital reflects the risk of the expected cash flow. The valuation denominator is fixed by the expectations of the corporation’s shareholders. The acquiring corporation may pay a premium to the extent that the acquirer can increase the target company’s cash flow (as compared to the cash flow realized under current management). The cost of capital may change as a result of an acquisition to the extent that the riskiness of the corporation’s cash flow changes. However, the basic methodology of calculating the cost of capital does not change.22 The returns that are generated by the S&P 500 and the NYSE represent returns to equity holders. While most of these companies are minority held, there is no evidence that higher rates of return could be earned if these companies were suddenly acquired by majority shareholders. The equity risk premium represents expected premiums that holders of securities of a similar nature can expect to achieve on average into the future. There is no distinction between minority owners and controlling owners.23
Forward-Looking Methods Forward-looking methods estimate the ERP by subtracting the current risk-free rate from the implied expected return for the stock market. Forward-looking methods can be categorized into three categories based on the individual procedures performed. 21 Roger J. Grabowski, Jeffrey M. Risius, and James P. Kovacs, “Discounted Cash Flow Approach: What Do the Results Represent?” Working Paper, 1995. 22 Michael Annin, “Using Ibbotson Associates’ Data to Develop Minority Discount Rates,” CPA Expert, Winter 1997. 23 Stocks, Bonds, Bills, and Inflation, Valuation Edition 2002 Yearbook, p. 81.
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One method uses fundamental information, such as earnings or dividends, to estimate a “bottom-up” rate of return for a number of companies. An expected rate of return for an individual company can be implied, for example, by solving for the present value discount rate that equates the current market price of a stock with the present value of expected future dividends. A bottom-up implied ERP begins with the averaging of the implied rates of return (weighted by market value) for a large number of individual companies. The bottom-up ERP then subtracts the government bond rate. The bottom-up method directly measures expectations concerning the overall market by using forecasts of the rate of return on publicly traded companies. The second method examines the relationships across publicly traded companies over time between real stock returns, price/earnings ratios, earnings growth, and dividend yields. An estimate of the real rate of equity return is developed from current economic observations applied to the historical relationships. Subtracting the current rate of interest provides an estimate of the expected ERP implied by the historical relationships. The third method relies on opinions of investors and financial professionals. These opinions are obtained through surveys concerning their views on the prospects of the overall market.
Bottom-Up Methods Merrill Lynch publishes bottom-up expected return estimates for the S&P 500 stock index. These estimates are derived from averaging return estimates for stocks in the S&P 500. While Merrill Lynch does not cover every company in the S&P 500 index, it does cover a high percentage of the companies as measured in market value terms. Merrill Lynch uses a multistage dividend discount model (DDM) to calculate expected returns for several hundred companies. The Merrill Lynch DDM uses projections from its own securities analysts. The resulting data are published monthly in the Merrill Lynch publication Quantitative Profiles. The Merrill Lynch expected return estimates have indicated an implied ERP ranging from 3 to 7 percent in recent years. The average implied ERP over the last 15 years is approximately 4.6 percent. In a DDM, first Merrill Lynch projects future company dividends. They then calculate the internal rate of return that sets the current market price equal to the present value of the expected future dividends. If the projections correspond to the expectations of the “market,” then Merrill Lynch has estimated the rate at which the market discounts these dividends in the market’s pricing of the stock. The DDM is a standard method for calculating the expected return on a security.24 The theory supporting this method assumes that the value of a stock is the present value of all future dividends. If a company is not currently paying dividends, the theory suggests that the company must be investing in projects today that will lead to even greater dividends in the future. A number of consulting firms reportedly use the Merrill Lynch DDM estimates to develop discount rates. One author comments on the Merrill Lynch data as follows:
24 See, for example: Sidney Cottle, Roger F. Murray, and Frank E. Block, Graham & Dodd’s Security Analysis, 5th ed. (New York:
McGraw-Hill, 1988), pp. 565–568.
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Two potential problems arise when using data from organizations like Merrill Lynch. First, what we really want is investor’s expectations, and not those of security analysts. However . . . several studies have proved beyond much doubt that investors, on the average, form their own expectations on the basis of professional analysts’ forecasts. The second problem is that there are many professional forecasters besides Merrill Lynch, and, at any given time, their forecasts of future market returns are generally somewhat different. . . . However, we have followed the forecasts of several of the larger organizations over a period of years, and we have rarely found them to differ by more than [plus or minus] 0.3 percentage points from one another.25 Expected rates of return would be underestimated if the effects of share repurchases are not adequately taken into consideration. However, Merrill Lynch personnel have indicated that their analysts take share repurchases into account by increasing long-term growth rates in earnings per share. If this effect is not completely modeled, the Merrill Lynch estimates may be biased downward. It is also possible that the DDM may understate expected returns to the extent (1) that expected dividends are measured based on earnings from assets in place and (2) that these earnings understate future growth opportunities. However, this is a larger problem in the analysis of smaller companies than in the analysis of the large companies that dominate the S&P 500. Value Line projections can be used to produce estimates of expected returns on the market. Value Line routinely makes “high” and “low” projections of price appreciation over a 3- to 5-year horizon for over 1500 companies. Value Line then uses these price projections to calculate estimates of total returns, making adjustments for expected dividend income. The high and low total return estimates are published each week in the Value Line Investment Survey. Midpoint total return estimates are published in Value Line Investment Survey for Windows CD database. There is some evidence that the Value Line projections, at least for earnings growth, tend to be biased high.26 Implied ERP estimates derived from Value Line data have been more volatile than the ERP estimates derived from the Merrill Lynch DDM model. Recent implied ERP estimates have ranged from slightly below zero (at the end of 1999) to >12 percent (at the end of 2002). The average implied ERP over the past 15 years (through the end of 2002) is 5.6 percent. Value Line estimates of future prices appear to be “sticky” (i.e., they tend to change slowly). Consequently, the expected premium appears to increase after a bear market and decrease after a bull market. Ibbotson Associates calculates the implied rates of return for a large number of companies derived from both a single-stage DDM and a three-stage DDM. These implied rates of return are reported annually in the Ibbotson Associates Cost of Capital Yearbook (with quarterly updates reported in the Cost of Capital Quarterly).27 Expected growth rates in dividends are derived from analysts’ estimates, as reported in the Institutional Broker’s Estimate System (I/B/E/S) Consensus
25 Eugene
Brigham and Louis Gapenski, Financial Management: Theory and Practice, 5th ed. (Fort Worth: Dryden Press, 1988),
p. 227. 26 David
T. Doran, “Forecasting Error of Value Line Weekly Forecasts,” Journal of Business Forecasting, Winter 1993–1994, pp. 22–26. 27 For example: Cost of Capital Yearbook 2002 (Chicago: Ibbotson Associates, 2002).
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Estimates database. Ibbotson Associates reports statistics for large composite groups of companies. From these statistics, the analyst can derive an ERP for the overall market. Since this publication commenced in 1994, the implied ERP estimates derived from the reported three-stage DDM rates of return have ranged from 5.7 to 8.0 percent. The implied ERP in 2002 was 6.9 percent, and the average implied ERP over the past 9 years was 6.5 percent. This conclusion is roughly 2 percent above the average estimates by Merrill Lynch and Value Line over the same time period. Several academic studies have used consensus forecasts of long-run earnings per share growth as a proxy for projected dividends in a DDM.28 The results of this analysis suggest that (1) ERP varies over time and (2) the level of ERP is inversely related to the level of interest rates. Another study extracted ex ante estimates of the ERP from conditional versions of the CAPM and an intertemporal version of CAPM.29 The results of this analysis suggest that the ERP varies over the business cycle. The ERP is lowest in periods of business expansion, and the ERP is highest in periods of recession. The ERP appears to be positively correlated with (1) long-term bond yields (increasing as bond yields increase) and (2) the default premium (increasing as the difference between Aaa- and Baa-rated bond yields increases). One study examined the behavior of analysts’ projections from several sources.30 These sources included (1) “top-down” estimates from I/B/E/S (based on analysts’ estimates of the aggregate S&P 500 index) and (2) bottom-up projections from I/B/E/S compiled analysts’ estimates of individual companies covered by the S&P 500 index. This study also compared the results to the Value Line median projected rates of return. The Value Line projected rates of return are generally higher than the market value weighted average projected rates of return. The study concluded that the top-down estimates behave consistently with financial theory, while the Value Line estimates behaved less consistently. The top-down estimates yielded the smallest average implied ERP (3.3 percent over the 1985–1995 sample period). The Value Line median projected return yielded the largest average implied ERP (8.8 percent).31 Other studies have indicated that both analysts’ earnings forecasts as reported by I/B/E/S and analysts’ earnings forecasts as reported by First Call are biased high.32 Exhibit 1.3 summarizes three forward-looking implied ERP estimates published over the past several years. In the past, former investment banking firm Kidder Peabody published estimates using a DDM. Generally, they obtained results similar to those published by Merrill Lynch. Various alternative sources of forward-looking ERP estimates have come and gone over the years.
28 Robert Harris and Felicia Marston, “Estimating Shareholder Risk Premia Using Analysts’ Growth Forecasts,” Financial Management, 1992; Charles Moyer and Ajay Patel, “The Equity Risk Premium: A Critical Look at Alternative Ex Ante Estimates,” Working Paper, 1997. 29 Fabio Fornari, “The Size of the Equity Premium,” Working Paper, 2002. 30 See Moyer and Patel, “The Equity Risk Premium: A Critical Look at Alternative Ex Ante Estimates.” 31 The median Value Line projected return is generally higher than the more correct market-weighted projected return. 32 James Claus and Jacob Thomas, “The Equity Premia as Low as Three Percent? Evidence from Analysts’ Earnings Forecasts for Domestic and International Stock Markets,” The Journal of Finance, October 2001, pp. 1629–1666; Alon Brav, Reuven Lehavy, and Roni R Michaely, “Expected Return and Asset Pricing,” Working Paper, December 2002.
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Exhibit 1.3
Summary of Forward-Looking Implied ERP Estimates ERP Estimate Summary Statistics Source of Estimates Merrill Lynch Value Line: 3- to 5-year horizon Ibbotson Associates
Range
Period
Mean (%)
3.5 to 6.7% –1.07 to 12.3% 5.7 to 8.0%
1988–2003 1988–2003 1994–2002
4.6 5.6 6.5
Projected Real Equity Returns Various analysts have published estimates of the expected ERP based on their analyses of the historical relationship of such variables as earnings growth, stock market levels (in terms of price/earnings ratios and dividend yields), changes in interest rates, and real stock returns. These analysts applied the observed relationships to the state of the current economic variables and stock market levels. Then, the analysts projected the future real returns on stocks. By subtracting the current interest rates, the analysts developed estimates of the expected ERP. Jeremy Siegel studied the link between real equity returns, price/earnings ratio, real growth, replacement cost of capital invested, and market value of capital. Siegel estimated that (1) the long-run price to earnings multiple will settle between 20× and 25× and (2) the real geometric average future total equity return will be approximately 5 percent. This conclusion converts to an expected geometric ERP of 2 percent (equivalent to approximately a 4 percent arithmetic average).33 Bradford Cornell studied the relationship between growth in real domestic product and earnings and dividends. Cornell estimated that “under any reasonable underlying assumptions about inflation, equity risk premiums cannot be more than 3 percent [geometric average] (equivalent to approximately 5 percent arithmetic average) because the earnings growth rate is constrained unconditionally in the long run by the real growth rate in the economy, which has been in the range of 1.5–3.0 percent.”34 Roger Ibbotson and Peng Chen prepared a forecast of ERP based on the contribution of earnings growth to price/earnings ratio growth and on growth in per capita gross domestic product. Their estimate of ERP was about 4 percent relative to long-term bonds on a geometric basis (equivalent to approximately a 6 percent arithmetic average).35
Surveys One survey of more than 500 finance and economics professors at leading universities found that, for long-term investments, the median forecast ERP (i.e., premium over Treasury bills) was 5 percent, with an interquartile range of 4–7 percent).36 33 Jeremy
Siegel, “Equity Risk Premium Forum,” AIMR, November 8, 2001, pp. 30–34. Cornell, “Equity Risk Premium Forum,” AIMR, November 8, 2001, pp 38–41. 35 Roger Ibbotson, “Equity Risk Premium Forum,” AIMR, November 8, 2001, pp. 100–104, 108. 36 Ivo Welch, “The Equity Premium Concensus Forecast Revisted,” Cowles Foundation Discussion Paper No. 1325, September 2001. 34 Bradford
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Adjusting for the horizon premium imbedded in long-term bonds versus Treasury bills, these survey results indicate a median forecast ERP (i.e., the premium over government bonds) of 3.6 percent, with an interquartile range of 2.6–5.6 percent. Another study reported the results from a series of surveys of chief financial officers of U.S. corporations conducted from mid-2000 to mid-2001. That study reported that the range of ERP, given a 10-year investment horizon, was 3.6–4.7 percent (i.e., the premium over 10-year government bonds).37 In a follow-up survey following the events of September 11, 2001, the respondents indicated an increase in the average expected ERP (i.e., the premium over 10-year government bonds) of approximately 1 percent. In the past, Greenwich Associates published an annual survey of several hundred pension plan officers. This annual survey included the respondents’ expected returns for the S&P 500 index for a 5-year holding period. This survey generally indicated an expected return premium over long-term bonds of between 2 and 3 percent.
Other Sources The following references present published opinions and guidelines on ERP. These references are not the only available sources regarding ERP. However, these references do represent a cross-section of available opinion on the subject. Principles of Corporate Finance takes no official position on the exact ERP. This text indicates, however, that a range of 6–8.5 percent premium over Treasury bills is reasonable for the United States. This range is equivalent to a premium over government bonds of approximately 4.6–7.1 percent. This text indicates a preference for figures toward the upper end of this range.38 Valuation: Measuring and Managing the Value of Companies recommends an ERP of 4.5–5 percent.39 The authors of that text based their estimates on the arithmetic average of realized returns observed over as long a period as possible. However, Valuation recognizes that the true ERP estimate lies between the geometric average and arithmetic average, adjusted downward for survivorship bias. Investment Valuation observes that the realized premium is 5.5 percent based on the geometric average realized return since 1926. Investment Valuation also observes that the average implied (forward-looking approach using expected dividends and expected dividend growth) ERP from 1960 to 2000 is only 4 percent.40 The author of that text uses 4 percent in most of his valuation examples. The Equity Risk Premium concludes that “reasonable forward-looking ranges for the future equity risk premiums in the long run are 3.5% to 5.5% over Treasury bonds. . . .”41
37 John R. Graham and Campbell R. Harvey, “Expectations of Equity Risk Premia, Volatility and Asymmetry from a Corporate Finance Perspective,” National Bureau of Economic Research Working Paper, December 2001. 38 Richard Brealey and Stuart Myers, Principles of Corporate Finance, 6th ed. (New York: McGraw-Hill, 2002), p. 160. 39 Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies, 3rd ed. (New York: John Wiley & Sons, 2000), pp. 260–261. 40 Aswath Damodaran, Investment Valuation: Tools and Techniques for Determining the Value of any Asset, 2d ed. (New York: John Wiley & Sons, 2002), pp. 175. 41 Bradford Cornell, The Equity Risk Premium: The Long-Run Future of the Stock Market (New York: John Wiley & Sons, 1999), p. 201.
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I / Business Valuation Technical Topics
Creating Shareholder Value recommends that “the premium should be based on expected rates of return rather than average historical rates. This approach is crucial because with the increased volatility of interest rates over the past two decades the relative risk of bonds increased, thereby lowering risk premiums to a range of 3 to 5 percent.”42 The Search for Value: Measuring the Company’s Cost of Capital recommends a long-term arithmetic average. However, that text recognizes that practitioners also use geometric averages and forward-looking methods.43 Graham and Dodd’s Security Analysis uses an “equity risk premium” of 2.75 percent over the yield on Aaa industrial bonds for valuing the aggregate S&P 400 index which approximates a 10-year historical average.44 This translates to a premium of approximately 3 percent over long-term government bonds. The authors of that text report the opinion of one security analyst who recommended a premium over the S&P Composite Bond yield of 3.5–5.5 percent in 1978 and 3.0–3.5 percent in 1983.45 This conclusion translates to premiums of approximately 4.5–7 percent in 1978 and 4–6 percent in 1983 over long-term government bonds. In Stocks for the Long Run, Jeremy Siegel comments that “as real returns on fixed-income assets have risen in the last decade, the equity premium appears to be returning to the 2–3 percent norm that existed before the postwar surge.”46 In The Quest for Value, G. Bennett Stewart recommends a 6 percent premium based on a long-run geometric average difference between the total returns on stocks and bonds.47
Realized Returns and the Size Effect The realized return premiums summarized above are averages. Several analysts have studied how the realized returns have varied across the various companies included in the averages. These studies have concluded that realized returns and the resulting premiums have varied with the size of the company. Generally, this relationship has shown that the realized returns and the resulting premiums for the largest companies have been less than the average and the realized returns and resulting premiums for the smaller companies have been greater than the average. This variation in realized returns based on size is not fully explained by beta. Ibbotson Associates has documented the size effect by dividing the return data since 1926 for the universe of NYSE, AMEX, and Nasdaq stocks into deciles, based on market capitalization. Ibbotson Associates calculates the market capitalization of each NYSE/AMEX/Nasdaq company (shares outstanding times market price per share) using the information in the CRSP database. Ibbotson Associates ranks the companies from largest market capitalization to smallest market capitalization.
42 Alfred
Rappaport, Creating Shareholder Value: A Guide for Managers and Investors (New York: The Free Press, 1998), p. 39. Ehrhardt, The Search for Value: Measuring the Company’s Cost of Capital (Boston: Harvard Business School Press, 1994), pp. 61–64. 44 Cottle, Murray, and Block, Graham & Dodd’s Security Analysis, 5th ed., p. 573. 45 Ibid., pp. 83–85. 46 Jeremy Siegel, Stocks for the Long Run, 2d ed., p. 18. 47 G. Bennett Stewart, The Quest for Value (New York: Harper Collins, 1990), pp. 436–438. 43 Michael
1 / The Equity Risk Premium
19
The 10 percent of the largest companies traded on the NYSE (i.e., those companies with the greatest stock market capitalization) are included in the first decile, the next 10 percent of the largest companies (in terms of market capitalization) are included in the second decile, and so forth. The smallest 10 percent of the companies (in terms of market capitalization) are included in the tenth decile. Companies traded on the AMEX and Nasdaq exchanges are added to these 10 portfolios using the breakpoints determined by the NYSE population. Companies added during the quarter are assigned to the appropriate portfolio after 2 months. Obviously, the number of companies included in each decile group changes as the number of companies included in the CRSP database changes over the years. The decile portfolios are rebalanced each quarter. From monthly returns, Ibbotson Associates calculates the average annual returns of each decile portfolio. The beta for each decile portfolio is calculated using the annual returns for each decile portfolio compared to the returns for a market portfolio represented by the S&P 500 index. Ibbotson Associates then calculates the expected return for each decile portfolio based on CAPM. That is, Ibbotson Associates multiplies the overall realized equity risk premium based on the S&P 500 index times the beta of the decile portfolio, plus the risk-free rate. The results demonstrate that the returns realized for each decile portfolio are not fully explained by beta. The long-term returns in excess of those predicted by applying CAPM are displayed in Exhibit 1.4. Graphically, these results are displayed in Exhibit 1.5. Ibbotson Associates also has reported the results of changing the benchmark used to calculate the market portfolio (i.e., the realized return premium) from the S&P 500 stock index to the NYSE total value weighted index. Those results support the relationship between size and realized return. Ibbotson Associates also examined alternative methods of calculating beta. Ibbotson Associates calculates betas based on excess annual returns. This method helps correct for certain problems associated with monthly data for smaller companies when using more common methods of estimating beta.48 These “annual” betas are higher for smaller companies than the betas derived using a monthly frequency of data. The annual betas are similar to betas calculated by Ibbotson Associates using the “sum beta” method. The sum beta method is an alternative way of handling monthly data. This method can provide a better measure of beta for small stocks by taking into account the lagged price reaction of stocks of small companies to movements in the stock market. The sum beta, when applied to the CAPM, does not account for the returns in excess of the riskless rate historically found in small stocks. Standard & Poor’s Corporate Value Consulting (S&P) publishes annual studies that corroborate the relationship between company size and average rates of return as reported by Ibbotson Associates.49 This study analyzes data going back to 1963. This is because the database developed by S&P uses both the CRSP data and data contained in Standard & Poor’s Compustat database (which contains companyspecific financial data). The Compustat database began in 1963. The Compustat 48 Using excess monthly returns with a simple linear regression (the most common method for calculating betas) creates problems due to the infrequent trading of many small companies’ stocks. See Roger Ibbotson, Paul Kaplan, and James Peterson, “Estimates of Small Stock Betas Are Much Too Low,” Journal of Portfolio Management, Summer 1997. 49 The Standard & Poor’s Corporate Value Consulting Risk Premium Report, available from Ibbotson Associates’ online Cost of Capital Center (www.ibbotson.com).
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Exhibit 1.4
Long-Term Returns in Excess of CAPM for Decile Portfolios of the NYSE/AMEX/Nasdaq (1926–2002) with Annual Beta
Size Decile 1 2 3 4 5 6 7 8 9 10 Mid-Cap, 3-5 Low-Cap, 6-8 Micro-Cap, 9-10
Beta* 0.94 1.04 1.08 1.16 1.20 1.19 1.30 1.37 1.45 1.62 1.13 1.26 1.49
Actual Return in Excess of Riskless Rate †
Cut-off ($MM)
CAPM Return in Excess of Riskless Rate ‡
6.01 7.63 8.28 8.80 9.25 9.70 9.92 10.94 11.89 15.52 8.59 9.99 12.96
$1144–$5013 $314–$1144 Under $314
Size Premium (Return in Excess of CAPM)
6.54 7.26 7.56 8.09 8.36 8.32 9.03 9.53 10.07 11.29 7.87 8.80 10.41
(0.53) 0.37 0.72 0.70 0.89 1.37 0.90 1.41 1.81 4.23 0.72 1.19 2.55
* Betas are estimated from annual portfolio total returns in excess of the 30-day U.S. Treasury bill total return vs. the S&P 500 total returns in excess of the 30-day U.S. Treasury bill, January 1926–December 2002. † Historical riskless rate is measured by the 77-year arithmetic mean income return component of 20-year government bonds (5.23%). ‡ Calculated by multiplying the equity risk premium by beta. The equity risk premium is estimated by the arithmetic mean total return of the S&P 500 (12.20%) minus the arithmetic mean income return component of 20-year government bonds (5.23%) from 1926 to 2002. NOTE: While practitioners often apply the size premium calculated using 60-month beta estimates (e.g., SBBI Valuation Edition 2003 Yearbook, p. 125), this exhibit presents the size premium calculated relative to an annual beta for comparison to the Standard & Poor’s Corporate Value Consulting Risk Premium Report. In the S&P study, the size premium is calculated using annual betas. SOURCE: Stocks, Bonds, Bills, and Inflation Valuation Edition 2003 Yearbook (Chicago: Ibbotson Associates, 2003, p. 133). DATA SOURCE: Center for Research in Security Prices, University of Chicago, Graduate School of Business.
Exhibit 1.5
Premium over CAPM for Size-Ranked Portfolios (Historical Data 1926–2002)
Premium over CAPM
5 4 3 2 1 0 −1 0.5
0.7
0.9
1.1
1.3
1.5
Betas for Size-Ranked Portfolios
SOURCE: Exhibit 1.4.
1.7
1.9
1 / The Equity Risk Premium
21
database does include earlier data for companies that were added to the Compustat database in 1963 or later. Ibbotson Associates measures “size” based on market value of equity only. However, there are reasons for seeking alternative measures of size. First, analysts may unwittingly introduce a bias when ranking companies by “market value” of equity.50 Market value is not just a function of size. It is also a function of discount rate. Some companies will not be risky (i.e., have a high discount rate) because they are small. Instead, these companies will be “small” (i.e., have a low market value) because they are risky. The use of fundamental accounting measures (such as total assets or net income) helps isolate the effects that are purely due to the small financial or operating size of the subject company. Second, market value of equity is an imperfect measure of the size of a company’s operations. Companies with large sales or total assets may have a small market value of equity if they are highly leveraged. S&P defines size using eight different measures: 1. 2. 3. 4. 5. 6. 7. 8.
Market value of equity Book value of equity Market value of invested capital (debt plus equity) Total assets Net income Earnings before interest, taxes, depreciation, and amortization (EBITDA) Net sales Number of employees
The study screens the universe of companies to exclude (1) financial companies, (2) companies lacking 5 years of publicly traded price history, (3) companies with sales below $1 million in any of the prior 5 fiscal years, and (4) companies with a negative 5-year average growth rate in sales. This screening process was in response to the argument that the “small cap” universe may consist of a disproportionate number of high-tech companies, start-up companies, and recent IPOs. In addition, this screening process was in response to the argument that these unseasoned companies may be inherently riskier than companies with a track record of viable performance. The study only considers companies with a history of profitable operations. Companies that report losses or have other high-risk characteristics are separated into a “high financial risk” portfolio. Without isolating the effects of high financial risk, the results may be biased for small companies. This is true to the extent that highly leveraged and financially distressed companies tend to have both high returns and low market values. Further, whereas Ibbotson Associates divides the market into 10 deciles, S&P divides the market into 25 portfolios. Overall, the study supports the inverse relationship between company size and average rates of return. The results indicate that the realized returns are greater than those expected by applying CAPM, except for the largest companies. The eight graphs in Exhibit 1.6 display the actual observed rates of return for the 25 portfolios compared to those predicted by CAPM.
50 Jonathan
Berk, “A Critique of Size Anomalies,” Review of Financial Studies, 8(2), 1995, pp. 275–286.
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Exhibit 1.6
Actual Observed Rates of Return for the 25 Portfolios Compared to Those Predicted by CAPM 12%
10%
10%
8%
8%
Premium over CAPM
Premium over CAPM
Smoothed Premium vs. Unadjusted Average 12%
6% 4% 2% 0% −2%
Smoothed Premium vs. Unadjusted Average
6% 4% 2% 0% −2%
−4% 1.0
2.0
3.0
4.0
5.0
6.0
−4% 1.0
1.5
2.0 2.5 3.0 3.5 4.0 Log of Average Book Value of Equity
Log of Average Market Value of Equity
Smoothed Premium vs. Unadjusted Average
12%
10%
10%
8%
8%
Premium over CAPM
Premium over CAPM
12%
6% 4% 2% 0% −2% −4% 0.0
0.5
1.0 1.5 2.0 2.5 3.0 Log of Average Net Income
3.5
2% 0%
−4% 1.0
4.0
Smoothed Premium vs. Unadjusted Average
12% 10% 8%
6% 4% 2% 0% −2%
2.0 3.0 4.0 5.0 Log of Average Market Value of Invested Capital
6.0
Smoothed Premium vs. Unadjusted Average
6% 4% 2% 0% −2%
−4% 1.0
2.0
3.0 4.0 Log of Average Total Assets
5.0
−4% 0.0
6.0
Smoothed Premium vs. Unadjusted Average
12%
10%
10%
8%
8%
Premium over CAPM
Premium over CAPM
4%
8%
6% 4% 2% 0% −2% −4% 1.0
Smoothed Premium vs. Unadjusted Average
6%
10%
12%
5.0
−2%
Premium over CAPM
Premium over CAPM
12%
4.5
1.0
2.0 3.0 Log of Average EBITDA
4.0
5.0
Smoothed Premium vs. Unadjusted Average
6% 4% 2% 0% −2%
1.5
2.0
2.5 3.0 3.5 Log of Average Sales
4.0
4.5
5.0
−4% 2.0
2.5
3.0 3.5 4.0 4.5 5.0 Log of Average Number of Employees
5.5
6.0
1 / The Equity Risk Premium
23
Criticisms of the Small Stock Effect Several criticisms have been made about the validity of the small stock effect. In fact, some analysts contend that the historical data are so flawed that practitioners can dismiss all research results that support the small stock effect.
The January Effect The January effect is the empirical regularity that rates of return for small stocks have historically tended to be higher in January than in the other months of the year. The existence of a January effect, however, does not present a challenge to the small stock effect. This is true unless it can be established that the effect is the result of a bias in the measurement of returns. Some academics have speculated that the January effect may be due to a bias related to tax-loss selling. Investors who have experienced a loss on a security may be motivated to sell their shares shortly before the end of December. An investor will make such a sale in order to realize the loss for income tax purposes. This tendency creates a preponderance of “sell” orders for such shares at year-end. If this is true, then (1) there may be some temporary downward pressure on prices of these stocks and (2) the year-end closing prices are likely to be at the “bid” rather than at the “ask” price. The prices of these stocks will only appear to recover in January when trading returns to a more balanced mix of buy and sell orders (i.e., more trading at the ask price). Such “loser” stocks will have temporarily depressed stock prices. This creates the tendency for such companies to be pushed down in the rankings when size is measured by market value. At the same time, “winner” stocks may be pushed up in the rankings when size is measured by market value. Thus, portfolios composed of small market value companies will tend to have more losers in December, with the returns in January distorted by the tax-loss selling. This argument vanishes if the analyst uses a measure other than market value (e.g., net income, total assets, net sales) to measure size.
Bid/Ask Bounce Bias There is an argument that the existence of bid/ask spread adds a bias to all stock returns. Bid/ask spreads may add a bias particularly to portfolios of less liquid (generally smaller) companies that have larger bid/ask spreads. This bias results because the movement from a bid to an ask price creates a measured rate of return that is greater in absolute value than a movement from the same ask price to the same bid price. Since trades occur randomly at either the bid or the ask, a small bias can creep into measured returns. Most studies of the small size effect (such as those by Ibbotson Associates and S&P) use the CRSP database to measure rates of return. To measure rates of return, CRSP generally uses the closing price. The closing price will be either a bid or an ask. In cases where there were no trades on a given day (the most illiquid stocks with the greatest bid/ask spread), CRSP uses the average of the bid and ask price. This procedure automatically ameliorates the bias to some extent.
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This bias can be most pronounced if one measures rates of return on a daily basis. Ibbotson Associates and S&P calculate returns monthly at the portfolio level. Then, they compound the portfolio returns for each 12 months of the year to get that year’s annual return. This procedure further mitigates much of the possible “bid/ask bounce” bias. The bid/ask bias has only a trivial impact on the observed small stock effect. Average bid/ask spreads are less than 4 percent of underlying stock price for the smallest decile of the NYSE. Spreads of even 4 percent would give rise to biases in measured returns that are, at most, only a few basis points. This assumes that annual returns are being compounded from monthly portfolio results, as in the S&P study. However, the small stock effect is observed even for midsized public companies— companies for which the bid/ask spread averages less than 1.5 percent.
Geometric versus Arithmetic Averages Some analysts have suggested that using geometric averages would correct for the bid/ask bounce bias. However, this argument is completely spurious. The difference between the higher arithmetic average and the lower geometric average does not arise from the bid/ask bounce. Geometric averages are always less than arithmetic averages due simply to the principles of mathematics.
Infrequent Trading and Small Stock Betas Some analysts have argued that betas for smaller, less frequently traded stocks are mismeasured when calculated using the common procedure of a single variable regression on monthly excess returns. These analysts argue that, in particular, small stock betas tend to be too low. Both Ibbotson Associates and S&P report portfolio betas that are measured from regressions of annual excess return data for which the infrequent trading problem is not an issue. Ibbotson Associates also reports sum betas. In all cases, the small stock effect is evident.
Delisting Bias A possible delisting bias exists in many studies that have used the CRSP database.51 The delisting bias may be due to the fact that CRSP in many (but not all) cases is missing prices for the period immediately after a stock is delisted from an exchange. This problem is not caused by a bias in the CRSP data per se. This is because the database explicitly flags all instances of missing returns. The possible bias occurs in how these missing returns are handled when one calculates average returns for portfolios of companies. There are procedures for effectively handling this issue. When these procedures are appropriately used, the size effect still exists after making the adjustment. The possible delisting bias was first documented by Tyler Shumway in a 1997 article.52 Shumway researched the archives of the over-the-counter market (and other sources). Shumway uncovered evidence of trading in securities (1) that had 51 This
section was adapted from David W. King, “Do Data Biases Cause the Small Stock Premium?” Business Valuation Review, June 2003, pp. 56–61. 52 Tyler Shumway, “The Delisting Bias in CRSP Data,” Journal of Finance, March 1997.
1 / The Equity Risk Premium
25
been delisted by the major exchanges and (2) for which returns were missing from the CRSP database. A stock exchange delisting may be a favorable or a neutral event (e.g., an acquisition, or a delisting from Nasdaq in order to trade on the New York Stock Exchange). However, there are a large number of companies that delist for performance reasons, such as failure to maintain adequate capitalization or inadequate trading volume. These are the situations for which CRSP is most likely to have missing information. Shumway’s original research indicated that, for securities delisted for performance reasons, the average loss to investors was about 30 percent. Since these negative returns are missing from the data, returns calculated from the CRSP data would tend to be biased high if the missing information is simply ignored. This is especially so for indices of small companies. This is because small companies are more likely to delist for performance reasons. Does this bias explain away the size effect? The evidence from the S&P study would suggest otherwise. S&P has adjusted for the delisting bias in annual updates published since 1998. In fact, the adjustment for delisting makes little difference in the S&P study results. In other words, the small stock effect is still present after making the delisting adjustment because companies with a history of losses (or with certain other indicators of poor financial performance) are placed in a separate high financial risk portfolio. Such companies are not included in any of the S&P sizeranked portfolios. Companies with poor financial performance are much more likely to incur a performance-related delisting than are profitable companies. When S&P first started adjusting for the delisting bias, it caused the average return on the high financial risk portfolio to decline by about 150 basis points. However, the delisting adjustment did not materially affect the average returns on the size-ranked portfolios. Moreover, CRSP recently completed a multiyear project of filling in the missing delisting data. The evidence from the CRSP white paper on the subject confirms that the delisting bias has been greatly exaggerated.53 First, CRSP now has returns for over 70 percent of performance-related delists on the NYSE, AMEX, and Nasdaq. The average performance-related delisting across this population was a loss of about 22 percent. Thus, the 30 percent loss assumed for missing returns in the S&P study now appears overstated. Second, CRSP compared returns on the CRSP capitalization-based portfolios under alternate assumptions about missing delisting returns.54 For the tenth decile of the NYSE/AMEX/Nasdaq population, the average bias created by ignoring the missing delisting returns is at most about 20 basis points (0.2 percent) on a compound market-weighted basis for the period 1926–2000. This assumes the extreme case that companies with missing delisting returns incur a 100 percent loss. If one assumes a 30 percent loss, the “bias” virtually disappears. This is important, because Ibbotson Associates uses the CRSP capitalization-based portfolios in deriving the size premiums over CAPM. Accordingly, analysts can safely conclude that there is little bias in the Ibbotson Associates data. Shumway authored a subsequent article showing that the size/return relationship is no longer apparent if one looks exclusively at companies traded on Nasdaq’s National Market System from its inception in 1972 through 1995.55 Focusing on 53
CRSP Delisting Returns, Center for Research in Security Prices, University of Chicago, April 2001, gsbwww.uchicago.edu/ research/crsp. 54 The CRSP cap-based portfolios form the basis for the small stock premiums published by Ibbotson Associates (with no adjustment for missing delisting returns). 55 Tyler Shumway, “The Delisting Bias in CRSP’s Nasdaq Data and Its Implications for the Size Effect,” Journal of Finance, December 1999.
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Nasdaq to the exclusion of other stock exchanges is interesting but problematical. The market-weighted Nasdaq index is often used as a benchmark for the performance of the technology sector. This is because Nasdaq companies with large capitalization are mainly in the technology sector. However, the Nasdaq population includes a large number of smaller firms from diverse industries. The technology sector has outperformed other sectors in recent decades. Therefore, it is not surprising to see the large capitalization Nasdaq group getting comparatively high returns. The S&P study includes Nasdaq stocks along with NYSE and AMEX companies. When all three exchanges are included together, there remains a small stock effect.
Transaction Costs Some analysts have suggested that the small stock effect should be set aside because various studies have ignored transaction costs in measuring rates of return.56 The analysts point out that small stocks have higher transaction costs than large stocks. In addition, the historical small stock premium can be greatly reduced if one makes certain assumptions about transaction costs and holding periods. However, in a discounted cash flow analysis, analysts typically use projected cash flows that do not make any adjustment for an investor’s hypothetical transaction costs. It may be that small stocks are priced in such a way as to reward investors for the costs of executing a transaction. If so, it would be a distortion to express the discount rate on a net-oftransaction-cost basis while the cash flow projections are on a before-transactioncost basis. Moreover, any reasonable adjustment for transaction costs should recognize that investors can mitigate these costs on an annual basis by holding their stocks for a longer period. In fact, investors in small companies tend to have longer holding periods than investors in large companies.
No Small Stock Premium Since 1982 Some analysts have commented on the fact that small companies have not outperformed large companies from 1982 onward.57 The only reason for breaking the data between pre- and post-1982 periods is that Ibbotson Associates changed the methodology for calculating its “small company” index returns in 1982. Through 1981, the Ibbotson Associates small company series was calculated using the returns on a synthetic portfolio constructed from CRSP data for stocks in the smallest quintile of the NYSE (ranked by market value). This is “synthetic” in the sense that it is not based on the returns of an actual fund. Actually, it is retrospectively calculated from a database of stock returns making assumptions about portfolio balance and reinvestment. From 1982 onward, Ibbotson Associates measured the small company returns using the actual returns on the Dimensional Fund Advisors Small Company 9-10 Fund (DFA). The DFA returns (1) are net of transaction costs and (2) are free of the delisting bias discussed above.
56 See
King, “Do Data Biases Cause the Small Stock Premium?”
57 Ibid.
1 / The Equity Risk Premium
27
Since 1982, small companies have, on average, not outperformed larger stocks (as measured by the Ibbotson Associates large company returns). This recent observation is sometimes cited to cast doubt on the integrity of the pre-1982 small company data. Some analysts contend that the small stock effect disappeared after 1981 because Ibbotson Associates switched from the “biased” CRSP data to the “unbiased” DFA returns. This post hoc ergo propter hoc argument does not withstand scrutiny. If one wants to illustrate the extent to which a “bias” is eliminated by using the DFA returns, it is not logical to compare the post-1981 DFA premium to a pre-1982 premium derived from CRSP data. Rather, one would more appropriately compare the DFA returns to CRSP returns over the same period. Exhibit 1.7 presents return premiums for the S&P 500 index for the period 1982 through 2002. These return premiums are calculated relative to the Ibbotson Associates income returns on long-term Treasury bonds. Exhibit 1.7 also presents return premiums for four alternate indexes that measure the performance of small companies. The first of these “bottom quintile” indexes is the Ibbotson Associates small company series (i.e., the DFA returns). This is followed by three capitalization-based CRSP indexes. One index captures returns on companies in the bottom quintile of the NYSE (the CRSP NYSE 9-10 index). Another index augments the NYSE sample by adding AMEX companies with capitalization that falls below the NYSE fifth quintile cutoff (the CRSP NYSE/AMEX 9-10 index). The last index adds companies from the Nasdaq National Market System with capitalization that falls below the NYSE cutoff (the CRSP NYSE/AMEX/Nasdaq index). The last of these indexes is the most similar to the DFA fund in terms of the types of companies included. The first index (i.e., NYSE only) is most similar to the Ibbotson Associates pre-1982 small company index. Some analysts contend that the CRSP-based indexes (which earned a premium over the S&P 5 00 before 1982) should be upwardly biased since the non-CRSP index (DFA) underperformed after 1982. However, the data indicate that the DFA fund outperformed all three of the CRSP indexes after 1982. The alleged upward bias, supposedly “corrected” by using DFA, is not evident. The post-1982 performance of DFA gives no support for the idea that the pre-1982 CRSP data has an upward bias. However, this leaves the question of why small stock returns have in fact not outperformed since 1982. This underperformance has led to speculation that, while the small stock effect may have existed in earlier periods, it is no longer relevant. The data suggest alternative views. Readers of the SBBI Yearbooks have long been
Exhibit 1.7
Alternative Stock Index Data: 1982–2002, Return Premiums over Treasury Bonds Equity Return Index S&P 500 index Ibbotson Associates small company/DFA index CRSP NYSE 9-10 index CRSP NYSE/AMEX 9-10 index CRSP NYSE/AMEX/Nasdaq 9-10 index
Geometric Average Return Premium (%)
Arithmetic Average Return Premium (%)
5.10 4.30 1.80 1.20 2.80
6.30 5.80 3.70 2.90 4.90
SOURCE: Derived from data provided by Ibbotson Associates and the Center for Research in Security Prices. All rights reserved.
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Exhibit 1.8
Small Stock Premium 1982–2002 40
0
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
−40
SOURCE: Derived from data in Stocks, Bonds, Bills, and Inflation 2003 Yearbook, Chicago: Ibbotson Associates, 2003.
aware that the small stock premium tends to move in cycles, with periods of low premiums followed by periods of high premiums. For this reason, analysts should not be astonished to find stocks underperforming for a lengthy period of time. Large stocks outperformed small stocks during the 15-year period 1946–1960 by an annual average of about 2 percent. This was a period of outstanding overall stock returns, on a par with the bull market of the 1980s and 1990s. Exhibit 1.8 plots the annual return premium for the Ibbotson Associates small company returns relative to the S&P 500 for each year 1982 through 2002. Small stocks underperformed (relative to large stocks) from 1984 to 1990. This period was followed by several years of positive premiums in the early 1990s. That period, in turn, gave way to several years of underperformance in the late 1990s. The premium has been positive during the last 4 calendar years. The overall pattern resembles the sort of cycles seen from 1926 to 1981. In this sense, small stocks have performed over the last 20 years much as they have always performed. Some analysts claim that the historical average small stock premium is greatly reduced if one excludes the period 1974 through 1983. During that period, small stocks outperformed large stocks by an extraordinary margin. But, the historical average largely bounces back again if one also excludes the subsequent period 1984–1990. It makes little sense to exclude a 10-year period from the calculation of an historical average merely because its average premium was higher than that of any other 10-year period. The poor relative performance of small stocks since the early 1980s has been attributed to poor fundamental performance.58 The growth in earnings and dividends by small companies has lagged behind the large-cap sector for most of this period. It is possible that small companies were not as well positioned to take advantage of the opportunities presented by globalization and technological innovation in the 1980s and 1990s. 58 An interesting comparison of small stock fundamentals in the United States and the United Kingdom can be found in Elroy Dimson and Paul Marsh, “U.K. Financial Market Returns 1955–2000,” The Journal of Business, January 2001. The fundamental performance of small stocks after 1980 is also analyzed in Eugene Fama and Kenneth French, “Size and Book-to-Market Factors in Earnings and Returns,” Journal of Finance, March 1995.
1 / The Equity Risk Premium
29
Advocates of the small stock effect can find satisfaction in the erratic performance of small cap stocks. If one believes that small stocks are riskier than large stocks, then it follows that small stocks should not always outperform large stocks in all periods. This is true even though the expected returns are higher for small stocks. One prominent market observer has written: “An important question that is not answered by the doubters of the small stock effect is why smaller capitalization stocks have had performance cycles at all.”59 The explanations of data bias that have been offered by the doubters are not such as would give rise to the small stock cycles that one observes in the historical data. For instance, stock delistings may follow cyclical business conditions, giving some cyclicality to the delisting bias. Nonetheless, the small stock premium is not strongly correlated with the business cycle. For example, during bull markets, small stocks sometimes outperform and sometimes underperform larger stocks. Moreover, the delisting effect is much too small to account for the wide swings that are evident over time in the small stock premium. It is even more difficult to imagine how transaction costs could give rise to the observed multiyear cycles because these transaction costs are incurred with every trade, every day.
Summary and Conclusion Estimating a reasonable ERP is one of the most important issues in cost of capital estimation. It is best to consider a variety of alternative sources including (1) the examination of realized returns over various time periods and (2) forward-looking estimates. What is a reasonable estimate of ERP in today’s environment? While considering the long-run historical arithmetic average realized returns, the Ibbotson Associates post-1925 historical arithmetic average provides an ERP estimate that is at the high end of reasonable estimates of the long-term normal ERP. Averages over alternate time periods tend to suggest a lower estimate for ERP. Analyses of what ERP could have been expected historically by investors also suggest a lower estimate for ERP. Analysts should also give consideration to forward-looking approaches. After considering the evidence, it appears that reasonable estimates of the normal ERP should be in the range of 3.5–6.0 percent. This is an estimate of the average ERP prevailing over time. This conclusion should be reconsidered in future periods as market conditions change. Evidence for the small stock effect generally comes from realized return data. The Ibbotson Associates study measures returns since 1926, using market value of equity to measure size. The Standard & Poor’s Corporate Value Consulting study measures returns since 1963, using eight alternative measures of size. Both studies support the existence of a small stock effect even after accounting for the higher average betas of small stocks.
59 Richard
Bernstein, Style Investing (New York: John Wiley & Sons, 1995), p. 142.
Chapter 2 The Discount for Lack of Control and the Ownership Control Premium—A Matter of Economics, Not Averages M. Mark Lee
Introduction Determinants of the Discount for Lack of Control Suboptimal Management of the Firm Treatment of Passive Equity Holders Valuing Ownership Control and Passive Ownership Interests in Operating Companies Ownership Control Premium Procedures Direct Procedures Discount for Lack of Control in Investment Companies Valuing Passive Ownership Interests in Family Investment Companies Public Closed-End Fund Data The Partnership Spectrum Data Conclusion
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Introduction The discount for lack of control and its opposite—the premium for ownership control—is the difference, expressed as a percentage, between (1) the value of the ownership of a controlling equity interest in a company1 and (2) the value of a noncontrolling equity interest in the same company. The relationship of the lack of control discount and the premium for ownership control for a given company is often expressed in the form of the following equations: aggregate noncontrol value of equity control value of equity control value of equity Premium for ownership control = −1 aggregate noncontrol value of equity
Discount for lack of control = 1 −
The fundamental valuation principle is that the value of an interest that has control of a business can be significantly greater than the value of an otherwise comparable noncontrolling equity interest in the same business. This extra value is the premium for control. Conversely, a noncontrolling ownership interest normally is perceived as worth significantly less than the controlling ownership interest; this reduction in value is the discount for lack of control (or, the minority interest discount). Often, there are variations in the premium or discount based on the perceived degree of ownership control.2 The terms “lack of control” and “control” refer to the legal power of an equity interest to direct the operations and affairs of a business, not to the interest’s size or percentage claim to an enterprise’s residual assets and earnings. Many public and private corporations have two classes of common stock outstanding, often with fewer shares outstanding in the class having voting control of the company. In partnerships, a holder of 1 percent or less of the residual equity, the general partner, frequently may exercise complete control over the business. Similarly, a large noncontrolling block of a widely held public company’s stock can exercise significant influence over the business’s operations. The concepts of the discount for lack of control and the premium for control are relatively straightforward. However, the use of simple averages of public acquisition price premiums to calculate the value of a controlling equity interest given the value of a passive, or noncontrolling, equity interest, or the value of a noncontrolling equity interest given the value of equity interest, is overly simplistic and seldom correct. Equally incorrect is the use of average discounts derived from public investment companies to compute the value of a passive ownership interest in a private investment company.
1 The
company may be a corporation, a partnership, a joint venture, or a legal pass-through entity.
2 A control premium is not the same as an acquisition premium. An acquisition premium is often defined as the difference between
the unaffected market price of a share of stock prior to the impact of a transaction and the price paid for a share of common stock in the transaction. For example, an acquirer (a) may pay more than control value because of synergies, or (b) may pay less than control value because the price premium offered is enough to clear the marketplace.
2 / The Discount for Lack of Control and the Ownership Control Premium
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Determinants of the Discount for Lack of Control The discount for lack of control and the control premium exist for two sets of reasons. 1. Owners of a passive ownership interest in an operating business have several disadvantages relative to a control shareholder: a. Inability to change the suboptimal management of the firm b. Unequal treatment as a result of (1) Disproportionate distribution of cash flow and other economic benefits to control equity holders (2) Timing of distributions of cash flow and other economic benefits to meet the needs of the control equity holders (3) Limited access to information 2. There are differences in the markets for passive ownership interests in a company and the market for the company as a whole.
Suboptimal Management of the Firm Generally, a buyer acquires a company at a price premium because the buyer believes that significant economic benefits can be achieved through either the better operation of the business or various synergies. These perceived benefits justify the acquisition premium.3 Nonsynergistic acquisitions include the acquisition of a public company by a leveraged buyout fund or a management-led leveraged buyout of noncontrolling stockholders. In such nonsynergistic acquisitions, the buyer often believes that the benefits of simply changing the management or financial structure of the company will more than pay for the difference between the acquisition price and the publicly traded price of the stock. Historically, however, buyers often have overestimated the potential benefits of an acquisition. Frequently, public companies are sold to the highest bidder in a competitive auction. While the highest bidder is the one that projects realization of the highest economic benefits from the acquisition, there is some question as to whether those benefits will be realized. Some academic studies indicate that the primary reason for the acquisition price premium is not economic, but the hubris of the acquirer. The acquirer’s executives (1) may believe that they are better managers; (2) may wish to make the acquisition because managers of larger companies are generally paid better than managers of smaller companies; or (3) may simply desire to run a larger enterprise. Academic studies concerning acquisitions of public companies have been mixed. Some large studies have shown little or no benefit to acquirers. Other studies have shown that acquirers have either significant losses or significant benefits. These losses or benefits depend on the industries analyzed and the acquisition techniques used. While hubris may be very important in determining the magnitude of the price premium in some competitive bidding situations, a buyer’s anticipation of profits from restructuring or synergy (whether or not realized by the buyer) generally is
3 Synergy
is additional economic value resulting from the combination of two or more businesses.
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far more important. The question for the buyer is whether the realized benefit can more than offset the acquisition price premium. On balance, it appears that the acquisition price premium paid by the buyer equals the present value of the economic benefits received. However, the wide variance in returns to the buyers in some of these studies demonstrates the old market maxim that many buyers tend to overpay for the target.4 Stockholder agreements and partnership agreements can often limit the optimal management of a company and its assets, especially in privately held businesses. These agreements limit certain ownership control prerogatives such as 1. 2. 3. 4. 5. 6.
Permitted business activities Permitted transfers or sales of ownership interests Permitted distributions or dividends Permitted financing of the business Permitted disposition of the assets of the business Merger, sale, and liquidation of the business
Often the unanimous consent of the equity holders is required to amend these agreements. As a result, the discount for lack of control may be increased. The portion of the lack of control discount due to the suboptimal management of a company can be viewed mathematically as follows: Discount for lack of control , Value of company s equity as currently managed =1 − , Value of company s equity if properly managed Conversely, the ownership control premium due to suboptimal management can be calculated as follows: Premium for ownership control , Value of company s equity if properly managed = −1 , Value of company s equity as currently managed
Treatment of Passive Equity Holders Disproportionate Benefits. Control shareholders in both public and private companies can redirect their companies’ cash flow for their own benefit. Common forms of reallocation include the following: 1. Unusually high cash compensation and/or bonuses 2. Unusually high benefit packages, including a. Severance b. Retirement c. Medical d. Legal, etc. 4 Robert F. Bruner in his article, “Does M&A Pay: A Survey of the Evidence for the Decision Maker,” Journal of Applied Finance, Spring/Summer 2002, pp. 43–57, reviewed the evidence from 14 informal studies and 300 scientific studies during the period from 1971 to 2001. This research showed that target shareholders earn sizable positive returns, that bidders earn no abnormal positive—or riskadjusted—returns, and that bidders and targets combined earn positive risk-adjusted returns. He reviewed 44 studies analyzing returns to buyer firms. Twenty studies reported negative returns with 13 of the 20 significantly negative. Twenty-four studies report positive returns, with 17 studies reporting significantly positive returns. He concluded that, on balance, mergers and acquisitions are profitable, but the wide variance of results around the zero risk-adjusted return to buyers suggests that executives should approach this activity with caution.
2 / The Discount for Lack of Control and the Ownership Control Premium
35
3. Unusually high option grants 4. Extraordinary perks, such as a. Multiple housing subsidies b. Transportation c. Living expense reimbursements d. Administrative expense reimbursements e. Nepotism 5. Transactions between the control shareholder and the company, etc. While these benefits may become excessive, they are not necessarily illegal.5 In fact, the insider transactions with the business sometimes may benefit noncontrolling equity holders as well. Nevertheless, to the extent that cash flows normally available to equity holders in proportion to their equity ownership are diverted for the benefit of the control shareholders, the lack of control discount is increased. Mathematically, the portion of the lack of control discount and ownership control premium due to the impact of the diverted cash flows can be viewed as follows: Discount for lack of control Value per share of diverted cash flows = 1− Value per share of company if properly managed Premium for ownership control Value per share of diverted cash flows = −1 Value per share of company as currently managed Timing and Magnitude of Distributions. One of the major prerogatives of control is the determination of the timing and magnitude of distributions from either the operations of the business or its sale or liquidation. In the case of publicly traded corporations, the basic control decisions are whether to pay such items as (1) regular cash dividends, (2) extra dividends, (3) in-kind distributions, and (4) liquidating distributions, and how much to pay. By custom, once a regular cash dividend is established for a public company, it is paid quarterly and is seldom reduced unless the company has severe problems. In theory, assuming equal taxation of income and capital gains, a passive equity holder in a company whose shares are publicly traded is indifferent to the payment of cash for dividends or the retention of cash to generate an appropriate return. If all earnings are retained by the company, the company’s equity value increases. The shareholder has the alternative of selling some shares on the open market to raise cash. 5 However,
they may become both excessive and illegal. According to a Tyco International, Ltd., press release, dated September 17, 2002, alleged abuses by executives that were in control of the business included the misuse of the following: a. Relocation Programs, under which certain executive officers, including Mr. Kozlowski, former CFO Mark Swartz, and former chief corporate counsel Mark Belnick used the company’s relocation program to take nonqualifying, interest-free loans. Mr. Swartz borrowed approximately $33,097,925 and Mr. Belnick borrowed approximately $14,635,597. b. The TyCom Bonus, by which Mr. Kozlowski caused Tyco to pay special, unapproved bonuses totaling $56,415,037 to 51 employees. c. The ADT Automotive Bonus by which Mr. Kozlowski and Mr. Swartz received cash bonuses, restricted shares, and “relocation” benefits valued at approximately $25,566,610 and $12,844,632, respectively. d. The Key Employee Loan (KEL) Program, which Mr. Kozlowski used to fund his personal lifestyle, including speculating in real estate, acquisition of antiques and furnishings for his properties (including properties purchased with unauthorized relocation loans), and the purchase and maintenance of his yacht. In Tyco’s case, the diversions of profits allegedly were not approved by the company’s board of directors. However, it is possible that similar diversions may be approved in a closely held business to the detriment of passive equity holders. The only recourse for these investors could be either sale of their interests at a significant discount or filing a minority shareholder oppression lawsuit.
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As a result, an analysis of the magnitude and timing of distributions generally is considered unnecessary. In contrast, the timing and size of distributions can be a serious problem in closely held companies. As the sale of a closely held equity interest is, at best, both time consuming and costly and may not even be possible, an equity holder in a closely held company may not realize the value of the retained earnings for many years. Furthermore, unlike a noncontrolling interest in a company whose shares are publicly traded, a passive equity holder in some private partnerships and S corporations is responsible for income taxes on the entity’s earnings. This is true even if these partners/shareholders do not receive distributions from the subject business to pay the income taxes. Determining the portion of the discount that is the cost of the unfavorable timing of distributions for a closely held company is both difficult and subjective. Three things are clear, however. First, investors are very reluctant to invest in situations in which there is no current income and no exit strategy—in other words, where there is no method for monetizing their investment and realizing liquidity within a reasonable period. Second, investors are extremely reluctant to invest in situations in which they have to pay taxes on deemed income that is not actually received. Third, if publicly owned companies in a particular industry normally pay significant dividends and a privately owned company in the same industry does not, then, all other things being equal, the passive shares in the privately owned company should have a greater discount for lack of control. Access to Information. The importance of accurate information is hard to overestimate. The impact of hidden corporate and accounting problems disclosed in recent years demonstrates this fact. The lack of creditability of the accounting information provided by some publicly owned corporations was considered one of the significant contributors to the stock market decline in 2001 and 2002.6 As a result, the U.S. government established the Accounting Oversight Board. And, the federal government required the U.S. Securities and Exchange Commission (SEC) to expand disclosure regulations and penalties imposed on the chief financial officers and chief executive officers of publicly owned corporations. While passive investors’ access to accurate information in publicly owned corporations sometimes is questionable, their access to information in privately owned corporations and partnerships is doubtful at best. Often, passive equity holders cannot obtain even the most routine information, much less all the information known by the controlling equity holder. The Stock Market and the M&A Market. The stock market and the mergers and acquisitions (M&A) market are two distinct and separate markets. The stock market is a market for noncontrolling ownership interests in common stock. The principal buyers and sellers are individuals, mutual funds, and financial institutions. Most stock markets are highly liquid, the investment horizons for each investor may be short, and risk tolerances can be greater than in illiquid markets. Financing is often readily available from banks and brokers at short-term money rates. Investors are generally passive. Individual investments are usually purchased as part of diversified portfolios. These factors lead to a greater tolerance for risk.
6 For example, the Associated Press reported the impact on July 3, 2002, in an article entitled, “Wall Street: Accounting Worries Continue to Plague Stock Market.” In part the article stated: “Stock indicators have been on an almost uninterrupted slide since the middle of May as a wave of disclosures about questionable accounting practices at several major U.S. firms badly damaged investor sentiment, which was already shaken by the collapse of energy giant Enron. . . .”
2 / The Discount for Lack of Control and the Ownership Control Premium
37
The M&A market is a market for whole companies. The principal buyers and sellers are controlling stockholders, corporations, and LBO firms. The market is illiquid. As a result, individual investment horizons tend to be longer. Risk tolerances in the short term tend to be lower than in a liquid market. Transactions are financed using long-term debt from banks and insurance companies, and subordinated debt and equity from mezzanine funds, large corporations, private equity funds, and wealthy individuals. The lead M&A investors typically take an active role in managing the companies they buy. The relationship of the prices for common stock in the stock market and the M&A market varies. It is not constant. Acquisition price premiums are not the same even within an industry. The relationship of the two markets is better shown in Exhibit 2.1. The oval in Exhibit 2.1 is the public stock market. The potential acquisition prices of the common stock of public companies overlaps their market prices and often may not be significantly different. However, when companies are acquired, while the acquisition prices of their common stocks are typically more than their market prices, the premiums vary greatly and sometimes may be negative. The acquisition value of a company will exceed its market value if (1) a potential acquirer believes that it can create sufficient added economic benefits, (2) a potential acquirer believes it can take advantage of favorable intermarket financing, (3) the market price of the target is depressed due to unfavorable treatment of passive shareholders, or (4) the prices for passive interests are depressed because of temporary market conditions. The additional economic benefits expected by the acquirer justifies the payment of the acquisition premium. However, the acquisition value of a company may be equal to or below its market value. For example, in emerging or speculative industries, such as the Internetrelated companies in 1998–1999, the control value of the common stock of a corporation as a whole may be less than the aggregate market value of common stock trading as noncontrolling interests. While a company may be viewed as very attractive to a purchaser of a minority interest in the public market, the company as a whole may be perceived as too risky at its publicly traded market price. As a result,
Exhibit 2.1
Relationship of Stock Market and M&A Market Stock Market Acquisition Value Exceeds Market Value If a Buyer Exists ______________________ Acquisition Value Equals or Is Less Than Market Value If a Buyer Exists
M&A Market
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individual and institutional investors may be willing to pay more per share for publicly traded noncontrolling interests as part of a diversified industry portfolio than individual acquirers will pay for the entire company.7 Similarly, companies sometimes spin off divisions or sell them in an initial public offering (IPO) rather than selling the business in the M&A market, because a higher pro rata price can be obtained in the public market than in an M&A transaction. Convergence of Values in the M&A and Stock Markets. Eric Nath has put forth the hypothesis that the common stock of most public companies, at least during boom times, tends to trade at or near its takeover or controlling ownership interest value. He noted that takeover transactions typically involve only 3–4 percent of publicly traded companies, implying that most stocks are fully priced. Otherwise, “as blood attracts sharks, a significant difference between the current price of a stock and its value to a controlling owner should trigger some form of takeover attack.”8 Many valuation analysts and investment bankers hold similar beliefs. If a company is in an industry that has not experienced any mergers or acquisitions in the recent past, or if these transactions have taken place in the same valuation pricing multiple range as in noncontrolling transactions, some justification will be necessary for valuing a controlling equity interest in a private company at market pricing multiples that are significantly higher than a passive interest in a public company. Applicability of a Discount for Lack of Control in a Private Company. While a controlling ownership interest in a private company may be valued at public market pricing multiples, passive interests in the same company may be valued at significantly lower pricing multiples. The discount for lack of control is not solely the result of the relative valuation of a company in the stock market and the acquisition market. It is also the result of (1) the specific treatment of the passive shareholders and (2) the specific quality of management in the subject company compared to public companies and acquired companies in the same industry. To the extent that the control shareholders of the subject company divert or time cash flows for their own use or poorly manage the firm relative to the public comparable companies, the discount for lack of control applicable to a passive interest increases and the value of the passive interest decreases.
Valuing Ownership Control and Passive Ownership Interests in Operating Companies Ownership Control Premium Procedures Historically, experts working for the Internal Revenue Service or the taxpayer often estimated the value of a block of common stock in a closely held company in two steps. First, they estimated the stock’s freely traded value using some variation of the guideline publicly traded company method. Second, based on the assumption that the market prices of the shares of these publicly traded companies 7 In these situations, there may be stock-for-stock transactions in which the consideration given by the acquirer is similarly highly priced common stock. The premiums in these transactions would be reported in Mergerstat based on the relative market prices. 8 Shannon P. Pratt, Business Valuation Discounts and Premiums (New York: John Wiley & Sons, 2001), p. 33.
2 / The Discount for Lack of Control and the Ownership Control Premium
39
reflect their value as noncontrolling interests, they simply added a premium for ownership control. This price premium for ownership control was generally based on the average acquisition price premium paid in public company acquisition transactions. This method, though widely used, has been rejected in some recent cases because it does not accurately measure the economic interests that are being analyzed.The use of average premiums can result in substantial overstatements or understatements of control value because •
•
•
The price of a passive ownership interest in a specific company is a function of (1) how well that company is managed, (2) how well the passive interest is treated by the controlling ownership interest, and (3) stock market conditions. The acquirer pays a specific acquisition price based on the acquirer’s view of the specific target company’s potential increase in value as a result of better management. The difference between the market price and the acquisition price determines the acquistion premium—the premium does not determine the acquisition price.
Acquisition price premiums vary widely and, as Nath points out, often may not exist at all. Some valuation analysts have determined the applicable premium for control by, first, determining the percentage or weighted percentage of rights the holder of the equity interest has out of a predetermined list of rights and, second, applying this percentage to an average premium based on selected merger and acquisition transactions. For example, a holder with complete voting control of a company, depending on state law, can: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.
Sell the company Sell the assets of the company Liquidate the company Acquire businesses, divisions, and operating assets Determine the company’s organizational form for tax purposes Determine the company’s legal form, domicile, and governance Make all operating decisions Make all investment and financing decisions Determine the kind, amount, and timing of all distributions, if any Determine compensation, benefits, and perquisites Control access to company information Control transferability and marketability of security and equity interests
If the subject control block could exercise 4 of these 12 powers, but not the 8 others, the concluded price premium would be calculated as one-third of the acquisition price premium (e.g., if the average premium was 36 percent, the premium for the block would be 12 percent). While an analysis of the powers of ownership of the block is extremely important, the above procedure elevates form over substance. First, the average price premium most likely is not applicable in any given situation. Second, the control premium is not a function of the number or weighted number of rights possessed by an interest. Rather, it is a function of the economic impact of these rights on the economic value of the ownership interest.
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Exhibit 2.2
Levels of Value Marketable, Noncontrolling Ownership Value
Marketable, Controlling Ownership Value
(Market approach—public companies) (Income approach—noncontrol cash flows)
(Market approach—acquisitions) (Income approach—control cash flows)
[Little or No Power] [Very High Liquidity]
[Nearly Total Power] [Low to Moderate Liquidity]
Discount for Difference in Degree of Marketability
Discount for Difference in Degrees of Marketability and Control
Nonmarketable, Noncontrolling Ownership Value
Nonmarketable, Noncontrolling Ownership Value
[Little or No Power] [Very High Liquidity]
[Little or No Power] [Very High Liquidity]
Direct Procedures The American Society of Appraisers uses a chart, developed by Michael Bolotsky, for defining controlling and noncontrolling values. This chart implies a nonlinear valuation process. The chart is presented in Exhibit 2.2.9 Valuation analysts generally agree that the fair market value of a noncontrolling ownership interest may be the same, lower, or higher than that of a controlling ownership interest. This indicates that controlling interests and noncontrolling, or passive, interests should be valued directly, incorporating (1) the economic benefits of control in control valuations and (2) the disadvantages of a passive interest in noncontrol valuations. The valuations should not be naively based on average ownership control premiums or on their reciprocals.
Discount for Lack of Control in Investment Companies The discount for lack of control for investment companies is defined differently than for operating companies. It is normally defined as the difference between the investment company’s net asset value per equity unit and the market value of the unit. The sources of the discount for lack of control for investment companies are very similar to those of operating companies.
9 Pratt,
Business Valuation Discounts and Premiums, pp. 6–8.
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The discount for lack of control can be magnified if 1. Management is suboptimal. a. Investment performance is poor. b. Holdings are either insufficiently diversified or contain significant amounts of less liquid or illiquid investment assets. c. Limitations are imposed on management due to the corporate charter or the partnership agreement. 2. Passive shareholders can be disadvantaged because a. Cash flow is diverted from passive investors to management and control shareholders in the form of (1) Excessive management fees (2) Other charges and expenses b. Distributions are (1) Nil (2) Uncertain as to the timing and magnitude (3) Unlikely to be realized from the underlying net asset value through (a) Distributions (b) Liquidation (c) Loans (d) Redemption (e) Merger or sale
Valuing Passive Ownership Interests in Family Investment Companies Public Closed-End Fund Data The typical valuation procedure used to estimate the passive interest value in a private investment company is: (1) determine the interest’s share of net asset value; (2) compare the subject entity to selected public closed-end investment companies or SEC-registered limited partnerships on the basis of portfolio composition, investment performance, distributions, and treatment of shareholders; and then (3) develop the appropriate discount from net asset value. However, the naïve use of an average discount for lack of control for the entire universe of closed-end funds is seldom appropriate. Some valuation analysts have attacked the use of publicly traded, closedend investment companies as guideline companies to determine the value of a noncontrolling interest. Their position is that these comparisons overestimate the discount for lack of control. In fact, the discount for lack of control should be increased for many private investment companies and limited partnerships because: 1. Publicly traded closed-end funds generally have better management. a. Publicly traded closed-end funds generally have superior performance. b. The asset mix of many publicly traded closed-end funds is more diversified and has fewer investments in restricted securities. c. Secondary sources provide independent analyses of management performance.
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2. Passive investors in publicly traded closed-end funds generally receive greater and more timely distributions. a. Closed-end funds are required by law to distribute at least 90 percent of their income or pay income taxes. b. Many closed-end funds have targeted payouts as high as 8–10 percent of net assets, and actually pay out more. c. Many closed-end funds have defined buyback policies. 3. Passive investors in closed-end funds generally have better access to information. a. Publicly traded closed-end funds are required by law to provide financial reports at least semiannually, and often report their net asset values weekly. b. Market prices of the common stocks of these companies are usually quoted daily and are available from secondary sources.
The Partnership Spectrum Data In its May/June issue, The Partnership Spectrum annually publishes information about secondary transactions in SEC-registered limited partnerships and private REITs. This empirical transaction information is developed by Partnership Profiles, Inc. The entities reported in The Partnership Spectrum studies are not actively traded on an organized securities exchange. They are bought and sold through a limited number of securities brokerage firms on the so-called limited partnership secondary market. These brokerage firms act as intermediaries matching buyers and sellers of these units. The Partnership Spectrum study compares the most recent valuation of the partnership interest (which may be estimated internally by the partnership’s general partners or by a third-party appraiser) to the weighted average trading price of the partnership interest during the months of April and May of that year. A summary of The Partnership Spectrum data is presented in Exhibit 2.3. According to the May/June 2002 issue of The Partnership Spectrum, its authors believe two economic factors, in addition to the type of investment, affect the discount. These two economic factors are described as follows:
Exhibit 2.3
The Partnership Spectrum (2001 Discount from Net Asset Value Studies) Partnership Category
Number of Partnerships
Average Discount from Net Asset Value
Average Distribution Yield
7 23 18 14 5 3
19% 19% 16% 26% 32% 35%
13.6% 10.5% 8.6% 6.5% 0.0% 0.0%
Insured mortgages Triple-net-lease Equity—Distributing (low or no debt) Equity—Distributing (moderate to high debt) Equity—Nondistributing Undeveloped land
SOURCE: The Partnership Spectrum, May/June 2002.
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First, while the partnership secondary market does provide a market for minority interests in otherwise non-traded limited partnerships, this market does not offer the liquidity of, say, the New York Stock Exchange where investors can convert their securities into cash in a matter of days. According to an internal study by American Partnership Board, the leading secondary market firm in terms of trading volume, the average amount of time required to secure a buyer for the units of a publicly registered partnership and release the net sale proceeds to the seller was approximately 60 days from the time the seller’s paperwork was approved. . . . The second factor that accounts for why partnership interests trade in the secondary market at discounts is that these are noncontrolling interests in every sense. . . . As previously discussed, price-to-value discounts for limited partnership interests have declined significantly over the years as secondary market buyers have shortened their liquidation time-frame expectations for nonlisted, publicly registered partnerships. Therefore, appraisers who base their valuations of minority interests solely on the price-to-value discount data reported in this study run the risk of valuing an interest having a long-term liquidation time frame by using discount data for partnerships having a much shorter liquidation scenario.10 The Partnership Spectrum data show that the discounts for lack of control of these partnerships are increased by 1. 2. 3. 4.
The type of investment The absence of distributions The uncertainty in cash flow The expected length of time until the liquidation of the partnership
Conclusion Discounts for lack of control and premiums for ownership control exist for specific economic reasons in a particular situation. The naïve use of average public company premium and discount data overly simplifies both the potential economic benefits associated with a controlling ownership interest and the economic penalties associated with a passive ownership interest.11
10 Partnership
Spectrum, May/June 2002, pp. 7–8. author would like to thank Gilbert E. Matthews, Dr. Michelle Patterson, and Eric Nath for reviewing this chapter. Mr. Nath was especially helpful in the preparation of Exhibit 2.1. 11 The
Chapter 3 Valuation of C Corporations Having Built-in Gains Jacob P. Roosma
Introduction Base Case Discussion of Methodology Financial Model of the Investment Alternatives Sensitivity Analyses Spread between the Investment Rate of Return and the Debt Interest Rate Investment Rate of Return Corporate Income Tax Rate Individual Income Tax Rate Inside Tax Basis Preliminary Conclusions of Sensitivity Analyses Some Real-World Assumptions Assumptions Regarding Expected Rates of Return Using Put Options to Address the Contingencies of Direct Asset Purchase Reasonableness Check Using the Price of the Put Option Investment Holding Period Adjustment Dividends Potential Value of the S Status Election Financial Model of the S Corporation Election Strategy Sensitivity Analyses—S Corporation Election Analysis Debt Interest Rate Spread between Investment Rate of Return and Debt Interest Rate Corporate Income Tax Rate Individual Income Tax Rate Inside Tax Basis Conclusion of Sensitivity Analyses Amortizable/Depreciable Appreciating Assets Short-Cuts Taken and Other Potential Criticisms Summary and Conclusion Other Implications for Business Valuations Involving the BIG Tax
46
I / Business Valuation Technical Topics
Introduction How should the analyst treat built-in gains (BIG) when estimating the fair market value of a 100 percent ownership interest in a C corporation under the asset-based approach? There is both controversy among practitioners and inconsistent guidance from judicial decisions with respect to the value impact, if any, of the BIG tax. The BIG tax is associated with a C corporation owning appreciated assets. Upon the sale of those assets, the C corporation would owe capital gains taxes. Some analysts allow for 100 percent of the BIG tax when estimating the value of a business enterprise. Other analysts apply a valuation discount that equates to less than a 100 percent allowance for the subject company’s BIG tax liability. Many variables affect the analysis. However, in all cases the fair market value of the C corporation depends upon the return on investment expected by the “hypothetical” buyer and seller. To illustrate the BIG tax valuation issue, first, we will create a set of facts to use as our benchmark for the analysis. Second, we will identify the variables that affect the analysis. Third, we will apply sensitivity analysis to those variables. Finally, we will explore two tactics the owner of the C corporation could employ that would narrow the risk-adjusted rate of return on investment: (1) hedge the value of the assets held by the C corporation and (2) elect to be taxed as an S corporation.
Base Case Let’s assume that an analyst is estimating the value of Alpha Corporation, a C corporation. Alpha Corporation is a holding company that owns marketable securities. The current fair market value of the owned marketable securities is $1000. Alpha Corporation has no liabilities. Let’s assume (1) that the value of the corporation equity (based on the net asset value of the securities) is $1000 and (2) that the inside tax basis of the corporation assets is zero. Let’s also assume a federal corporate income tax rate of 34 percent and no state tax. The fair market value of the Alpha Corporation stock would be $660, assuming a valuation adjustment (i.e., discount) for 100 percent of the BIG tax liability. The economic attractions of a C corporation that has a BIG tax liability are summarized as follows: 1. The hypothetical willing buyer has the ability to buy the underlying asset at a price discount (compared to the market value of the asset). Therefore, the buyer will enjoy the economic returns on $1,000 in assets for a purchase price of only $660. This $340 valuation discount represents, effectively, an interest-free loan of $340. 2. The aforementioned de facto interest-free loan is contingent in that it does not have to be repaid (in part or in full, either to the seller or to the Internal Revenue Service), to the extent that the underlying asset declines in value before it is actually sold. Therefore, some analysts argue—and many judicial decisions have held—that the value of the subject C corporation should be greater than the net asset value of the underlying asset adjusted for (i.e., reduced by) 100 percent of the BIG tax liability.
3 / Valuation of C Corporations Having Built-in Gains
47
The valuation issues addressed in this chapter include the following: 1. Under what circumstances should a BIG tax valuation discount be applied in the analysis of a C corporation that has appreciated owned assets? 2. Should the BIG tax valuation discount equal 100 percent of the corporation’s contingent BIG tax liability as of the valuation date, or should it be some lesser amount? 3. Is there a methodology (or quantitative model) that can effectively estimate the appropriate amount of the BIG tax valuation discount based on the specific facts and circumstances of the subject C corporation?
Discussion of Methodology This chapter presents a BIG tax valuation discount methodology. This methodology is based on a comparative analysis of the returns associated with (1) a purchase of a C corporation having the attributes described above and (2) an alternative direct purchase of the underlying appreciated assets. In each of the comparative analyses presented in the following example, let’s assume a consistent set of hypothetical facts. First, the underlying asset has a fair market value of $1000. Second, the inside tax basis of the underlying asset is zero. Third, the corporate income tax rate is 34 percent. And, fourth, the individual income tax rate is 20 percent. In this BIG tax valuation discount methodology, we assume that the willing buyer can acquire 100 percent of the C corporation stock for $660. In this case, the acquirer will, of course, control the corporate-owned underlying asset. As an alternative, the willing buyer can directly purchase (and directly own) the underlying asset by borrowing $340 and by purchasing the underlying asset at its $1000 market price. In either case, the willing buyer (1) makes a direct cash investment of $660 and (2) receives the economic returns associated with the ownership of an underlying asset worth $1000. From a valuation perspective, the differences between these two purchase alternatives are as follows: 1. The direct asset purchase alternative requires the payment of cash interest for the investment holding period. This is a plus factor for the investment in the C corporation (indirect ownership of underlying asset) purchase alternative. 2. The debt associated with the direct asset purchase alternative is fixed and not contingent on any particular return on the underlying asset. This is a plus factor for the investment in the C corporation purchase alternative. 3. The direct asset purchase alternative has a greater income tax basis (i.e., $1000) than the investment in the C corporation alternative (i.e., $660). This is a plus factor for the direct asset purchase alternative. 4. The investment in the C corporation alternative will have all of the investment returns (i.e., taxable income) subject to double taxation. This is a plus factor for the direct asset purchase alternative. The principal advantage of the investment in the C corporation alternative (relative to the direct asset purchase alternative) relates to whether the size of the incremental income tax burden of the C corporation is less than the avoided cost of debt service of the direct asset purchase. The remainder of this chapter is devoted to the development of a quantitative model that will compare and contrast the two purchase alternatives under various scenarios. We will then use this model to quantify the appropriate BIG tax valuation discount related to a C corporation that has appreciated owned assets.
48
I / Business Valuation Technical Topics
Financial Model of the Investment Alternatives Exhibit 3.1 (entitled Base Case Scenario) presents a financial model that compares the after-tax results of the two purchase alternatives over a 10-year investment holding period. The following economic variables serve as the basis for the Base
Exhibit 3.1
Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Inputs
Outputs
Expected return
10.0%
Inside basis
Year 10 benefit of direct holding
0
0
Corporate tax rate
34%
Individual tax rate
20%
Loan rate
Breakdown of Differences between Investment Alternatives
10.0%
Purchase price—corporation
Year 10 net additional tax—buy the corp.
773
Year 10 total debt service (net of tax)—buy asset direct and borrow
773
660 (reflects 100% discount for BIG tax)
Year 10 Terminal Values Purchase
Purchase
of Corp.
with
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
with BIG
Borrowing
Asset price
1,000
1,100
1,210
1,331
1,464
1,611
1,772
1,949
2,144
2,358
2,594
2,594
2,594
Built-in gain
1,000
Inside gain
Proceeds less inside basis
2,594
None
Tax on inside gain—corporate
Times corporate tax rate
882
None
Proceeds to shareholder/owner
1,712
2,594
Pretax amount to shareholder/owner Outside basis of shareholder/basis of owner Amount taxable to shareholder/owner
Subtract basis—purchase price of corporation/asset
660
1,000
Income taxable to individual shareholder/owner
1,052
1,594
Taxable amount times individual rate
210
319
Predebt, after-tax cash inflow
1,501
2,275
Subtract principal direct buyer’s proceeds
None
340
None
542
Benefit of interest deduction—borrowing
None
108
Terminal values
1,501
1,501
Less: Equity invested
660
660
Net after-tax gain on disposition
841
841
Tax—individual BIG tax
340
Borrowing (equal to BIG tax)
340
Balance of borrowing
340
374
411
453
498
548
602
663
729
802
0
34
37
41
45
50
55
60
66
73
80
34
71
113
158
208
262
323
389
462
542
Interest—borrowing Cumulative cost of borrowing
882
3 / Valuation of C Corporations Having Built-in Gains
49
Case Scenario. And, the Base Case Scenario will serve as the benchmark against which all other BIG tax valuation discount scenarios will be compared. Value of the underlying asset: $1000 Inside tax basis of the underlying asset: $0 Purchase price of 100% of the C corporation stock: $660 (100% adjustment for BIG tax) Expected investment rate of return: 10% Debt interest rate: 10% Corporate income tax rate: 34% Individual income tax rate: 20% To simplify the initial series of illustrative examples, let’s assume that the underlying asset is (1) nonamortizable and nondepreciable and (2) generates no income. In the Base Case Scenario and other illustrative examples, let’s assume that the interest expense is accumulated and represents an addition to the income tax basis on disposition of the directly purchased underlying asset. It is noteworthy that the Base Case Scenario assumptions present the most favorable case for measuring the potential economic advantage of the purchase of the C corporation relative to the direct purchase of the underlying asset. For example, the Base Case Scenario assumes that (1) the inside tax basis of the corporate owned asset is zero and (2) the avoided cost of borrowing is equal to the expected investment rate of return. Exhibit 3.1 presents the results of the Base Case Scenario analysis. The calculation of the expected after-tax returns on these two purchase alternatives indicates that the willing buyer is indifferent as to the two alternative purchase structures. In other words, the after-tax investment returns are identical for the two alternative purchase structures. It is noteworthy that the Base Case Scenario analysis (and all subsequent calculations in the analysis) assumes that the purchase price of the C corporation is equal to the underlying asset’s net asset value (i.e., $1000), adjusted for 100 percent of the BIG tax liability (i.e., $340). In other words, the Base Case Scenario analysis assumes that the willing buyer pays $660 for the C corporation stock. Of course, the $660 purchase price equates to a BIG tax valuation discount of 34 percent (i.e., the assumed corporate income tax rate).
Sensitivity Analyses Spread between the Investment Rate of Return and the Debt Interest Rate In the Base Case Scenario, the debt interest rate is assumed to be equal to the expected investment rate of return on the asset. Now, in this sensitivity analysis, let’s assume that the debt interest rate is less than the expected investment rate of return on the underlying asset. Changing no other assumptions, this sensitivity analysis results in a greater after-tax investment return for the direct purchase of the underlying asset relative to the purchase of the C corporation. The greater the
50
I / Business Valuation Technical Topics
positive spread between the investment return and the debt interest rate, the greater the economic advantage of the direct asset purchase alternative. It is noteworthy that assuming the debt interest rate to be greater than the expected investment rate of return is irrational. That is because, under those conditions, the willing buyer would never make the direct asset purchase. The results of this sensitivity analysis are presented in Exhibit 3.2.
Exhibit 3.2
Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for Debt Interest Rate Inputs
Outputs
Expected return
10.0%
Inside basis
Year 10 benefit of direct holding
262
0
Corporate tax rate
34%
Individual tax rate
20%
Loan rate
Breakdown of Differences between Investment Alternatives
5.0%
Purchase price—corporation
Year 10 net additional tax—buy the corp.
773
Year 10 total debt service (net of tax)—buy asset direct and borrow
511
660 (reflects 100% discount for BIG tax)
Year 10 Terminal Values Purchase
Purchase
of Corp.
with
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
with BIG
Borrowing
Asset price
1,000
1,100
1,210
1,331
1,464
1,611
1,772
1,949
2,144
2,358
2,594
2,594
2,594
Built-in gain
1,000 None
Inside gain
Proceeds less inside basis
2,594
Tax on inside gain—corporate
Times corporate tax rate
882
None
Proceeds to shareholder/owner
1,712
2,594
Subtract basis—purchase price of corporation/asset
660
1,000
Income taxable to individual shareholder/owner
1,052
1,594
Taxable amount times individual rate
210
319
Predebt, after-tax cash inflow
1,501
2,275
Subtract principal direct buyer’s proceeds
None
340
None
214
Benefit of interest deduction—borrowing
None
43
Terminal values
1,501
1,764
Less: Equity invested
660
660
Net after-tax gain on disposition
841
1,104
Pretax amount to shareholder/owner Outside basis of shareholder/basis of owner Amount taxable to shareholder/owner Tax—individual BIG tax
340
Borrowing (equal to BIG tax)
340
Balance of borrowing
340
357
375
394
413
434
456
478
502
527
0
17
18
19
20
21
22
23
24
25
26
17
35
54
73
94
116
138
162
187
214
Interest—borrowing Cumulative cost of borrowing
554
3 / Valuation of C Corporations Having Built-in Gains
51
Investment Rate of Return As presented in Exhibit 3.3, changes in the expected investment rate of return (all other analytical assumptions held constant) have no effect on the economic outcome. Of course, this conclusion assumes that the debt interest rate is also changed to be identical to the expected investment rate of return.
Exhibit 3.3
Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for Investment Rate of Return Inputs
Outputs
Expected return
25.0%
Inside basis
Year 10 benefit of direct holding
0
0
Corporate tax rate
34%
Individual tax rate
20%
Loan rate
Breakdown of Differences between Investment Alternatives
25.0%
Purchase price—corporation
Year 10 net additional tax—buy the corp.
2,601
Year 10 total debt service (net of tax)—buy asset direct and borrow
2,601
660 (reflects 100% discount for BIG tax)
Year 10 Terminal Values Purchase
Purchase
of Corp.
with
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
with BIG
Borrowing
Asset price
1,000
1,250
1,563
1,953
2,441
3,052
3,815
4,768
5,960
7,451
9,313
9,313
9,313
Built-in gain
1,000
Inside gain
Proceeds less inside basis
9,313
None
Tax on inside gain—corporate
Times corporate tax rate
3,166
None
Proceeds to shareholder/owner
6,147
9,313
Subtract basis—purchase price of corporation/asset
660
1,000
Income taxable to individual shareholder/owner
5,487
8,313
Taxable amount times individual rate
1,097
1,663
Predebt, after-tax cash inflow
5,049
7,651
Subtract principal direct buyer’s proceeds
None
340
None
2,826
Benefit of interest deduction—borrowing
None
565
Terminal values
5,049
5,049
Less: Equity invested
660
660
Net after-tax gain on disposition
4,389
4,389
Pretax amount to shareholder/owner Outside basis of shareholder/basis of owner Amount taxable to shareholder/owner Tax—individual BIG tax
340
Borrowing (equal to BIG tax)
340
Balance of borrowing
340
425
531
664
830
1,038
1,297
1,621
2,027
2,533
0
85
106
133
166
208
259
324
405
507
633
85
191
324
490
698
957
1,281
1,687
2,193
2,826
Interest—borrowing Cumulative cost of borrowing
3,166
52
I / Business Valuation Technical Topics
Corporate Income Tax Rate As presented in Exhibit 3.4, changing the corporate income tax rate (all other analytical assumptions held constant) has no effect on the economic outcome. However, increasing the assumed corporate income tax rate
Exhibit 3.4
Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for Corporate Income Tax Rate Inputs
Outputs
Expected return
10.0%
Inside basis
Year 10 benefit of direct holding
0
0
Corporate tax rate
50%
Individual tax rate
20%
Loan rate
Breakdown of Differences between Investment Alternatives
10.0%
Purchase price—corporation
Year 10 net additional tax—buy the corp.
1,137
Year 10 total debt service (net of tax)—buy asset direct and borrow
1,137
500 (reflects 100% discount for BIG tax)
Year 10 Terminal Values Purchase
Purchase
of Corp.
with
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
with BIG
Borrowing
Asset price
1,000
1,100
1,210
1,331
1,464
1,611
1,772
1,949
2,144
2,358
2,594
2,594
2,594
Built-in gain
1,000 None
Inside gain
Proceeds less inside basis
2,594
Tax on inside gain—corporate
Times corporate tax rate
1,297
None
Proceeds to shareholder/owner
1,297
2,594
Pretax amount to shareholder/owner Outside basis of shareholder/basis of owner Amount taxable to shareholder/owner
Subtract basis—purchase price of corporation/asset
500
1,000
Income taxable to individual shareholder/owner
797
1,594
Taxable amount times individual rate
159
319
Predebt, after-tax cash inflow
1,137
2,275
Subtract principal direct buyer’s proceeds
None
500
None
797
Benefit of interest deduction—borrowing
None
159
Terminal values
1,137
1,137
Less: Equity invested
500
500
Net after-tax gain on disposition
637
637
Tax—individual BIG tax
500
Borrowing (equal to BIG tax)
500
Balance of borrowing
500
550
605
666
732
805
886
974
1,072
1,179
0
50
55
61
67
73
81
89
97
107
118
50
105
166
232
305
386
474
572
679
797
Interest—borrowing Cumulative cost of borrowing
1,297
3 / Valuation of C Corporations Having Built-in Gains
53
1. Reduces the purchase price of the C corporation (and the outside income tax basis) 2. Increases the income tax due on the inside asset appreciation gains 3. Increases both the principal amount required to be borrowed and the amount of the interest expense related to the direct asset purchase alternative These factors are exactly offsetting, making the conservative assumption that interest costs are simply an addition to basis for purposes of measuring the tax benefit of the interest deduction.
Individual Income Tax Rate As indicated in Exhibit 3.5, changing the individual income tax rate (all other analytical variables held constant) has no effect on the economic outcome where the inside tax basis is zero. However, where the inside tax basis is greater than zero, increasing the individual income tax rate reduces the economic disadvantage of the C corporation purchase alternative.
Inside Tax Basis As indicated in Exhibit 3.6, the inside tax basis is assumed to be zero. This is the most favorable assumption for finding an economic advantage for the purchase of the C corporation alternative. Where the inside tax basis is greater than zero (all other analytical variables held constant), the direct asset purchase alternative indicates a greater after-tax investment rate of return. This is because this scenario assumes that there will be less borrowing. This is despite the fact that the outside tax basis of the C corporation purchase alternative is greater.
Preliminary Conclusions of Sensitivity Analyses Based on the foregoing sensitivity analysis, the C corporation purchase alternative has a lower expected after-tax investment rate of return than the direct asset purchase alternative, in the following circumstances: 1. When the investment rate of return is greater than the debt interest rate 2. When the inside tax basis is greater than zero
Some Real-World Assumptions Exhibit 3.7 presents the Base Case Scenario adjusted for a “normal” spread between (1) the debt interest rate and (2) the investment rate of return. The normal spread included in Exhibit 3.7 is based on the historical equity risk premium—that is, the excess of the market equity rate of return over the risk-free rate of return. The historical large capitalization company equity rate of return is about 13 percent. The historical excess of large capitalization company rates of return over the long-term risk-free income rate of return is about 8 percent. From a lender’s perspective, the direct asset purchase loan is well secured by the amount of collateral (i.e., the value of the directly purchased underlying asset).
54
I / Business Valuation Technical Topics
Exhibit 3.5
Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for Individual Income Tax Rates Inputs
Outputs
Expected return
10.0%
Inside basis
Year 10 benefit of direct holding
0
0
Corporate tax rate
34%
Individual tax rate
50%
Loan rate
Breakdown of Differences between Investment Alternatives
10.0%
Purchase price—corporation
Year 10 net additional tax—buy the corp.
611
Year 10 total debt service (net of tax)—buy asset direct and borrow
611
660 (reflects 100% discount for BIG tax)
Year 10 Terminal Values Purchase
Purchase
of Corp.
with
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
with BIG
Borrowing
Asset price
1,000
1,100
1,210
1,331
1,464
1,611
1,772
1,949
2,144
2,358
2,594
2,594
2,594
Built-in gain
1,000 None
Inside gain
Proceeds less inside basis
2,594
Tax on inside gain—corporate
Times corporate tax rate
882
None
Proceeds to shareholder/owner
1,712
2,594
Subtract basis—purchase price of corporation/asset
660
1,000
Income taxable to individual shareholder/owner
1,052
1,594
Taxable amount times individual rate
526
797
Predebt, after-tax cash inflow
1,186
1,797
Subtract principal direct buyer’s proceeds
None
340
None
542
Benefit of interest deduction—borrowing
None
271
Terminal values
1,186
1,186
Less: Equity invested
660
660
Net after-tax gain on disposition
526
526
Pretax amount to shareholder/owner Outside basis of shareholder/basis of owner Amount taxable to shareholder/owner Tax—individual BIG tax
340
Borrowing (equal to BIG tax)
340
Balance of borrowing
340
374
411
453
498
548
602
663
729
802
0
34
37
41
45
50
55
60
66
73
80
34
71
113
158
208
262
323
389
462
542
Interest—borrowing Cumulative cost of borrowing
882
And, the direct asset purchase loan is additionally secured by the existence of put options (discussed subsequently). Accordingly, a reasonable assumed spread between the investment rate of return and the debt interest rate is a minimum of 6 percent. This assumed 6 percent spread provides the lender with a 2 percent rate of return in excess of the risk-free rate
3 / Valuation of C Corporations Having Built-in Gains
55
Exhibit 3.6
Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for Inside Tax Basis Inputs
Outputs
Expected return
10.0%
Inside basis
Year 10 benefit of direct holding
325
750
Corporate tax rate
34%
Individual tax rate
20%
Loan rate
Breakdown of Differences between Investment Alternatives
10.0%
Purchase price—corporation
Year 10 net additional tax—buy the corp.
518
Year 10 total debt service (net of tax)—buy asset direct and borrow
193
915 (reflects 100% discount for BIG tax)
Year 10 Terminal Values Purchase
Purchase
of Corp.
with
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
with BIG
Borrowing
1,000
1,100
1,210
1,331
1,464
1,611
1,772
1,949
2,144
2,358
2,594
2,594
2,594
Asset price Built-in gain
250
Inside gain
Proceeds less inside basis
1,844
None
Tax on inside gain—corporate
Times corporate tax rate
627
None
Proceeds to shareholder/owner
1,967
2,594
Subtract basis—purchase price of corporation/asset
915
1,000
Income taxable to individual shareholder/owner
1,052
1,594
Taxable amount times individual rate
210
319
Predebt, after-tax cash inflow
1,756
2,275
Subtract principal direct buyer’s proceeds
None
85
None
135
Benefit of interest deduction—borrowing
None
27
Terminal values
1,756
2,082
Less: Equity invested
915
915
Net after-tax gain on disposition
841
1,167
Pretax amount to shareholder/owner Outside basis of shareholder/basis of owner Amount taxable to shareholder/owner Tax—individual BIG tax
85
Borrowing (equal to BIG tax)
85
Balance of borrowing
85
94
103
113
124
137
151
166
182
200
Interest—borrowing
0
9
9
10
11
12
14
15
17
18
20
9
18
28
39
52
66
81
97
115
135
Cumulative cost of borrowing
220
of return. Giving consideration to the put options associated with the direct asset purchase debt (discussed subsequently), the credit position is arguably risk-free to the lender. This position suggests an 8 percent spread. As presented in Exhibit 3.7, the direct asset purchase alternative generates a greater after-tax investment return relative to the C corporation purchase alternative.
56
I / Business Valuation Technical Topics
Exhibit 3.7
Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Base Case Scenario Adjusted for “Normal” Spread Inputs Expected return
Outputs 13.0%
Inside basis
Year 10 benefit of direct holding
480
0
Corporate tax rate
34%
Individual tax rate
20%
Loan rate
Breakdown of Differences between Investment Alternatives
5.0%
Purchase price—corporation
Year 10 net additional tax—buy the corp.
991
Year 10 total debt service (net of tax)—buy asset direct and borrow
511
660 (reflects 100% discount for BIG tax)
Year 10 Terminal Values Purchase
Purchase
of Corp.
with
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
with BIG
Borrowing
Asset price
1,000
1,130
1,277
1,443
1,630
1,842
2,082
2,353
2,658
3,004
3,395
3,395
3,395
Built-in gain
1,000
Inside gain
Proceeds less inside basis
3,395
None
Tax on inside gain—corporate
Times corporate tax rate
1,154
None
Proceeds to shareholder/owner
2,240
3,395
Subtract basis—purchase price of corporation/asset
660
1,000
Income taxable to individual shareholder/owner
1,580
2,395
Taxable amount times individual rate
316
479
Predebt, after-tax cash inflow
1,924
2,916
Subtract principal direct buyer’s proceeds
None
340
None
214
Benefit of interest deduction—borrowing
None
43
Terminal values
1,924
2,405
Less: Equity invested
660
660
Net after-tax gain on disposition
1,264
1,745
Pretax amount to shareholder/owner Outside basis of shareholder/basis of owner Amount taxable to shareholder/owner Tax—individual BIG tax
340
Borrowing (equal to BIG tax)
340
Balance of borrowing
340
357
375
394
413
434
456
478
502
527
0
17
18
19
20
21
22
23
24
25
26
17
35
54
73
94
116
138
162
187
214
Interest—borrowing Cumulative cost of borrowing
554
Assumptions Regarding Expected Rates of Return The analysis has thus far assumed (1) that there is a positive expected rate of return associated with the purchase of the underlying asset and (2) that the rate of return is at least equal to the debt interest. This assumption is rational. Of course, positive rates of return are expected on any investment. This is because no rational investor
3 / Valuation of C Corporations Having Built-in Gains
57
would make an investment (whether a corporation stock purchase or a direct asset purchase) with a negative expected investment return. If the willing buyer expected a negative investment rate of return, then the model indicates that the C corporation purchase would be more attractive than the direct purchase of the underlying asset. However, if the willing buyer did indeed expect a negative rate of return associated with the direct asset purchase, the rational buyer would either (1) avoid the direct asset purchase alternative altogether or (2) sell short the direct asset. Selling short generates a greater after-tax economic benefit for the direct asset purchase alternative than for the C corporation purchase alternative.
Using Put Options to Address the Contingencies of Direct Asset Purchase All of the analysis thus far assumed both (1) a positive expected rate of investment return as well as (2) positive actual rates of return over the 10-year investment holding period horizon. This is a reasonable way to consider investment decision making among alternative purchase structures. This is because all investment decision making is predicated on expected rates of return. Actual rates of return do, however, deviate from expected rates of return. And, that rate of return deviation may be material to the investment decision process. For example, let’s assume that the investment becomes worthless at the moment right after the purchase is made. Let’s make this assumption for both investment structures—the purchase of the C corporation and the direct purchase of the underlying asset. Under this assumption, the purchase of the C corporation generates a more favorable economic outcome (i.e., the after-tax loss is less) than the direct asset purchase alternative. The willing buyer in the C corporation purchase alternative lost $660. The willing buyer in the direct asset purchase alternative both lost $660 and had to repay a $340 asset purchase loan. However, the willing buyer in the direct asset purchase alternative had an asset tax basis of $1000. The amount of the economic benefit of the C corporation purchase relative to the direct asset purchase is dependent on both the corporate income tax rate and the individual tax rate. The direct asset purchase buyer loses the entire amount that was borrowed. And, that debt amount is a function of the corporate income tax rate. However, the direct asset purchase buyer has a greater tax basis in the directly purchased asset. This greater tax basis generates economic benefit, which is a function of the individual income tax rate. The direct asset purchase buyer can cover this contingency by purchasing a put option. This put option would have a strike price equal to the fair market value of the underlying asset. The put option would be in an amount equal to the value of the underlying asset times the corporate income tax rate. The intrinsic value of the put option would exactly offset the amount by which the rate of investment return on the C corporation purchase exceeded the rate of investment return on the direct asset purchase. This would be true under any combination of income tax rate assumptions and asset tax basis assumptions. Note the assumption (where the corporation has any positive tax basis in the underlying asset) that the sale at a loss will generate a tax benefit equal to the income tax rate times the amount of the loss. That assumption increases the
58
I / Business Valuation Technical Topics
potential attractiveness of the C corporation purchase alternative in this analysis. To the extent that there is no “inside” tax benefit available from the loss, the put strategy would be correspondingly adjusted. This situation is illustrated in Exhibits 3.8 and 3.9. Whether the direct asset purchase alternative is more attractive than the C corporation purchase alternative depends on the price of the put option relative to the economic advantage of the direct asset purchase alternative.
Exhibit 3.8
Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Put Analysis—Base Case Scenario Inputs
Output
Inside basis
0
Benefit
Corporate tax rate
50%
Individual tax rate
50%
Purchase price—corporation
500 (reflects 100% discount for BIG tax)
Put amount
500 (underlying asset times corporate tax rate)
Terminal Values
Begin
Purchase
Asset price
1,000
Built-in gain
1,000
Purchase
of Corp.
with
with BIG
Borrowing
-
500 (value of put)
Inside gain
-
None
Tax on inside gain—corporate
-
None
Pretax amount to shareholder/owner
-
500
Outside basis of shareholder/basis of owner
500
Amount taxable to shareholder/owner
1,000
(500)
(500)
(250)
(250)
250
750
None
500
Terminal values
250
250
Less: Amount invested
500
500
(250)
(250)
Tax expense—individual BIG tax
500
Cash flow before debt Borrowing (equal to BIG tax)
After-tax loss on disposition
500
Relative to C corporation, better off to buy direct by
0
0
3 / Valuation of C Corporations Having Built-in Gains
59
Exhibit 3.9
Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Put Analysis—Stress Testing Inputs Inside basis
Output Benefit
250
Corporate tax rate
0
34%
Individual tax rate
20%
Purchase price—corporation
745 (reflects 100% discount for BIG tax)
Put amount
340 (underlying asset times corporate tax rate)
Begin
End
Terminal Values Purchase
Put
Purchase
of Corp.
with
with BIG
Borrowing
None
170 (value of put)
500
500
250
None
85
None
Pretax amount to shareholder/owner
415
670
Outside basis of shareholder/basis of owner
745
1,000
Asset price
1,000
Built-in gain
500
750
Inside gain Tax on inside gain—corporate
Amount taxable to shareholder/owner
(330)
(330)
(66)
(66)
481
736
None
255
Terminal values
481
481
Less: Amount invested
745
745
(264)
(264)
Tax expense—individual BIG tax
255
Cash flow before debt Borrowing (equal to BIG tax)
After-tax loss on disposition
255
Relative to C corporation, better off to buy direct by
0
Reasonableness Check Using the Price of the Put Option The model calculates the year 10 after-tax economic benefit of the two purchase structure alternatives. In this calculation, the model allows for the differences in income tax rates and in asset purchase financing. The price of the put option should be measured in today’s dollars for purposes of comparing the two purchase structure
60
I / Business Valuation Technical Topics
alternatives to the put option. The value of the year 10 economic benefit should be discounted to its present value. This procedure raises the question of what present value discount rate to use to bring the year 10 economic benefit of the direct asset purchase alternative to today’s dollars. The present value discount rate for this calculation should be adjusted to reflect the fact that the excess of the year 10 economic benefit of the direct asset purchase is after individual income taxes. The rate of return assumption is, therefore, adjusted to reflect the fact that the year 10 economic benefit is presented after tax at individual income tax rates. The present value of the after-tax amount of the excess return is the maximum amount that the direct asset purchase buyer would pay for the put option. The maximum price of the put option (assuming the willing buyer would pay 100 percent of the economic benefit of the direct asset purchase scenario for the put) using “real world” assumptions amounts to about 42 percent of the value of the underlying asset. The Black-Scholes option pricing model indicates a price for a 10year put (assuming the market level of volatility, a strike price equal to current market value, and no dividends) which is less than the upper limit of 42 percent of the market value of the underlying asset. Under assumptions consistent with the normal spread between debt interest rates and investment rates of return, it is reasonable to conclude that the C corporation purchase alternative is less attractive than the direct asset purchase alternative. This is true after allowing for the price of the put option. This analysis is presented in Exhibit 3.10.
Investment Holding Period Adjustment For illustrative purposes, the foregoing analyses assumed a zero investment holding period. That is, the analyses assumed that the underlying asset became worthless at the moment immediately after the purchase. A series of future options on put options could be structured to ensure against the loss of expected debt interest expense to be paid over the assumed 10-year holding period. For example, to cover the potential debt interest in year 10, the buyer could purchase an option to buy a put option exercisable 10 years hence for the expected interest expense amount in year 10. Using an estimate of the price of these future options equal to one-half the price of the put on the debt principal will not alter the basic conclusion under the aforementioned normal spread between the investment rate of return and the debt interest rate.
Dividends So far, all of the model analyses have assumed no dividends. Dividends paid to individuals are taxed at ordinary individual income tax rates. Dividends (net of the dividends paid exclusion) paid to the C corporation are taxed at ordinary corporate income tax rates.
3 / Valuation of C Corporations Having Built-in Gains
61
Exhibit 3.10
Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Calculation of Maximum Price of Put—Direct Investor Inputs Expected return Inside basis Corporate tax rate Individual tax rate Loan rate Expected return after individual tax Purchase price—corporation
Outputs 13.0% Year 10 benefit of direct holding 480 0 Breakdown of Differences between Investment Alternatives 34% 20% Year 10 net additional tax—buy the corp. 991 5.0% Year 10 total debt service (net of tax)—buy asset direct and borrow 511 10.4% Price of Put Option Relative to PV of Benefit of Direct Holding 660 (reflects 100% discount for BIG tax) PV of benefit of direct holding at expected return net of individual tax 179 Maximum price of put options as a % of asset value—direct purchase 53% Pay no more than $179 for 10 year put on $340 stock w/ strike price at market
Year 10 Terminal Values Purchase of Corp. with BIG
Purchase with Borrowing
3,395
3,395
Proceeds less inside basis Times corporate tax rate
3,395 1,154
None None
Proceeds to shareholder/owner
2,240
3,395
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Asset price Built-in gain Inside gain Tax on inside gain—corporate
1,000 1,000
1,130
1,277
1,443
1,630
1,842
2,082
2,353
Pretax amount to shareholder/owner Outside basis of shareholder/basis of owner
3,004
3,395
Subtract basis—purchase price of corporation/asset
660
1,000
Income taxable to individual shareholder/owner
1,580
2,395
Taxable amount times individual rate
316
479
Predebt, after-tax cash inflow
1,924
2,916
Subtract principal direct buyer’s proceeds
None
340
None
214
Benefit of interest deduction—borrowing
None
43
Terminal values
1,924
2,405
Less: Equity invested
660
660
Net after-tax gain on disposition
1,264
1,745
Amount taxable to shareholder/owner Tax—individual BIG tax
2,658
340
Borrowing (equal to BIG tax)
340
Balance of borrowing Interest—borrowing Cumulative cost of borrowing
340 0
357 17 17
375 18 35
394 19 54
413 20 73
434 21 94
456 22 116
478 23 138
502 24 162
527 25 187
554 26 214
62
I / Business Valuation Technical Topics
Potential Value of the S Status Election The projection period for all of the scenario analyses was deliberately set at 10 years. The reason for the selection of that investment time period is the ability of the C corporation buyer to elect to be taxed under Subchapter S of the Internal Revenue Code. That election could potentially allow the C corporation to avoid the BIG tax liability entirely. Expansion of the model to allow for the avoidance of the BIG tax liability makes the C corporation purchase alternative decidedly more attractive than the direct asset purchase alternative, for obvious reasons. However, in order to avoid the BIG tax liability by making an S corporation election, the C corporation will not be able to sell the underlying asset for 10 years. Therefore, this purchase structure alternative will suffer from a lack of marketability during this period. Any sale of the underlying asset prior to the expiration of the 10-year holding period would make the direct asset purchase structure a better investment alternative.
Financial Model of the S Corporation Election Strategy The lack of marketability attributable to the S corporation election is measured by setting the after-tax terminal value of the C corporation purchase equal to the aftertax, after-debt terminal value of the direct asset purchase alternative. Solving for the beginning dollar amount of underlying asset required to be inside the C corporation (electing S corporation status) provides the amount of underlying assets necessary to provide an equivalent rate of return to the direct asset purchase alternative. The required investment is a lesser amount since both (1) the cost of the asset purchase debt and (2) the BIG tax liability are avoided. The required investment amount, however, has a bearing on whether the willing buyer would be willing to “lock up” the ownership position for 10 years. In this case, the required investment value (using real world assumptions) calculated is $803. This amount implies a lack of marketability discount of 19.7 percent. Most valuation analysts would likely agree that the appropriate lack of marketability discount for a 10-year lock-up period is at least 19.7 percent. One could also solve for the beginning amount of the underlying asset (lacking marketability for 10 years) for the direct asset purchase alternative. If the $1000 marketable asset value is discounted by a percent at least equal to or greater than the corporate income tax rate, then there can be no question that the direct asset purchase is the economically advantageous alternative. There would be no asset purchase debt and no put option.
Sensitivity Analyses—S Corporation Election Analysis Debt Interest Rate As presented in Exhibit 3.11, where the debt interest rate equals the expected rate of return, the implied maximum lack of marketability discount equals the corporate income tax rate.
3 / Valuation of C Corporations Having Built-in Gains
63
Exhibit 3.11
Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Subchapter S Election Adjusted for Rates Inputs Expected return
Output
Inside basis Corporate tax rate Individual tax rate Loan rate
Implied maximum lack of marketability discount
15.0%
34.0%
0 34% 20% 15.0%
Asset price—freely traded
1000
Purchase price—corporation
660 (reflects 100% discount for BIG tax)
I
II
III S Election
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
660
759
873
1,004
1,154
1,327
1,527
1,756
2,019
2,322
2,670
Asset price
1,000
1,150
1,323
1,521
1,749
2,011
2,313
2,660
3,059
3,518
4,046
Built-in gain
1,000
S corporation equivalent value
Purchase
Purchase
Equivalent
with
of Corp.
Freely Traded
Borrowing
Elect S
Stock 2,670
4,046
4,046
Inside gain
Proceeds less inside basis
None
None
Tax on inside gain—corporate
Times corporate tax rate
None
None
None
Proceeds to shareholder/owner
4,046
4,046
2,670
Subtract basis—purchase price of corporation/asset
1,000
660
660
Income taxable to individual shareholder/owner
3,046
3,386
2,010
Taxable amount times individual rate
609
677
402
Predebt, after-tax cash inflow
3,436
3,368
2,268
Subtract principal direct buyer’s proceeds
340
None
1,035
None
Pretax amount to shareholder/owner
Outside basis of shareholder/basis of owner Amount taxable to shareholder/owner Tax—individual BIG tax
340
Borrowing (equal to BIG tax)
340
Balance of borrowing
340
Interest—borrowing
-
Cumulative cost of borrowing
None
391
450
517
595
684
786
904
1,040
1,196
51
59
67
78
89
103
118
136
156
1,375 179
51
110
177
255
344
446
564
700
856
1,035
Benefit of interest deduction—borrowing
207
None
None
Terminal values
2,268
3,368
2,268
Less: Equity invested
660
660
660
Net after-tax gain on disposition
1,608
2,708
1,608
Spread between Investment Rate of Return and Debt Interest Rate As presented in Exhibit 3.12, the greater the excess of the investment rate of return over the debt interest rate, the less advantageous the C corporation (with an S status election) purchase alternative.
Corporate Income Tax Rate As presented in Exhibit 3.13, changing the corporate income tax rate (all other analytical assumptions held constant) has a material effect on the economic outcome. Increasing the corporate income tax rate has the effect of
64
I / Business Valuation Technical Topics
Exhibit 3.12
Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Subchapter S Election Adjusted for Investment Return Inputs Expected return
Output
Inside basis Corporate tax rate
Implied maximum lack of marketability discount
25.0%
7.2%
0 34%
Individual tax rate
20%
Loan rate
7.0%
Asset price—freely traded
1000
Purchase price—corporation
660 (reflects 100% discount for BIG tax)
I
II
III S Election
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
928
1,160
1,450
1,813
2,266
2,833
3,541
4,426
5,532
6,916
8,644
Asset price
1,000
1,250
1,563
1,953
2,441
3,052
3,815
4,768
5,960
7,451
9,313
Built-in gain
1,000
S corporation equivalent value
Purchase
Purchase
Equivalent
with
of Corp.
Freely Traded
Borrowing
Elect S
Stock 8,644
9,313
9,313
Inside gain
Proceeds less inside basis
None
None
Tax on inside gain—corporate
Times corporate tax rate
None
None
None
Proceeds to shareholder/owner
9,313
9,313
8,644
Subtract basis—purchase price of corporation/asset
1,000
660
660
Income taxable to individual shareholder/owner
8,313
8,653
7,984
Taxable amount times individual rate
1,663
1,731
1,597
Predebt, after-tax cash inflow
7,651
7,583
7,048
Subtract principal direct buyer’s proceeds
340
None
329
None
Pretax amount to shareholder/owner
Outside basis of shareholder/basis of owner Amount taxable to shareholder/owner Tax—individual BIG tax
340
Borrowing (equal to BIG tax)
340
Balance of borrowing
340
Interest—borrowing
-
Cumulative cost of borrowing
None
364
389
417
446
477
510
546
584
625
24
25
27
29
31
33
36
38
41
669 44
24
49
77
106
137
170
206
244
285
329
Benefit of interest deduction—borrowing
66
None
None
Terminal values
7,048
7,583
7,048
Less: Equity invested
660
660
660
Net after-tax gain on disposition
6,388
6,923
6,388
1. Reducing the C corporation purchase price (and the outside tax basis) 2. Increasing the tax liability on the inside asset gains 3. Increasing (a) the amount required to be borrowed by the direct asset purchase buyer and (b) the associated amount of debt interest expense These factors all contribute to the attractiveness of the C corporation purchase alternative (with an S status election).
Individual Income Tax Rate As presented in Exhibit 3.14, changing the individual tax rate (all other analytical variables held constant) has no effect on the economic outcome.
3 / Valuation of C Corporations Having Built-in Gains
65
Exhibit 3.13
Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Subchapter S Election Adjusted for Corporate Tax Rate Inputs Expected return
Output 10.0%
Inside basis Corporate tax rate Individual tax rate Loan rate
Implied maximum lack of marketability discount
50.0%
0 50% 20% 10.0%
Asset price—freely traded
1000
Purchase price—corporation
500 (reflects 100% discount for BIG tax)
I
II
III S Election
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
500
550
605
666
732
805
886
974
1,072
1,179
1,297
Asset price
1,000
1,100
1,210
1,331
1,464
1,611
1,772
1,949
2,144
2,358
2,594
Built-in gain
1,000
S corporation equivalent value
Purchase
Purchase
Equivalent
with
of Corp.
Freely Traded
Borrowing
Elect S
Stock 1,297
2,594
2,594
Inside gain
Proceeds less inside basis
None
None
Tax on inside gain—corporate
Times corporate tax rate
None
None
None
Proceeds to shareholder/owner
2,594
2,594
1,297
Pretax amount to shareholder/owner
Outside basis of shareholder/basis of owner
Subtract basis—purchase price of corporation/asset
Amount taxable to shareholder/owner
1,000
500
500
Income taxable to individual shareholder/owner
1,594
2,094
797
Taxable amount times individual rate
319
419
159
Predebt, after-tax cash inflow
2,275
2,175
1,137
Subtract principal direct buyer’s proceeds
500
None
797
None
Tax—individual BIG tax
500
Borrowing (equal to BIG tax)
500
Balance of borrowing
500
Interest—borrowing
-
Cumulative cost of borrowing
None
550
605
666
732
805
886
974
1,072
1,179
50
55
61
67
73
81
89
97
107
1,297 118
50
105
166
232
305
386
474
572
679
797
Benefit of interest deduction—borrowing
159
None
None
Terminal values
1,137
2,175
1,137
Less: Equity invested
500
500
500
Net after-tax gain on disposition
637
1,675
637
Inside Tax Basis As presented in Exhibit 3.15, the inside tax basis is assumed to be zero. This is the most favorable assumption for finding an economic advantage for the C corporation purchase alternative. Where the inside tax basis is greater than zero (all other analytical variables held constant), the economic advantage of the C corporation purchase (with an S election) diminishes.
Conclusion of Sensitivity Analyses It would appear that a normal lack of marketability discount on the underlying asset would obviate the potential economic advantage of the C corporation purchase (with
66
I / Business Valuation Technical Topics
Exhibit 3.14
Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Subchapter S Election Adjusted for Individual Tax Rate Inputs Expected return
Output 10.0%
Inside basis
34.0%
0
Corp tax rate
34%
Individual tax rate
50%
Loan rate
Implied maximum lack of marketability discount
10.0%
Asset price—freely traded
1000
Purchase price—corporation
660 (reflects 100% discount for BIG tax)
I
II
III S Election
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
660
726
799
878
966
1,063
1,169
1,286
1,415
1,556
1,712
Asset price
1,000
1,100
1,210
1,331
1,464
1,611
1,772
1,949
2,144
2,358
2,594
Built-in gain
1,000
S corporation equivalent value
Purchase
Purchase
Equivalent
with
of Corp.
Freely Traded
Borrowing
Elect S
Stock 1,712
2,594
2,594
Inside gain
Proceeds less inside basis
None
None
None
Tax on inside gain—corporate
Times corporate tax rate
None
None
None
Proceeds to shareholder/owner
2,594
2,594
1,712
Pretax amount to shareholder/owner
Outside basis of shareholder/basis of owner
Subtract basis—purchase price of corporation/asset
1,000
660
660
Income taxable to individual shareholder/owner
1,594
1,934
1,052
Taxable amount times individual rate
797
967
526
Predebt after-tax cash inflow
1,797
1,627
1,186
Subtract principal direct buyer’s proceeds
340
None
542
None
Amount taxable to shareholder/owner Tax—individual BIG tax
340
Borrowing (equal to BIG tax)
340
Balance of borrowing
340
Interest—borrowing
-
Cumulative cost of borrowing
374
411
453
498
548
602
663
729
802
34
37
41
45
50
55
60
66
73
882 80
34
71
113
158
208
262
323
389
462
542
Benefit of interest deduction—borrowing
271
None
None
Terminal values
1,186
1,627
1,186
Less: Equity invested
660
660
660
Net after-tax gain on disposition
526
967
526
an S election) relative to the direct asset purchase alternative. The negative value impact of the impaired investment liquidity is greater than the potential economic advantage of the C corporation purchase alternative.
Amortizable/Depreciable Appreciating Assets The alternative analyses presented thus far have assumed that the underlying assets are nonamortizable/nondepreciable and generate no income. In the following analyses, we will eliminate these two assumptions. The most common type of amortizable/depreciable asset having appreciation characteristics is real property (e.g., a building). The direct asset purchase alternative
3 / Valuation of C Corporations Having Built-in Gains
67
Exhibit 3.15
Analysis of Comparative Returns, Value of C Corporations with Built-in Gains, Subchapter S Election Adjusted for Inside Basis Inputs Expected return Inside basis Corporate tax rate Individual tax rate Loan rate
Output 10.0%
Implied maximum lack of marketability discount
8.5%
750 34% 20% 10.0%
Asset price—freely traded
1000
Purchase price—corporation
915 (reflects 100% discount for BIG tax)
I
II
III S Election
S corporation equivalent value Asset price Built-in gain
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
915
1,007
1,107
1,218
1,340
1,474
1,621
1,783
1,961
2,158
2,373
1,000
1,100
1,210
1,331
1,464
1,611
1,772
1,949
2,144
2,358
2,594
Purchase
Purchase
Equivalent
with
of Corp.
Freely Traded
Borrowing
Elect S
Stock 2,373
2,594
2,594
250
Inside gain
Proceeds less inside basis
None
None
None
Tax on inside gain—corporate
Times corporate tax rate
None
None
None
Proceeds to shareholder/owner
2,594
2,594
2,373
Pretax amount to shareholder/owner
Outside basis of shareholder/basis of owner Amount taxable to shareholder/owner
Subtract basis—purchase price of corporation/asset
1,000
915
915
Income taxable to individual shareholder/owner
1,594
1,679
1,458
Taxable amount times individual rate
319
336
292
Predebt after-tax cash inflow
2,275
2,258
2,082
Subtract principal direct buyer’s proceeds
85
None
135
None
Tax—individual BIG tax
Borrowing (equal to BIG tax) Balance of borrowing Interest—borrowing Cumulative cost of borrowing
85
85 85 -
94
103
113
124
137
151
166
182
200
9
9
10
11
12
14
15
17
18
220 20
9
18
28
39
52
66
81
97
115
135
Benefit of interest deduction—borrowing
27
None
None
Terminal values
2,082
2,258
2,082
Less: Equity invested
915
915
915
Net after-tax gain on disposition
1,167
1,343
1,167
allows depreciation of the full fair market value of the depreciable component of the real property investment. This attribute is contrasted with the purchase of the C corporation (with the control of the corporate-owned real property). This alternative purchase structure simply allows for the continued depreciation of the existing real property depreciable basis. The depreciation expense will, therefore, be lower for the C corporation purchase relative to the direct asset purchase. This will be true at least for the initial 10 years of the holding period. The present value of the incremental depreciation expense is a plus factor for the direct asset purchase alternative. Whether one can assume the C corporation electing S status will liquidate after 10 years (to obtain a fresh start step-up in basis of the asset in the hands of the stockholders) depends on: (1) the estimated fair market value of the asset 10 years hence,
68
I / Business Valuation Technical Topics
(2) the basis of the C corporation stock, (3) the tax “life” of the asset, and (4) the income taxes potentially payable on liquidation.
Short-Cuts Taken and Other Potential Criticisms Throughout this chapter, we made the following simplifying assumptions: • • •
• •
Transaction costs were ignored. Dividends were assumed to be zero. Dividends would, in fact, increase the income tax expense of the individual. The price of a 10-year put option was estimated using market volatility, current risk-free rates, zero dividends, and a 10-year duration in a Black-Scholes model. However, the Black-Scholes model may not be the best model for estimating the price of a long-term put option. Moreover, the price of a series of put options covering the interest component of the direct asset purchase scenario was ignored. If the cost of these options was half again as much as the put on the debt principal (which probably overstates the case), the basic conclusion remains the same. The proceeds from the sale or exercise of the put option were assumed to be equal to the put option intrinsic value. The price of put options was not considered in the estimate of the lack of marketability discount. This discount was used in measuring the rate of return on the direct asset purchase alternative so as to set it equal to the C corporation purchase alternative. The effect of this simplifying assumption is small, and it likely does not change the basic conclusion.
Some other simplifying assumptions were made in connection with taxation issues as follows: •
• •
• • •
The income tax benefit of the interest expense deduction was simply considered as an addition to basis in year 10 and the individual tax rate was employed. To the extent that a current deduction would be available at ordinary income tax rates, it would be a plus to the direct asset purchase alternative. The income tax basis in the put option was ignored in all calculations. The proceeds from the exercise of the put option were assumed to offset the loss on the underlying asset. The income tax benefit of the loss was calculated at the assumed individual income tax rate. Losses at the individual level were assumed to generate an economic benefit equal to the individual income tax rate times the amount of the loss. Losses inside the C corporation were assumed to generate income tax benefits equal to the corporate income tax rate times the amount of the loss. State and local income taxes were ignored.
Summary and Conclusion How should the analyst treat “built-in” gains when estimating the fair market value of a 100 percent ownership interest in a C corporation? This chapter presented a methodology (or quantitative model) that effectively estimates the appropriate BIG
3 / Valuation of C Corporations Having Built-in Gains
69
tax valuation discount, based on the specific facts and circumstances of the subject C corporation. As always, the facts and circumstances of each situation affect the valuation conclusion. However, based on (1) the tax status of the subject assets or entity and (2) the attributes of the subject ownership interest, the effect of any BIG tax liability should be considered in the valuation of most C corporations. Based on the analyses presented in this chapter, no premium (over the tax-adjusted net asset value) should be assigned to the stock of a C corporation that owns appreciated assets. This general conclusion holds (1) whether the assets owned by the corporation are appreciating or wasting and (2) whether these assets are amortizable/depreciable or nonamortizable/nondepreciable. Where a C corporation owns appreciated assets, there is no economic advantage to the purchase of the C corporation stock with built-in gains—relative to the direct purchase of the underlying assets and a put option. Therefore, no rational willing buyer would pay a price premium over the tax-adjusted net asset value of the corporation. And, no rational willing seller would accept less than the taxadjusted net asset value of the corporation. The principal reason for this conclusion is the fact that 100 percent of the gains inside the corporation are subject to double taxation. This double taxation offsets the apparent economic benefits to the C corporation purchase structure alternative described in the introduction to this chapter. No reputable tax adviser recommends that a client structure his or her affairs in a way that will subject investment returns to double taxation if it can be avoided. The economic benefit of buying the C corporation stock and then electing S corporation status is more than offset by the fact that the underlying asset becomes unmarketable for 10 years. This 10-year holding period after the S election is necessary in order to “reset” the asset basis and, thus, eliminate the BIG tax liability. Any sale of the underlying asset within the S corporation’s 10-year holding period would make the direct asset purchase alternative preferable to the stock purchase alternative. Where the underlying asset is a wasting, depreciable/amortizable asset that is not expected to be sold in the foreseeable future, the difference in the value of the C corporation stock purchase and the direct asset purchase is the present value of the difference in the depreciation tax deduction. All other factors held equal, the investor gets more depreciable basis with a direct purchase of the underlying asset as compared to the C corporation stock purchase.
Other Implications for Business Valuations Involving the BIG Tax All of the analyses presented in this chapter assume the value of a 100 percent ownership interest in the subject corporation. With regard to the valuation of a noncontrolling ownership interest in a closely held corporation, any appropriate (1) discount for lack of ownership control and (2) discount for lack of marketability would be applied after adjusting for the BIG tax liability valuation discount.
Chapter 4 The S Corporation Economic Adjustment Daniel R. Van Vleet
Introduction Basic Premises Business Valuation Approaches Income-Based Approaches Asset-Based Approach Conceptual Mismatch between S Corporations and C Corporations The S Corporation Economic Adjustment S Corporation Equity Adjustment Multiple Application of the SEAM Primary Assumptions and Potential Adjustments S Corporation Perpetuity Assumption Cash Investment Returns and Unrealized Capital Gains Recognition of Capital Gains Taxes Tax Status of Buyers and Sellers Current Income Tax Law Profitability Assumption Summary and Conclusion
72
I / Business Valuation Technical Topics
Introduction Analysts have long debated the economic impact of income taxes on the value of the equity securities of subchapter S corporations. Until recently, these arguments typically centered on whether it was more appropriate to use an individual ordinary income tax rate or a C corporation income tax rate to tax-affect the reported net income1 of the S corporation. Regardless of which rate was used, there was a general consensus that income taxes should be estimated and deducted from the S corporation reported net income when publicly traded C corporations were used in the valuation analysis. Between 1999 and 2002, the U.S. Tax Court handed down three important decisions that fundamentally challenged the way analysts view the value of equity ownership interests of S corporations. In Gross v. Commissioner,2 Heck v. Commissioner,3 and Adams v. Commissioner4 the Tax Court held that estimated income taxes should not be deducted from the projected net income of S corporations when using the income approach to business valuation. Although these decisions focused on the income approach, the valuation theory used by the Tax Court conceptually extends to the market approach and the asset-based approach to business valuation. If analysts blindly adopt the valuation theory used by the Tax Court, the economic implications could be enormous. These potential implications extend well beyond the federal gift and estate tax environment into a variety of arenas, including valuations performed for mergers or acquisitions, employee stock ownership plans, shareholder disputes, marital dissolutions, and estimation of economic damages, among others. This chapter provides a discussion of (1) the general economic characteristics of business valuation approaches, (2) certain differences in the income tax treatment of S corporations and C corporations and their respective shareholders, and (3) the differences in net economic benefit derived by S corporation and C corporation shareholders. A mathematical framework is provided that may be used to adjust the indicated value of S corporation equity securities when empirical analyses of C corporations are used to estimate value. As will be demonstrated, the analysis and discussion contained in this chapter is only relevant to the value of S corporation equity securities that lack ownership control (i.e., that are valued on a noncontrolling ownership interest basis).
Basic Premises There are two basic premises to the discussion contained in this chapter. The first premise is that there are significant differences in the income tax treatment of S corporations and C corporations and their respective shareholders. These differences are briefly described as follows: 1 Throughout this chapter, S corporation reported net income is defined as net income prior to the payment of federal and state income tax at the shareholder level. 2 Gross v. Commissioner, T.C. Memo 1999-254, aff’d 272 F.3d 333 (6th Cir. 2001). 3 Heck v. Commissioner, T.C. Memo 2002-34 (Feb. 5, 2002). 4 Adams v. Commissioner, T.C. Memo 2002-80 (Mar. 28, 2002).
4 / The S Corporation Economic Adjustment
•
•
•
73
C corporations are subject to corporate income taxes at the entity level. Conversely, S corporations are not subject to these same corporate income taxes. S corporation shareholders recognize a pro rata share of the reported net income of the S corporation on their personal income tax returns. In essence, the shareholders pay the corporate income tax of the S corporation on their personal income tax returns. Under current tax law, dividends from C corporations are subject to dividend income tax rates at the shareholder level.5 Conversely, dividends received by shareholders of S corporations are generally not subject to income taxes. The undistributed income of an S corporation changes the tax basis of its equity securities. Conversely, the undistributed income of a C corporation does not change the tax basis of its equity securities.
The second premise is that capital markets are efficient, at least over the long term. Consequently, stock prices, investment rates of return, and price/earnings multiples of publicly traded C corporations inherently reflect the income tax treatment of C corporations and their respective shareholders. Based on these two premises, there is a conceptual mismatch between (1) the economic characteristics of the empirical market data (i.e., investment rates of return, price/earnings multiples, etc.) of publicly traded C corporations and (2) the economic benefits enjoyed by S corporation shareholders. These differences have the potential to distort the value of S corporation equity securities when empirical studies of C corporations are used to estimate that value. It is difficult—if not impossible—to develop accurate and robust empirical studies of actual corporate security transactions that specifically isolate and quantify the value differences solely attributable to the income tax characteristics of S corporations and C corporations and their respective shareholders. This is due to (1) the nearly infinite variety of corporate and individual security transaction structures and (2) the paucity of information available on transactions involving S corporation equity ownership interests. Consequently, there is a need for a mathematical framework that conceptually addresses the relevant income tax–related differences between S corporations and C corporations. There is also a need for a mathematical framework that permits the adjustment of estimated values of S corporation equity securities when publicly traded C corporations are used in the valuation analysis. In order to be useful, this mathematical framework should be applicable to generally accepted approaches and methods of business valuation.
Business Valuation Approaches There are three basic approaches to the valuation of equity interests in a business enterprise: (1) the income approach, (2) the market approach, and (3) the assetbased approach. The current discourse regarding the S corporation valuation controversy has generally focused on the income approach to business valuation—and most notably, the discounted cash flow method (see Chap. 5 of this book). This is principally due to the fact that the discounted cash flow analysis used by the Tax Court 5
Throughout this article, the term “shareholder level” refers to a noncontrolling ownership interest in the equity of a business enterprise.
74
I / Business Valuation Technical Topics
in the Gross, Heck, and Adams decisions did not tax-affect the subject S corporation projected net income. In essence, the Tax Court found that it was not appropriate to tax-affect S corporation income when using a present value discount rate derived from empirical studies of publicly traded C corporations. Theoretically, the three business valuation approaches should arrive at relatively similar and theoretically consistent value indications. However, eliminating the tax effect from the income approach has the potential of creating widely divergent and theoretically inconsistent value indications among the three valuation approaches. If S corporation equity securities have an inherent economic benefit vis-à-vis C corporation equity securities, then this economic benefit should be reflected in all business valuation approaches, not solely in the income approach. In order to assess whether the S corporation organizational form has an impact on the various analytical approaches to business valuation, it is necessary to understand the general economic nature of corporate transactions and how empirical studies of these transactions are reflected within the various business valuations approaches. In order to simplify the following explanations, the three business valuation approaches have been grouped into two categories: (1) income-based approaches and (2) asset-based approaches.
Income-Based Approaches For purposes of this discussion, the income approach and market approach are both classified as income-based business valuation approaches. The income approach uses projections of future income to estimate value. The market approach uses measurements of historical income to estimate value. The indicated value of equity provided by each of these approaches is based on a measurement of income and the application of a capitalization rate. The capitalization rate is a percentage—or a multiple—used to convert a measurement of projected or historical income into a value indication. Capitalization rates used in the income approach generally take the form of a single-period capitalization rate or a multi-period present value discount rate. Capitalization rates used in the market approach generally take the form of a market-derived pricing multiple. Income Approach. Within the income approach, there are a variety of applicable valuation methods. The two most commonly used methods are (1) the discounted cash flow method and (2) the single-period direct capitalization method. Both of these methods use a capitalization rate—typically derived from empirical studies of investment rates of return of publicly traded C corporations—to estimate the value of the subject company. Depending on the nature of the economic income being capitalized (i.e., net cash flow, net income, etc.), investment rates of return of publicly traded companies may be included in an analysis of the weighted average cost of capital (WACC) or other income capitalization rate models. Regardless of which way they are used, these investment rates of return provide the fundamental basis for calculating the capitalization rates used in the income approach. A fundamental business valuation principle is that the economic characteristics of income and capitalization rates should be conceptually consistent with each other in order to calculate supportable estimates of value. In order to determine whether the economic characteristics of the income and capitalization rates are consistent with each other when valuing S corporations, it is necessary to understand how investment rates of return are calculated.
4 / The S Corporation Economic Adjustment
75
Equity investors in corporations expect to receive an investment rate of return that is comprised of some combination of income (i.e., cash dividends) and capital gains or losses. The following formula presents the mathematical calculation of the investment rate of return for an equity security: k1 =
( S1 − S0 ) + d1 S0
where k1 = Investment rate of return during period 1 S1 = Stock price at end of period 1 S0 = Stock price at beginning of period 1 d1 = Dividends paid during period 1 The above formula illustrates the fundamental principle that the investment rates of return of equity securities—and, therefore, the capitalization rates—are derived from a combination of the capital appreciation of the security (S1 – S0) and dividend payments (d1). Theoretically, capital appreciation and dividend payments are generated by the net income of the corporation. In other words, net income is either paid to the shareholders in the form of dividends or retained in the company (resulting in the capital appreciation of equity).6 Consequently, investment rates of return that are measured empirically and used somehow to estimate capitalization rates inherently reflect (1) corporate income taxes at the entity level, (2) capital gains taxes at the shareholder level, and (3) dividend income taxes at the shareholder level. To the extent that there are differences among the income, capital gains, and dividend income tax treatment of S corporations and C corporations and their respective shareholders, the value indications provided by the income approach are potentially distorted when capitalization rates of publicly traded C corporations are used to value S corporation equity securities. Market Approach. Within the market approach, there are likewise a variety of applicable valuation methods. The two most commonly used methods are (1) the guideline publicly traded company method and (2) the guideline merged and acquired company method. The guideline publicly traded company method estimates the value of the subject company based on the application of a capitalization rate (or a market-derived pricing multiple) extracted from empirical studies of stock prices and earnings fundamentals of guideline publicly traded C corporations. General investment theory tells us that these pricing multiples are based on the same fundamental principles as investment rates of return. Essentially, a market-derived pricing multiple is an investment rate of return adjusted for expected future growth. Therefore, these pricing multiples reflect the same economic attributes as publicly traded company investment rates of returns. Consequently, these multiples inherently reflect the same income tax characteristics as the investment rates of return used in the income approach.
6 There
are a multitude of economic factors that contribute to the capital appreciation (or depreciation) of equity besides retained earnings, including macroeconomic conditions, capital market conditions, general interest rates, transaction activity, etc. It is not feasible to mathematically model all of the components that either contribute to or detract from the capital appreciation of an equity security. Therefore, the discussion contained in this chapter is based on the assumption that capital appreciation is derived solely from retained earnings.
76
I / Business Valuation Technical Topics
The guideline merged and acquired company method estimates the value of the subject company based on the application of market-derived pricing multiples extracted from empirical studies of transaction prices and earnings fundamentals of companies involved in merger or acquisition transactions. The guideline merged and acquired company method typically generates a controlling ownership interest value indication of the subject company. When using this method to value an equity ownership interest that lacks control, a valuation discount for lack of control is typically quantified and applied. This discount is often estimated using empirical studies of acquisition price premiums paid for publicly traded companies in control-event merger or acquisition transactions. The inverse of this acquisition price premium is often considered a reasonable proxy for the valuation discount for lack of control. When this lack of control discount is appropriately estimated and applied, the analyst has essentially adjusted the merged and acquired company transaction pricing multiples to publicly traded company pricing multiples. As such, these transaction pricing multiples—adjusted for lack of control—inherently reflect the same income tax characteristics as publicly traded company investment rates of return. Therefore, to the extent that there are differences between the income tax treatment of (1) S corporations and C corporations and (2) their respective shareholders, the value indications provided by the market approach may be distorted. This potential distortion may result when public company market-derived pricing multiples or acquisition price premiums paid for publicly traded companies are used in the valuation analysis.
Asset-Based Approach Within the asset-based approach, there are also a variety of applicable valuation methods. The two most common methods are (1) the asset accumulation method and (2) the adjusted net asset or excess earnings method. The asset-based approach is not commonly used to value a noncontrolling equity ownership interest of a profitable going-concern operating business enterprise. (The asset-based approach is often preferred for investment holding companies, however.) This is principally due to the fact that profitable going-concern operating business enterprises typically have a variety of intangible assets that should be discretely valued in order to properly estimate total asset value. In addition, the indication of value provided by the asset-based approach is typically on a controlling ownership interest basis. The combination of these two factors results in a business valuation approach that is often difficult and prohibitively expensive to implement when quantifying a noncontrolling equity ownership interest value. Typically, the asset-based approach provides an equity value indication on a control basis. As such, the indication of value should be adjusted for a discount for lack of control when valuing a noncontrolling equity interest. When this discount is quantified using price premiums paid for the merger or acquisition of publicly traded companies, the analyst has effectively adjusted the controlling interest value indication to a value that is conceptually consistent with the indication of value provided by the guideline publicly traded company method. As such, the value indication provided by the asset-based approach inherently reflects the same income tax characteristics as publicly traded company investment rates of return. Therefore, to the extent that there are differences between the income tax treatment of S corporations and C corporations and their respective shareholders, the value
4 / The S Corporation Economic Adjustment
77
Exhibit 4.1
Net Economic Benefit to Shareholders Zero Distribution of Earnings
100% Distribution of Earnings
C Corp.
S Corp.
C Corp.
S Corp.
C Corp.
S Corp.
$
$
$
$
$
$
Income before income taxes
100,000
Corporate income taxes at 35%
(35,000)
Net income
50% Distribution of Earnings
65,000
100,000 NA
100,000 (35,000)
100,000
65,000
-
100,000 NA
100,000 (35,000)
100,000 NA
100,000
65,000
100,000
Dividends to S corporation shareholders
NA
NA
50,000
NA
100,000
Income tax due by shareholders at 35%
NA
(35,000)
NA
(35,000)
NA
(35,000)
Net cash flow to S corporation shareholders
NA
(35,000)
NA
15,000
NA
65,000
Dividends to C corporation shareholders
-
NA
32,500
NA
65,000
NA
Income tax on dividends at 15%
-
NA
4,875
NA
9,750
NA
Net cash flow to C corporation shareholders
-
NA
27,625
NA
55,250
NA
65,000
100,000
65,000
100,000
65,000
100,000
(32,500)
(50,000)
(65,000)
(100,000)
Net income
-
Dividends to shareholders Net capital gains
65,000
Effect of increase in income tax basis of shares Net taxable capital gains Capital gains tax liability at 15% Net capital gains benefit to shareholders Net cash flow to shareholders
-
100,000 (100,000)
32,500 -
50,000
-
-
(50,000)
-
-
65,000
-
32,500
-
-
-
9,750
-
4,875
-
-
-
55,250
100,000
27,625
50,000
-
65,000
(35,000)
27,625
15,000
55,250
Net capital gains benefit to shareholders
55,250
-
100,000
27,625
50,000
-
-
Net economic benefit to shareholders
55,250
65,000
55,250
65,000
55,250
65,000
NA: Not applicable.
indication provided by the asset-based approach may be distorted. This potential distortion may result when acquisition price premiums paid for publicly traded companies are used in the valuation analysis.
Conceptual Mismatch between S Corporations and C Corporations There are a variety of economic differences—both tax-related and non-tax-related— between S corporations and C corporations. This chapter will not address the majority of these economic differences. Instead, the discussion will focus on the valuation implications attributable to the income tax and capital gains tax differences between S corporations and C corporations at the shareholder level.7 Exhibit 4.1 demonstrates 7 The
general nature of these differences was discussed in the “Basic Premises” section of this chapter.
78
I / Business Valuation Technical Topics
these income tax–related differences by calculating the net economic benefit derived by the shareholders of S corporations and C corporations. Exhibit 4.1 was created using assumptions based on current federal income tax law:8 • • • • • • •
Distribution (i.e., cash dividend) scenarios of zero percent of net income, 50 percent of net income, and 100 percent of net income C corporation corporate income tax rate of 35 percent Individual ordinary income tax rate of 35 percent Income tax rate on dividends of 15 percent Capital gains tax rate of 15 percent The capital gains tax liability is economically recognized when incurred The capital appreciation of equity is solely derived from increases in retained earnings on a dollar-for-dollar basis A review and analysis of Exhibit 4.1 leads to the following important conclusions:
•
•
•
8 On
The net economic benefit (the bottom line of Exhibit 4.1) to S corporation shareholders is greater than to C corporation shareholders regardless of the assumed dividend payout ratio. This is due to the fact that S corporation shareholders have two distinct income tax advantages: (1) dividends are not taxable at the shareholder level and (2) undistributed (i.e., retained) earnings increase the tax basis of S corporation shares. C corporation shareholders do not enjoy either of these income tax benefits. The net economic benefit to C corporation shareholders remains the same regardless of dividend payout ratio. The dividend payout ratio alters the proportion of the net economic benefit attributable to either dividends or capital appreciation. If dividends and capital appreciation are taxed at identical rates, the dividend payout ratio does not affect the total net economic benefit to the shareholder. However, if dividends and capital appreciation are taxed at different rates, changes in the dividend payout ratio will affect the total net economic benefit received by the shareholder. Under current federal income tax law, the tax rate on dividends and capital appreciation is equivalent. Therefore, the information provided in Exhibit 4.1 assumes that the income tax rates are identical for dividends and capital gains. The net economic benefit to S corporation shareholders remains the same regardless of dividend payout ratio. This is due to the fact that S corporation shareholders receive either cash—after the payment of income taxes on the taxable income of the S corporation—or tax-free capital appreciation in the value of the stock. The mix of economic benefit of either cash or tax-free capital appreciation changes as the dividend payout ratio changes. However, the net economic benefit to S corporation shareholders remains the same regardless of dividend payout ratio.
May 29, 2003, President George W. Bush signed into law the Jobs and Growth Tax Reconciliation Act of 2003. Under this legislation, the income tax rates on individual ordinary income, long-term capital gains, and qualified dividend income were significantly reduced. The top marginal tax rate on individual ordinary income was reduced from 38.6 to 35 percent. Between 2003 and 2008, the new law reduces the income tax rates on both capital gains and dividends to 15 percent for taxpayers in the upper income tax brackets. The capital gains and dividend income tax provisions of the new law are set to expire in 2009. The effective date for the individual ordinary income and dividend income tax provisions is January 1, 2003. The effective date for the capital gains income tax provision is May 6, 2003.
4 / The S Corporation Economic Adjustment
79
Exhibit 4.1 illustrates the differences in net economic benefit derived by S corporation and C corporation shareholders resulting from the disparate income tax treatment of the two types of corporations and their respective shareholders. These differences result in an economic mismatch between (1) the information derived from empirical studies of transactions involving C corporation equity securities and (2) the net economic benefits enjoyed by S corporation shareholders. Traditionally, analysts have attempted to correct for these differences by estimating income taxes and subtracting this amount from the reported net income of the subject S corporation. Unfortunately, this adjustment does not properly resolve the mismatch. Also, it is difficult—if not impossible—to formulate accurate empirical studies of equity security transactions that specifically isolate the economic differences solely attributable to the differing income tax treatments of C corporations and S corporations. Consequently, a mathematical framework that adjusts the indicated equity value of an S corporation to account for these differences would be beneficial. A suggested mathematical framework is provided in the following section of this chapter and is referred to as the S corporation economic adjustment (SEA).
The S Corporation Economic Adjustment The SEA contemplates the differing income tax treatments of S corporations and C corporations. As such, the SEA is the first step in creating a mathematical framework that may be used to adjust the indicated value of S corporation equity securities when empirical studies and analyses of C corporations are used to estimate that value. The SEA is based on equations that model the net economic benefits to C corporation shareholders (NEBC) and S corporation shareholders (NEBS). The NEBC equation is comprised of two principal components: (1) net cash received by shareholders from dividends after the payment of income taxes at the entity level and income taxes on dividends at the shareholder level and (2) net capital appreciation of the equity security after recognition of capital gains taxes at the shareholder level. The equation for the first component of the NEBC equation is provided below: Net cash from dividends = Ip × (1 − tc) × Dp × (1 − td) where Ip = Reported income prior to federal and state income tax (Ip > 0) tc = C corporation effective income tax rate Dp = Dividend payout ratio td = Income tax rate on dividends The first component of the NEBC equation performs the following calculation: Income prior to federal and state income tax (Ip) Multiplied by Equals Multiplied by Equals Multiplied by Equals
One minus the C corporation effective income tax rate (1 − tc) C corporation income net of corporate income tax Dividend payout ratio (Dp) Dividends paid to shareholders One minus the income tax rate on dividends (1 − td) Cash received by shareholders from dividends net of personal income tax
80
I / Business Valuation Technical Topics
The equation for the second component of the NEBC equation is provided below: Net capital appreciation = Ip × (1 − tc) × (1 − Dp) × (1 − tcg) where Ip tc Dp tcg
= Reported income prior to federal and state income tax (Ip > 0) = C corporation effective income tax rate = Dividend payout ratio = Capital gains tax rate
The second component of the NEBC equation performs the following calculation: Reported income prior to federal and state income tax (Ip) Multiplied by One minus the C corporation effective income tax rate (1 – tc) Equals C corporation income net of corporate income tax Multiplied by One minus the dividend payout ratio (1 − Dp) Equals Earnings retained in the corporation Multiplied by One minus the capital gains tax rate (1 − tcg) Equals Net capital appreciation of shareholder equity Adding together the first and second component of the NEBC equation results in an equation that models the total net economic benefit to the C corporation shareholder. The NEBC equation in its entirety is stated algebraically below: NEBC = [Ip × (1 − tc) × Dp × (1 − td)] + [Ip × (1 − tc) × (1 − Dp) × (1 − tcg)] The NEBS equation is much less complex. The NEBS equation simply multiplies S corporation reported net income by one minus the individual ordinary income tax rate (1 − ti). This is the only adjustment necessary, because the income tax paid at the shareholder level represents the only income tax–related economic drain to the reported net income of the S corporation. The remaining S corporation reported net income (i.e., after payment of income tax at the shareholder level) provides either tax-free dividends or tax-free capital appreciation9 of the equity security. The NEBS equation is provided below: NEBS = Ip × (1 − ti) Obviously, there is a mathematical inequality between the NEBC and NEBS equations. This inequality represents the difference between the net economic benefit derived by S corporation shareholders and the net economic benefit derived by C corporation shareholders. This inequality is referred to in this chapter as the SEA. The basic SEA equation is provided below: SEA = NEBS − NEBC A detailed version of the SEA equation is provided below: SEA = [Ip × (1 − ti)] − {[Ip × (1 − tc) × Dp × (1 − td)] + [Ip × (1 − tc) × (1 − Dp) × (1 − tcg)]} 9 The authors assume that capital appreciation of equity is derived entirely from the undistributed earnings of the S corporation. Since undistributed earnings increase the income tax basis of the S corporation shares, the capital appreciation is thereby tax-free.
4 / The S Corporation Economic Adjustment
81
The algebraically simplified version of the SEA equation is provided below: SEA = Ip × (tc + tcg − ti − tctcg + Dptd − Dptcg − Dptctd + Dptctcg) The SEA quantifies the difference in net economic benefit derived by S corporation and C corporation shareholders. As such, the SEA may be used to adjust the net economic benefit enjoyed by the S corporation shareholder to a number that is equivalent to the net economic benefit enjoyed by the C corporation shareholder. Exhibit 4.2 demonstrates the application of the SEA formula. The following assumptions are used in the calculation of the SEA, as provided in Exhibit 4.2: tc tcg ti td Dp
= C corporation effective income tax rate of 35 percent = Capital gains tax rate of 15 percent = Individual ordinary income tax rate of 35 percent = Dividend income tax rate of 15 percent = Dividend payout ratios of zero percent, 50 percent, and 100 percent
Exhibit 4.2
S Corporation Economic Adjustment Zero Distribution of Earnings
100% Distribution of Earnings
C Corp.
S Corp.
C Corp.
S Corp.
C Corp.
S Corp.
$
$
$
$
$
$
Income before income taxes
100,000
Corporate income taxes at 35%
(35,000)
Net income
50% Distribution of Earnings
65,000
100,000 NA 100,000
100,000 (35,000) 65,000
100,000 NA
100,000 (35,000)
100,000 NA
100,000
65,000
100,000
Dividends to S corporation shareholders
NA
NA
50,000
NA
100,000
Income tax due by shareholders at 35%
NA
(35,000)
NA
(35,000)
NA
(35,000)
Net cash flow to S corporation shareholders
NA
(35,000)
NA
15,000
NA
65,000
-
Dividends to C corporation shareholders
-
NA
32,500
NA
65,000
NA
Income tax on dividends at 15%
-
NA
4,875
NA
9,750
NA
Net cash flow to C corporation shareholders
-
NA
27,625
NA
55,250
NA
65,000
100,000
65,000
100,000
(32,500)
(50,000)
(65,000)
(100,000)
Net income Dividends to shareholders Net capital gains Effect of increase in income tax basis of shares Net taxable capital gains Capital gains tax liability at 15% Net capital gains benefit to shareholders Net cash flow to shareholders Net capital gains benefit to shareholders S corporation economic adjustment (SEA) Net economic benefit to shareholders
NA: Not Applicable.
65,000 65,000 -
100,000
100,000 (100,000)
32,500 -
50,000
-
-
(50,000)
-
-
65,000
-
32,500
-
-
-
9,750
-
4,875
-
-
-
-
-
55,250 55,250 NA 55,250
100,000
27,625
50,000
(35,000)
27,625
15,000
100,000
27,625
50,000
-
(9,750)
NA
(9,750) 55,250
NA 55,250
55,250
55,250
55,250
65,000 (9,750) 55,250
82
I / Business Valuation Technical Topics
The selection of the numerical components of the SEA equation is properly left to the discretion of the analyst. However, the following recommendations are provided for consideration: •
• •
• •
C corporation effective income tax rate (tc)—the effective income tax rate of the publicly traded C corporations that have been selected as guidelines for the S corporation Capital gains tax rate (tcg)—a composite of combined federal and state longterm capital gains tax rates Individual ordinary income tax rate (ti)—a composite of combined federal and state individual income tax rates that would apply if the total S corporation net income were subject to individual ordinary income tax rates Income tax rate on dividends (td)—a composite of combined federal and state individual income tax rates on dividends Dividend payout ratio (Dp)—the dividend payout ratio of the publicly traded C corporations that have been selected as guidelines for the S corporation
A review of Exhibit 4.2 indicates that the SEA adjusts the NEBS to a point where the NEBS and NEBC are equivalent. Consequently, the SEA quantifies the incremental net economic benefit of being an S corporation shareholder vis-à-vis a C corporation shareholder. As such, the SEA equation is useful in creating a factor that may be used to adjust the appraised value of the equity of an S corporation when empirical studies and analyses of C corporations are used to estimate value. A discussion of this factor is provided in the following section of this chapter and is referred to as the S corporation equity adjustment multiple (SEAM).
S Corporation Equity Adjustment Multiple The SEAM is calculated using the percentage premium an investor would theoretically be willing to pay for an S corporation share versus an otherwise identical C corporation share. This percentage premium is calculated by dividing the incremental net economic benefit of being an S corporation shareholder vis-à-vis a C corporation shareholder (i.e., the SEA) by the net economic benefit of being a C corporation shareholder (i.e., the NEBC). This percentage is then added to 1.0 to calculate the SEAM, which may then be used to adjust the indicated equity value of an S corporation when empirical analyses of C corporations are used to estimate value. The basic SEAM equation is provided below: SEAM = 1 +
SEA NEBC
A detailed version of the SEAM equation is provided below: SEAM [ I p × (1 − ti )] − {[ I p × (1 − tc ) × Dp × (1 − td )] + [ I p × (1 − tc ) × (1 − Dp ) × (1 − tcg )]} = 1+ [ I p × (1 − tc ) × Dp × (1 − td )] + [ I p × (1 − tc ) × (1 − Dp ) × (1 − tcg )] The algebraically simplified version of the SEAM equation is provided below: SEAM = 1 +
tc + tcg − ti − tc tcg − Dptd − Dptcg − Dptc td − Dptc tcg 1 − tc − tcg + tc tcg − Dptd + Dptcg + Dptc td − Dptc tcg
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Exhibit 4.3
S Corporation Equity Adjustment Multiples C Corporation Effective Income Tax Rates (tc)*
Individual Ordinary Income Tax Rates (ti)
40.00%
35.00%
30.00%
30.00% 35.00% 40.00%
1.3725 1.2745 1.1765
1.2670 1.1765 1.0860
1.1765 1.0924 1.0084
* The effective income tax rates of the publicly traded C corporations used to value the subject S corporation.
Exhibit 4.3 illustrates the range of SEAMs when differing individual ordinary income tax rates and C corporation effective income tax rates are assumed in the analysis. The following assumptions were used in the preparation of Exhibit 4.3: tc = C corporation effective income tax rates of 30–40 percent tcg = Capital gains tax rate of 15 percent ti = Individual ordinary income tax rates of 30–40 percent td = Dividend income tax rate of 15 percent A review of Exhibit 4.3 indicates that higher assumed C corporation income tax rates relative to lower assumed individual ordinary income tax rates results in higher SEAMs. This is due to the fact that a higher C corporation income tax rate relative to a lower individual ordinary income tax rate serves to increase the disparity in net economic benefit between C corporation shareholders and S corporation shareholders. This increasing disparity theoretically results in greater values of S corporation equity securities vis-à-vis C corporation equity securities. The SEAM equation (1) includes these income tax differences in the analysis and (2) adjusts the S corporation equity value accordingly. Alternatively, higher assumed individual ordinary income tax rates relative to lower C corporation income tax rates reduces the disparity in net economic benefit between S corporation shareholders and C corporation shareholders. This declining disparity theoretically results in lower values of S corporation equity securities vis-à-vis C corporation equity securities. The SEAM equation (1) includes these income tax differences in the analysis and (2) adjusts the S corporation equity value accordingly.
Application of the SEAM Once the SEAM has been properly calculated, the application in business valuation analysis is relatively simple. The analyst first estimates the equity value of the S corporation—on a noncontrolling ownership interest basis—as though it were a C corporation and then multiplies this concluded value by the SEAM. The resulting indication of value may then be adjusted with discounts (e.g., for lack of marketability) as appropriate.
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Exhibit 4.4
Application of the SEAM: Market Approach Historical ($) S corporation reported net income Estimated corporate income taxes (at 35%)* C corporation equivalent net income Tax-affected interest expense [$100,000 × (1 − 35%)] Debt-free net income (DFNI) DFNI market pricing multiple (derived from empirical studies of guideline publicly traded C corporations) Indicated value of total invested capital on a marketable, noncontrolling ownership interest basis Interest-bearing debt invested capital Indicated value of C corporation equity on a marketable, noncontrolling ownership interest basis S corporation equity adjustment multiple (SEAM)† Indicated value of S corporation equity on a marketable, noncontrolling ownership interest basis Discount for lack of marketability (at 40%) Indicated value of S corporation equity on a nonmarketable, noncontrolling ownership interest basis
1,000,000 (350,000) 650,000 65,000 715,000 10 7,150,000 (2,000,000) 5,150,000 1.15 5,922,500 (2,369,000) 3,553,500
* Should be consistent with the corporate income tax rate used in the calculation of the SEAM. † The SEAM of 1.15 was selected for illustration purposes only and is not based on a specific calculation.
Exhibit 4.5
Application of the SEAM: Income Approach Projected Year 1 ($) S corporation reported net income Estimated corporate level income taxes (at 35%)* C corporation equivalent net income Tax-affected interest expense ($100,000 × (1 − 35%)) Depreciation expense Capital expenditures Incremental changes in working capital† Debt-free net cash flow Income capitalization rate (derived from empirical studies of guideline publicly traded C corporations) Indicated value of total invested capital on a marketable, noncontrolling ownership interest basis Interest-bearing debt invested capital Indicated value of C corporation equity on a marketable, noncontrolling ownership interest basis S corporation equity adjustment multiple (SEAM)‡ Indicated value of S corporation equity on a marketable, noncontrolling ownership interest basis Discount for lack of marketability (at 40%) Indicated value of S corporation equity on a nonmarketable, noncontrolling ownership interest basis
* Should be consistent with the corporate effective income tax rate used in the calculation of the SEAM. † Typically, the incremental working capital requirement will not equal zero. ‡ The SEAM of 1.15 was selected for illustration purposes only and is not based on a specific calculation.
1,000,000 (350,000) 650,000 65,000 200,000 (200,000) — 715,000 0.10 7,150,000 (2,000,000) 5,150,000 1.15 5,922,500 (2,369,000) 3,553,500
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Exhibit 4.6
Application of the SEAM: Asset-Based Approach Projected Year 1 ($) Indicated value of total assets Indicated value of total liabilities Indicated value of equity on a control basis Discount for lack of control (at 20%) Indicated value of C corporation equity on a marketable, noncontrolling ownership interest basis S corporation equity adjustment multiple (SEAM)* Indicated value of S corporation equity on a marketable, noncontrolling ownership interest basis Discount for lack of marketability (at 40%) Indicated value of S corporation equity on a nonmarketable, noncontrolling ownership interest basis
10,000,000 (3,562,500) 6,437,500 (1,287,500) 5,150,000 1.15 5,922,500 (2,369,000) 3,553,500
* The SEAM of 1.15 was selected for illustration purposes only and is not based on a specific calculation.
Exhibits 4.4 to 4.6 provide examples of how to apply the SEAM in various business valuation approaches.10 The SEAM equation is based on fundamental financial theory related to equity investment rates of return of publicly traded companies. Transactions involving these securities are almost universally conducted on a noncontrolling interest basis. Consequently, the SEAM equation inherently assumes a noncontrolling equity ownership interest. Therefore, it would be fundamentally incorrect to apply the SEAM to indicated values of equity on a control basis. Also, it is not appropriate to apply the SEAM to indicated values of total invested capital (i.e., both debt and equity capital) or total asset value. This is simply due to the fact that the SEAM is an adjustment factor that only applies to equity capital. It is critical to point out that the calculation of the SEAM is merely the beginning point of estimating the value differences between S corporation equity securities and C corporation equity securities. Other factors—both quantitative and qualitative—should be considered and analyzed prior to concluding that an equity ownership interest in an S corporation is worth more—or less—than an equity ownership interest in an otherwise identical C corporation. A discussion of some of these factors is provided below.
Primary Assumptions and Potential Adjustments The SEAM is based on the following primary assumptions: • • •
The S corporation organizational form of the subject company will continue in perpetuity. Investors are indifferent between cash investment returns and unrealized capital gains. Investors in C corporations recognize capital gains taxes when incurred.
10 Exhibits 4.4, 4.5, and 4.6 assume that C corporation after-tax capitalization rates or market-derived pricing multiples are used in the valuation analysis.
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• • •
Buyers are willing to pay sellers for the S corporation income tax benefits. Beneficial aspects of current income tax law regarding S corporations relevant to C corporations will continue in perpetuity. The subject S corporation will continue to be a profitable enterprise in perpetuity.
A discussion of these primary assumptions—and potential analytical adjustments—is provided below.
S Corporation Perpetuity Assumption Investors would not be willing to pay a price premium for an S corporation equity security if the S election would be revoked upon purchase. If the revocation of the S election were a foreseeable near-term possibility, investors would likely require a discount from the C corporation equivalent value due to the negative tax implications associated with a revocation. Alternatively, investors may be willing to pay a price premium—all other factors being equal—if the S election is expected to continue in perpetuity. Between these two points lies a curvilinear line that may be estimated based on an analysis of (1) the expected remaining life of the S election and (2) the present value of the incremental net economic benefits of the S corporation (i.e., the SEA) during the estimated remaining life of the S election. Many of the risks that shorten the remaining life of a corporation are similar for S corporations and C corporations. Business threats such as bankruptcy, litigation, structural industry changes, macroeconomic and microeconomic conditions, and geopolitical risks apply similarly to both S corporations and C corporations. Consequently, the indication of value of S corporation equity provided by empirical studies and analyses of C corporations inherently contemplate these risks. To the extent that S corporations are subject to risk factors inconsistent with C corporation risk factors, the SEAM premium may overstate the indicated value of S corporation equity. Certainly, one of these risk factors is the potential for revocation of the S election. Even if the S election is expected to continue in perpetuity, the SEAM does not specifically contemplate any risk of revocation. Consequently, when applying the SEAM, analysts should consider (1) whether the terms and conditions of shareholder agreements discourage shareholder behavior that may endanger the S election and (2) whether the subject S corporation is in danger of revocation of the S election. The presence of either of these conditions may require a qualitative adjustment to the SEAM-adjusted value of S corporation equity.
Cash Investment Returns and Unrealized Capital Gains The SEAM inherently assumes that S corporation investors are indifferent between cash in the form of dividend payments and unrealized net capital appreciation of the equity securities. Typically, this is not the case. This is especially true when one considers that S corporation shareholders are required to recognize a pro rata share of the reported net income of the S corporation on their personal income tax returns. As such, S corporation investors may be faced with the unhappy prospect of having to pay income taxes on S corporation taxable income while receiving no distributions to pay the tax. Consequently, investors may be more willing to pay a premium—all other factors being equal—for an S corporation that distributes some or all of its earnings. Therefore, the dividend history, historical distribution policies,
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expected future distribution policies, and projected cash flows of the subject S corporation are important matters to consider in the application of the SEAM. It cannot be overemphasized that the SEAM equation inherently assumes that the subject S corporation is expected to distribute 100 percent of its net income. If this is not the case, the SEAM may systematically overstate the value of S corporation equity. If the subject S corporation is not expected to make regular “tax distribution” dividend payments to the shareholders, the SEAM may substantially overstate the value of S corporation equity. Typically any adjustment for the expected future distributions of the subject S corporation is recognized and quantified in the selection of the discount for lack of marketability. It is noteworthy that the dividend payout ratio (Dp) used in the SEAM equation is the dividend payout ratio of similar publicly traded C corporations, not the dividend payout ratio of the subject S corporation. Once again, the SEAM formula assumes that the dividend payout ratio of the subject S corporation is 100 percent of reported net income.
Recognition of Capital Gains Taxes The SEAM equation assumes that C corporation investors recognize capital gains tax liabilities when incurred rather than when realized. Under current U.S. tax law, capital gains taxes are not assessed until the asset is sold. To the extent that C corporation investors discount the contingent nature of the capital gains tax liability, the SEAM may overstate the value of S corporation equity. It would be extremely difficult—if not impossible—to estimate the potential investment holding period and the associated capital gains tax liability of the average C corporation investor. The most reasonable analysis is to assume that (1) capital gains are derived from retained earnings and (2) investors recognize the capital gains tax liability when incurred rather than when realized. Since the retained earnings of the S corporation increase the tax basis of the S corporation equity, the S corporation is theoretically not subject to the capital gains tax liability. C corporation shareholders do not receive this same beneficial tax treatment. The SEAM equation models this tax treatment and assumes that C corporation investors recognize the economic impact of the contingent capital gains tax liabilities when incurred. To the extent this is not true, the SEAM may overstate the value of S corporation equity.
Tax Status of Buyers and Sellers The SEAM inherently assumes that buyers are willing to pay a premium for the tax attributes of the seller. In other words, the SEAM assumes that a potential buyer would be willing to pay a premium to the seller for the S corporation organizational form. Certainly this would be the subject of negotiations between buyers and sellers. To the extent the buyer was not a qualified S corporation shareholder, the buyer would be resistant to paying for a tax benefit from which only the seller would benefit. On the other hand, the seller would attempt to maximize the price of his ownership interest by locating a pool of potential buyers that would qualify for the S corporation tax benefits and thereby pay the premium. The SEAM assumes that the pool of potential buyers is comprised of qualified S corporation shareholders. The SEAM also assumes that these buyers would recognize—and pay for—the economic benefits attributable to the income tax treatment of S corporations. If it can be demonstrated that the pool of most likely buyers
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is comprised of C corporations—or other nonqualified S corporation shareholders— then the SEAM premium would likely overstate the value of the S corporation equity. Even if the pool of most likely buyers is comprised of nonqualified S corporation shareholders, a portion of the SEAM premium may still be applicable to the analysis. The sellers may be willing to accept a reduction in the SEAM premium as a result of negotiations with a nonqualified buyer. In this case, the most likely scenario would be a negotiated premium that falls somewhere between the SEAM-adjusted indication of value and the C corporation equivalent value.
Current Income Tax Law The SEAM analysis inherently assumes that the current law related to the beneficial income tax treatment of S corporations vis-à-vis C corporations will continue in perpetuity. In most instances, this may be the most reasonable assumption. However, the Jobs and Growth Tax Reconciliation Act of 2003 significantly reduced the income tax rates on individual ordinary income, dividend income, and capital gains income. These tax rates are important components of the SEAM equation. Certainly, the SEAM declines when income tax rates on dividends and capital gains are reduced. However, the SEAM increases when the income tax rate on individual ordinary income is reduced. Also, the capitalization rates of publicly traded companies may be affected as capital market investors recognize and incorporate favorable—or unfavorable— income tax treatment into security prices. Consequently, the overall total effect due to the Jobs and Growth Tax Reconciliation Act of 2003 on the SEAM-adjusted value of S corporation equity securities is unclear. Theoretically, the net effect is minimal.
Profitability Assumption The SEAM adjusts the S corporation equity value for the beneficial income tax treatment attributable to S corporation shareholders vis-à-vis C corporation shareholders. If the subject S corporation is not expected to be profitable for some or all of the foreseeable future, there may be some reduction—or elimination—of the incremental economic value attributable to the beneficial income tax treatment of S corporation shareholders. Therefore, the SEAM may overstate the value of the equity of an S corporation that is not expected to be profitable during specific time periods in the foreseeable future.
Summary and Conclusion The SEAM is a mathematical model that may be used to adjust the appraised value of equity of an S corporation when empirical analyses of C corporations are used to estimate that value. The SEAM contemplates the differences in net economic benefits attributable to shareholders resulting from the differing income tax treatments of S corporations and C corporations and their respective shareholders. The SEAM is not a black box in which to throw numbers and expect meaningful results. A careful and reasoned approach to the initial business valuation analysis and the SEAM analysis is required to estimate meaningful and appropriately supported indications of value of S corporation equity securities.
Chapter 5 Applying the Income Approach to S Corporation and Other Pass-Through Entity Valuations Roger J. Grabowski and William P. McFadden*
Introduction Pass-Through Entities General Advantages of Pass-Through Entities Restrictions and Benefits of an S Corporation Economic Basis for Considering Income Taxes Considerations in the Valuation of Pass-Through Entities Fair Market Value and the Pool of Likely Buyers for S Corporation Shares Controlling Ownership Interest Valuation Considerations Noncontrolling Ownership Interest Valuation Considerations How Should S Corporations Be Valued Using the DCF Method? Three Suggested Methods of S Corporation Valuation Applying the Three Methods to Value an S Corporation Traditional Method The Gross Method Valuing a Controlling Ownership Interest The Modified Gross Method C Corporation Equivalent Method The Pretax Discount Rate Method Valuing a Noncontrolling Ownership Interest Summary of Before Lack of Marketability Discount Example Summary of Example with 5 Percent Long-Term Growth Rate Assumed Effect of Jobs and Growth Tax Relief Reconciliation Act of 2003 Proposals to Simplify Subchapter S Conclusion * The authors wish to thank Matthew Steele, John Moose, David King, Jim Krillenberger, Nate
Levin, and Cynthia Collins for their assistance in preparing this analysis. This work should not be construed as representing the official organization position of Standard & Poor’s. Comments may be e-mailed to
[email protected]
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Introduction Recent court decisions have challenged traditional thinking regarding the valuation of ownership interests in subchapter S corporations (S corporations) and other passthrough entities. For example, the “traditional” application of the income approach to valuing S corporations has been to subtract income taxes as if the S corporation were taxed as an ordinary C corporation. Next, a discount rate (i.e., rate of return) derived from publicly traded stock data (using C corporation data) would be applied in the discounting process. This traditional approach was supported by Internal Revenue Service (IRS) instructions as quoted by the petitioner (i.e., the taxpayer) in Gross.1 As cited, an IRS guide for income, estate, and gift taxes suggested an S corporation valuation procedure: “You need only to adjust the earnings from the business to reflect estimated corporate income taxes that would have been payable had the subchapter S election not been made.”2 Further, an examination handbook for IRS estate tax examiners states: “If you are comparing a subchapter S corporation to the stock of similar firms that are publicly traded, the net income of the former must be adjusted for income taxes using the corporate tax rates applicable for each year in question, and certain other items, such as salaries.”3 However, in Gross, the Tax Court rejected the IRS instructions (as quoted by the petitioner) as being a required valuation procedure: “Both statements lack analytical support, and we refuse to interpret them as establishing respondent’s advocacy of tax-affecting as a necessary adjustment to be made in applying the discounted cash flow analysis to establish the value of an S corporation. Even if we were to interpret the excerpts as petitioners do, petitioners do not claim that the excerpts have the force of a regulation or ruling . . .” The Tax Court pointed out that by tax-affecting the subject S corporation earnings, the petitioner’s expert “introduced a fictitious tax burden, equal to an assumed corporate tax rate of 40 percent, which he applied to reduce each future period’s earnings, before such earnings were discounted to their present value.” The valuation experts in Gross took extremely opposed and simplified positions. The petitioner’s expert fully tax-affected the S corporation’s earnings as if it were a C corporation. The IRS expert applied no income tax to the S corporation’s earnings. This was because S corporation distributions to its shareholders are not taxed at the corporate—or entity—level. In its commentary, the Tax Court discussed the concept of properly matching the income tax characteristics of the discount rate applied with the projected cash flow as better methodology: “If in determining the present value of any future payment, the discount rate is assumed to be an aftershareholder-tax rate of return, then the cash flow should be reduced (tax-affected) to an after-shareholder-tax amount.” The Tax Court further stated: “We believe that the principal benefit that shareholders expect from an S corporation election is a reduction in the total tax burden imposed on the enterprise. The owners expect to save money, and we see no reason why that savings ought to be ignored as a matter of course in valuing (an ownership interest in) the S corporation” (parenthetical phrase added).
1 Gross
v. Commissioner, T.C. Memo 1999-254, aff’d 272 F.3d 333 (6th Cir. 2001). Training for Appeals Officers (Chicago: CCH Incorporated, 1998), pp. 7–12. 3 Examination Technique Handbook for Estate Tax Examiners, IRM 4350, Dec. 16, 1987, pp. 4350–4357. 2 IRS Valuation
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In Heck,4 the Tax Court described the government’s expert as identifying several restrictions of the subject S corporation, such as those “impairing liquidity, including restrictions on the number and type of persons that can be shareholders. Nevertheless, he views S corporation status as a benefit and fails to quantify the relevant advantages and disadvantages.” This commentary speaks to the need to analyze and quantify the advantages and disadvantages of S corporation status. That analysis should be based on (1) the specific facts and circumstances of the subject business and (2) the likely buyers for the ownership interest being valued. In other words, proper S corporation valuation is not a simple formula application. In Wall,5 the issue with tax-affecting S corporation earnings under the traditional method was also noted. Commenting on the S corporation escape from double taxation, the Tax Court stated: “This could make an S corporation at least somewhat more valuable than an equivalent C corporation. However, tax-affecting an S corporation’s income, and then determining the value of that income by reference to the rates of return on taxable investments, means that an appraisal will give no value to S corporation status.” The implications are (1) that an S corporation price premium would be generally expected and (2) that a valuation procedure that results in no premium for S corporation status may not be correct. In referring to the taxpayer expert’s application of the traditional method of tax-affecting S corporation earnings at C corporation rates, the Tax Court stated: “. . . we believe it is likely to result in an undervaluation of [the subject S corporation] stock.” In its opinion the Tax Court restated: “We also note that both experts’ income-based analyses probably understated [the subject S corporation] value, because they determined [its] future cash flows on a hypothetical after-tax basis, and then used market rates of return on taxable investments to determine the present value of those cash flows.” In Adams,6 the taxpayer expert dealt with the problem of matching the S corporation income tax characteristics in discounting (i.e., the tax characteristics of the applied rate of return should match the tax characteristics of the cash flow being discounted) by converting the corporate after-tax rate of return to a pre-corporatetax rate of return. The intention was to put the discounted cash flow (DCF) analysis on an equal pretax basis for all its elements. However, the Tax Court did not allow the discount rate to be adjusted to a pre-corporate-level income tax equivalent. The Tax Court stated: “The result here of a zero tax on estimated prospective cash flows and no conversion of the capitalization rate from after-corporate tax to before corporate tax is identical to the result in Gross v. Commissioner of zero corporate tax rate on estimated cash flows and a discount rate with no conversion from after-corporate tax to before-corporate tax.” All of these cases point to a rejection of the traditional valuation procedure of automatically income-tax-affecting S corporations as if they were C corporations. Many commentators, especially from the valuation community, immediately disagreed with the Tax Court, arguing that there cannot be any differences in the value of an S corporation and a C corporation since the willing buyer can always purchase a C corporation and, assuming the willing buyer qualifies as an S corporation shareholder, the willing buyer can then convert the C corporation to an S corporation.
4 Heck
v. Commissioner, T.C. Memo 2002-34 (Feb. 5, 2002). v. Commissioner, T.C. Memo 2001-75 (Mar. 27, 2001). 6 Adams v. Commissioner, T.C. Memo 2002-80 (Mar. 28, 2002). 5 Wall
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Valuation analysts have questioned why anyone would pay the willing seller for something the willing buyer can do himself. Commentators who take that position fail to recognize that the Tax Court was valuing, in each case, the stock of an S corporation—not the underlying business owned by the S corporation. Stock comes with certain inherent characteristics, and the Tax Court recognized those specific characteristics in each case. The Tax Court emphasized the reality of how and where income taxes are paid. And, the Tax Court emphasized the need to match the income tax characteristics of the measured cash flows with the selected discount rate. The Tax Court recognized that the economic advantages and disadvantages of S corporation election may vary based on specific facts and circumstances. Accordingly, the valuation process should take into account all factors affecting the underlying analytical assumptions.
Pass-Through Entities While the Tax Court cases cited above specifically address the valuation of stock of S corporations, the issue of properly applying the selected valuation method is broader. There are a variety of so-called “pass-through” entities that are subject to valuation: subchapter S corporations, partnerships (general or limited liability), real estate investment trusts (REITs), closed-end investment funds, and limited liability corporations (LLCs). These entities “pass through” their reported tax characteristics directly to owners. These tax characteristics include income, gains, losses, deductions, and credits. Owners include these items on their individual income tax returns. Passed through tax items also retain their tax character. For example, capital gains pass to owners still as capital gain income—and not as ordinary income—as would be the case with a C corporation. For pass-through entities, the federal income tax resulting from the entities’ taxable income is owed directly by the owners— regardless of the actual cash distributed to the owners. There is no second income tax due on distributions (as is due on dividends received by owners of shares of a C corporation). The avoidance of double taxation is a key feature of pass-through entities. And, the avoidance of double taxation has become a central consideration in their proper valuation, as evidenced in Gross. The concept of taxing C corporation earnings based on reported income and then taxing that same income again at the shareholder level when it is paid out as dividends is the result of an historic evolution of the U.S. tax code. It is, in many ways, an interplay between government and business objectives. Dividend payout levels were very liberal in the nineteenth century. During that time period, corporations distributed nearly all of their profits as dividends. The early forms of the “corporate income tax” were really dividend taxes on full corporate payouts. A shift in corporate practice regarding dividends and retained earnings began after 1900. At that time, large corporations were formed that were run by professional management. The new breed of managers valued operational control over cash flow for purposes of corporate growth. Consequently, (1) the increase in corporate retained earnings and (2) the loss of dividend-related tax revenue preceded an increase in individual tax rates. In addition, the Great Depression era undistributed profits tax was implemented, due to what was considered to be corporate
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over-saving. Ultimately, business accepted a full double taxation system and a higher corporate rate in exchange for the right to retain earnings without government involvement. This history paved the way for the system of double taxation of C corporation dividends that is in place today, at least prior to the dividend deduction tax relief which was implemented in 2003. However, in the late 1950s, Congress created the subchapter S corporation as (1) a pass-through entity and (2) a limited fix to the double taxation on C corporation dividends. S corporations also retained the limited liability characteristics of the C corporations. Today, S corporations and other pass-through entities are an extremely popular form for small-to-medium size businesses. The common use of pass-through entities creates unique valuation issues.
General Advantages of Pass-Through Entities Is there an incremental value for an entity because it is a pass-through entity and not a C corporation? Tax and legal advisors have offered tax-structuring advice for many years to owners of businesses. These advisors will typically quantify the tax saving and other ownership advantages of various possible tax structures. The decision of which particular pass-through entity structure to elect is based on many factors, including (1) the expected cash flow of the business, (2) the level and timing of distributions, (3) the number of owners, (4) the personal income tax bracket of the owners, (5) the importance of legal protection against liability, (6) the need for future capital, (7) the need to control owners’ actions, and (8) the expected permanency of the business. The available pass-through entity forms offer different advantages in taxes, legal protection, control, and flexibility. For example, private ownership of real estate is predominantly through passthrough entities. Small groups of owners have traditionally used a partnership as the preferred organizational form for owning a real estate business. REITs were established by Congress as a means to establish, in essence, a “mutual fund” of real properties. More than 10 years ago, publicly traded C corporations were converting to publicly traded “master limited partnerships” (MLPs) (i.e., the equivalent of REITs for operating businesses) until such conversions were banned by Congress.7 Tax advisors often recommend conducting operating businesses (1) in partnership form (e.g., a joint venture formed by two corporations), (2) in the LLC form (e.g., a joint venture, a subsidiary, or even a new business), or (3) in subchapter S form (subject to restrictions on the number and type of shareholders). Also, as the nature of a business changes, such as a strategic change from reinvestment of cash flow to cash flow distribution, the advantages of a pass-through entity form become more apparent. The preference for pass-through entities— given their tax, legal, and management advantages in particular business settings and for particular buyers—has long been established. For example, they may allow the initial losses of a small start-up business to be passed through to the owner’s individual income tax return where the losses may offset other taxable income. In addition to the quantifiable tax advantages, the suitability of these business forms 7 In
a March 2002 paper, “Taxes and the Relative Valuation of S Corporations and C Corporations,” David J. Denis (Purdue University) and Atulya Sarin (Santa Clara University) reported that MLPs were valued at a price premium (as large as 43 percent) relative to a comparable C corporation.
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in meeting the personal and business objectives of the owners increases their attractiveness.
Restrictions and Benefits of an S Corporation In order to be eligible to make an S corporation election, the corporation must remain in compliance with a number of requirements. Even when the subject corporation meets these requirements, the election may not benefit every business environment or set of circumstances. The primary restrictions and drawbacks of an S corporation include the following: • • • • • •
The subject corporation must be a U.S. domestic corporation. The S corporation is restricted to no more than 75 shareholders. Partnerships, corporations, and many types of trusts may not be shareholders. Nonresident aliens may not be shareholders. The S corporation can have only one class of stock although different voting rights are allowed. Unanimous consent is required by the shareholders to make the S corporation election.
Additionally, a significant disadvantage can occur when a noncontrolling shareholder becomes liable for income taxes in excess of the cash distributions received. This is true unless the shareholder agreement protects the shareholder by requiring distributions at least equal to the imputed income tax owed on the equity interest. In contrast, C corporations can accumulate earnings, paying income tax only at the corporate level without shareholders being individually taxed. If the S corporation accumulates earnings (such as for business expansion) without making distributions, shareholders may be subject to “phantom income.” That is, the shareholders are taxed on S corporation income generated whether or not the S corporation distributes cash to pay the related taxes. The potential for this state of affairs can result in considerable shareholder risk. The major benefits of an S corporation election include the following: • •
•
8 The
The income from the S corporation is subject to only one level of taxation at the individual shareholder level (i.e., no double taxation). The shareholders of an S corporation receive an increase in their basis to the extent that taxable income exceeds distributions to shareholders (i.e., income retained by the S corporation adds to the tax basis of the shareholders’ stock, which will reduce the gain upon sale). This is known as a pass-through basis adjustment. The shareholder of an S corporation may realize more proceeds upon the sale of the S corporation itself. That is, the S corporation is more likely to sell assets to a buyer of the S corporation business.8 The buyer will receive increased depreciation and amortization for tax purposes due to the “step-up in basis” of the assets to reflect the amount paid (as compared to a carryover basis of the assets for tax purposes if the purchase were of stock of a C corporation). Accordingly, the buyer will be willing to pay a higher price. The S corporation shareholder will
owner of an S corporation can sell stock (subject to capital gains treatment) and agree that the buyer can make an Internal Revenue Code Section 338 election. This election treats the sale of stock as if it were the sale of assets, allowing for a step-up in basis of the assets.
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receive proceeds on sale that are taxed only once. However, gains on sale of assets by a C corporation would be taxed (1) at the corporate level and (2) then again at the shareholder level upon distribution.9 The tax treatment of the likely exit strategy becomes an important consideration in the valuation process.
Economic Basis for Considering Income Taxes The income tax treatment of distributions received by holders of a security does matter. This is not just a theoretical issue. This fact is demonstrated by observed market pricing differences. At the simplest level, we see differences in pricing of comparably rated publicly traded bonds, which are fully taxable compared to bonds with tax-exempt interest payments. In other words, the market prices the securities of comparable risk at comparable after-tax returns. Investors are willing to pay a price premium for the taxexempt status of a bond in the form of a lower yield to maturity. After taxes, the yields of taxable and tax-exempt bonds of identical risk should be equivalent. So as fundamental premises, (1) income taxes do matter and (2) income taxes are taken into account by market investors—considering their point of view as individual taxpayers.
Considerations in the Valuation of Pass-Through Entities Unlike S corporations, shares of a privately owned REIT can be valued directly through observation of rates of return and market-derived pricing multiples for comparable public REITs (i.e., through the application of the market approach). Public REITs are pass-through entities with the same tax characteristics as the private REIT being valued. Accordingly, how to treat the pass-through tax attributes when analyzing a privately owned REIT is not controversial. However, analysts are often called on to value an entity with pass-through tax attributes where available public data on discount rates and market-derived pricing multiples can only be derived from entities with tax structures that differ from those of a pass-through entity (i.e., from public C corporations). The above-cited Tax Court decisions emphasized the need to match the tax characteristics of the subject S corporation’s cash flow with the tax characteristics of the selected discount rate. In Adams, one expert simply converted the C corporation rate of return to a pre–corporate income tax equivalent, an adjustment that was not accepted by the Tax Court. The Tax Court criticisms and suggestions in these cases do not, however, preclude other adjustments to S corporation earnings. Other adjustments may consider differences in income tax rates, risks, and probable investment outcomes in order to achieve a more comprehensive solution to the S corporation
9 In the sale of an interest in a partnership, the buyer may also benefit through a step-up in basis of his/her proportionate share of the assets if an Internal Revenue Code Section 754 election is made. This election may be allowed under the partnership agreement typically by election of the incoming partner or only upon agreement of the general partner. In essence, this election equalizes the partner’s “outside basis” (i.e., investment cost) and the partner’s proportionate “inside basis.” See Matthew A. Melone, “Partnership Final Regs,” Valuation Strategies, May/June 2000.
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valuation issue.10 Appropriate adjustments are best understood by first reviewing the various economic benefits of a pass-through entity vis-à-vis a C corporation. This will help to assess (1) the nature of potential S corporation adjustments and (2) other factual considerations that can affect value.
Fair Market Value and the Pool of Likely Buyers for S Corporation Shares The nature of the willing buyer and the willing seller is an abstraction and one should consider them as hypothetical persons rather than as specific individuals or entities. Applying the hypothetical willing buyer/willing seller premise means that hypothetical buyers and hypothetical sellers have reasonable knowledge of relevant facts. The hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and the market for the property.11 Courts have determined that fair market value of property should reflect the highest and best use to which the property could be put on the valuation date.12 Highest and best use requires study of the market for the property to determine in which market the likely selling price will be maximized. What does the hypothetical willing buyer/willing seller premise mean in the context of valuing a controlling ownership interest in a business (e.g., 100 percent of the stock of an S corporation)? The willing seller must understand the market of potential buyers (i.e., the pool of likely buyers) consistent with achieving maximum economic advantage. In certain cases, the willing seller may conclude that the market consists of a number of potential synergistic buyers. Theoreticians often espouse that the synergistic buyer should not give the seller any of the benefits that the seller expects to realize from the proposed transaction. But, in reality, synergistic buyers often give up some (and sometimes a great deal) of the synergistic value to the sellers in order to outbid other potential buyers. For many sellers, highest and best use may equate to sale of the subject business to any one of several likely synergistic buyers. In one case, the Tax Court stated that the hypothetical buyer and hypothetical seller must be disposed to maximum economic gain.13 Since the Court in that case determined that there were potential synergistic buyers for the subject business, the Court directed that synergy should be considered. In valuing a noncontrolling ownership interest in a private entity (e.g., a noncontrolling block of stock in an S corporation), assuming the willing buyer and willing seller have reasonable knowledge of all relevant facts, the buyer and seller should know the marketplace in which a hypothetical sale would normally occur. Knowledge of that marketplace includes (1) understanding of restrictions placed on the pool of likely buyers (e.g., a shareholder agreement that restricts ownership to qualified S corporation shareholders who will not cause the S election to terminate,
10 The Tax
Court found that the taxpayer’s expert did not match the tax characteristics of the cash flow (pre-personal-income-tax) with the characteristics of the discount rate (pre-corporate-income-tax). 11 United States v. Simmons, 346 F.2d 213,217 (5th Cir. 1965); Rev. Rul. 59-60, 1959-1 C.B. 237. 12 Mitchell v. U.S., 267, U.S. 341,344-345 (1925); Hilborn v. Commissioner, 85 T.C. 677 (1985); Stanley Works & Subs. v. Commissioner, 87 T.C. 389,400 (1986). 13 BTR Dunlop Holdings, et al. v. Commissioner, T.C. Memo 1999-377 (Nov. 15, 1999).
5 / Applying the Income Approach to S Corporation
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thus reducing the pool of likely buyers), (2) the identities of other shareholders, and (3) the blocks of stock owned by the various shareholders. In one example, the Court found that the owners of interests in a series of real estate entities had a long and intertwined history of investing together. That Court concluded that a willing seller would sell to other insiders to maximize his selling price and that the pool of likely buyers for the subject noncontrolling interests were the other insiders. Because of their long history of investing together, insiders would pay a higher price than would outsiders (in part to keep outsiders out). Therefore, the Court determined that the interests were to be valued as if sold to an insider.14 Further, application of the willing buyer/willing seller premise should reflect the reality that some blocks of stock—though small, noncontrolling ownership interests in and of themselves—represent so-called “swing” blocks. Such blocks afford some existing shareholders the opportunity to gain a controlling position (and afford some other shareholders the opportunity to block another from gaining control). Since the hypothetical willing buyer and willing seller are presumed to be dedicated to achieving the maximum economic advantage, the value of such a swing block may even attract a premium (compared to even a proportionate value of the enterprise).15
Controlling Ownership Interest Valuation Considerations In valuing a controlling ownership interest in an S corporation, the analyst should assess the probability that the likely buyers of a controlling interest will be able to avail themselves of continuing the S corporation status. In other words, is the likely buyer a qualified S corporation shareholder who could continue S corporation status indefinitely? Or, is the likely buyer a C corporation? If the pool of likely buyers is made up of qualified S corporation shareholders, then those buyers of a controlling interest can realize all three of the above-listed economic benefits (i.e., no double taxation, pass-through basis adjustment, and increased proceeds upon sale of assets). However, if the pool of likely buyers consists mostly of C corporations, no price premium will be assigned to the S corporation election for the first two benefits because these likely buyers are unable to continue the S corporation election. That leaves any possible price premium in the value of the S corporation versus a C corporation attributable only to the third benefit (i.e., the increased proceeds on sale of assets).16,17 14 Wilf
v. Wilf, Unpublished decision, Tax Court of New Jersey, Essex County, NJ. of Curry v. U.S., 706 F.2d 1424, 1429 (7th Cir. 1983). 16 In a June 2001 article, “The Impact of S Corporation Status,” Business Valuation Review, Brian H. Burke calculates the value of selling assets. Burke notes that from his experience “the difference in value will usually have an order of magnitude in the range of 15% to 20%” (page 17). In a study dated May 16, 2002, “The Effect of Organizational Form on Acquisition Price,” Merle Erickson (University of Chicago) and Shiing-wu Wang (University of Southern California) report that the median acquisition multiples paid by acquiring C corporations measured for “matched pairs” of (comparable) S and C corporations. The median acquisition pricing multiple paid for S corporations exceeded the median multiple paid for C corporations (e.g., median price-to-revenue multiples for S corporation acquisitions were 31 percent greater than for matched C corporation acquisitions). And, the average income tax benefits in S corporation acquisitions equaled approximately 12–17 percent of the deal value. This study includes only taxable transactions (i.e., no transactions in which stock was exchanged for stock). 17 For a discussion of the impact of the S corporation election on value, see Sidney R. Finkel, “Is There an S Corporation Premium?” Valuation Strategies, July/August 2001. That article addresses a premium for an ownership control position. While it briefly addresses the S corporation election benefits when valuing a noncontrolling interest, that discussion is incomplete. Also see Mark O. Dietrich, “Computing Premium for S Status Based on Buyer’s Benefit,” Valuation Strategies, May/June 2003. 15 Estate
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In valuing S corporation stock—even a 100 percent interest—the analyst needs to remember that there is value to an existing S corporation. This is particularly true with an entity that has been an S corporation either since its incorporation or for at least the past 10 years. First, because the S corporation election requires unanimous consent of the shareholders, any buyer of less than 100 percent of the stock cannot unilaterally make an S corporation election. Controlling interest shareholder(s) owning a supermajority (say 80 percent) may be able to effectuate an S corporation election. However, this can be accomplished only after “squeezing out” any noncontrolling shareholders who will not agree to the S corporation election. Second, unless the S corporation is a “seasoned” S corporation (i.e., an S corporation since its incorporation or for at least 10 years), the sale of S corporation assets is subject to a built-in gains tax. This will reduce the desirability of selling the stock at what may prove to be the optimum time. This is due to reluctance of the owner(s) to incur the built-in gains tax. While the tax does not reduce the price for which the assets will sell, the presence of the built-in gains tax does reduce the marketability of the stock compared to the stock of a seasoned S corporation.
Noncontrolling Ownership Interest Valuation Considerations If the analyst is valuing a noncontrolling ownership interest, the noncontrolling owner can only be assured that he or she will benefit from the first two economic benefits (i.e., no double taxation and pass-through basis adjustment). And, the first two economic benefits exist only so long as the S corporation election continues. The benefit of selling assets of the S corporation can only be realized if and when the controlling shareholder(s) decides to sell the business operated by the S corporation. The likely succeeding buyer of a noncontrolling ownership interest (and the one who will pay the highest amount) will typically be a qualified S corporation shareholder. That buyer will desire to continue the first two economic benefits. Often, the shareholder agreement does not allow an existing S corporation shareholder to sell his or her interest to anyone other than a qualified S corporation shareholder. And usually, the shareholder can only sell if the buying shareholder agrees to abide by the shareholder agreement. These common shareholder agreement provisions are intended to protect the S corporation election. The amount a noncontrolling ownership interest buyer is willing to pay for these various benefits, will depend on (1) the income tax status of the buyer, (2) the nature of the interest being purchased, and (3) in part, on the S corporation risks taken. These S corporation risks may offset those economic benefits. For example, a buyer of a noncontrolling interest is unable to determine distribution policy. Unless the buyer is protected from being required to pay personal income taxes in excess of distributions received, he or she will not pay a “full” premium justified by only theoretical economic benefits. The buyer may end up owing personal income taxes in excess of cash distributions made. For that reason, many S corporation shareholder agreements require distributions at least equal to the accrued income taxes due by the shareholders. This is typically true unless such distributions would result in the corporation becoming insolvent. If there is no such contractual income tax protection, the historical practice of the subject S corporation distributions often serves as the basis for establishing future expectations for distributions. If history shows that distributions have always at least been sufficient for the shareholders to pay the income taxes due on the S corporation
5 / Applying the Income Approach to S Corporation
99
income, then the analyst may assume that there is a likelihood that the practice will continue. This may be particularly strong evidence in cases where the controlling shareholder(s) do not have other sources of cash with which to pay income taxes. Absent shareholder agreement protection, the theoretical benefit of avoiding double taxation may be offset in whole or in part by an increased discount for lack of ready marketability.18 The noncontrolling shareholder may be subject to a controlling shareholder’s intention to change distribution policy to increase capital investments for projects that may or may not reap benefits that the noncontrolling shareholders will realize in the foreseeable future. Or, the controlling shareholders may even decide to “squeeze out” the noncontrolling shareholders by reducing or eliminating distributions. These specific risks should be weighed against the identified advantages.
How Should S Corporations Be Valued Using the DCF Method? To meet the valuation tests the Tax Court has suggested, analysts should first directly address (1) the economic benefits of S corporation status and (2) the likelihood that those economic benefits will continue for the subject S corporation during the expected investment holding period. This involves an analysis of the overall facts and circumstances of the specific situation. In applying the income approach, the IRS’s witness in Gross and experts on both sides in Heck used the DCF method. In their analyses, no income tax was applied at the entity level. The available cash flow was discounted using what was called “a C corporation discount rate.” That meant a discount rate based upon data derived from returns on investments in publicly traded C corporations.19 For the remainder of this chapter, that method will be referred to as the “Gross method.” The Gross experts’ analyses matched a pre-personalincome-tax cash flow with a pre-personal-income-tax discount rate. The Gross experts’ analyses, however, ignored the important fact that cash flow from an S corporation to its shareholders is not exactly like dividends from a C corporation because of differences in taxation between an S corporation’s taxable income on the one hand and C corporation dividends and capital gains on the other hand. These differences may be significant when viewed from the individual shareholder’s (the willing seller’s and willing buyer’s) tax perspective.
Three Suggested Methods of S Corporation Valuation In response to these Tax Court decisions, more refined valuation methods are appropriate. We have identified three methods to directly apply the DCF method to an ownership interest in an S corporation. These three methods consider both the tax differences and the variation in probable outcomes that affect the valuation analysis. These three methods are described as follows:
18 By either (1) increasing the discount rate or (2) increasing the percentage discount for lack of marketability applied to the indicated value at the end of the valuation process. 19 In Gross, the IRS’s expert discounted the cash flow expected by the shareholder at the equity rate of return. In Heck, experts for both sides discounted invested capital cash flow by the weighted average cost of capital, subtracting long-term debt from the invested capital value indication.
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1. The analyst can modify the Gross method to better take into account the differences between an S corporation and a C corporation when distributions do not equal the tax due on the subject taxable income (i.e., the modified Gross method). 2. The analyst can convert an after-personal-tax cash flow from the S corporation to a pre-personal-income-tax C corporation equivalent dividend. The analyst can then apply a C corporation discount rate. The adjusted cash flow to the S corporation shareholder is then equivalent to the dividends from a C corporation. As a result, the imputed C corporation equivalent dividend will match the discount rate (i.e., the C corporation equivalent method).20 3. The analyst can (a) convert the after-corporate-income-tax discount rate derived from public C corporation returns to an after-personal-income-tax equivalent discount rate, (b) convert that discount rate to a pre-personal-income-tax equivalent discount rate, and (c) discount the pre-personal-income-tax cash flow expected to be realized by the S corporation shareholder using the pre-personalincome-tax equivalent discount rate (i.e., the pretax discount rate method).21
Applying the Three Methods to Value an S Corporation The first example presents a base case S corporation valuation using the “traditional” method (see Exhibit 5.1). The second valuation example follows the method adopted by the Court in Gross (the Gross method) (see Exhibit 5.2). In Gross and Heck, the Tax Court valued noncontrolling ownership interests. In Adams, the Tax Court valued a controlling ownership interest. In all three cases, the Tax Court assumed that the S corporation election would continue indefinitely. The remaining examples apply the three suggested methods (i.e., the modified Gross, C corporation equivalent, and pretax discount rate methods) for both controlling and noncontrolling interest valuations. The relative values depend on the specific facts assumed in each instance. The examples are based on a consistent set of facts in order to illustrate the application of the methods.
Traditional Method This first example is a valuation of an S corporation using the DCF method. This example applies the traditional S corporation valuation method. That is, this method values the entity as if it were a C corporation. The method applies corporate level income tax to the S corporation cash flow. For simplicity, the example assumes that the entity is debt-free and will remain that way. And, the example assumes zero long-term average growth in cash flow. The appropriate C corporation equity discount rate 20 For a discussion of this approach, see J. Michael Julius, “Converting Distributions from S Corporations and Partnerships to a C Corporation Dividend Equivalent Basis,” Business Valuation Review, June 1997; Gregory A. Barber, “Valuation of Pass-Through Entities,” Valuation Strategies, March/April 2001; and Edward Giardina, “The Gross Decision—Where Do We Go from Here? Valuation Strategies, May/June 2002. 21 It has been suggested that a fourth method would be (1) to convert all cash flow to an after-personal-income-tax amount and (2) to discount the cash flow to present value using an equity rate of return adjusted to an after-personal-income-tax equivalent. Because the capital gains taxes due on sale are a function of the sales price and purchase price, the current value to a willing buyer requires solution of an equation (single equation with one unknown). The application of this method is the subject of a working paper by the chapter authors.
5 / Applying the Income Approach to S Corporation
101
Exhibit 5.1
Value of a Debt-Free S Corporation with No Expected Growth: The Traditional Method (as if C Corporation) Valuation Variables (1) Expected growth rate
0%
(2) Pretax margin
12.5%
(3) Depreciation as a % of sales
4.0%
(4) Reinvestment rate
150%
(5) Net working capital as a % of sales
10.0%
(6) Rate of return on equity
18.4% Projected Fiscal Year 1
(7) Revenue (2) × (7)
(8) Income before tax (9) Entity level tax rate
(8) × (9)
(10) Entity level tax
2
Terminal
3
4
Value
$ 5,000,000
$ 5,000,000
$ 5,000,000
$ 5,000,000
$ 5,000,000
625,000
625,000
625,000
625,000
625,000
40.0%
40.0%
40.0%
40.0%
40.0%
(250,000)
(250,000)
(250,000)
(250,000)
(250,000)
(11) Net income
(8) − (10)
375,000
375,000
375,000
375,000
375,000
(12) Depreciation
(3) × (7)
200,000
200,000
200,000
200,000
200,000
(13) Capital expenditures
(4) × (12)
(300,000)
(300,000)
(300,000)
(300,000)
(300,000)
(14) Net working capital (increase)/decrease
(5) × (7)
(15) Net cash flow
(11) to (14)
(16) Present value factor
18.4%
(17) Discounted cash flow
(15) × (16)
275,000
-
-
275,000
-
275,000
275,000
0.8446
0.7133
0.6025
0.5089
$ 232,264
$ 196,169
$ 165,683
$ 139,935
(18) Sum of discounted cash flow
(17)
734,050
(19) PV terminal value
See Box A
760,515
Capitalization rate
N/A
Terminal value
(20) Pass-through basis adjustment (21) Asset sale amortization benefit (22) Indicated value (marketable, 100% controlling ownership interest)
(18) to (21)
275,000 0.5536
Box A 18.4% 1,494,565
N/A
Present value factor
0.5089
$ 1,494,565
PV of terminal value
$ 760,515
SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.
(i.e., equity rate of return) used to discount the after-tax cash flow may be derived from historical returns on publicly traded stocks. For example, the total historical return on publicly traded microcapitalization stocks from 1926 through year-end 2000 was 18.4 percent.22 That is, as an alternative to investing in the typical small, private S corporation business, one could purchase a portfolio of small public stocks. Assuming the expected returns are similar to historical realized returns, the investor would expect an 18.4 percent rate of return from such a portfolio. The example uses this 18.4 percent rate as the appropriate C corporation equity discount rate or rate of return. Such a rate of return is an after-corporate-income-tax but prepersonal-income-tax equity rate of return. All examples assume the willing buyer at the valuation date is a qualified S corporation shareholder and expects to (1) hold the investment for 4 years and (2) then sell the investment at the “terminal value.” The terminal value is calculated by capitalizing the normalized cash flow expected in the fifth year. This terminal value is equivalent to the value the subsequent willing buyer would realize from holding the investment in perpetuity. Exhibit 5.1 presents the valuation calculations. The indicated value (before application of any discount for lack of ready marketability) equals $1,494,565 for 100 percent of the S corporation equity. 22 Stocks,
Bonds, Bills, and Inflation (SBBI) Valuation Edition 2001 Yearbook, Table 1-1, Arithmetic Mean Return for 1926–2000 (Chicago: Ibbotson Association, 2001).
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The example converts to present value the total projected cash flow. If the analyst is valuing a controlling interest, the controlling shareholder(s) can direct distributions. If the analyst is valuing a noncontrolling ownership interest, either (1) the cash flow valued should be equated to the expected distributions or (2) the indicated value should be adjusted by applying a discount for lack of control because noncontrolling shareholders may never realize distributions as large as the indicated cash flow.
The Gross Method Exhibit 5.2 presents a valuation of an entity consistent with Gross, Heck, and Adams (with no assumed change in the S corporation status). This analysis (1) replaces the 40 percent entity level income tax with any state/local income taxes that are tax deductions at the entity level (the example assumes 1.5 percent of taxable income) and (2) uses the same discount rate as the previous example. S corporations are required to file state income tax returns as well as federal income tax returns. Many states have state income taxes, franchise taxes, or personal property taxes that apply to S corporation income at the entity level. In Illinois, for example, S corporations are subject to a state personal property replacement income tax of 1.5 percent. As presented in Exhibit 5.2, the indicated value (before application of any discount for lack of ready marketability) is $2,802,310 for 100 percent of the S corporation equity. Exhibit 5.2
Value of a Debt-Free S Corporation with No Expected Growth: The Gross Method Valuation Variables (1) Expected growth rate
0%
(2) Pretax margin
12.5%
(3) Depreciation as a % of sales
4.0%
(4) Reinvestment rate
150%
(5) Net working capital as a % of sales
10.0%
(6) Rate of return on equity
18.4%
(7) Capital gains tax rate
25.0% Projected Fiscal Year 1
(8) Revenue (9) Income before tax
(2) × (8)
(10) Entity level tax rate
2
Terminal
3
4
Value
$ 5,000,000
$ 5,000,000
$ 5,000,000
$ 5,000,000
$ 5,000,000
625,000
625,000
625,000
625,000
625,000
1.5% (9,375)
1.5% (9,375)
1.5% (9,375)
1.5% (9,375)
1.5% (9,375)
(11) Entity level tax
(9) × (10)
(12) Net income
(9) − (11)
615,625
615,625
615,625
615,625
(13) Depreciation
(3) × (8)
200,000
200,000
200,000
200,000
200,000
(14) Capital expenditures
(4) × (13)
(300,000)
(300,000)
(300,000)
(300,000)
(300,000)
(15) Net working capital (increase)/decrease
(5) × (8)
(16) Net cash flow
(12) to (15)
(17) Present value factor
18.4%
0.8446
0.7133
0.6025
0.5089
(18) Discounted cash flow
(16) × (17)
$ 435,494
$ 367,816
$ 310,655
$ 262,378
(19) Sum of discounted cash flow
(18)
1,376,343
(20) PV terminal value as if an S corporation* (21) Indicated value (marketable, noncontrolling ownership interest)
515,625
515,625
515,625
515,625
1,425,967 (19) + (20)
$ 2,802,310
* Calculated as (terminal cash flow)/(discount rate − growth rate) × year 4 residual present value factor. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.
615,625
515,625 0.5536
5 / Applying the Income Approach to S Corporation
103
Valuing a Controlling Ownership Interest The willing buyer today may not pay the $2,802,310 if he or she has any expectation that the investment will not be held in perpetuity. Assume that the most likely buyer at the time of the expected resale of the entity is a nonqualified S corporation shareholder. Accordingly, a sale to that buyer would end the S corporation election. That next likely buyer will value the entity as a C corporation. Upon re-sale at the end of the fourth year, the current owner will realize: • •
•
The C corporation value, assuming carry-over income tax basis of the entity’s assets The tax savings resulting from any basis adjustment from the valuation date to the expected date of re-sale (resulting from the assumed cash distributions being less than taxable income) The additional price the likely buyer would pay because he/she can purchase assets and obtain a “step-up in” the basis of the entity’s assets resulting in increased future depreciation/amortization tax deductions
The Modified Gross Method Exhibit 5.3 presents an analysis consistent with the Tax Court’s suggestions in Gross and Heck for the first 4 years. In that period, the cash flow is discounted at the C corporation equity discount rate. However, this example assumes that the likely buyer at the end of the fourth year is a not a qualified S corporation shareholder. In Gross, distributions were approximately equal to 100 percent of the taxable income. Therefore, the pass-through entity basis adjustment was not addressed. In Heck, even though distributions, as determined by the Court, were less than taxable income, neither (1) the pass-through basis adjustment nor (2) the fact that the taxable income exceeded distributions was addressed. In Adams, the difference between taxable income and distributions was not addressed. In all three cases, it was assumed that the S corporation elections continued in perpetuity. The economic benefits from a step-up in basis to the succeeding buyer on the resale were not addressed. The example in Exhibit 5.3 adds those elements to the valuation analysis. The pass-through basis adjustment results in income tax savings. In order to be consistent with the C corporation pre-personal-income-tax equity rate of return of 18.4 percent, this analysis converts the capital gains tax savings to a pretax equivalent cash flow and then converts that amount to present value using the same 18.4 percent equity rate of return. The expected resale price or terminal value is calculated with the succeeding buyer valuing the entity as if it were a C corporation. In all examples where it is assumed the likely buyer at the end of the fourth year is a C corporation, the analysis assumes that: 1. One-half of the cash flow estimated in the terminal value calculation results from intangible assets and these intangible assets are amortizable for income tax purposes using 15-year straight-line amortization. 2. In an asset sale, the buyer would be willing to pay an additional purchase price equal to the present value of the income tax savings due to the step-up in basis of the intangible assets; this is the maximum amount that the buyer would be willing to pay.23 23 For simplicity, we have assumed only a step-up in the value of the intangible assets; the willing buyer would also be willing to pay for the step-up in the value of the tangible assets.
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Exhibit 5.3
Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with No Expected Growth: The Modified Gross Method Valuation Variables (1) Expected growth rate
0%
(2) Pretax margin
12.5%
(3) Depreciation as a % of sales
4.0%
(4) Reinvestment rate
150%
(5) Net working capital as a % of sales
10.0%
(6) Rate of return on equity
18.4%
(7) Capital gains tax rate
25.0% Projected Fiscal Year 1
(8) Revenue (2) × (8)
(9) Income before tax (10) Entity level tax rate
(9) × (10)
(11) Entity level tax
2
Terminal
3
4
Value
$ 5,000,000
$ 5,000,000
$ 5,000,000
$ 5,000,000
$ 5,000,000
625,000
625,000
625,000
625,000
625,000
1.5%
1.5%
1.5%
1.5%
40.0%
(9,375)
(9,375)
(9,375)
(9,375)
(250,000)
(12) Net income
(9) − (11)
615,625
615,625
615,625
615,625
375,000
(13) Depreciation
(3) × (8)
200,000
200,000
200,000
200,000
200,000
(300,000)
(300,000)
(300,000)
(300,000)
(300,000)
(14) Capital expenditures
(4) × (13)
(15) Net working capital (increase)/decrease
(5) × (8)
(16) Net cash flow
(12) to (15)
515,625
-
515,625
-
-
515,625
515,625
(17) Present value factor
18.4%
0.8446
0.7133
0.6025
0.5089
(18) Discounted cash flow
(16) × (17)
$ 435,494
$ 367,816
$ 310,655
$ 262,378
(19) Sum of discounted cash flow
(18)
1,376,343
(20) PV terminal value as if a C corporation
760,515
-
275,000 0.5536
Box A
(21) Pass-through basis adjustment
(30)
67,847
Terminal value before benefit
(22) Asset sale amortization benefit
See Box A
96,978
Estimated % of intangible assets
(23) Tax adjustment
(35)
(24) Indicated value (marketable, 100% controlling ownership interest)
(19) to (23)
(218,395)
Intangible assets
$ 2,083,289
$ 1,494,565 50% 747,283
Step-up factor (15-yr. period)
1.2550
Step-up value of intangible assets
937,864
Addition to selling price
190,581
PV of addition to selling price
96,978
Projected Fiscal Year 1
2
3
4
$ 100,000
$ 100,000
$ 100,000
$ 100,000
(25) Net income less net cash flow
(12) − (16)
(26) Sum of cash flow differential
(25)
(27) Tax benefit of 25% (capital gains rate)
(25) × 25%
100,000
(28) Pretax equivalent cash flow
(27) / (1-25%)
133,333
400,000
(29) Present value factor
(17)
0.5089
(30) Pass-through basis adjustment
(28) × (29)
67,847
Note: We are adding the benefit of the tax pass-through basis adjustment for explanatory purposes even though the expected proceeds upon sale at the end of year four in the zero growth rate scenario is less than the indicated value (purchase price).
SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.
In Exhibit 5.3, we have calculated (1) the present value of the terminal value (valued as if it were a C corporation) using the 18.4 percent equity discount rate and (2) the additional purchase price attributable to the asset sale using a less risky 10 percent discount rate.24 24 Under Internal Revenue Code Section 197, the amount paid for intangible assets including goodwill is amortizable over 15 years.
The resulting income tax savings is less risky than the underlying cash flow from the business operations. As such, some analysts believe the income tax savings due to the “step-up” in basis should be discounted using a discount rate that is less than the discount rate appropriate for the underlying business cash flow.
5 / Applying the Income Approach to S Corporation
105
There is one final adjustment that needs to be made. Because distributions are assumed to be less than the income subject to income taxes to the S corporation shareholders, we need to reduce the indicated value for the present value of the income taxes due on the taxable income in excess of distributions (free cash flow). The added income taxes are converted to their pretax equivalent at an ordinary income tax rate. The present value is calculated at a C corporation pre-personal-income-tax equity discount rate of 18.4 percent.
C Corporation Equivalent Method Exhibit 5.4 displays the calculation of the after-personal-income-tax cash flow. The income tax is based on taxable income. In the example, distributions are less than the taxable income. The after-personal-income-tax cash flow is then converted to an equivalent C corporation cash flow. The conversion is made as if the distributions were dividends and taxed at an assumed 45 percent personal income tax rate. The C corporation discount rate matches the C corporation equivalent cash flow. The example directly measures all three economic benefits of the S corporation that can be realized by a controlling S corporation shareholder. The discount rate, however, does not truly match the nature of the cash flow. The 18.4 percent C corporation pre-personal-income-tax equity discount rate embodies a mix of ordinary income and capital gain income. That mix of income differs from the taxation that confronts the shareholder of the S corporation.
The Pretax Discount Rate Method The conversion of an after-corporate-income-tax discount rate to its pretax equivalent rate is not a simple procedure. Some analysts suggest that the conversion may simply be made as follows: kb =
ka 1− t
where kb = Before-tax equity discount rate (rate of return) ka = After-tax equity discount rate (rate of return) t = Corporate income tax rate However, that straightforward conversion only applies in limited cases. For example, let BTCF = EBT + NCC − NWC − CAPX and ATCF = EBT × (1 − t) + NCC − NWC − CAPX where BTCF = Before-income-tax cash flow EBT = Earnings before income taxes
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I / Business Valuation Technical Topics
Exhibit 5.4
Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with No Expected Growth: The C Corporation Equivalent Method Valuation Variables (1) Expected growth rate
0%
(2) Pretax margin
12.5%
(3) Depreciation as a % of sales
4.0%
(4) Reinvestment rate
150%
(5) Net working capital as a % of sales
10.0%
(6) Rate of return on equity
18.4%
(7) Capital gains tax rate
25.0% Projected Fiscal Year 1
(8) Revenue (9) Income before tax (10) Entity level tax rate (11) Entity level tax
(2) × (8) (9) × (10)
2
Terminal
3
4
Value
$ 5,000,000
$ 5,000,000
$ 5,000,000
$ 5,000,000
$ 5,000,000
625,000
625,000
625,000
625,000
625,000
1.5% (9,375)
1.5% (9,375)
1.5% (9,375)
1.5% (9,375)
40.0% (250,000)
(12) Net income
(9) − (11)
615,625
615,625
615,625
615,625
375,000
(13) Depreciation
(3) × (8)
200,000
200,000
200,000
200,000
200,000
(14) Capital expenditures (15) Net working capital (increase)/decrease
(4) × (13) (5) × (8)
(300,000)
(300,000)
(300,000)
(300,000)
(300,000)
(16) Net cash flow
(12) to (15)
515,625
515,625
515,625
515,625
275,000
Pass-through cash flow adjustment (17) Personal income tax*
(12) × 45%
(277,031)
(277,031)
(277,031)
(277,031)
(123,750)
(18) After-personal-tax cash flow
(16) − (17)
238,594
238,594
238,594
238,594
151,250
(19) C corporation-equivalent cash flow†
(18) / (1 - 45%)
433,807
433,807
433,807
433,807
275,000
-
-
-
-
(20) Present value factor
18.4%
0.8446
0.7133
0.6025
0.5089
(21) Discounted cash flow
(19) × (20)
$ 366,391
$ 309,452
$ 261,361
$ 220,744
(22) Sum of discounted cash flow
(21)
1,157,948
(23) PV terminal value as if a C corporation‡
760,515
-
0.5536
Box A
(24) Pass-through basis adjustment
(32)
67,847
Terminal value before benefit
(25) Asset sale amortization benefit
See Box A
96,978
Estimated % of intangible assets
50%
(26) Indicated value (marketable, 100% controlling ownership interest)
(22) to (25)
$ 2,083,289
Intangible assets
747,283
Step-up factor (15-yr. period)
1.2550
Step-up value of intangible assets
937,864
Addition to selling price § PV of addition to selling price
190,581
Projected Fiscal Year 1 (27) Net income less net cash flow
(12) − (16)
(28) Sum of cash flow differential
(27)
400,000
$ 100,000
(29) Tax benefit of 25% (capital gains rate)
(28) × 25%
100,000
(30) C corporate-equivalent cash flow
(29) / (1-25%)
133,333
(31) Present value factor
(20)
0.5089
(32) Pass-through basis adjustment
(30) × (31)
67,847
2 $ 100,000
$ 1,494,565
3 $ 100,000
4 $ 100,000
Note: We are adding the benefit of the tax pass-through basis adjustment for explanatory purposes even though the expected proceeds upon sale at the end of year four in the zero growth rate scenario is less than the indicated value (purchase price).
* Terminal year calculation is (16) × 45%. † This is the pre-personal-tax C corporation-equivalent cash flow. ‡ Calculated as (residual cash flow)/(discount rate − growth rate) × year 4 present value factor. § PV factor equals year 4 present value factor. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.
96,978
5 / Applying the Income Approach to S Corporation
107
NCC = Noncash charges resulting from expenses such as depreciation and amortization NWC = Changes in investment in net working capital CAPX = Capital expenditures ATCF = After-tax cash flow If, for illustrative purposes, we assume that (1) the only difference between before-tax cash flow and after-tax cash flow is the multiplication of (1 – t) times EBT (that is, noncash expenses for depreciation and amortization equals expected changes in net working capital minus expected capital expenditures) and (2) we can determine the value of the business by applying a constant perpetual growth in cash flow (g) valuation model where value = cash flow/(k – g) (often called the Gordon growth model), we get the following: After-tax value =
ATCF BTCF × (1 − t ) = ka − g ka − g
Before-tax value = BTCF × (kb − g) Since we are solving for the relationship between kb and ka that produces an equivalent value, we solve the following for kb: BTCF BTCF × (1 − t ) = kb − g ka − g kb =
ka − g +g 1− t
where g is the expected long-term constant annual growth rate in cash flow. Even in this simplified case, unless g = 0, the simple conversion formula does not work.25 Further, if (1) noncash expenses do not equal changes in net working capital minus expected capital expenditures, or (2) if the appropriate model for determining the value of the business is more complex than the Gordon growth model, then the solution for the equivalent discount rate is much more complicated. In addition, the analyst should adjust the ka (after-tax equity discount rate) for the differences in taxation between (1) the assumed returns from a market portfolio of comparable-risk publicly traded securities and (2) the distributions from a “private” S corporation. As discussed above, the total historical realized return on publicly traded microcap stocks was 18.4 percent.26 As an alternative to investing in the typical small, private S corporation business, an investor could purchase a portfolio of small public stocks. Assuming the expected returns are similar to historical realized returns, the investor would expect an 18.4 percent rate of return from such a portfolio—with returns realized as they have been historically as follows: 1. 2.7+ percent representing income returns taxed at ordinary income tax rates 2. 15.6+ percent representing capital appreciation taxed at capital gains rates
25 Mary Ann
Lerch, “Pretax/After Conversion Formula for Capitalization Rates and Cash Flow Discount Rates,” Business Valuation Review, March 1990; Shannon P. Pratt, Appendix G, “Converting After-Tax Discount Rates to Pretax Discount Rates,” Cost of Capital Estimation and Application, 2d ed. (New York: John Wiley & Sons, 2002). 26 SBBI Valuation Edition 2001 Yearbook, Table 1-1, Arithmetic Mean Return for 1926–2000.
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I / Business Valuation Technical Topics
On an after-personal-income-tax basis, an investor would then expect an average annual after-personal-income-tax return (year-in and year-out) as follows: 2.7% (1 − 0.45) + 15.6% (1 − 0.25) = 13.2% (rounded) where 45 percent is the assumed personal income tax rate (federal plus effective state income tax rate) and 25 percent is the assumed capital gains tax rate (federal plus effective state income tax rate). Each year that the investor owns the S corporation stock, the investor will be taxed at the ordinary income tax rate (assumed to be 45 percent) on the S corporation income passed through to the shareholder. Therefore, the equivalent pre-personalincome-tax rate of return during the years the S corporation investment is held, when income is taxed at ordinary income tax rates, is 13.2% = 24% 1 − 0.45 And, the equivalent pre-personal-income-tax rate of return on the capital gain in the year of sale is 13.2% = 17.6% 1 − 0.25 Assuming, for illustrative purposes, that we can convert an after-tax discount rate to a pretax discount rate as illustrated above (remembering in this example that we made some simplifying assumptions and g = 0), Exhibit 5.5 displays the results from 1. Converting the 13.2 percent after-personal-income-tax equity rate of return to its pretax equivalent of 24 percent for purposes of calculating the present value of the cash flows (13.2%/(1 − 0.45) = 24%—because distributions are taxable at ordinary income tax rates) in years 1 through 4 2. Converting the 13.2 percent to its pretax equivalent of 17.6 percent for calculating the present value of the terminal value (13.2%/(1 − 0.25) = 17.6%— because the terminal value will be taxed at capital gain rates) The nature of the discount rate in this example better matches the income tax characteristics confronting the S corporation shareholder (1) while he or she holds the investment and (2) then again when the shareholder expects to resell the investment. Next, we add the pass-through basis adjustment. This adjustment (1) converts the income taxes that will be saved to a pretax equivalent at a capital gains tax rate and (2) calculates the present value at the pretax equivalent rate of 17.6 percent. This rate is used because the pass-through basis adjustment results in a reduction of capital gains taxes. We likewise calculate the present value of the increased terminal sale proceeds from the tax savings. The increased terminal sale proceeds are due to amortization available from the step-up in basis at the pretax equivalent rate of 17.6 percent. This rate is used because the additional sales proceeds will be taxed at a capital gains rate. Again, because distributions are less than the taxes due on the taxable income to the S corporation shareholders, we need to reduce the indicated value for the present value of the income taxes due in excess of distributions. The added income taxes are converted to their pretax equivalent at an ordinary income tax rate. The present value is calculated at a pretax equivalent equity rate of return of 24 percent.
Exhibit 5.5
Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with No Expected Growth: The Pretax Discount Rate Method Valuation Variables (1) Expected growth rate
0%
(2) Pretax margin
12.5%
(3) Depreciation as a % of sales
4.0%
(4) Reinvestment rate
150%
(5) Net working capital as a % of sales
10.0%
(6) Rate of return on equity
18.4%
(7) Capital gains tax rate
25.0% Projected Fiscal Year 1
(8) Revenue (9) Income before tax
(2) × (8)
2
Terminal
3
4
Value
$ 5,000,000
$ 5,000,000
$ 5,000,000
$ 5,000,000
$ 5,000,000
625,000
625,000
625,000
625,000
625,000
(10) Entity level tax rate
1.5%
1.5%
1.5%
1.5%
40.0%
(9,375)
(9,375)
(9,375)
(9,375)
(250,000)
(11) Entity level tax
(9) × (10)
(12) Net income
(9) − (11)
615,625
615,625
615,625
615,625
375,000
(13) Depreciation
(3) × (8)
200,000
200,000
200,000
200,000
200,000
(300,000)
(300,000)
(300,000)
(300,000)
(300,000)
(14) Capital expenditures
(4) × (13)
(15) Net working capital (increase)/decrease
(5) × (8)
(16) Net cash flow
(12) to (15)
515,625
515,625
-
-
515,625
515,625
(17) Present value factor*
24.0%
0.8065
0.6504
0.5245
0.4230
(18) Discounted cash flow
(16) × (17)
$ 415,827
$ 335,344
$ 270,439
$ 218,096
(19) Sum of discounted cash flow
(18)
1,239,705
(20) PV terminal value as if a C corporation†, ‡
781,422
275,000 0.5536
Box A
(21) Pass-through basis adjustment
(30)
69,712
Terminal value before benefit
(22) Asset sale amortization benefit
See Box A
99,644
Estimated % of intangible assets
(23) Tax adjustment
(35)
(24) Indicated value (marketable, 100% controlling ownership interest)
(19) to (23)
(196,714)
Intangible assets
$ 1,993,770
$ 1,494,565 50% 747,283
Step-up factor (15-yr. period)
1.2550
Step-up value of intangible assets
937,864
Addition to terminal price
190,581
PV of addition to terminal price‡
99,644
Projected Fiscal Year 1 (25) Net income less net cash flow
(12) − (16)
(26) Sum of cash flow differential
(25)
400,000
$100,000
(27) Tax benefit of 25% (capital gains rate)
(26) × 25%
100,000
(28) Pretax equivalent cash flow
(27) / (1-25%)
133,333
(29) Present value factor
(17)
0.5228
(30) Pass-through basis adjustment
(28) × (29)
69,712
2 $100,000
3 $100,000
4 $100,000
Note: We are adding the benefit of the tax pass-through basis adjustment for explanatory purposes even though the expected proceeds upon sale at the end of year 4 in the zero growth rate scenario is less than the indicated value (purchase price).
Projected Fiscal Year 1
2
3
4 $ 45,000
(31) Tax on income in excess of net cash flow
(25) × 45%
$ 45,000
$ 45,000
$ 45,000
(32) Pretax equivalent
(31) / (1-0.45)
81,818
81,818
81,818
81,818
(33) Present value factor
(17)
0.8065
0.6504
0.5245
0.4230
(34) Discounted tax adjustment
(32) × (33)
65,982
53,212
42,913
34,607
(35) Tax adjustment
(34)
196,714
* Pretax rate is calculated as [(13.2% − g)/(1 − 45%)] + g where 13.2% equals the after-personal-tax return, g equals expected growth rate, and 45% is the personal tax rate. Refer to the working paper for support of 13.2%. † Calculated as (terminal cash flow)/(discount rate − growth rate) × present value factor. A terminal C corporation discount rate of 18.4% is used in the terminal value calculation. ‡ The terminal discount rate calculation uses a capital gains tax rate of 25% rather than 45%, resulting in a discount rate of 17.6%. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.
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Valuing a Noncontrolling Ownership Interest Exhibits 5.6, 5.7, and 5.8 parallel the prior three examples (i.e., Exhibits 5.3, 5.4, and 5.5). Exhibits 5.6, 5.7, and 5.8 differ from the prior examples in that we are now assuming (1) that the willing buyer is a noncontrolling shareholder and (2) that he or she has no expectation that the entity will be sold at the end of the 4-year expected investment period. We also assume that (1) the likely succeeding buyer will be a qualified S corporation shareholder, (2) the resale price or terminal value will be calculated without subtracting an entity level income tax (which assumes that the economic benefit will continue), and (3) there will be no additional terminal price paid because the succeeding noncontrolling interest buyer will only receive the economic benefits of carry-over tax basis of the entity’s assets. In Exhibits 5.6 and 5.8, the effect of the tax adjustment (based on the assumption that taxes due on taxable income will exceed the distributions) affects both (1) the 4 years in which the willing buyer expects to hold the investment and (2) the expected resale price or terminal value that the likely succeeding buyer will pay.
Summary of Before Discount for Lack of Marketability Example In summary, the value indications in the exhibits discussed above (before any discount for lack of marketability) are as follows: Reference Exhibit 5.1 Exhibit 5.2
S Corporation Valuation Method The traditional (as if C corporation) method The Gross method (no end to the S corporation)
Indicated Value $1,494,565 $2,802,310
Controlling ownership interest valued with assumed terminal sale to a C corporation: Exhibit 5.3 Exhibit 5.4 Exhibit 5.5
The modified Gross method The C corporation equivalent method The pretax discount rate method
$2,083,289 $2,083,289 $1,993,770
Do these value conclusion results make economic sense? Part of the increased value compared to the traditional method is due to the economic benefit that qualified S corporation shareholders realize from electing S corporation status—given the assumed taxable income and distributions in the example. During each of the 4 projected years, the C corporation would pay $250,000 in entity level income taxes (Exhibit 5.1). The shareholders would then pay an additional $123,750 in personal income taxes,27 for total income taxes equal to $373,750. The S corporation election causes the entity level income taxes to be only $9375 (Exhibit 5.3). The shareholders would pay $277,031 in personal income taxes,28 for a total equal to $286,406. The S corporation shareholders save $87,344 by making the S corporation election. 27 $275,000 28 $615,525
per year distribution/dividend times a 45 percent personal income tax rate. per year in net income passed through to the shareholders times a 45 percent personal income tax rate.
Exhibit 5.6
Value of a Debt-Free S Corporation (Noncontrolling Ownership Interest Basis) with No Expected Growth: The Modified Gross Method Valuation Variables (1) Expected growth rate
0%
(2) Pretax margin
12.5%
(3) Depreciation as a % of sales
4.0%
(4) Reinvestment rate
150%
(5) Net working capital as a % of sales
10.0%
(6) Rate of return on equity
18.4%
(7) Capital gains tax rate
25.0% Projected Fiscal Year 1
(8) Revenue (9) Income before tax
(2) × (8)
Terminal
3
4
Value
$ 5,000,000
$ 5,000,000
$ 5,000,000
$ 5,000,000
$ 5,000,000
625,000
625,000
625,000
625,000
625,000
(10) Entity level tax rate (11) Entity level tax
2
(9) × (10)
1.5%
1.5%
1.5%
1.5%
1.5%
(9,375)
(9,375)
(9,375)
(9,375)
(9,375)
(12) Net income
(9) − (11)
615,625
615,625
615,625
615,625
615,625
(13) Depreciation
(3) × (8)
200,000
200,000
200,000
200,000
200,000
(14) Capital expenditures
(4) × (13)
(300,000)
(300,000)
(300,000)
(300,000)
(300,000)
(15) Net working capital (increase)/decrease
(5) × (8)
(16) Net cash flow
(12) to (15)
(17) Present value factor
18.4%
(18) Discounted cash flow
(16) × (17)
(19) Sum of discounted cash flow
(18)
(20) PV terminal value as if an S corporation* (21) Terminal value tax adjustment† (22) Pass-through basis adjustment
515,625
515,625
515,625
515,625
0.8446
0.7133
0.6025
0.5089
$ 435,494
$ 367,816
$ 310,655
$ 262,378
515,625 0.5536
1,376,343 1,425,967 (226,269)
(31)
67,847
(24) Tax adjustment
(35)
(218,395)
(25) Indicated value (marketable, noncontrolling ownership interest)
(19) to (24)
(23) Asset sale amortization benefit‡
N/A $ 2,425,493
Note: The willing buyer at the end of the 4th year will realize the benefit of a pass-through basis adjustment when the stock is sold. Since the timing of the resale is unkown in this example, no additional value was considered.
Projected Fiscal Year 1
2
3
4
$100,000
$100,000
$100,000
$100,000
(26) Net income less net cash flow
(12) − (16)
(27) Sum of cash flow differential
(26)
(28) Tax benefit of 25% (capital gains rate)
(27) × 25%
100,000
(29) Pretax equivalent cash flow
(28) / (1-25%)
133,333
400,000
(30) Present value factor
(17)
0.5089
(31) Pass-through basis adjustment
(29) × (30)
67,847
Note: We are adding the benefit of the tax pass-through basis adjustment for explanatory purposes even though the expected proceeds upon sale at the end of year 4 in the zero growth rate scenario is less than the indicated value (purchase price).
Projected Fiscal Year 1
2
3
4
(32) Tax on income in excess of net cash flow
(26) × 45%
$ 45,000
$ 45,000
$ 45,000
$ 45,000
(33) Pretax equivalent
(32) / (1-0.45)
81,818
81,818
81,818
81,818
(34) Present value factor
(17)
0.8446
0.7133
0.6025
0.5089
(35) Discounted tax adjustment
(33) × (34)
69,103
58,364
49,294
41,634
(36) Tax adjustment
(35)
218,395
* Calculated as (terminal cash flow)/(discount rate − growth rate) × year 4 terminal present value factor. † Calculated as {[(12) − (16)] × 45%}/(1 − 45%). This pretax equivalent value is then capitalized by (18.4% − growth rate). The result is discounted by the year 4 present value factor. ‡ There is no step-up in asset value for a sale of a noncontrolling ownership position. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.
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Exhibit 5.7
Value of a Debt-Free S Corporation (Noncontrolling Ownership Interest Basis) with No Expected Growth: The C Corporation Equivalent Method Valuation Variables (1) Expected growth rate
0%
(2) Pretax margin
12.5%
(3) Depreciation as a % of sales
4.0%
(4) Reinvestment rate
150%
(5) Net working capital as a % of sales
10.0%
(6) Rate of return on equity
18.4%
(7) Capital gains tax rate
25.0% Projected Fiscal Year 1
(8) Revenue (9) Income before tax
(2) × (8)
2
(9) × (10)
4
Value
$ 5,000,000
$ 5,000,000
$ 5,000,000
$ 5,000,000
$ 5,000,000
625,000
625,000
625,000
625,000
625,000
(10) Entity level tax rate (11) Entity level tax
Terminal
3
1.5%
1.5%
1.5%
1.5%
1.5%
(9,375)
(9,375)
(9,375)
(9,375)
(9,375)
(12) Net income
(9) − (11)
615,625
615,625
615,625
615,625
615,625
(13) Depreciation
(3) × (8)
200,000
200,000
200,000
200,000
200,000
(14) Capital expenditures
(4) × (13)
(300,000)
(300,000)
(300,000)
(300,000)
(300,000)
(15) Net working capital (increase)/decrease
(5) × (8)
(16) Net cash flow
(12) to (15)
515,625
515,625
515,625
515,625
515,625
(17) Personal income tax
(12) × 45%
(277,031)
(277,031)
(277,031)
(277,031)
(277,031)
(18) After-personal-tax cash flow
(16) − (17)
238,594
238,594
238,594
238,594
238,594
(19) C corporation-equivalent cash flow*
(18) / (1 - 45%)
433,807
433,807
433,807
433,807
433,807
-
-
-
-
-
Pass-through cash flow adjustment
(20) Present value factor
18.4%
0.8446
0.7133
0.6025
0.5089
(21) Discounted cash flow
(19) × (20)
$ 366,391
$ 309,452
$ 261,361
$ 220,744
(22) Sum of discounted cash flow
(21)
1,157,948
(23) PV terminal value as if an S corporation† (24) Pass-through basis adjustment
1,199,697 (32)
67,847
(25) Asset sale amortization benefit‡ (26) Indicated value (marketable, noncontrolling ownership interest)
N/A (22) to (25)
$ 2,425,493
Note: The willing buyer at the end of the 4th year will realize the benefit of a pass-through basis adjustment when the stock is sold. Since the timing of the resale is unkown in this example, no additional value was considered.
Projected Fiscal Year
(27) Net income less net cash flow
(12) − (16)
(28) Sum of cash flow differential
(27)
1
2
3
4
$ 100,000
$ 100,000
$ 100,000
$ 100,000
400,000
(29) Tax benefit of 25% (capital gains rate)
(28) × 25%
100,000
(30) C corporate-equivalent cash flow
(29) / (1-25%)
133,333
(31) Present value factor
(20)
0.5089
(32) Pass-through basis adjustment
(30) × (31)
67,847
* This is the pre-personal-tax C corporation-equivalent cash flow. † Calculated as (terminal cash flow)/(discount rate − growth rate) × year 4 present value factor. ‡ There is no step up in asset value for a sale of a noncontrolling ownership position. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.
0.5536
Exhibit 5.8
Value of a Debt-Free S Corporation (Noncontrolling Ownership Interest Basis) with No Expected Growth: The Pretax Discount Rate Method Valuation Variables (1) Expected growth rate
0%
(2) Pretax margin
12.5%
(3) Depreciation as a % of sales
4.0%
(4) Reinvestment rate
150%
(5) Net working capital as a % of sales
10.0%
(6) Rate of return on equity
18.4%
(7) Capital gains tax rate
25.0% Projected Fiscal Year 1
(8) Revenue (9) Income before tax
(2) × (8)
2
(9) × (10)
4
Value
$ 5,000,000
$ 5,000,000
$ 5,000,000
$ 5,000,000
$ 5,000,000
625,000
625,000
625,000
625,000
625,000
(10) Entity level tax rate (11) Entity level tax
Terminal
3
1.5%
1.5%
1.5%
1.5%
1.5%
(9,375)
(9,375)
(9,375)
(9,375)
(9,375)
(12) Net income
(9) − (11)
615,625
615,625
615,625
615,625
615,625
(13) Depreciation
(3) × (8)
200,000
200,000
200,000
200,000
200,000
(300,000)
(300,000)
(300,000)
(300,000)
(300,000)
(14) Capital expenditures
(4) × (13)
(15) Net working capital (increase)/decrease
(5) × (8)
(16) Net cash flow
(12) to (15)
(17) Present value factor*
24.0%
(18) Discounted cash flow
(16) × (17)
(19) Sum of discounted cash flow
(18)
(20) PV terminal value as if an S corporation†, ‡
515,625
515,625
515,625
515,625
0.8065
0.6504
0.5245
0.4230
$ 415,827
$ 335,344
$ 270,439
$ 218,096
515,625 0.5536
1,239,705 1,123,294
(21) Terminal value tax adjustment§ (22) Pass-through basis adjustment
-
(178,242) (31)
69,712
(24) Tax adjustment
(36)
(196,714)
(25) Indicated value (marketable, noncontrolling ownership interest)
(19) to (24)
(23) Asset sale amortization benefit
N/A $ 2,057,756
Note: The willing buyer at the end of the 4th year will realize the benefit of a pass-through basis adjustment when the stock is sold. Since the timing of the resale is unkown in this example, no additional value was considered.
Projected Fiscal Year 1 (26) Net income less net cash flow
(12) − (16)
(27) Sum of cash flow differential
(26)
400,000
(28) Tax benefit of 25% (capital gains rate)
(27) × 25%
100,000
(29) Pretax equivalent cash flow
(28) / (1-25%)
133,333
(30) Present value factor
(17)
0.5228
(31) Pass-through basis adjustment
(29) × (30)
69,712
$ 100,000
2 $ 100,000
3 $ 100,000
4 $ 100,000
Note: We are adding the benefit of the tax pass-through basis adjustment for explanatory purposes even though the expected proceeds upon sale at the end of year four in the zero growth rate scenario is less than the indicated value (purchase price).
Projected Fiscal Year 1
2
3
4
(32) Tax on income in excess of net cash flow
(26) × 45%
$ 45,000
$ 45,000
$ 45,000
$ 45,000
(33) Pretax equivalent
(32) / (1-0.45)
81,818
81,818
81,818
81,818
(34) Present value factor
(17)
0.8065
0.6504
0.5245
0.4230
(35) Discounted tax adjustment
(33) × (34)
65,982
53,212
42,913
34,607
(36) Tax adjustment
(35)
196,714
* Pretax rate is calculated as [(13.2% − g)/(1 − 45%)] + g where 13.2% equals the after-personal-tax return, g equals expected growth rate, and 45% is the personal tax rate. Refer to the working paper for support of 13.2%. † Calculated as (terminal cash flow)/(discount rate − growth rate) × present value factor. ‡ The terminal discount rate calculation uses a capital gains tax rate of 25% rather than 45%. See the first footnote (*). § Calculated as {[(12) − (16)] × 45%}/(1 − 45%). This pretax equivalent value is then capitalized by (24% − growth rate). The result is discounted by the residual present value factor in third footnote (‡). SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.
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If (1) the existing shareholders elected S corporation status and (2) the pool of likely buyers are qualified S corporation shareholders, then the willing sellers and the willing buyers will value the cash flow as an S corporation for some number of years. To do otherwise would ignore the actual amount of income taxes saved. Obviously, the relative net tax advantage is a function of the company’s expected distributions and the relative marginal corporate and personal income tax rates.29 The increased value results from the savings of a variable expense (i.e., federal income taxes). The remaining part of the increased value in the example is the increased expected resale price or terminal value from selling the corporate assets at the end of year 4.30 As discussed above, some commentators claim that no willing buyer would pay any price premium for an existing S corporation. They argue that any qualified S corporation shareholder purchasing the entity could elect S corporation status. Of course, this reasoning ignores the motivations of the willing seller. The willing seller realizes that the existing S corporation election saves income taxes. As long as the pool of likely buyers are predominately qualified S corporation shareholders, the willing seller will not allow the price he or she will receive to be penalized by allowing the willing buyer to assume income taxes that will not be paid. Buyer/seller negotiations will result in some price premium (compared to the value of a C corporation) being paid. An existing S corporation election may be particularly valuable if the willing buyer acquires less than 100 percent of the stock because an S corporation election requires unanimous consent of the shareholders. In addition, an existing S corporation can generally sell corporate assets without being subject to the built-in gains tax.31 Other commentators claim that the underlying business risk is measured by the C corporation discount rate. Therefore, these commentators assert that the entity should be valued as a C corporation. In the examples, we have used the C corporation discount rates. We only converted the cash flow or the discount rate to account for differences in taxation. Researchers studying information contained in transaction databases have compared transaction prices paid for S corporations versus C corporations (based on 100 percent of the corporations). The results of some of these studies indicate virtually no price difference, except for the larger corporations.32 This research does not encompass noncontrolling ownership interests. How do the results of these studies reconcile with the analyses presented above? Shareholders of smaller corporations are typically involved in operating the business. As such, the willing sellers can realize proceeds on sale of the business outside of the selling price for their stock because the sellers can receive payments under employment agreements and noncompetition agreements, which are tax deductible to the buyer and taxed as ordinary income to the seller. Let’s assume that the subject corporation is incorporated as a C corporation. The willing sellers can realize sale proceeds equivalent to those that the S corporation owners could realize.
29 In
“Taxes and the Relative Valuation of S Corporations and C Corporations,” Denis and Sarin find that under current statutory income tax rates, an S corporation will generally be valued at a price premium over an identical C corporation (with the price premium as large as 54 percent). 30 The increase in the selling price from selling assets is 13 percent, consistent with the observations cited in footnote 9 herein. 31 A C corporation that converts to an S corporation is subject to a built-in gains tax for 10 years. 32 Michael J. Mattson, Donald S. Shannon, and David E. Upton, “Some Evidence on ‘Premiums,’ ” Shannon Pratt’s Business Valuation Update, November 2002 and December 2002.
5 / Applying the Income Approach to S Corporation
115
The value of the “step-up” in basis of the entity’s assets can be passed through to the willing buyers. This would occur through the tax deductions they realize on payments for employment agreements and noncompetition agreements. Sellers will use these agreements as a way to circumvent the “built-in” gains tax that would result if the C corporation sold corporate assets directly to the willing buyer. The values allocated to employment agreements and noncompetition agreements are added to the price paid for the stock when the total transaction consideration is reported in the transaction databases. But, such a sale price allocation can be challenged and changed upon audit by the IRS. And, the transaction databases do not reflect the final sale price allocation results. For larger corporations, on the other hand, there is a separation between ownership of stock and management. Nonmanagement shareholders will not be able to participate in employment agreements or noncompetition agreements. In these cases, the willing sellers only receive value for their stock through the sale of the stock. The willing buyer will pay for the step-up in the basis of the entity’s assets to reduce his or her future income taxes. And, this additional purchase price will be reflected in the value paid for the stock of an S corporation. The observed transaction prices also reflect this difference. The current financial accounting standards that require all acquisitions to be accounted for as a purchase of assets do not change this relationship because the step-up in basis in an entity’s assets only affects income taxes for transactions that are taxable for federal income tax purposes.33 The results in Exhibits 5.6, 5.7, and 5.8, where we are valuing a noncontrolling ownership interest with an assumed resale following the expected investment holding period of four years to qualified S corporation shareholder(s), are as follows: Reference Exhibit 5.6 Exhibit 5.7 Exhibit 5.8
S Corporation Valuation Method The modified Gross method The C corporation equivalent method The pretax discount rate method
Indicated Value $2,425,493 $2,425,493 $2,057,756
These value conclusion results (for 100 percent of the entity interests) indicate a maximum value when assuming no future termination of S corporation status or changes in distributions. Further, these results are before any discount for lack of ready marketability. All else being equal, one would expect the discount for lack of ready marketability to be greater for the noncontrolling ownership interests than for the controlling ownership interests.
Summary of Example with 5 Percent Long-Term Growth Rate Assumed Exhibits 5.9 through 5.16 present parallel analyses with the only change from the previous exhibits being a 5 percent assumed average long-term growth rate in cash flow (i.e., g = 5%)—rather than zero percent growth rate. The results (before any discount for lack of ready marketability) are as follows: 33 Statement of Financial Accounting Standards No. 141 mandates financial reporting requirements only and not income tax accounting requirements. There will still be acquisitions that are nontaxable to the sellers (e.g., an exchange of stock of the acquiring corporation stock of the seller) for which no step-up in basis for the buyer will occur. The step-up in basis can occur in a taxable transaction.
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Exhibit 5.9
Value of a Debt-Free S Corporation with 5 Percent Expected Growth Rate: The Traditional Method (as if a C Corporation) Valuation Variables (1) Expected growth rate
5%
(2) Pretax margin
12.5%
(3) Depreciation as a % of sales
4.0%
(4) Reinvestment rate
150%
(5) Net working capital as a % of sales
10.0%
(6) Rate of return on equity
18.4% Projected Fiscal Year 1
(7) Revenue (2) × (7)
(8) Income before tax (9) Entity level tax rate
(8) × (9)
(10) Entity level tax
2
Terminal
3
4
Value
$ 5,000,000
$ 5,250,000
$ 5,512,500
$ 5,788,125
$ 6,077,531
625,000
656,250
689,063
723,516
759,691
40.0%
40.0%
40.0%
40.0%
40.0%
(250,000)
(262,500)
(275,625)
(289,406)
(303,877) 455,815
(11) Net income
(8) − (10)
375,000
393,750
413,438
434,109
(12) Depreciation
(3) × (7)
200,000
210,000
220,500
231,525
243,101
(13) Capital expenditures
(4) × (12)
(300,000)
(315,000)
(330,750)
(347,288)
(364,652)
(14) Net working capital (increase)/decrease
(5) × (7)
(23,810)
(25,000)
(26,250)
(27,563)
(28,941)
(15) Net cash flow
(11) to (14)
251,190
263,750
276,938
290,784
305,324
(16) Present value factor
18.4%
(17) Discounted cash flow
(15) × (16)
(18) Sum of discounted cash flow
(17)
(19) PV terminal value
See Box A
(20) Pass-through basis adjustment (21) Asset sale amortization benefit (22) Indicated value (marketable, 100% controlling ownership interest)
(18) to (21)
0.8446
0.7133
0.6025
0.5089
$ 212,154
$ 188,143
$ 166,850
$ 147,967
715,115
0.5536
Box A
1,159,441
Capitalization rate
N/A
Terminal value
13.4% 2,278,534
N/A
Present value factor
0.5089
$ 1,874,556
PV of terminal value
$ 1,159,441
SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.
Reference Exhibit 5.9 Exhibit 5.10
S Corporation Valuation Method The traditional (as if C corporation) method The Gross method (no end to S corporation)
Indicated Value $1,874,556 $3,670,265
Controlling ownership interest valued with assumed terminal sale to a C corporation: Exhibit 5.11 Exhibit 5.12 Exhibit 5.13
The modified Gross method The C corporation equivalent The pretax discount rate method
$2,509,565 $2,509,565 $2,515,489
The results for a noncontrolling ownership interest valued with an assumed resale to a qualified S corporation shareholder(s) (for 100 percent of the entity interests) are as follows: Reference Exhibit 5.14 Exhibit 5.15 Exhibit 5.16
S Corporation Valuation Method The modified Gross method The C corporation equivalent method The pretax discount rate method
Indicated Value $3,004,818 $3,004,818 $2,940,160
Again, all else being equal, one would expect the discount for lack of ready marketability to be greater for the noncontrolling interests than for the controlling interests.
5 / Applying the Income Approach to S Corporation
117
Exhibit 5.10
Value of a Debt-Free S Corporation with 5 Percent Expected Growth Rate: The Gross Method Valuation Variables (1) Expected growth rate
5%
(2) Pretax margin
12.5%
(3) Depreciation as a % of sales
4.0%
(4) Reinvestment rate
150%
(5) Net working capital as a % of sales
10.0%
(6) Rate of return on equity
18.4%
(7) Capital gains tax rate
25.0% Projected Fiscal Year 1
(8) Revenue (2) × (8)
(9) Income before tax (10) Entity level tax rate (11) Entity level tax
(9) × (10)
2
3
Terminal Value
4
$ 5,000,000
$ 5,250,000
$ 5,512,500
$ 5,788,125
$ 6,077,531
625,000
656,250
689,063
723,516
759,691
1.5%
1.5%
1.5%
1.5%
1.5%
(9,375)
(9,844)
(10,336)
(10,853)
(11,395)
(12) Net income
(9) − (11)
615,625
646,406
678,727
712,663
748,296
(13) Depreciation
(3) × (8)
200,000
210,000
220,500
231,525
243,101
(14) Capital expenditures
(4) × (13)
(300,000)
(315,000)
(330,750)
(347,288)
(364,652)
(15) Net working capital (increase)/decrease
(5) × (8)
(23,810)
(25,000)
(26,250)
(27,563)
(28,941)
(16) Net cash flow
(12) to (15)
491,815
516,406
542,227
569,338
597,805
(17) Present value factor
18.4%
0.8446
0.7133
0.6025
0.5089
(18) Discounted cash flow
(16) × (17)
$ 415,385
$ 368,373
$ 326,682
$ 289,710
(19) Sum of discounted cash flow
(18)
1,400,150
(20) PV terminal value as if an S corporation*
0.5536
2,270,115
(21) Indicated value (marketable, 100% controlling ownership interest)
(19) + (20)
$ 3,670,265
* Calculated as (residual cash flow)/(discount rate − growth rate) × year 4 residual present value factor. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.
Effect of Jobs and Growth Tax Relief Reconciliation Act of 2003 The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the federal personal capital gains tax rate from 20 to 15 percent and the federal personal income tax rate applicable to dividends from 38.6 (the previous top marginal income tax rate) to 15 percent (until 2009). The prior examples were modified to take these reductions into account. The 45 percent personal income tax rate on ordinary income was reduced to 41.5 percent (combined federal plus effective assumed state income tax rate) and the personal capital gains rate to 20 percent (combined federal plus effective assumed state income tax rate) from 25 percent used above. These rates are approximations and were selected to indicate the directional impact of this legislation on the differences between the traditional method and the other methods. The results for the first set of examples (before any discount for lack of ready marketability) are as follows: Reference Exhibit 5.1 Exhibit 5.2
S Corporation Valuation Method The traditional (as if C corporation) method The Gross method (no end to the S corporation)
Indicated Value $1,494,565 $2,802,310
(continued on p.122)
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I / Business Valuation Technical Topics
Exhibit 5.11
Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with 5 Percent Expected Growth Rate: The Modified Gross Method Valuation Variables (1) Expected growth rate
5%
(2) Pretax margin
12.5%
(3) Depreciation as a % of sales
4.0%
(4) Reinvestment rate
150%
(5) Net working capital as a % of sales
10.0%
(6) Rate of return on equity
18.4%
(7) Capital gains tax rate
25.0% Projected Fiscal Year 1
(8) Revenue (9) Income before tax
(2) × (8)
(10) Entity level tax rate
2
3
Terminal 4
Value
$ 5,000,000
$ 5,250,000
$ 5,512,500
$ 5,788,125
$ 6,077,531
625,000
656,250
689,063
723,516
759,691
1.5%
1.5%
1.5%
1.5%
40.0%
(9,375)
(9,844)
(10,336)
(10,853)
(303,877) 455,815
(11) Entity level tax
(9) × (10)
(12) Net income
(9) − (11)
615,625
646,406
678,727
712,663
(13) Depreciation
(3) × (8)
200,000
210,000
220,500
231,525
243,101
(14) Capital expenditures
(4) × (13)
(300,000)
(315,000)
(330,750)
(347,288)
(364,652)
(15) Net working capital (increase)/decrease
(5) × (8)
(23,810)
(25,000)
(26,250)
(27,563)
(28,941)
(16) Net cash flow
(12) to (15)
491,815
516,406
542,227
569,338
305,324
(17) Present value factor
18.4%
0.8446
0.7133
0.6025
0.5089
(18) Discounted cash flow
(16) × (17)
$ 415,385
$ 368,373
$ 326,682
$ 289,710
(19) Sum of discounted cash flow
(18)
1,400,150
(20) PV terminal value as if a C corporation*
1,159,441
(21) Pass-through basis adjustment
(30)
(22) Asset sale amortization benefit (23) Tax adjustment
See Box A (35)
(24) Indicated value (marketable, 100% controlling ownership interest)
(19) to (23)
Box A
90,514
Terminal value before benefit
147,847 (288,387)
Estimated % of intangible assets Intangible assets
$ 2,509,565
Step-up factor (15-yr. period) Step-up value of intangible assets Addition to terminal price PV of addition to terminal price†
Projected Fiscal Year
(25) Net income less net cash flow
(12) − (16)
(26) Sum of cash flow differential
(26)
1
2
3
4
$ 123,810
$ 130,000
$ 136,500
$ 143,325
533,635
(27) Tax benefit of 25% (capital gains rate)
(25) × 25%
133,409
(28) Pretax equivalent cash flow
(26) / (1-25%)
177,878
(29) Present value factor
(17)
0.5089
(30) Pass-through basis adjustment
(28) × (29)
90,514
0.5536
Projected Fiscal Year 1
2
3
4
(31) Tax on income in excess of net cash flow
(25) × 45%
$ 55,714
$ 58,500
$ 61,425
$ 64,496
(32) Pretax equivalent
(31) / (1-0.45)
101,299
106,364
111,682
117,266
(33) Present value factor
(17)
0.8446
0.7133
0.6025
0.5089
(34) Discounted tax adjustment
(32) × (33)
85,556
75,873
67,286
59,671
(35) Tax adjustment
(34)
288,387
* Calculated as (terminal cash flow)/(discount rate − growth rate) × year 4 present value factor. † PV factor equals year 4 present value factor. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.
$ 2,278,534 50% 1,139,267 1.2550 1,429,817 290,550 147,847
5 / Applying the Income Approach to S Corporation
119
Exhibit 5.12
Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with 5 Percent Expected Growth Rate: The C Corporation Equivalent Method Valuation Variables (1) Expected growth rate
5%
(2) Pretax margin
12.5%
(3) Depreciation as a % of sales
4.0%
(4) Reinvestment rate
150%
(5) Net working capital as a % of sales
10.0%
(6) Rate of return on equity
18.4%
(7) Capital gains tax rate
25.0% Projected Fiscal Year 1
(8) Revenue (9) Income before tax
(2) × (8)
2
(9) × (10)
4
Value
$ 5,000,000
$ 5,250,000
$ 5,512,500
$ 5,788,125
$ 6,077,531
625,000
656,250
689,063
723,516
759,691
(10) Entity level tax rate (11) Entity level tax
Terminal
3
1.5%
1.5%
1.5%
1.5%
40.0%
(9,375)
(9,844)
(10,336)
(10,853)
(303,877) 455,815
(12) Net income
(9) − (11)
615,625
646,406
678,727
712,663
(13) Depreciation
(3) × (8)
200,000
210,000
220,500
231,525
243,101
(14) Capital expenditures
(4) × (13)
(300,000)
(315,000)
(330,750)
(347,288)
(364,652)
(15) Net working capital (increase)/decrease
(5) × (8)
(23,810)
(25,000)
(26,250)
(27,563)
(28,941)
(16) Net cash flow
(12) to (15)
491,815
516,406
542,227
569,338
305,324
(17) Personal income tax*
(12) × 45%
(277,031)
(290,883)
(305,427)
(320,698)
(137,396)
(18) After-personal-tax cash flow
(16) − (17)
214,784
225,523
236,800
248,640
167,928
(19) C corporation-equivalent cash flow†
(18) / (1 - 45%)
390,517
410,043
430,545
452,072
305,324
(20) Present value factor
18.4%
0.8446
0.7133
0.6025
0.5089
(21) Discounted cash flow
(19) × (20)
$ 329,828
$ 292,500
$ 259,396
$ 230,039
(22) Sum of discounted cash flow
(21)
1,111,763
Pass-through cash flow adjustment
(23) PV terminal value as if a C corporation‡
1,159,441
(24) Pass-through basis adjustment
(32)
(25) Asset sale amortization benefit
See Box A
(26) Indicated value (marketable, 100% controlling ownership interest)
(22) to (25)
0.5536
Box A
90,514
Terminal value before benefit
147,847
Estimated % of intangible assets
50%
$ 2,509,565
Intangible assets
1,139,267
Step-up factor (15-yr. period)
1.2550
Step-up value of intangible assets
1,429,817
Addition to terminal price § PV of addition to terminal price
147,847
Projected Fiscal Year 1
2
3
4
$ 123,810
$ 130,000
$ 136,500
$ 143,325
(27) Net income less net cash flow
(12) − (16)
(28) Sum of cash flow differential
(27)
533,635
(29) Tax benefit of 25% (capital gains rate)
(28) × 25%
133,409
(30) C corporate-equivalent cash flow
(29) / (1-25%)
177,878
(31) Present value factor
(20)
0.5089
(32) Pass-through basis adjustment
(30) × (31)
90,514
$ 2,278,534
* Terminal year calculation is (16) × 45% † This is the pre-personal-tax C corporation-equivalent cash flow. ‡ Calculated as (terminal cash flow)/(discount rate − growth rate) × year 4 present value factor. § PV factor equals year 4 present value factor. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.
290,550
Exhibit 5.13
Value of a Debt-Free S Corporation (Controlling Ownership Interest Basis) with 5 Percent Expected Growth Rate: The Pretax Discount Rate Method Valuation Variables (1) Expected growth rate
5%
(2) Pretax margin
12.5%
(3) Depreciation as a % of sales
4.0%
(4) Reinvestment rate
150%
(5) Net working capital as a % of sales
10.0%
(6) Rate of return on equity
18.4%
(7) Capital gains tax rate
25.0% Projected Fiscal Year 1
(8) Revenue (9) Income before tax
(2) × (8)
2
(9) × (10)
4
Value
$ 5,000,000
$ 5,250,000
$ 5,512,500
$ 5,788,125
$ 6,077,531
625,000
656,250
689,063
723,516
759,691
(10) Entity level tax rate (11) Entity level tax
Terminal
3
1.5%
1.5%
1.5%
1.5%
40.0%
(9,375)
(9,844)
(10,336)
(10,853)
(303,877) 455,815
(12) Net income
(9) − (11)
615,625
646,406
678,727
712,663
(13) Depreciation
(3) × (8)
200,000
210,000
220,500
231,525
243,101
(14) Capital expenditures
(4) × (13)
(300,000)
(315,000)
(330,750)
(347,288)
(364,652)
(15) Net working capital (increase)/decrease
(5) × (8)
(23,810)
(25,000)
(26,250)
(27,563)
(28,941)
(16) Net cash flow
(12) to (15)
491,815
516,406
542,227
569,338
305,324
(17) Present value factor*
19.9%
(18) Discounted cash flow
(16) × (17)
(19) Sum of discounted cash flow
(18)
(20) PV terminal value as if a C corporation†, ‡
0.8340
0.6955
0.5800
0.4837
$ 410,157
$ 359,159
$ 314,503
$ 275,399
1,359,218 1,191,314
(21) Pass-through basis adjustment
(30)
(22) Asset sale amortization benefit
See Box A
(23) Tax adjustment
(35)
(24) Indicated value (marketable, 100% controlling ownership interest)
(19) to (23)
0.5536
Box A
93,002
Terminal value before benefit
151,912
Estimated % of intangible assets
50%
Intangible assets
1,139,267
(279,957) $ 2,515,489
$ 2,278,534
Step-up factor (15-yr. period)
1.2550
Step-up value of intangible assets
1,429,817
Addition to terminal price
290,550
PV of addition to terminal price‡
151,912
Projected Fiscal Year 1
2
3
4
$ 123,810
$ 130,000
$ 136,500
$ 143,325
(25) Net income less net cash flow
(12) − (16)
(26) Sum of cash flow differential
(25)
533,635
(27) Tax benefit of 25% (capital gains rate)
(26) × 25%
133,409
(28) Pretax equivalent cash flow
(27) / (1-25%)
177,878
(29) Present value factor
(17)
0.5228
(30) Pass-through basis adjustment
(28) × (29)
93,002
Projected Fiscal Year 1
2
3
4
(31) Tax on income in excess of net cash flow
(25) × 45%
$ 55,714
$ 58,500
$ 61,425
$ 64,496
(32) Pretax equivalent
(31) / (1-0.45)
101,299
106,364
111,682
117,266
(33) Present value factor
(17)
0.8340
0.6955
0.5800
0.4837
(34) Discounted tax adjustment
(32) × (33)
84,480
73,976
64,778
56,724
(35) Tax adjustment
(34)
279,957
* Pretax rate is calculated as [(13.2% − g)/(1 − 45%)] + g where 13.2% equals the after-personal-tax return, g equals expected growth rate, and 45% is the personal tax rate. Refer to the working paper for support of 13.2%. † Calculated as (terminal cash flow)/(discount rate − growth rate) × present value factor. A terminal C corporation discount rate of 18.4% is used in the terminal value calculation. ‡ The terminal discount rate calculation uses a capital gains tax rate of 25% rather than 45%, resulting in a discount rate of 17.6%. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.
Exhibit 5.14
Value of a Debt-Free S Corporation (Noncontrolling Ownership Interest Basis) with 5 Percent Expected Growth Rate: The Modified Gross Method Valuation Variables (1) Expected growth rate
5%
(2) Pretax margin
12.5%
(3) Depreciation as a % of sales
4.0%
(4) Reinvestment rate
150%
(5) Net working capital as a % of sales
10.0%
(6) Rate of return on equity
18.4%
(7) Capital gains tax rate
25.0% Projected Fiscal Year 1
(8) Revenue (9) Income before tax
(2) × (8)
2
(9) × (10)
4
Value
$ 5,000,000
$ 5,250,000
$ 5,512,500
$ 5,788,125
$ 6,077,531
625,000
656,250
689,063
723,516
759,691
(10) Entity level tax rate (11) Entity level tax
Terminal
3
1.5%
1.5%
1.5%
1.5%
1.5%
(9,375)
(9,844)
(10,336)
(10,853)
(11,395) 748,296
(12) Net income
(9) − (11)
615,625
646,406
678,727
712,663
(13) Depreciation
(3) × (8)
200,000
210,000
220,500
231,525
243,101
(14) Capital expenditures
(4) × (13)
(300,000)
(315,000)
(330,750)
(347,288)
(364,652)
(15) Net working capital (increase)/decrease
(5) × (8)
(23,810)
(25,000)
(26,250)
(27,563)
(28,941)
(16) Net cash flow
(12) to (15)
491,815
516,406
542,227
569,338
597,805
(17) Present value factor
18.4%
(18) Discounted cash flow
(16) × (17)
(19) Sum of discounted cash flow
(18)
(20) PV terminal value as if an S corporation* (21) Terminal value tax adjustment† (22) Pass-through basis adjustment
0.8446
0.7133
0.6025
0.5089
$ 415,385
$ 368,373
$ 326,682
$ 289,710
0.5536
1,400,150 2,270,115 (467,573)
(31)
90,514
(24) Tax adjustment
(36)
(288,387)
(25) Indicated value (marketable, noncontrolling ownership interest)
(19) to (24)
(23) Asset sale amortization benefit‡
N/A $ 3,004,818
Note: The willing buyer at the end of the 4th year will realize the benefit of a pass-through basis adjustment when the stock is sold. Since the timing of the resale is unkown in this example, no additional value was considered.
Projected Fiscal Year 1
2
3
4
$123,810
$130,000
$136,500
$143,325
(26) Net income less net cash flow
(12) − (16)
(27) Sum of cash flow differential
(26)
533,635
(28) Tax benefit of 25% (capital gains rate)
(27) × 25%
133,409
(29) Pretax equivalent cash flow
(28) / (1-25%)
177,878
(30) Present value factor
(17)
0.5089
(31) Pass-through basis adjustment
(29) × (30)
90,514
Projected Fiscal Year 1
2
3
4
(32) Tax on income in excess of net cash flow
(26) × 45%
$ 55,714
$ 58,500
$ 61,425
$ 64,496
(33) Pretax equivalent
(32) / (1-0.45)
101,299
106,364
111,682
117,266
(34) Present value factor
(17)
0.8446
0.7133
0.6025
0.5089
(35) Discounted tax adjustment
(33) × (34)
85,556
75,873
67,286
59,671
(36) Tax adjustment
(35)
288,387
* Calculated as (terminal cash flow)/(discount rate − growth rate) × year 4 terminal present value factor. † Calculated as {[(12) − (16)] × 45%}/(1 − 45%). This pretax equivalent value is then capitalized by (18.4% − growth rate). The result is discounted by the year 4 present value factor. ‡ There is no step-up in asset value for a sale of a noncontrolling ownership position. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.
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Exhibit 5.15
Value of a Debt-Free S Corporation (Noncontrolling Ownership Interest Basis) with 5 Percent Expected Growth Rate: The C Corporation Equivalent Method Valuation Variables (1) Expected growth rate
5%
(2) Pretax margin
12.5%
(3) Depreciation as a % of sales
4.0%
(4) Reinvestment rate
150%
(5) Net working capital as a % of sales
10.0%
(6) Rate of return on equity
18.4%
(7) Capital gains tax rate
25.0% Projected Fiscal Year 1
(8) Revenue (2) × (8)
(9) Income before tax
2
(9) × (10)
4
Value
$ 5,000,000
$ 5,250,000
$ 5,512,500
$ 5,788,125
$ 6,077,531
625,000
656,250
689,063
723,516
759,691
(10) Entity level tax rate (11) Entity level tax
Terminal
3
1.5%
1.5%
1.5%
1.5%
1.5%
(9,375)
(9,844)
(10,336)
(10,853)
(11,395) 748,296
(12) Net income
(9) − (11)
615,625
646,406
678,727
712,663
(13) Depreciation
(3) × (8)
200,000
210,000
220,500
231,525
243,101
(14) Capital expenditures
(4) × (13)
(300,000)
(315,000)
(330,750)
(347,288)
(364,652)
(15) Net working capital (increase)/decrease
(5) × (8)
(23,810)
(25,000)
(26,250)
(27,563)
(28,941)
(16) Net cash flow
(12) to (15)
491,815
516,406
542,227
569,338
597,805
(17) Personal income tax
(12) × 45%
(277,031)
(290,883)
(305,427)
(320,698)
(336,733)
(18) After-personal-tax cash flow
(16) − (17)
214,784
225,523
236,800
248,640
261,072
(19) C corporation-equivalent cash flow*
(18) / (1 - 45%)
390,517
410,043
430,545
452,072
474,676
Pass-through cash flow adjustment
(20) Present value factor
18.4%
0.8446
0.7133
0.6025
0.5089
(21) Discounted cash flow
(19) × (20)
$ 329,828
$ 292,500
$ 259,396
$ 230,039
(22) Sum of discounted cash flow
(21)
1,111,763
(23) PV terminal value as if an S corporation†
0.5536
1,802,542
(24) Pass-through basis adjustment
(32)
90,514
(25) Asset sale amortization benefit‡
N/A
(26) Indicated value (marketable, noncontrolling ownership interest)
(22) to (25)
$ 3,004,818
Note: The willing buyer at the end of the 4th year will realize the benefit of a pass-through basis adjustment when the stock is sold. Since the timing of the resale is unkown in this example, no additional value was considered.
Projected Fiscal Year 1 (27) Net income less net cash flow
(12) − (16)
(28) Sum of cash flow differential
(27)
533,635
(29) Tax benefit of 25% (capital gains rate)
(28) × 25%
133,409
(30) C corporate-equivalent cash flow
(29) / (1-25%)
177,878
(31) Present value factor
(20)
0.5089
(32) Pass-through basis adjustment
(30) × (31)
90,514
$123,810
2 $130,000
3 $136,500
4 $143,325
* This is the pre-personal-tax C corporation-equivalent cash flow. † Calculated as (terminal cash flow)/(discount rate − growth rate) × year 4 present value factor. ‡ There is no step-up in asset value for a sale of a noncontrolling ownership position. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.
Controlling interest valued with assumed resale to a C corporation: Exhibit 5.3 Exhibit 5.4 Exhibit 5.5
The modified Gross method The C corporation equivalent method The pretax discount rate method
$2,095,364 $2,095,364 $1,963,964
5 / Applying the Income Approach to S Corporation
123
Exhibit 5.16
Value of a Debt-Free S Corporation (Noncontrolling Ownership Basis) with 5 Percent Growth Rate: The Pretax Discount Rate Method Valuation Variables (1) Expected growth rate
5%
(2) Pretax margin
12.5%
(3) Depreciation as a % of sales
4.0%
(4) Reinvestment rate
150%
(5) Net working capital as a % of sales
10.0%
(6) Rate of return on equity
18.4%
(7) Capital gains tax rate
25.0% Projected Fiscal Year 1
(8) Revenue (9) Income before tax
(2) × (8)
2
(9) × (10)
4
Value
$ 5,000,000
$ 5,250,000
$ 5,512,500
$ 5,788,125
$ 6,077,531
625,000
656,250
689,063
723,516
759,691
(10) Entity level tax rate (11) Entity level tax
Terminal
3
1.5%
1.5%
1.5%
1.5%
1.5%
(9,375)
(9,844)
(10,336)
(10,853)
(11,395) 748,296
(12) Net income
(9) − (11)
615,625
646,406
678,727
712,663
(13) Depreciation
(3) × (8)
200,000
210,000
220,500
231,525
243,101
(14) Capital expenditures
(4) × (13)
(300,000)
(315,000)
(330,750)
(347,288)
(364,652)
(15) Net working capital (increase)/decrease
(5) × (8)
(23,810)
(25,000)
(26,250)
(27,563)
(28,941)
(16) Net cash flow
(12) to (15)
491,815
516,406
542,227
569,338
597,805
(17) Present value factor*
19.9%
(18) Discounted cash flow
(16) × (17)
(19) Sum of discounted cash flow
(18)
(20) PV terminal value as if an S corporation†, ‡ (21) Terminal value tax adjustment§
0.8340
0.6955
0.5800
0.4837
$ 410,157
$ 359,159
$ 314,503
$ 275,399
0.5536
1,359,218 2,219,601 (457,169)
(22) Pass-through basis adjustment
(31)
98,467
(23) Asset sale amortization benefit¶ (24) Tax adjustment
(36)
N/A (279,957)
(25) Indicated value (marketable, noncontrolling ownership interest)
(19) to (24)
$ 2,940,160
Note: The willing buyer at the end of the 4th year will realize the benefit of a pass-through basis adjustment when the stock is sold. Since the timing of the resale is unknown in this example, no additional value was considered.
Projected Fiscal Year 1 (26)
Net income less net cash flow
(12) − (16)
(27)
Sum of cash flow differential
(26)
533,635
(28)
Tax benefit of 25% (capital gains rate)
(27) × 25%
133,409
(29) (30)
Pretax equivalent cash flow Present value factor (c)
(28) / (1-25%) (17)
177,878 0.5536
(31)
Pass-through basis adjustment
(29) × (30)
$ 98,467
$ 123,810
2 $ 130,000
3 $ 136,500
4 $ 143,325
Projected Fiscal Year 1 (32)
Tax on income in excess of net cash flow
(26) × 45%
(33)
Pretax equivalent
(32) / (1-.45)
(34)
Present value factor
(35) (36)
2
3
4
$ 55,714
$ 58,500
$ 61,425
$ 64,496
101,299
106,364
111,682
117,266
(17)
0.8340
0.6955
0.5800
0.4837
Discounted tax adjustment
(33) × (34)
84,480
73,976
64,778
56,724
Tax adjustment
(35)
$ 279,957
* Pretax rate is calculated as [(13.2% − g)/(1 − 45%)] + g where 13.2% equals the after-personal-tax return, g equals expected growth rate, and 45% is the personal tax rate. Refer to the working paper for support for the 13.2%. † Calculated as (terminal cash flow)/(discount rate − growth rate) × present value factor. ‡ The terminal discount rate and discount factor calculations use a 25% capital gains tax rate rather than 45%. See first footnote (*). § Calculated as {[(12) − (16)] × 45%}/(1 − 45%). This pretax equivalent value is then capitalized by (24% − growth rate). The result is discounted by the terminal present value factor in third footnote (‡). ¶ There is no step-up in asset value for a sale of a noncontrolling ownership position. SOURCE: Standard & Poor’s Corporate Value Consulting, a division of the McGraw-Hill Companies. All rights reserved.
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Noncontrolling interest valued with assumed resale to a qualified S corporation shareholder: Exhibit 5.6 Exhibit 5.7 Exhibit 5.8
The modified Gross method The C corporation equivalent method The pretax discount rate method
$2,467,651 $2,461,651 $2,013,389
The second set of examples displays parallel analyses. The only change from the first set of examples is a 5 percent assumed average long-term growth in free cash flow (i.e., g = 5%) rather than zero percent growth. The results (before any discount for lack of ready marketability) are as follows: Reference Exhibit 5.9 Exhibit 5.10
S Corporation Valuation Method Indicated Value The traditional (as if C corporation) method $1,874,556 The Gross method (no end to the S corporation) $3,670,265
Controlling interest valued with assumed resale to a C corporation: Exhibit 5.11 Exhibit 5.12 Exhibit 5.13
The modified Gross method The C corporation equivalent method The pretax discount rate method
$2,525,279 $2,525,279 $2,466,784
Noncontrolling interest valued with assumed resale to qualified a S corporation shareholder: Exhibit 5.14 Exhibit 5.15 Exhibit 5.16
The modified Gross method The C corporation equivalent method The pretax discount rate method
$3,082,697 $3,082,697 $2,752,660
The results of the analyses contained herein are based on using the historical return on C corporation stocks as a basis for a present value discount rate. To the extent that the change in the income tax rates alters the expected rate of return on C corporation stocks, the results reported would change. Does the change in the federal income tax rate on C corporation dividends eliminate the benefit of an S corporation election? The change in the law did not eliminate the corporate tax on the sale of appreciated property (built-in gain). For example, if a C corporation owns appreciated property and distributes such property as a dividend to its shareholders, the gain on the property (the difference between the fair market value of the property and its income tax basis) is subject to the corporate income tax. While the shareholders will only pay personal income tax on the dividend at the reduced rate, there is still double taxation. Stock in an S corporation that owns appreciated property and is not subject to the built-in capital gains tax (i.e., the S corporation election was made more than 10 years ago) would be valued at a greater amount than stock in that same S corporation were it currently subject to the built-in gains tax.
Proposals to Simplify Subchapter S Several proposals have been put forth in Congress that are designed to simplify subchapter S and to allow S corporations greater flexibility to access capital markets.34 For example, one proposal allows certain family members to elect to be treated as 34 See Joint Committee on Taxation Description (JCX-62-03) of Background and Proposals on S Corporations, For Ways and Means Select Revenue Measures Subcommittee Hearing on June 19, 2003 prepared by the Staff of the Joint Committee on Taxation.
5 / Applying the Income Approach to S Corporation
125
one shareholder for purposes of determining the number of S corporation shareholders. Another proposal increases the maximum number of eligible shareholders from 75 to 150. Still another proposal would eliminate the built-in gains tax to the extent that amounts are (1) reinvested in the S corporation business, (2) used to pay principal or interest on certain corporate debt, or (3) distributed to shareholders to pay income taxes on the built-in gain.
Conclusion These results are not intended to imply that an S corporation should always be valued at x percent greater than the value of an identical C corporation. The difference between S corporation and C corporation value is a function of the specific facts and circumstances in any particular valuation assignment. Rather, the examples are intended to describe the application of the three proposed S corporation valuation methods. All three methods—(1) the modified Gross method, (2) the C corporation equivalent method, and (3) the pretax discount rate method—are preferred over the traditional (or the Gross) method because these three methods allow for the direct measurement of the income tax benefits of an S corporation under a set of specific assumptions. The valuation analyses become more complicated if the corporation has debt financing. The principal value drivers include (1) the amount of cash distributions the S corporation shareholders expect to receive, (2) the expected investment holding period of the S corporation interest, and most importantly, (3) the characteristics of the pool of likely buyers for the subject interest. The analytical standards for S corporation valuation have become more rigorous in response to the current direction of the Tax Court on this issue. The proper application of the income approach to S corporation valuation provides a measurement of all the specific factors and assumptions that affect (1) the appropriate income tax treatment and (2) the subject interest in the S corporation’s value.
Chapter 6 S Corporation ESOP Valuation Issues David Ackerman and Susan E. Gould
Introduction The Current Tax Laws Authorization of S Corporation ESOPs Repeal of Unrelated Business Income Tax New Distribution Rules Exemption from Prohibited Transaction Rules Denial of Special ESOP Tax Incentives No Section 1042 Tax-Deferred Sales Limit on Contributions No Deduction for Dividends New Antiabuse Rules for S Corporation ESOPs Perceived Abuses Disqualified Persons Nonallocation Year Penalties for Violation of the Nonallocation Rules Regulations Effective Dates The S Corporation Election Taxation of S Corporations and Their Shareholders Eligibility to Make the S Election Advantages of the S Corporation Election Avoidance of Double Tax Tax Savings on the Sale or Liquidation of a Business Pass-Through of Losses Other Benefits Disadvantages of the S Corporation Election Shareholder Limitations One-Class-of-Stock Limitation Limitation on Other Benefits Fiscal Year State Income Tax Considerations
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I / Business Valuation Technical Topics
Advantages of an S Corporation ESOP Disadvantages of an S Corporation ESOP Valuation Issues for S Corporation ESOPs Fair Market Value S Corporation Valuations versus C Corporation Valuations—The Conventional Method Recent Judicial Precedent Range of Value 100 Percent S Corporation ESOPs Valuation Conclusion Planning Opportunities Should ESOP Companies Make the S Election? Tax-Deferred Sales to ESOPs Limits on Plan Contributions Corporate-Level Income Tax Should S Corporations Adopt ESOPs? Unresolved Issues Use of S Corporation Distributions to Pay Off an ESOP Loan Distribution of S Corporation Earnings to Plan Participants Special Issues for S Corporation ESOPs Lack of Marketability Discount Repurchases from Plan Participants ESOP Income Tax Shield Sale of an S Corporation ESOP S Corporation ESOPs and Step Transactions S Corporation ESOPs in Distress Situations S Corporation ESOPs and Acquisitions Managing Repurchase Obligation in an S Corporation ESOP Conclusion
Introduction Effective January 1, 1998, for the first time, a corporation that has stock owned by an employee stock ownership plan (ESOP) became eligible to make the election to be treated as an “S corporation” for federal income tax purposes.1 An S corporation generally is not directly subject to federal income tax.2 Instead, the individual shareholders of the corporation are subject to income tax on the corporation’s earnings. This is true whether the corporate earnings are distributed to the shareholders as dividends or are retained in the corporation.3 An important economic advantage of this tax election is that only one level of income tax is imposed on the earnings of an S corporation. Regular, or C, corporations are subject to a “double tax.” This “double tax” occurs once at the corporate level4 and again at the shareholder level—when the after-tax corporate earnings are distributed to the shareholders.5 Until 1998, a trust 1 Internal
Revenue Code (Code) § 1361(c)(6). § 1363(a). 3 Code § 1366(a). 4 Code § 11. 5 Code § 301. 2 Code
6 / S Corporation ESOP Valuation Issues
129
forming a part of an employee benefit plan was not an eligible shareholder for an S corporation.6 This rule was changed by the Small Business Job Protection Act of 1996 (the 1996 Act).7 Because so many closely held companies are S corporations, the removal of the restriction on employee benefit trusts as permitted shareholders of an S corporation was an important development in the ESOP arena. However, the 1996 Act contained a number of additional provisions that substantially diminished the economic attractiveness of an S corporation for an ESOP. Fortunately, the most serious of these limitations was removed by the Taxpayer Relief Act of 1997 (the 1997 Act),8 before the effective date (i.e., January 1, 1998) of the new S corporation ESOP rules. Later (as a result of some perceived abuses of the S corporation ESOP structure), some limitations on the use of ESOPs by S corporations were enacted as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (the 2001 Act). These limitations affect only S corporation ESOPs that cover small groups of employees. This chapter summarizes the rules relating to S corporation ESOPs, as set forth in the 1996, 1997, and 2001 Acts.9 This chapter also provides a brief analysis of situations (1) where either an ESOP may be appropriate for an S corporation or (2) where an existing ESOP company might benefit from making the S election. To provide a context for this discussion, this chapter also provides a brief summary of how S corporations are taxed and of the economic benefits of the S election. The chapter includes a discussion of the pertinent valuation issues for an S corporation ESOP company. Finally, the chapter presents a discussion of several special topics related to S corporation ESOP companies.
The Current Tax Laws Authorization of S Corporation ESOPs The 1996 Act eliminated the prohibition on ownership of S corporation stock by an employee benefit plan trust.10 This kind of trust is treated as a single S corporation shareholder. In other words, each participant in the plan is not treated as an individual shareholder.11 This is of critical importance because S corporations are limited to a maximum of 75 shareholders.
Repeal of Unrelated Business Income Tax Congress included in the 1996 Act a provision that shares of an S corporation held by an employee benefit trust would be treated as an interest in an “unrelated trade or business.” The result of this provision was that the trust’s share of the S corporation income would be taken into account in computing the trust’s unrelated business
6 Code
§ 1361, before amendment by the Small Business Job Protection Act of 1966, P.L. 104-188 (the 1996 Act). 104-188. 8 P.L. 105-34. 9 Sections of this chapter are reproduced with permission from Chapter 8, “ESOPs and S Corporations” in Selling to an ESOP, 7th ed. (Oakland, CA: National Center for Employee Ownership, 2002). 10 Code § 1361(c)(6), as added by P.L. 104-188. 11 S. Rep. No. 105-35, 105th Cong., 1st Sess. (1997). 7 P.L.
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income tax (UBIT).12 In addition, any gain or loss realized in connection with the disposition of employer securities would be taken into account for this purpose.13 This raised a number of difficult issues. For example, consideration had to be given to how the trust would pay its tax liabilities as they became due. Presumably, the plan sponsor would provide the funds necessary to pay the taxes. This raised the question of whether the funding of the taxes, whether by direct payment or by means of contributions to the plan, would constitute “contributions” subject to the tax-deduction limitation and to the limits on annual additions to participants’ accounts.14 Additionally, the prudence of the acquisition of stock of an S corporation may be subject to challenge. This is because the plan could acquire virtually any other investment assets without incurring tax on the income generated by those assets.15 These issues were eliminated by the 1997 Act. The 1997 Act repealed the application of the unrelated business income tax to ESOPs that hold stock of an S corporation.16
New Distribution Rules Generally, participants in an ESOP are entitled to demand that their benefits be distributed to them in the form of stock of the sponsoring employer.17 This raises the possibility of an involuntary termination of an S election made by an ESOP company. This involuntary termination could occur in either of two ways. First, a participant may request that the shares of employer stock allocated to his or her account be rolled over to an individual retirement account (IRA). However, an IRA is not eligible to own shares of an S corporation.18 Second, over time, if enough participants in the plan elect to take their benefits in the form of employer shares, the 75shareholder limit may be exceeded. These problems were resolved by the 1997 Act. The 1997 Act permits an S corporation that sponsors an ESOP to require the participants in the plan to take their benefits in the form of cash.19
Exemption from Prohibited Transaction Rules Another problem with the 1996 Act was that it failed to extend to S corporations two important exemptions from the prohibited transaction rules that are available to C corporations. The first exemption was for purchases by an ESOP of employer
12 Code
§ 512(e), before amendment by the 1997 Act. § 512(e)(1)(B), before amendment by the 1997 Act. 14 These limitations are set forth in §§ 404 and 415 of the Code. For a discussion of this issue, see Stephen D. Smith and Robert E. Stiles, “S Corporation ESOPs and Liberty Check Printers,” Journal of Employee Ownership Law and Finance, Summer 1997, pp. 127–137. 15 See Employee Retirement Income Security Act of 1974 (ERISA), P.L. 93-406, § 404(a)(1)(B), 88 Stat. 829 (29 U.S.C. § 10011368). See also, Smith and Stiles, “S Corporation ESOPs and Liberty Check Printers,” p. 131. 16 1997 Act, § 1523, Code § 512(e)(3). 17 Code § 409(h)(1)(A). This right can be denied to ESOP participants if the articles of incorporation or bylaws of the ESOP company restrict the ownership of substantially all outstanding employer securities to employees or to a qualified retirement plan. Code § 409(h)(2). 18 Code § 1361(b)(1)(B). However, in PLR 200122034 (February 28, 2001), the Internal Revenue Service ruled that momentary ownership of S corporation stock by an IRA would not result in an involuntary termination of the corporation’s S election where the stock had been received in a direct transfer from an ESOP and was subject to the requirement that it be immediately sold back to the sponsor of the ESOP. 19 Code § 409(h)(2). 13 Code
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securities from “parties in interest” or “disqualified persons.” This exemption applies where the acquisition is for “adequate consideration” and no commission is charged.20 This exemption was not extended to S corporations.21 Second, the 1996 Act failed to repeal the rule under which an S corporation with a shareholder-employee who owned 50 percent or more of its stock was prohibited from selling its shares to its own ESOP.22 The 1997 Act repealed those provisions of prior law that excluded S corporations from the full scope of the exemptions from the prohibited transaction rules.23
Denial of Special ESOP Tax Incentives The 1996 Act included three provisions that substantially diminish the economic advantages of S corporation status for an ESOP. 1. Upon the sale of an individual shareholder’s stock to an ESOP, he or she will not qualify for the tax-deferred “rollover” (commonly referred to as the Section 1042 capital gains deferral after the applicable Internal Revenue Code Section) that is available to individual shareholders of a C corporation who sell stock to an ESOP.24 2. The increased limits for tax deductions for contributions to a leveraged ESOP, when used to pay principal and interest on an exempt loan to the plan, are not available for S corporations.25 3. S corporations are not entitled to deduct cash dividends paid on stock held by an ESOP (a) that are used to pay principal or interest on a loan used to acquire the stock or (b) that are passed through to plan participants.26 Although there were proposals to repeal these provisions as part of the 1997 Act— and thereby to extend to S corporation ESOPs all of the tax incentives provided for C corporation ESOPs—these proposals were not included in the final legislation. Thus, although S corporations are now eligible to sponsor ESOPs, they are subject to important limits on using their ESOPs. These limits do not apply to C corporations.
No Section 1042 Tax-Deferred Sales The tax incentive that has spurred the most interest in ESOPs for closely held companies is the opportunity provided under Internal Revenue Code Section 1042 for a tax-free “rollover.” This is a “rollover” of the proceeds of a sale of stock by a 20 ERISA
§ 408(e); Code § 4975(d)(13). the laws in effect in 1996, this exemption did not apply to an acquisition by a plan of property from an employee or officer of an S corporation who owns more than 5 percent of the outstanding stock of the corporation. ERISA, § 408(d); Code § 4975(d); and Code § 1379(d), before amendment by P.L. 105-34. For purposes of this rule, the constructive ownership rules of § 318 of the Code applied in determining the share ownership of an employee or officer of an S corporation. Code § 1379(d), before amendment by P.L. 105-34; ERISA, § 408(d); Code § 4975(d), before amendment by P.L. 105-34. 22 ERISA § 408(d); Code § 4975(d), before amendment by P.L. 105-34. 23 1997 Act § 1506(b), amending ERISA § 408(d) and amending Code § 4975(d) and (f). However, the 1997 Act did not repeal those provisions of prior law that prohibit a person who owns 5 percent or more of the outstanding shares of an S corporation from purchasing shares of the corporation from an ESOP sponsored by that corporation. A repeal of this prohibition may be useful in connection with planning an S corporation (1) in connection with its ESOP share repurchase obligations or (2) in connection with the termination of an S corporation ESOP. 24 1996 Act § 1316(d)(3), amending Code § 1042(c)(1)(A). 25 1996 Act § 1316(d)(1), amending Code § 404(a)(9). 26 1996 Act § 1316(d)(2), amending Code § 404(k)(1). 21 Under
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shareholder to an ESOP if the proceeds are reinvested in securities of other domestic corporations.27 The rollover provides for a deferral of a capital gains tax liability on the sale of stock to the ESOP. This rollover is applicable if the proceeds are reinvested in qualified replacement properties (QRPs), generally stocks or bonds of domestic operating companies. However, this special tax treatment is available only with sales of stock of closely held C corporations. The 1996 Act amended Section 1042 to specify that it will not apply in the case of a sale of S corporation stock to an ESOP.28
Limit on Contributions The maximum amount that a corporation may deduct for contributions to an ESOP generally is 25 percent of the compensation paid to all employees participating in the plan for the taxable year.29 Increased limits for employer contributions are available to C corporations (but not to S corporations), for amounts allocated to repay an ESOP loan incurred to finance the purchase of employer stock. Contributions by a C corporation used to pay interest on this kind of a loan are fully deductible. In addition, contributions used to pay the principal amount of an ESOP loan are deductible up to 25 percent of the compensation of the participating employees.30 However, contributions by an S corporation used to pay interest on an ESOP loan will count against the 25 percent limit.31
No Deduction for Dividends Dividends paid on shares held by a C corporation ESOP may be deducted under the following circumstances: (1) if they are paid in cash to plan participants, (2) if they are paid to the plan and passed through to the participants within 90 days after the end of the plan year, (3) if they are used to repay a loan incurred to purchase the company stock on which the dividends are paid, or (4) if they are paid to the plan and, at the election of the plan participants, are reinvested in employer securities.32 However, this deduction for dividends on stock held by an ESOP is not available for S corporations.33 Where an S corporation ESOP owns all of the outstanding shares of the corporation, the fact that dividends are not deductible will not have any effect. This is because the corporation’s income will not be subject to tax—either at the corporate or at the shareholder level.34 However, in the situation where an ESOP owns less than all of the outstanding shares of the plan sponsor, the failure of Congress to extend the dividends-paid deduction to S corporation ESOPs may result in greater taxable income for the other shareholders than would be the case with a C corporation declaring the same amount of dividends. 27 Code
§ 1042(a). § 404(c)(1)(A). 29 Code § 404(a)(3)(A). 30 Code § 404(a)(9). 31 Code § 404(a)(9)(C). 32 Code § 404(k). 33 Code § 404(k)(1). 34 Code §§ 1363(a) and 501(a). 28 Code
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New Antiabuse Rules for S Corporation ESOPs Perceived Abuses The Economic Growth and Tax Relief Reconciliation Act of 2001 contained a number of important changes in the laws that apply to S corporations that sponsor ESOPs. These changes were designed to eliminate two perceived abuses of the laws allowing S corporations to sponsor ESOPs. The first abuse may arise when an S corporation that sponsors an ESOP has only one or few employees. For example, a highly paid professional may defer taxes indefinitely by (1) incorporating his or her business and (2) transferring all of the stock of the corporation to an ESOP. The professional person would be the sole participant in the ESOP. And, the sole purpose for setting up the ESOP would be to defer tax on the income generated from the professional’s business activities. This use of an ESOP obviously does not serve the public policy underlying ESOP legislation. That public policy is to promote broad-based employee ownership and enhance employee productivity. A second potential abuse of ESOPs by S corporations involves a so-called “tax holiday” for newly formed enterprises. In these enterprises, executives and outside investors hold stock options and other forms of equity interests which, over time, will substantially dilute the ESOP’s ownership. The equity interests for the executives and outside investors could be designed in such a way as to defer their recognition of income over a period of several years. During that time, all of the corporate earnings would be reported by the ESOP and thereby escape taxation, creating a “tax holiday.” If the ESOP will be substantially diluted after the stock options are exercised and the other equity interests vest, the ESOP will serve only to avoid taxes and not to promote employee ownership.35 The antiabuse rules for S corporation ESOPs contained in the 2001 Tax Act are designed to eliminate the two abuses described above and similar tax-avoidance schemes. Under the new law, an ESOP that holds shares of an S corporation is prohibited from allocating employer securities to certain persons who are identified as “disqualified individuals” during any “nonallocation year.”36 The term “nonallocation year” means a year in which disqualified persons own at least 50 percent of the outstanding shares of the plan sponsor.37
Disqualified Persons For purposes of the new law, a person is a “disqualified person” if either (1) he or she is deemed to own 10 percent or more of the “deemed-owned shares” of the corporation or (2) the aggregate number of shares deemed to be owned by the person (together with the shares deemed to be owned by members of his or her family) is at least 20 percent of the total deemed-owned shares of the corporation.38 A participant 35 For an example of how an abusive “tax holiday” transaction might have been structured, see Martin D. Ginsburg, “The Taxpayer
Relief Act of 1997: Worse Than You Think,” Tax Notes, September 29, 1997, p. 1790. 36 Code § 409(p)(1). 37 Code § 409(p)(3). 38 Code § 409(p)(4).
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in an S corporation ESOP is deemed to own (1) shares that are allocated to his or her ESOP account and (2) a portion of the shares which are held in the suspense account and that have not been allocated to participants’ accounts.39 A participant’s share of unallocated stock is the amount of that stock that would be allocated to him or her if the unallocated stock were allocated to all participants in the plan in the same proportion as the most recent stock allocation under the plan.40 In addition, an individual who owns “synthetic equity” in an S corporation will be deemed to own the shares of stock on which the synthetic equity is based, if this will result in the treatment of him or her as a disqualified person.41 The term “synthetic equity” is defined to mean any stock option, warrant, restricted stock, deferred issuance stock right, or similar interest or right that gives the holder the right to acquire or receive stock of the S corporation in the future.42 Except to the extent that regulations to be issued in the future may otherwise provide, the term “synthetic equity” also includes stock appreciation rights, phantom stock units, and similar rights to future cash payments based on the value of stock or growth in the value of stock.43 In determining whether an individual is a “disqualified person,” only shares held for the benefit of the individual through the ESOP or on which synthetic equity is based count as “deemed-owned shares.” Shares held outright by an individual, outside of the ESOP, are not “deemed-owned shares.”
Nonallocation Year If any participants in an S corporation ESOP are “disqualified persons,” there will be a nonallocation year. The new antiabuse rules will be triggered if these disqualified persons own at least 50 percent of the outstanding shares of the corporation.44 In determining whether the disqualified persons own 50 percent or more of the outstanding shares, this amount includes not only the shares actually owned by the disqualified persons but also the “deemed-owned” shares plus shares that a person is considered to own for federal income tax purposes under attribution-ofownership rules.45 Under these rules, an individual is considered as owning stock that is held by his or her spouse and by his or her children, grandchildren, and parents.46 Moreover, for purposes of the new S corporation antiabuse rules, an individual also will be considered to own shares held by any of his or her brothers or sisters, or brothers-in-law or sisters-in-law, or by any children or grandchildren of any brother or sister or brother-in-law or sister-in-law.47 Individuals also are considered to own shares that are held in partnerships, estates, trusts, and corporations that they control.48
39 Code
§ 409(p)(4)(C)(i). § 409(p)(4)(C)(ii). 41 Code § 409(p)(5). 42 Code § 409(p)(6)(C). 43 Ibid. 44 Code § 409(p)(e)(A). 45 Code § 409(p)(3)(B). 46 Code § 318(a). 47 Code §§ 409(p)(3)(B)(i)(I), 409(p)(4)(D). 48 Code § 318(a). 40 Code
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Putting all these rules together, in order to determine whether an S corporation is subject to the new legislation, the company’s shareholdings should be analyzed as follows: 1. Step One: Determine whether any of the participants in the plan are disqualified persons: a. Determine whether any participants in the plan will be deemed to own at least 10 percent of the total number of deemed-owned shares. b. Determine whether any of the participants in the plan are disqualified persons by reason of aggregate deemed ownership (1) by the participant and (2) by members of his or her family of at least 20 percent of the total number of deemed-owned shares. 2. Step Two: Determine the aggregate amount of shares owned or deemed to be owned by all of the disqualified persons, taking into account the attribution-ofownership rules and the new synthetic-equity rules. If the amount of shares of the company owned or deemed to be owned by the disqualified persons is at least 50 percent of the corporation’s total outstanding shares at any time during any plan year, then that year is a “nonallocation year” and the new law is applicable.49 Problems of interpretation are presented by the broad definition of the term “synthetic equity.” The statute provides that this term includes any option or right to acquire shares, not merely the right to acquire newly issued shares.50 Therefore, the law may be interpreted to mean that a person who has the right to purchase outstanding shares from a shareholder, such as on the death of the shareholder, will be deemed to own the number of shares he or she has the option to acquire. This could present a trap for the unwary, since there is no abuse presented by an option to acquire alreadyoutstanding shares. This is because this transaction will not dilute the ESOP. It could be argued that the statutory language should be interpreted, in accordance with the legislative intent, to exclude rights to acquire existing shares from the definition of synthetic equity. However, in the absence of clear guidance on this matter, all buy-sell and other option agreements covering shares of S corporations that sponsor ESOPs should be reexamined to assure avoidance of the penalties described below.
Penalties for Violation of the Nonallocation Rules If (1) there is a nonallocation year and (2) the antiabuse law applies, then no shares of the company’s stock may be allocated for that year to the accounts of any disqualified persons. Also, no other assets may be allocated to their accounts in lieu of the tax-qualified plan that the company sponsors.51 If prohibited allocations are made to disqualified persons, then the company will be subject to an excise tax equal to 50 percent of the amount of the prohibited allocations.52 In addition, the shares allocated to the accounts of the disqualified persons will be treated as having been distributed to the disqualified persons. And, the disqualified persons will be
49 Code
§ 409(p)(3). § 409(p)(6)(C). 51 Code § 409(p)(1). 52 Code § 4979A(a). 50 Code
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subject to tax on the value of those shares.53 The statute does not specify how shares that are deemed to have been distributed are to be treated in future years. If they are treated as continuing to be held by the persons to whom they were deemed to have been distributed, then those persons will be personally liable for tax on their proportionate share of the S corporation’s income. In addition to the penalties described above, it is possible that if prohibited allocations are made by an S corporation ESOP, the ESOP then may be disqualified. The law requires that the plan document should prohibit allocations to disqualified persons during nonallocation years. Therefore, any prohibited allocation would violate the plan document.54 The Internal Revenue Service (IRS) usually takes the position that violation of a plan document results in disqualification of the plan.55 If an S corporation ESOP is disqualified, then the ESOP no longer would be a permitted holder of S corporation stock.56 And, the corporation’s S election would be automatically terminated. There is a footnote in the Conference Committee report on the 2001 Tax Act that states that this result is not the congressional intent.57 However, it is not known what position the IRS will take on this matter. To avoid potential plan disqualification, an S corporation that sponsors an ESOP and that may be subject to the prohibited allocation rules, should consider incorporating “fail-safe” language into its plan. This may be done by requiring a change in the ESOP trust asset mix among participant accounts so as to prohibit allocations to disqualified persons during nonallocation years. This change would also assure that the disqualified persons will not hold more than 50 percent of the total outstanding and deemed-owned shares of the corporation. Additional penalties will be imposed if any synthetic equity is owned by a disqualified person in any nonallocation year. Then, the company will be subject to an excise tax equal to 50 percent of the value of the shares on which the synthetic equity is based.58 It is important to note that the tax is imposed on the value of the shares to which the synthetic equity relates, and not the value of the synthetic equity itself.59 Therefore, a substantial tax may be assessed even where the synthetic equity itself is of little or no value. For example, a tax will be assessed where the strike price with respect to an option is equal to or greater than the fair market value of the stock covered by the option. The tax on synthetic equity appears to be especially onerous. This is because the tax appears to be imposed on the same synthetic equity for every nonallocation year.
Regulations The new law directs the Treasury Department to issue regulations as necessary to carry out the purposes of the new law.60 In addition, the Treasury Department is authorized, “by regulation or other guidance of general applicability,” to provide that 53 Code
§ 409(p)(2)(A). § 409(p)(1). 55 See, for example, Rev. Proc. 2001-17, § 5.01(2), defining the term “Qualification Failure” as “any failure that adversely affects the qualification of a plan,” including a failure to follow plan provisions. 56 Code § 1361(c)(6)(A). 57 House Conference Report 107-84, May 26, 2001, § VI.4(g), N. 122. 58 Code § 4974A(a)(4). 59 Code § 4979A(e)(2)(B). 60 Code § 409(p)(7)(A). 54 Code
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a nonallocation year occurs in any case “in which the principal purpose of the ownership structure of an S corporation constitutes an avoidance or evasion” of the new law.61 This provision will enable the Treasury Department to ward off attempts to evade the law by schemes that are carefully arranged to approach but not cross over the prohibited lines.
Effective Dates The new law generally is effective for plan years beginning after December 31, 2004.62 However, the new law will apply for plan years ending after March 14, 2001, (1) in the case of any ESOP established after that date or (2) in the case of any ESOP established on or before that date if the plan sponsor did not have an S election in effect on that date.63 For the first nonallocation year of an S corporation ESOP, the 50 percent excise tax will be applied against the total value of all of the deemed-owned shares of all of the disqualified persons. This is true regardless of the amounts actually allocated to their accounts during that year.64 For S corporations that sponsor ESOPs and that are not be able to avoid the new antiabuse rules by any of the planning techniques described above, it probably will be advisable to terminate either the ESOP or the S election before the effective date of the new law.
The S Corporation Election Taxation of S Corporations and Their Shareholders The primary effect of the S election is that all items of an S corporation’s income and loss are passed through to the corporation’s shareholders.65 Each shareholder is allocated his or her proportionate share of each item of corporate income, deduction, loss, and credit.66 The S corporation itself generally will not be subject to federal income tax.67 A shareholder’s basis in his or her stock of an S corporation is (1) increased by his or her share of the corporate income and (2) decreased by distributions received by the shareholder from the corporation and by his or her share of the corporation’s items of loss and deduction.68 However, a shareholder’s basis in stock of an S corporation may not be reduced below zero.69 Distributions from S corporations to their shareholders generally are tax-free to the extent of the
61 Code
§ 409(p)(7)(B). 107-16, 115 Stat. 38 § 656(d). 63 Ibid. 64 Code § 4979A(e)(2)(C). 65 Code § 1366. 66 Code § 1366(a). 67 Code § 1363(a). 68 Code § 1367(a). 69 Code § 1367(a)(2). 62 P.L.
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shareholders’ bases in their stock.70 Nevertheless, a shareholder will be subject to tax on any distribution to the extent that it exceeds his or her stock basis.71
Eligibility to Make the S Election Generally, a corporation should meet the following requirements for it to be eligible to make the S election:72 • •
•
The corporation may not have more than 75 shareholders. All shareholders must be U.S. citizens or U.S. residents, and they must be natural persons, estates, or certain types of trusts (including, effective as of January 1, 1998, employee benefit trusts). The corporation may have only one class of stock outstanding (but different voting rights are permitted for different shares of stock).73
In addition, the following types of corporations are ineligible to make the S election: • • • •
Financial institutions that use the reserve method of accounting for bad debts Insurance companies Certain so-called “possession corporations” (corporations that derive most of their income from sources within a possession of the United States) Domestic international sales corporations (DISCs)74
Advantages of the S Corporation Election The S corporation election has several economic advantages for corporations and for their shareholders.
Avoidance of Double Tax An important tax advantage of the S election is that only one level of tax is imposed on the earnings of an S corporation. C corporations are subject to a “double tax”: once at the corporate level75 and again at the shareholder level (when the after-tax corporate earnings are distributed to the shareholders).76 Many closely held C corporations have been able to avoid the double tax by distributing earnings to their shareholders in the form of tax-deductible compensation.77 However, this is not a
70 Code
§ 1368(c). § 1368(b)(2). 72 Code § 1361(b). 73 Code § 1361(c)(4). 74 Code § 1361(b)(2). 75 Code § 11. 76 Code § 301. 77 See James P. Holden and A.L. Suwalsky Jr., 202-3d T.M. Reasonable Compensation, and David Ackerman and Thomas J. Kinasz, “Tax Considerations in Organizing Closely Held Corporations,” Chapter 2 of Closely Held Corporations (Chicago: Illinois Institute for Continuing Legal Education, 1990), pp. 2–12. 71 Code
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complete answer to the double-tax problem (1) for C corporations with earnings that exceed the amount that can be deemed to be “reasonable” compensation or (2) for corporations with shareholders who are not actively involved in the conduct of their business operations. No deductions will be allowed to a corporation for salaries or bonuses paid to shareholder-employees that are in excess of a reasonable amount. The result is that the excessive “compensation” will be treated as a nondeductible dividend for federal income tax purposes.”78 The ability to have the earnings of an S corporation taxed at the shareholder level became very attractive in 1986, when individual tax rates were reduced below corporate rates.79 The maximum income tax rate on individuals was reduced to 28 percent, which was six percentage points below the maximum corporate income tax rate of 34 percent. It became possible for a corporation to obtain an annual tax savings of 6 percent of its taxable income by making an S election.80 Because the maximum income tax rate on individuals has been increased to 39.6 percent81 while the maximum corporate income tax rate now is 35 percent,82 the single shareholderlevel tax for an S corporation is significantly less advantageous than under prior law. And, in cases where corporate earnings can be withdrawn on a fully taxdeductible basis, the S election may be disadvantageous.
Tax Savings on the Sale or Liquidation of a Business Shareholders of a C corporation are subject to a double tax on (1) a sale of their corporation’s assets or (2) a liquidation of their corporation. First, the corporation will pay a tax on the difference between the sale or liquidation proceeds and its basis in its assets.83 Then, the shareholders will pay an additional tax on the distribution of the after-tax proceeds.84 This taxation effect is illustrated by the following example. Let’s assume that a liquidating corporation sells its assets in 2002 at a gain of $100,000 and that the shareholders’ aggregate bases for their stock equals the corporation’s basis for its assets. A 34 percent corporate tax will be imposed upon the gain, leaving the corporation with after-tax profits of $66,000. Upon the distribution of the proceeds to the shareholders, an additional tax in the amount of $13,200 will be imposed (20% of $66,000), leaving the shareholders with after-tax proceeds of $52,800. If the corporation in the above example was an S corporation, only one level of tax would be imposed. The tax would be imposed on the shareholders at a maximum rate of 20 percent. The result of this is that the total tax would be $20,000, as compared to $47,200. And, the after-tax profit available to the shareholders would be
78 Ibid. 79 See David Ackerman, “Benefits of S Corporation Election for Closely Held Corporations under the Tax Reform Act of 1986,” Taxes, June 1987, pp. 372–386. 80 This analysis does not take into account that C corporations other than personal service corporations are entitled to special low tax rates for income of $75,000 or less. Code § 11(b)(1)(A) and (b). These lower rates gradually are phased out for corporate income above $100,000 by the imposition of a 5% surtax of taxable income between $100,000 and $335,000. Code § 11(b). 81 Code § 1. The 2001 Act provides for gradual reductions in the maximum tax rate on individuals over the next few years to 35% in 2006. 82 Code § 11(b)(1)(D). 83 Code § 1001. 84 Code § 301.
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Exhibit 6.1
Tax on the Sale of Appreciated Property and Liquidation, Assumes a $100,000 Taxable Gain C Corporation Corporate gain Corporate income tax
$100,000 (34,000)
After-tax corporate profit Tax on distribution less basis (20% × $66,000)
66,000 (13,200)
After-tax profit
$52,800
Effective income tax rate [($100,000 − $52,800) ÷ $100,000]
47.2%
S Corporation Corporate gain Corporate income tax
$100,000 —
After-tax corporate profit Tax on distribution less basis (20% × $100,000)
100,000 (20,000)
After-tax profit
$80,000
Effective income tax rate [($100,000 − $80,000) ÷ $100,000]
20%
$80,000, as compared to $52,800. Exhibit 6.1 summarizes the comparison of these two different sets of tax results. If the transaction takes the form of a liquidation, gain would be recognized by the corporation to the extent of the excess of the fair market value of its assets over the corporation’s basis in its assets.85 And, the taxation results would be the same. A double tax would be imposed on the C corporation and its shareholders. However, only one level of tax would be imposed on the S corporation and its shareholders because the corporate gain would pass through to the shareholders. And, the shareholders’ tax basis would be increased by the amount of the gain recognized.86 If the transaction takes the form of a sale of stock, the corporate-level tax could be avoided even if the corporation had not made an S election. This is true provided that the purchaser did not make an election under Section 338 of the Code to treat the transaction as purchase of assets for federal income tax purposes. However, unless the Section 338 election is made, the acquirer corporation will not be entitled to step up the basis of the purchased assets to the price paid for the stock. Accordingly, the acquirer corporation depreciation and amortization deductions will be less than would be the case after a transaction structured as a purchase of assets. On the other hand, if the purchaser makes the Section 338 election, the acquired corporation will be treated for tax purposes as if it had sold its assets. And, as the new shareholder of the acquired corporation, the purchaser will bear the burden of the tax imposed on the constructive gain recognized by the acquired corporation. In order to both avoid this tax and obtain the benefit of a step-up in the basis of the acquired corporation’s assets, a purchaser of a business normally will prefer to structure an acquisition as a purchase of assets. In an asset purchase structure, the 85 Code 86 See
§ 336(a). notes 97–103 and accompanying text.
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acquirer will normally pay a higher price than for a stock purchase structure. Therefore, substantial benefits can be obtained by the owners of an S corporation when the corporation is sold. This is true even when the sale of the corporation is in the form of a sale of stock. To limit the benefits that can be obtained by converting a C corporation to an S corporation, Congress has enacted a corporate-level tax on S corporations that formerly were C corporations. This tax is imposed on any gain (1) that arises before the effective date of the S election (i.e., the built-in gain) and (2) that is recognized by the S corporation within 10 years after the conversion by reason of a sale or distribution of its assets.87 The built-in gain tax is assessed at a tax rate equal to the highest rate of corporate tax.88 This tax applies in each year to the lesser of the S corporation’s built-in gain or its taxable income.89 Any recognized built-in gain not taxed by reason of the taxable-income limitation is carried forward to later tax years in which the S corporation has additional taxable income.90 Let’s return to the above example. If the value of the corporation assets on the date of its S election exceeded the corporation’s assets basis by $50,000, it would be subject to a corporate-level tax on $50,000 of the gain realized on the sale of its assets. Because the built-in gain tax applies only to S corporations that were previously C corporations, the tax can be completely avoided if an S election is made at the time that a corporation is first incorporated.
Pass-Through of Losses Just as the earnings of an S corporation are “passed through” and taxed to its shareholders, so are the S corporation’s losses.91 The shareholders may apply these losses to reduce their income from other sources, up to an amount equal to the S corporation tax basis in their stock.92 Therefore, S elections are often made by owners of start-up ventures (1) who desire the limited liability and other features of incorporation and (2) who anticipate that losses will be incurred at the outset of corporate operations.93 Losses of a C corporation may be used only to offset prior or future corporate income.94
Other Benefits Other benefits of the S election include the following: (1) avoidance of the corporate alternative minimum tax,95 (2) reduction of the risks of a challenge by the IRS
87 Code
§ 1374. Congress has considered, but not yet passed, legislation that would impose the tax at the time that the S election is made. Budget of the U.S. Govt., FY 1998, Legislative Proposals (1997). 88 Code § 1374(b)(1). 89 Code § 1374(d)(2). 90 Code § 1374(d)(2)(B). 91 Code § 1366. 92 Code § 1366(d). 93 For a potentially abusive use of S corporation ESOPs to take advantage of the pass-through of losses of a start-up venture, see Ginsburg, “The Taxpayer Relief Act of 1997: Worse Than You Think.” 94 Code § 172(b). 95 Code § 1363(a). However, an S corporation shareholder may be subject to the alternative minimum tax as a result of the passthrough of items of tax preference of the S corporation. See Code § 1366(b).
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to the amount of compensation paid to shareholders,96 (3) avoidance of the accumulated earnings tax,97 and (4) the availability of the cash method of accounting.98
Disadvantages of the S Corporation Election The S corporation election has several disadvantages, as discussed below.
Shareholder Limitations An S corporation may have no more than 75 shareholders.99 This limitation may require a corporation to closely monitor and control the distribution of its stock. In addition, some investors may be frustrated by the limitations on the kinds of trusts that may hold stock of an S corporation.
One-Class-of-Stock Limitation The one-class-of-stock limitation restricts planning options for the capital structure of an S corporation. For example, no preferred stock can be issued to outside investors by an S corporation. However, the issuance by an S corporation of most types of stock options, stock warrants, or convertible debentures generally will not constitute the creation of a second class of stock.100 Many existing C corporation ESOP companies have capital structures that include convertible preferred stock or so-called “super” common stock. These kinds of shares are often issued where it is anticipated that dividends will be used to pay off an ESOP loan. This is because the annual loan payments exceed the maximum amount that may be contributed to the plan on a tax-deductible basis. In this situation, it is generally desirable to limit the dividends to shares held by the ESOP. In this way, the dividend cost can be limited. And, double taxation on dividends that otherwise would be payable to other shareholders can be avoided.101 Where a C corporation has created a second class of stock for 96 Because
an S corporation is not usually subject to the corporate tax, it generally makes no difference whether distributions to shareholders of S corporations are characterized as compensation or dividends. This does not mean, however, that there is no limit on the amount of compensation that may be paid to the corporation’s officers. To the extent that the officers’ compensation exceeds a reasonable amount, the shareholders of the corporation may be able to impose limits under applicable corporate laws. The board of directors of a corporation must act in the best interest of the shareholders in managing the affairs of the corporation, and directors who approve excessive officer compensation may be held liable for mismanagement. Where some or all of the shares of a corporation are held by an ESOP, the ESOP trustee should monitor the actions of the board of directors. Among other things, the ESOP trustee should evaluate the amount of compensation being paid to the officers. To the extent that the officers’ compensation is excessive, corporate earnings to which the ESOP and the other shareholders would otherwise be entitled are being diverted to the officers. 97 Code § 1363(a). Because S corporations generally are not subject to federal income tax and business earnings of an S corporation are taxed to the shareholders whether or not distributed, there is no reason to penalize accumulations of income in an S corporation. 98 Most regular corporations with annual gross receipts in excess of $5 million are prohibited from using the cash method of accounting. Code § 448. However, limitations on the use of the cash method of accounting do not apply to S corporations. Code § 448(a). 99 Code § 1361(b)(1)(A). 100 Rev. Rul. 67-269, 1967-2 C.B. 298, See, e.g., Treas. Regs. §§ 1361-1(b)(4), 1361-1(l)(4)(iii). See also David Ackerman, “Stock Options for S Corporations,” Journal of Employee Ownership Law and Finance, Summer 2001, pp. 55–78. 101 For discussions of the use of “super” common and convertible preferred stocks in ESOPs, see Gregory K. Brown and Kim Schultz Abello, “ESOPs and Security Design: Common Stock, Super Common, or Convertible Preferred?” Journal of Pension Planning & Compliance, Summer 1997, pp. 99–105, and Jared Kaplan, “Is ESOP a Fable? Fabulous Uses and Benefits or Phenomenal Pitfalls?” Taxes, December 1987, pp. 792–793.
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these reasons, it may not be feasible to make the S election. This is because the S election would require the elimination of the special class of stock created for the ESOP.
Limitation on Other Benefits Persons who own 2 percent or more of the outstanding shares of an S corporation may not exclude from their income the value of fringe benefits that are provided to them.102 Examples of these types of benefits include (1) group term life insurance, (2) certain health and accident plans, (3) death benefits, and (4) meals and lodging reimbursement.
Fiscal Year The taxable year of an S corporation must be the calendar year. This is true unless the corporation can establish, to the satisfaction of the IRS, a business purpose for using a different fiscal year.103 Not surprisingly, the deferral of income to stockholders for a limited period of time will not be treated as a legitimate purpose for using a different fiscal year.104 However, an S corporation may adopt a taxable year other than the calendar year. This is the case if shareholders holding more than one-half of the shares of the corporation have the same tax year or are changing to the corporation’s tax year.105 This means that, if an ESOP holds more than one-half of the outstanding shares of an S corporation, the S corporation may adopt the same taxable year as the ESOP. This is true even if that year is not the calendar year. Where the principal shareholders of an S corporation change to a new tax year to be adopted by the corporation, the shareholders may not change their tax year without first obtaining IRS approval.106 There is an exception to the general rule under which an S corporation may elect to adopt a tax year ending not earlier than September 30.107 In that case, however, payments in the nature of advance tax deposits are required. Those advance tax deposits take away the advantage of the tax deferral.108
State Income Tax Considerations Although most states recognize S corporation status for purposes of their tax laws, not all states follow the federal pattern. Some states tax S corporations and not their shareholders. Some states tax both the S corporation and its shareholders. And,
102 Code
§ 1372. §§ 44, 1378. An example of a business purpose that will be accepted for adopting a taxable year other than the calendar year is a change to a tax year that coincides with the corporation’s “natural business year.” A taxable year will be deemed to be a natural business year if 25% or more of the corporation’s gross receipts in each of the last three 12-month periods proposed to serve as the taxable year have been recognized in the last 2 months of those periods. Rev. Proc. 83–25 § 4.04, 1983-1 C.B. 689, 692. 104 Code § 1378(b). 105 Rev. Proc. 83–25 § 4.02, 1983-1 C.B. 689. 106 Ibid. 107 Code § 444(b). 108 Code §§ 444(c)(1), 7519. 103 Code
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some states do not tax either the corporation or the shareholders. If the S election is made by a corporation that is incorporated in a state that does not follow the federal rules regarding S corporation tax treatment, difficult state tax compliance programs can arise. This is especially true if multistate business operations are involved.109
Advantages of an S Corporation ESOP A significant advantage or benefit of the ability of an S corporation to sponsor an ESOP is that this greatly broadens the pool of employees that could potentially own stock in the employer company. There are roughly as many S corporations in existence as C corporations. Although not all S corporations would be good ESOP candidates, clearly a significant number of additional companies could potentially sponsor a new benefit for its employees. For the shareholders of S corporations, the ability to sell stock to an ESOP provides an attractive opportunity to gain some liquidity and to transfer the ownership of their company to the employees and to the next generation. This ESOP benefit has been available for C corporation shareholders for many years. In an S corporation that is owned 100 percent by the ESOP, significant cash flow benefits accrue to the company. These benefits are a result of the fact that the company does not have to make a distribution to its shareholders for income tax payments. These cash flows can provide enhanced debt service coverage or additional investment opportunities that would otherwise be unavailable to the company. The following two exhibits illustrate the potential cash flow enhancement for an S corporation that is 100 percent owned by an ESOP. As presented in Exhibit 6.2, the sample S corporation, with $10 million in revenues increasing at 5 percent per year, earns a pretax margin of 10 percent of revenues. In the first year, the company, owned by individual shareholders, would make an annual distribution in cash to its shareholders to enable them to meet the income tax obligation on the income earned by the company. In the first year, this distribution amounts to roughly $400,000. After the distribution for income taxes, the sample S corporation has $600,000 in cash flow in the first year that is available for investments by the company and for debt payments. For the same sample S corporation, which is owned 100 percent by an ESOP, the company would not have to make cash distributions to the ESOP. This is because the ESOP trust does not pay taxes on the income it earns in the S corporation. As presented in Exhibit 6.3, these cash flows can be retained inside the company. On an annual basis, the S corporation would have cash flow available for investments and debt payment of $1.0 million in the first year. This available cash flow is 67 percent higher than the S corporation presented in Exhibit 6.2. Over a 5-year period, these cash flow savings amount to over $2.2 million, as presented in Exhibit 6.3. In an S corporation that is owned less than 100 percent by the ESOP, cash flow benefits still accrue to the ESOP. And, these cash flow benefits may be deployed for the benefit of the company. Since the S corporation must make pro rata cash distributions to all shareholders to provide cash to the non-ESOP shareholders to meet 109 For a thorough discussion of this issue, see James E. Maule, S Corporations: State Law and Taxation. Deerfield, IL: Callaghan,
1992.
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Exhibit 6.2
Sample S Corporation—No ESOP Ownership ($ in 000s) Year 1
Year 2
Year 3
Year 4
Year 5
10,000
10,500
11,025
11,576
12,155
Pretax income Pretax margin
1,000 10%
1,050 10%
1,103 10%
1,158 10%
1,216 10%
Cash flow: Pretax income Less: Distributions for income taxes
1,000 (400)
1,050 (420)
1,103 (441)
1,158 (463)
1,216 (486)
600
630
662
695
729
Revenue
Cash flow available for investments and debt
their annual tax obligation, the ESOP shares will accrue significant cash dividends on an annual basis. These cash distributions provide additional return to the ESOP shares in addition to any ongoing equity appreciation. Exhibit 6.4 illustrates the same sample S corporation, which is owned 70 percent by individuals and 30 percent by the ESOP. The company continues to make cash distributions to the shareholders in order to meet the income tax obligation. And, the ESOP receives its pro rata portion of these distributions. Based on an assumed value of $10.00 per share in the first year, increasing 5 percent per year, the ESOP receives an additional cash distribution of $0.40 per share in the first year. As a result of this additional cash dividend, the ESOP’s total return each year is approximately 9.2 percent per year. This 9.2 percent total return is compared to the 5 percent per year of equity appreciation for the first S corporation. At the end of the 5-year period, the ESOP shares would have a share value of $12.16, and an additional cash account balance of $2.16.
Exhibit 6.3
Sample S Corporation—100 Percent ESOP Owned ($ in 000s)
Revenue
Year 1
Year 2
Year 3
Year 4
Year 5
10,000
10,500
11,025
11,576
12,155
Pretax income Pretax margin
1,000 10%
1,050 10%
1,103 10%
1,158 10%
1,216 10%
Cash flow: Pretax income Less: Distributions for income taxes
1,000 —
1,050 —
1,103 —
1,158 —
1,216 —
Cash flow available for investments and debt
1,000
1,050
1,103
1,158
1,216
Cash flow in S corporation (with no ESOP) Cash flow enhancement
600 67%
630 67%
662 67%
695 67%
729 67%
400 2,210
420
441
463
486
Income taxes saved each year Cash flow savings—5-year total
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Exhibit 6.4
Sample S Corporation—30 Percent ESOP Owned
Revenue ($000s) Pretax income ($000s) Pretax margin Cash flow: Pretax income ($000s) Less: Distributions for income taxes ($000s) Cash flow available for investments and debt ($000s) Cash distribution to ESOP ($000s)
Year 1
Year 2
Year 3
Year 4
Year 5
10,000 1,000 10%
10,500 1,050 10%
11,025 1,103 10%
11,576 1,158 10%
12,155 1,216 10%
1,000 (400) 600
1,050 (420) 630
1,103 (441) 662
1,158 (463) 695
1,216 (486) 729
120
126
132
139
146
Value per share ($) Total return per share
10.00
10.50 5%
11.03 5%
11.58 5%
12.16 5%
Shares outstanding (000s) Shares owned by ESOP (000s) Cash distribution to ESOP—per share ($)
1,000 300 0.40
1,000 300 0.42
1,000 300 0.44
1,000 300 0.46
1,000 300 0.49
0.92 9.20%
0.97 9.20%
1.01 9.20%
1.07 9.20%
Total return to ESOP—per share ($) Total return to ESOP (%) Ending share value ($) Total cash in ESOP—per share—5-year total ($)
12.16 2.21
These cash distributions that go into the ESOP trust may, in some cases, be used by the trustee to (1) repay ESOP debt, (2) repurchase shares from departing participants, or (3) even purchase shares from other outside shareholders or the company treasury. Alternatively, the cash may be invested in an appropriate investment fund on behalf of the participants. In all cases, the availability of the cash to be used by the ESOP for various purposes results from the fact that the ESOP trust does not have to pay taxes on its pro rata share of the company’s income.
Disadvantages of an S Corporation ESOP Clearly, one of the principal disadvantages to an S corporation shareholder selling stock to an ESOP is that the selling shareholders are not eligible to elect Section 1042 capital gains deferral on the sale. The Section 1042 treatment would be the case in a C corporation ESOP stock sale. However, this may not be a significant disadvantage. This is because many S corporation shareholders have a relatively high basis in their shares as a result of years of undistributed earnings. Another disadvantage of the S corporation ESOP is that the company must abide by certain requirements in order to maintain its S corporation status. As previously mentioned, this includes (1) a limit on the total number of shareholders (currently 75) and (2) a limit on the type of shareholders (U.S. citizens or resident (green-card) aliens, estates for a reasonable period of probate, or certain trusts such as ESOPs and grantor trusts). These limitations may prevent the purchase of a block of the stock by a financial buyer such as an investment firm. This may limit the
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company’s ability to secure adequate capital. Another requirement of the S election is that the company, in most circumstances, must adopt a calendar year as its fiscal year. Although it is initially a potential administrative burden to adopt a calendar year, it is likely that most businesses could operate effectively with a calendar fiscal year. Another disadvantage is the restriction that there may be only one class of stock in an S corporation. As a result, certain capital structures that make use of a dividend-paying security (or a number of securities that each have different financial characteristics) are prohibited. These structures are often used in heavily negotiated transactions, without which a sale to an ESOP or other investor may not ever occur. It is permissible to have both voting and nonvoting stock in an S corporation. This would not violate the single-class-of-stock rule for S corporations. This is true as long as (1) all of the other features of the securities are substantially identical and (2) neither security has rights or preferences in favor of the other. In order to maintain the single class of stock in the S corporation, the S corporation should be careful with the types of debt that it issues. For purposes of the singleclass-of-stock test, debt in an S corporation can be considered equity if it more closely resembles equity. If the debt is classified as equity and has different rights and features than the existing stock, then the S election could be jeopardized. This may be a significant disadvantage when trying to structure a highly leveraged transaction with an S corporation ESOP. This is because it may limit the financing available to the company. However, there are certain safe harbors that describe the features and characteristics that can be incorporated into a debt issue without jeopardizing the S election. In any transaction employing complicated debt securities in an S corporation ESOP, it is important to have a legal advisor provide an opinion that the debt would not be classified as equity. There are additional disadvantages that relate to specific elements of the ESOP. These include the fact that S corporation dividends to the ESOP are not deductible by the company. However, dividends paid to an ESOP are tax-deductible for a C corporation under certain circumstances. In addition, the S corporation must include (1) contributions to the ESOP to repay the interest due on the ESOP loan and (2) the annual forfeitures inside the ESOP plan in its calculations of the ESOP contribution limits under IRC Section 415. The combination of these limitations may make it harder for an S corporation ESOP to repay the ESOP loan and allocate all of the stock to the participants within a reasonable period of time. A C corporation ESOP can provide for delaying any payments to terminated participants until the entire ESOP loan is repaid. In comparison, a final disadvantage of an S corporation ESOP is that the S corporation ESOP may not delay payments to terminated ESOP participants until the ESOP loan is repaid. This would appear to create two potentially significant problems for an S corporation implementing a large leveraged ESOP: (1) cash flow and (2) contribution limits under IRC Section 415. At first glance, this requirement would seem to be a significant burden on an S corporation ESOP in terms of cash. This is because the company could be repaying the ESOP bank loan and repurchasing shares from participants at the same time. However, since the company is an S corporation ESOP, there is enhanced cash flow, as discussed previously in this chapter. If the company is 100 percent owned by the ESOP, then there is both no tax liability and no cash flow for taxes on an annual basis. Otherwise, there would be distributions of cash flowing into the ESOP. This cash could ultimately be used to repurchase shares from terminated participants or to purchase treasury shares to provide new capital to the company. During the implementation
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stage, it is crucial in an S corporation ESOP to conduct a study of participants’ age, turnover, and benefit levels. As long as the company maintains profitability, careful implementation analysis should indicate if there will be adequate cash flow availability to meet the debt requirements and all potential repurchases. Another potential disadvantage of the S corporation ESOP is that it should be careful not to violate the “antiabuse” regulations passed in 2001. These regulations were described earlier in this chapter. However, careful planning and expert legal advice can prevent violations of these regulations. And, in all likelihood, most companies can operate quite effectively within these requirements. Finally, for C corporations that convert to S corporation status, there are two additional conditions that accompany the S election. First, the company converting from C to S status is subject to a 10-year holding period requirement. During that 10-year period, the company may not convert back to C or be sold. The penalty for violating this 10-year period is a potentially significant tax on built-in gains on the assets. For many companies, this can result in significant tax liability. Finally, upon adoption of the S election, the company is required to recapture the value of its last in first out (LIFO) reserves if it is using the LIFO inventory method of accounting. This recapture may result in taxable income in the period immediately prior to the S election. Despite (1) the disadvantages associated with an S corporation election and (2) the complexity of implementing an S corporation ESOP, the economic benefits can be significant. As a result, S corporation ESOPs have become very popular in recent years.
Valuation Issues for S Corporation ESOPs The valuation questions with regard to an S corporation ESOP company revolve around two issues: 1. Is an S corporation that is partially or wholly owned by an ESOP valued the same as any other S corporation? 2. Is an S corporation valued the same as an otherwise identical C corporation? We will discuss these two significant issues. We will then discuss special issues for S corporation ESOP valuations, including the lack of marketability discount, the ESOP “income tax shield,” and the sale of an S corporation ESOP.
Fair Market Value To review, a common definition of fair market value (which is the litmus test for valuations of privately held stock held by ESOPs), is “the value at which an asset would trade hands between a willing buyer and willing seller, both having access to relevant facts, neither being under compulsion to act.” Generally, this definition is interpreted to refer to hypothetical, average buyers and sellers in the marketplace, without regard to special-purpose buyers (e.g., strategic buyers) or sellers (e.g., liquidation sellers). As a result, the definition of fair market value, when considered with respect to the S corporation ESOP, does not confer value from the ESOP tax structure on the
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value of the subject stock. While it is true that the ESOP receives an economic advantage that translates to additional value for the participants, this economic benefit does not confer additional value on the stock itself. Only another special-purpose buyer (e.g., another S corporation ESOP) could enjoy the same economic advantage. Therefore, this economic benefit is not part of the fair market value of the subject stock. Analysts sometimes refer to the enhanced economic benefit of the S corporation structure for the ESOP as “investment value” in order to differentiate it from the traditional fair market value terminology. Typically, in a C corporation, investment value to the ESOP shareholder will be equal to the fair market value. For an S corporation ESOP shareholder, it is possible the investment value may be greater than the fair market value. As presented in Exhibit 6.4 earlier in this chapter, the investment value is illustrated by the 9.2 percent return earned by the ESOP shareholders. That return included the annual cash distributions into the ESOP trust. However, the fair market value of the ESOP stock is the same $10.00 to $12.16 per share as estimated for the company in its entirety. Regarding the purchase of stock by an ESOP, some analysts may adjust the price that the ESOP can pay for the stock based on the tax advantages the ESOP will enjoy once it owns the stock. However, this adjustment would be incorrect for a number of reasons. Most importantly, the selling shareholder could not command that price premium from any other hypothetical buyer. In addition, the Department of Labor has prohibited an ESOP from paying for the tax advantages (in a C corporation setting) that the ESOP “brings to the table.” Finally, the ESOP would not have an exit strategy for its investment vehicle that would confer on it that same price premium. This is because there is no other buyer for the S corporation stock that would experience the same tax-exempt status. Therefore, an analyst would be incorrect to attribute a price premium or enhanced value (for the tax-exempt status of the ESOP) to the fair market value of an S corporation being purchased by an ESOP.
S Corporation Valuations versus C Corporation Valuations—The Conventional Method We now turn to the second question: Is an S corporation valued the same as an otherwise identical C corporation? The conventional method for estimating the value of an S corporation has been to treat the S corporation as if it were no different than an otherwise identical C corporation. In the various market approach and income approach methods, the conventional methodology does not incorporate any benefit or disadvantage of the S corporation structure. This has different practical implications for each valuation method, as discussed below. In the market approach, the two primary methods (i.e., the guideline publicly traded company method and the guideline merged and acquired company method) are applied in a similar manner for an S corporation as for a C corporation. The majority of the data used in each method are derived from C corporations. This is because (1) publicly traded companies are typically C corporations and (2) acquisition data related to nonpublic transactions in S corporations are difficult to gather. In each method, an estimate of invested capital and various earnings measures are determined for the guideline companies/transactions. Pricing multiples are then computed based on these guideline data. And, the market-derived pricing multiples
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are applied to the S corporation according to a comparison of the guideline companies/transactions to the subject company in terms of risk profile, financial strength, and other factors. In each method, common measures of economic income include EBIT and EBITDA. Since both the guideline company/transaction data and the S corporation income measures are pretax, no other adjustment is made to the S corporation value estimate. In some cases, after-tax earnings measures (such as net income) are derived from the guideline companies/transactions. In that case, the conventional procedure has been to (1) tax-affect the S corporation earnings at the comparable C corporation income tax rate and (2) apply the pricing multiples derived from the guideline companies/transactions. Again, there would be no other adjustment to the S corporation value estimate based on this conventional valuation procedure. In the income approach, the commonly used valuation methods are (1) the discounted cash flow method and (2) the direct capitalization method. These valuation methods apply a market-derived discount rate or direct capitalization rate typically to an after-tax cash flow measure. The conventional procedure has been (1) to taxaffect the S corporation earnings at the comparable C corporation income tax rates and (2) to use these adjusted earnings in the cash flow measure in the discounted cash flow or capitalization methods. Again, there would be no other adjustment to the S corporation value estimate derived with this procedure.
Recent Judicial Precedent Recent court decisions have suggested that the conventional procedures for estimating S corporation value (by incorporating the income tax rates of a C corporation) are incorrect. These recent judicial decisions have sparked a debate over the correct procedure for estimating the value of an S corporation.110 From an economic perspective, there is a clear economic benefit to the S corporation shareholder related to paying less income taxes. The relevant valuation questions include the following: 1. How great is this economic benefit? 2. What are the risks associated with this economic benefit? 3. How, if at all, does this economic benefit translate into an effect on the S corporation stock fair market value?
Range of Value The debate regarding S corporation value has ranged from suggestions that an S corporation could potentially be worth up to 50 percent more than a C corporation due to the lack of taxation at the corporate level to the conventional procedure that implies no difference in value between an S corporation and a C corporation and everything in between. In addition, the value implications of the S corporation economic benefit may be different for a controlling ownership interest than for a noncontrolling ownership interest. The next section of this chapter attempts to frame
110 See Gross v. Commissioner, 272 F.3d 333 (6th Cir. Nov. 19, 2001), aff’g T.C. Memo 1999-254 (July 29, 1999); Estate of Adams v. Commissioner, T. C. Memo 2002-80 (Mar. 28, 2002); and Estate of Heck v. Commissioner, T.C. Memo 2002-34 (Feb. 5, 2002).
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(1) the range of value issue and (2) the factors an analyst should consider in estimating S corporation value within the applicable range. Factors Affecting the Potential Range of Value of an S Corporation. The value of the S election, if any, results from the ability of the S corporation to distribute earnings to the shareholders that are not subject to double taxation. For example, if a corporation has excess cash flow (after paying reasonable compensation, providing cash for the payment of corporate taxes, and retaining sufficient cash for investment in the business), the C corporation can only distribute those earnings to shareholders as a dividend. Dividends are taxable to shareholders as ordinary income. The same company with an S corporation structure could distribute those earnings to shareholders, and these distributions would not be taxable to the shareholders. Arguably, the S corporation value is no greater than that of a C corporation if there is no excess cash flow that can be, or is, distributed to the shareholders. If there are no additional cash distributions, then the primary benefit of the S structure (i.e., the avoidance of double taxation), is not enjoyed by the shareholders. In some cases, the S corporation does not even have enough cash to make distributions to the shareholders to meet their income tax liability on their pro rata share of the income. In that case, one could argue that the S structure should indicate a value discount to an otherwise identical C corporation. In this case, the S corporation shareholders would not enjoy any of the benefits of avoiding double taxation. But, in addition, the shareholders would have negative cash flow as they would be required to use other capital resources to meet the tax liability of their pro rata portion of the S corporation income. Another complication in the debate about the value of S corporation status is that, if the company does not distribute all of its earnings, the shareholders’ basis in their shares is adjusted upward each year for undistributed earnings. Although the shareholders may not experience the advantage of avoiding double taxation on current distributions or dividends, ultimately the capital gains tax liability on a sale of their stock may be reduced due to adjustments to the basis in their stock. Many analysts have developed models that incorporate the economic effect of all of these differences (and many others) between an S and a C corporation. In some cases, these models do conclude that the stock of an S corporation may be valued differently (either positively or negatively) from the stock of a comparable C corporation. These models are affected by several assumptions, including the following: 1. 2. 3. 4. 5. 6. 7.
The applicable personal and corporate income tax rates The applicable capital gains tax rates The remaining life of the S corporation The potential timing of a liquidity event such as a sale of the corporation The potential structure of such a sale The level of “ongoing” distributions (above the distributions for taxes) Other variables that may be highly subjective
In addition, there are often risk factors for an S corporation that need to be incorporated into any new economic model attempting to quantify a difference in value between otherwise identical S and C corporations. These include risks such as (1) a potential change in the tax laws relating to the S corporation structure, (2) the risk that the company would not make adequate distributions even to meet the individual shareholders’ tax liability, and (3) more limited marketability of the S corporation company.
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In many cases, these additional risks would more than offset the additional value, if any, of the S corporation structure. What Does the Market Evidence Suggest? Market evidence suggests that there is no price premium for the S corporation status. Several studies have been conducted that compare the sales prices of S corporations (where data can be gathered) and C corporations. Although not entirely conclusive, the data suggest that buyers do not pay more for S corporations. This may be due to a wide variety of reasons, including, but not limited to: 1. A lower number of buyers for an S corporation due to limits on the type of shareholders (e.g., investment firms cannot be S corporation shareholders). This reduces the chances that the seller can maximize his/her value in the open market. 2. Recently converted S corporations assume the built-in gains tax liability if a sale occurs before the 10-year holding period expires. This may reduce the marketability of the S corporation company. 3. Since 1993, the highest individual income tax rates have been higher than the highest corporate income tax rates. This fact negates many of the economic benefits of the S election. 4. The limitations of the S corporation structure (i.e., shareholders, classes of stock) may offset the S corporation economic benefits. Most importantly is the fact that for the S corporation economic benefit to translate into enhanced value from a fair market value perspective, the S corporation owner (ESOP or otherwise) has to be able to monetize that enhanced value. That monetization occurs through a liquidity event such as a sale of the stock. To assess the potential value of the S corporation structure economic benefit, the analyst should determine the likelihood of finding a buyer that will experience the same economic impact that will also be willing and able to purchase the company. Although there are a large number of S corporations in the United States, the reality is that many of these companies are small, sole proprietorship types of businesses. For most companies in excess of $10 or $20 million in revenues, the likelihood is low of finding another S corporation with the financial wherewithal and desire to purchase the company. In addition, the most likely buyers of any company—public companies and financial investors (such as private equity funds)—will not be able to maintain the S structure of the target company postacquisition. As a result, they will not enjoy the economic benefits of the acquired company S structure. And, therefore, these buyers will not pay for this economic benefit. Under the fair market value test (i.e., willing buyer and willing seller), S corporation owners cannot always expect to monetize the S corporation economic value in a sale of the company.
100 Percent S Corporation ESOPs In the situation of an S corporation owned 100 percent by the ESOP trust, the economic benefit of the ESOP trust tax-exempt status can, over time, enhance the value of the S corporation stock. This is because, in this situation, the S corporation would not have to make distributions to its shareholders to meet any income tax obligation. Instead, the S corporation could retain the cash flow to be used for the economic benefit of the company.
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For example, the cash flow could be used to reduce debt, invest in new projects, and/or modernize equipment. These company investments represent equity value enhancements that a hypothetical buyer would be willing to pay for. The company’s reinvestment of this cash would, over time, enhance the value of the company. As a result of the enhanced cash flow, a 100 percent S corporation ESOP company could have significantly higher than average stock value growth. This is the value that a hypothetical willing buyer would pay for in the marketplace. And, this is value that an analyst should consider in estimating fair market value. It is important to recognize that this incremental value occurs over time. The S corporation fair market value should not include the future benefit of the incremental cash flow—that is, by capitalizing the annual tax savings. Instead, as each year passes and the tax savings of the 100 percent S corporation ESOP accrue each year, the incremental annual cash flow value should be encompassed in the fair market value.
Valuation Conclusion In summary, the valuation of an S corporation for ESOP purposes involves several significant issues. The analyst should consider the relative value of the S corporation versus an otherwise identical C corporation. In most cases, the S corporation will be valued by the same methodology used for valuing C corporations. The analyst should also consider the tax-exempt status of the ESOP trust. However, as discussed above, the analyst should estimate value based only on a hypothetical willing buyer and willing seller (rather than based on a special-purpose buyer). As a result, the analyst should not conclude an enhanced fair market value of the corporation stock due solely to the tax-exempt status of the ESOP trust. This is because only another S corporation ESOP (i.e., a special-purpose buyer) could purchase this enhanced value. However, when considering the prudence of the proposed transaction, the ESOP trustee or fiduciary may want to consider the enhanced investment value of the S corporation ESOP investment.
Planning Opportunities Should ESOP Companies Make the S Election? The question of whether existing ESOP companies should make the S election can be determined only on a case-by-case basis. That is because this decision depends on each company’s particular set of facts and circumstances. In some cases, the opportunity for the tax deferral described above will be appealing. However, most individual S corporation shareholders require distributions to cover the income taxes on their share of the corporation income. Therefore, the ESOP companies that will derive a significant benefit from the tax-deferral opportunity may be limited to those companies where the ESOP owns all, or substantially all, of the outstanding shares.
Tax-Deferred Sales to ESOPs The failure of Congress to extend to S corporations the same ESOP tax incentives that are available to C corporations will also limit the number of ESOP companies
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that make the S election. Most importantly, where individual shareholders of an ESOP company are planning a future tax-deferred sale of some or all of their shares to the ESOP, the S election will be unattractive. However, it may be possible for a shareholder who desires a tax-deferred sale to an ESOP to obtain the best of both worlds. This would occur by arranging (1) for the sale to close in a year when the plan sponsor is a C corporation and (2) for the S election to be effective for a later year. A problem will remain for business owners who desire two- or three-stage ESOP buyouts. If an S election is made after the first ESOP sale, subsequent sales of stock to the ESOP will not qualify for the tax deferral. That is true unless the S election is terminated before the subsequent sales. Once an S election is terminated, it cannot be reinstated for 5 years.111 However, this rule does not apply to any termination of an S election in a taxable year beginning before January 1, 1997.112
Limits on Plan Contributions The attractiveness of the S election for an ESOP company may also be reduced by the limit on the amount that can be contributed to leveraged ESOPs by an S corporation. This S corporation contribution limit is lower than the amount that can be contributed by a C corporation. The limit on tax-deductible contributions is normally 25 percent of covered compensation. In the case of an S corporation, contributions applied to pay interest on an ESOP loan count against the limit.113 In contrast, contributions to an ESOP by a C corporation for this purpose do not count against the limit.114 Where the annual payments due under the ESOP loan exceed the maximum amount that can be contributed to the ESOP on a tax-deductible basis, it may be possible to cover the shortfall with dividends. However, as discussed above,115 the IRS has taken the position that distributions by an S corporation on shares held by an ESOP (that are not pledged to secure an ESOP loan) cannot be used to pay down the loan. Therefore, in the case of a highly leveraged ESOP company, the S election may be impractical. This is true at least until the ESOP indebtedness is paid down or refinanced. One strategy for dealing with the lower contribution limits available for S corporation ESOPs is simply to extend the term of the ESOP loan. The term of the ESOP loan may be extended to the point where the annual contribution required to service the debt falls within the 25 percent limit. This can be accomplished under a “back-to-back” loan structure. In such a structure, the plan sponsor borrows funds from an outside lender on normal commercial terms (with, for example, a seven-year amortization period). Then, the plan sponsor loans the borrowed funds to the ESOP on extended payment terms (for example, a 15-year amortization period). No prepayment penalty should be provided for in the loan agreement between the plan sponsor and the ESOP. That way, if the plan sponsor’s covered payroll increases, the ESOP loan can be repaid more rapidly. The interest rate on the ESOP loan could be
111 Code § 1362(g). The IRS has stated that it will not exercise its authority to waive this rule when a 50% ownership change has occurred if that ownership change arises in connection with a sale of stock to an ESOP that qualifies for nonrecognition of gain under Section 1042 of the Code. PLR 199952072 (Sept. 27, 1999). 112 1996 Act, § 1317(b). 113 Code § 404(a)(9)(C). 114 Code § 404(a)(9)(B). 115 See notes 32–36 and accompanying text.
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set at the minimum rate required to avoid triggering imputed interest, regardless of the interest payable to the outside lender. This will minimize the effect of the requirement that interest payments on an ESOP loan for an S corporation must be counted against the 25 percent limit.
Corporate-Level Income Tax Another factor that an ESOP company should take into account in determining whether to make the S election is whether the election may trigger unanticipated corporate-level taxation. As a general rule, S corporations are not subject to federal income tax. However, there are three exceptions. First, an S corporation that formerly was a C corporation is subject to tax on built-in gains recognized within 10 years of the effective date of the S election.116 As discussed below, “built-in” gains are gains that are attributable to the period before the effective date of the S election.117 If an ESOP company anticipates selling its assets or liquidating within 10 years from the date of the S election, the built-in gain tax may substantially diminish the economic benefits of the S election. A second corporate-level tax to which an S corporation may be subjected is the LIFO “recapture” tax. When a C corporation that uses the LIFO inventory method makes the S election, it must include as income (over a 4-year period), the excess of the value of its inventory determined on a first-in, first-out (FIFO) basis over its value determined on a LIFO basis.118 Finally, a corporation that makes the S election may be subject to tax on “excess net passive income.”119 ESOP companies that derive a substantial amount of their income from passive sources (such as rents, royalties, dividends, and interest) should evaluate the possible imposition of this tax before making the S election.
Should S Corporations Adopt ESOPs? Until now, S corporation shareholders who desired to implement ESOPs were forced to choose between the economic benefits of an ESOP and the economic benefits of the S election. This choice often has turned on the shareholders’ plans for business succession. Where a sale of the business was contemplated, the avoidance of a double tax often made the S election more attractive than the ESOP. On the other hand, where shareholders seek to transfer ownership to family members or to existing management groups, the opportunity to arrange for a tax-deferred sale to an ESOP—and to finance the transaction on a tax-advantaged basis—often outweighs the benefits of the S election.120 In most cases, the same analysis will continue to apply for S corporation shareholders contemplating an ESOP. However, now there will be some situations where 116 Code
§ 1374. § 1374(d). 118 Code § 1363(d). 119 Code § 1375. 120 For detailed discussions of the use of ESOPs in ownership succession planning for closely held businesses, see David Ackerman and Idelle A. Howitt, “Tax-Favored Planning for Ownership Succession via ESOPs,” Estate Planning, November/December 1992, pp. 331–337, and David Ackerman, “Innovative Uses of Employee Stock Ownership Plans for Private Companies,” DePaul Business Law Journal, Spring 1990, pp. 227–254. 117 Code
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the S election can be maintained and an ESOP can be adopted. Most notably, this will be the case where a tax-deferred sale to an ESOP is not a critical component of the new plan. This would be the case where the ESOP is being created to serve primarily as an employee benefit plan and not (1) as a tax-advantaged financing technique or (2) as a means of providing liquidity for current shareholders. In some cases, S corporation shareholders have built up a significant tax basis in the S corporation shares. And, the sale of their shares to an ESOP may be attractive even without the opportunity for a deferral of the capital gains tax. An S corporation shareholder’s basis in the corporation shares (1) is increased by his or her share of the corporation’s income and (2) is reduced by distributions.121 To the extent that an S corporation has retained earnings, the shareholders will have an increased tax basis in the shares. Another situation in which an S corporation shareholder may have a high stock basis is where the stock has recently been inherited. In that case, the shareholder’s basis is equal to the fair market value as of the date of the decedent’s death.122 Where an S corporation shareholder has a high basis in his or her shares, the shares can be sold at a reduced capital gain. The less the amount of the gain, the less important the tax-deferral election becomes.
Unresolved Issues There are some areas of ambiguity regarding the interpretation of the current laws governing S corporation ESOPs.
Use of S Corporation Distributions to Pay Off an ESOP Loan One area of ambiguity is whether S corporation distributions on allocated ESOP shares may be used to pay down an ESOP loan. As a general rule, Section 4975 of the Code prohibits loans between a tax-qualified plan and a disqualified person.123 For purposes of this rule, the term “loan” refers not only to a loan made directly by a disqualified person to an ESOP, but also to a guarantee of a loan to an ESOP by a disqualified person.124 There is an exemption from the prohibition on loans to ESOPs that applies where (1) the loan is primarily for the benefit of participants in the plan and their beneficiaries, (2) the loan is at a reasonable rate of interest, and (3) no collateral is given to a disqualified person other than qualifying employer securities.125 The regulations interpreting Section 4975(d)(3) provide that, in order for a disqualified person to qualify for this exemption, the lender may not have any right to the ESOP assets other than (1) collateral given for the loan (which may only be qualifying employer securities), (2) contributions to the plan (other than 121 Code
§ 1367(a). § 1014. 123 Code § 4975(c)(1)(B). The term “disqualified person” is defined to mean, among other persons, any officer, director, or highly compensated employee of the plan sponsor, any person owning 10% or more of the outstanding shares of the plan sponsor, or the plan sponsor itself. Code § 4975(e)(2). 124 Treas. Regs. § 54.4975-7(b)(ii). 125 Code § 4975(d)(3). 122 Code
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contributions of employer securities), and (3) earnings attributable to the collateral and to the investment of the contributions.126 Under the Section 4975(d)(3) regulations, it would appear that distributions by an S corporation on stock pledged as collateral to secure an ESOP loan could be used to pay off the loan. This is because the distributions would constitute earnings “attributable to” the collateral given to secure the loan. However, distributions by an S corporation on stock that has not been pledged as collateral to secure an ESOP loan could not be used to pay off an ESOP loan under the Section 4975 regulations. This is because distributions on those shares would not be earnings attributable to the collateral for the loan. In the case of a C corporation, dividends paid on employer securities that were not pledged to secure an ESOP loan still may be used to pay off the loan under Section 404(k)(5)(B). This Section provides that a plan will not be treated as engaging in a prohibited transaction merely by reason of the application by the plan of a “dividend” to make payments on the loan taken out to purchase those securities. Because distributions of S corporation earnings technically are not “dividends” within the meaning of the Code,127 the IRS has taken the position that distributions by an S corporation on stock that is not pledged as collateral to secure an ESOP loan cannot be used to pay off that loan. This is true even though a comparable distribution from a C corporation could be so used.128 It is not clear whether Congress intended that different rules would apply to S corporations and C corporations.129
Distribution of S Corporation Earnings to Plan Participants A second area of ambiguity regarding the current rules for S corporation ESOPs relates to how distributions of S corporation earnings to ESOP participants should be treated. Distributions received from a tax-qualified plan by a participant before he or she has attained age 59 1/2 are subject to a 10 percent excise tax.130 However, this tax does not apply to “dividends” on stock of a C corporation as described in
126 Treas.
Regs. § 4975-7(b)(5). However, at least one court has held that a repayment of an ESOP loan from sources other than those enumerated in the Section 4975 regulations would not be prohibited. Benefits Committee of Saint-Gobain Corp. v. Key Trust Co., 2001 U.S. Dist. LEXIS 9280 (N.D. Ohio 2001). 127 The term “dividend” is defined in Code § 316 to mean any distribution of property made by a corporation to its shareholders out of its current or accumulated “earnings and profits.” In the case of a corporation, a distribution that is a dividend is included in the gross income of the shareholders to whom the dividend is paid. Code § 301(c). Different rules are provided for distributions of property made by S corporations with respect to their stock. If an S corporation has no earnings and profits from years during which it was a C corporation, then distributions generally will be tax-free to the extent of the shareholders’ basis in their stock. Code § 1368(b). An S corporation shareholder will be subject to tax on any distribution to the extent that it exceeds his or her stock basis. Code § 1368(b)(2). If a C corporation converts to S corporation status at a time when it has accumulated earnings and profits, then distributions will remain tax-free up to the amount of the corporation’s “accumulated adjustments account,” which is an account consisting of the corporation’s net undistributed income accumulated after 1982. Code § 1368(c). If a distribution exceeds the accumulated adjustments account, the excess amount is treated as a dividend to the extent of the corporation’s accumulated earnings and profits. Code § 1368(c)(2). In other words, a distribution by an S corporation with respect to its stock is not a “dividend” for tax purposes unless the amount of the distribution exceeds the corporation’s accumulated adjustments account and the corporation has accumulated earnings and profits. 128 PLR 199938052 (July 2, 1999). 129 For a more detailed discussion of this issue and an argument that, contrary to the IRS position, all distributions on S corporation shares held by an ESOP may be used to pay off an ESOP loan, see David Ackerman, “Technical Issues Under the New S Corporation ESOP Laws,” Journal of Employee Ownership Law and Finance, Winter 1999, pp. 3–20. 130 Code § 72(t).
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Section 404(k) of the Code.131 Section 404(k) provides, as a general rule, that in the case of a C corporation, there will be allowed as a deduction the amount of any dividend paid on shares held by an ESOP. The deduction is allowed if the dividend (1) is paid in cash to the participants in the plan, (2) is used to make payments on an ESOP loan, or (3) is reinvested in employer securities.132 Distributions by S corporations technically do not constitute “dividends” within the meaning of the Code.133 Therefore, the question arises whether the pass-through of S corporation earnings to ESOP plan participants should be treated in the same manner as dividends declared by a C corporation that are passed through to ESOP participants. Alternatively, should the excise tax on premature distributions apply? A related issue is whether the consent of the ESOP participants must be obtained before distributions from an S corporation to an ESOP may be passed through to the participants. No accrued benefit under an employee benefit plan with a present value in excess of $5000 may be immediately distributed to a participant in the plan without his or her consent.134 This provision does not apply to a distribution of dividends to which Section 404(k) applies.135 Because the exception applies only to “dividends,” it would be argued that the general rule requiring employee consent to distributions applies to all distributions from an S corporation ESOP. This would include distributions of the S corporation’s earnings. It is not clear whether Congress intended that different rules apply with regard to distributions of C corporation earnings and S corporation earnings. Another issue relating to S corporation earnings distributions to ESOP participants is whether these distributions are eligible for a tax-free rollover into an IRA or another tax-qualified plan. The regulations exclude from the definition of an “eligible rollover distribution” dividends paid on employer securities as described in Section 404(k).136 The IRS has taken the position that distributions by an S corporation on stock that is not pledged as collateral to secure an ESOP loan cannot be used to pay off that loan. This is because those distributions are not “dividends” within the meaning of IRC Section 404(k). Therefore, it would seem to follow that S corporation distributions should not be treated as dividends that are not eligible for a tax-free rollover.137
Special Issues for S Corporation ESOPs Lack of Marketability Discount For most ESOP companies, a discount for lack of marketability discount is applied to the value of the stock held by the ESOP. This discount recognizes that, although the ESOP participants have put rights on their shares, these rights are subject to the 131 Code
§ 72(t)(2)(A)(vi). § 404(k)(2). 133 See note 38 and accompanying text. 134 Code § 411(a)(11). 135 Code § 404(k)(1). 136 Treas. Regs. § 1.402(c)-2, Q&A 4(d). 137 The authors are aware that representatives of the national office of the Internal Revenue Service have informally expressed the view that distributions of S corporation earnings are not “dividends” within the meaning of Code § 316 and that, therefore: (1) S corporation distributions are subject to the 10 percent excise tax on premature distributions if they are passed through to participants in an ESOP, (2) the consent of an ESOP participant must be obtained before a distribution from an S corporation to an ESOP may be passed through to him or her, and (3) S corporation distributions are eligible for a tax-free rollover into an IRA. 132 Code
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ability of the company to meet this obligation. Many analysts apply a small discount (in the range of 1–10 percent), depending on the specific facts and circumstances of the company. Some of the factors that affect this discount are: (1) the average age of the participants, (2) the percentage of the company owned by the ESOP, (3) the financial condition of the company, and (4) any funds set aside by the company to meet this obligation. With an S corporation ESOP, the analyst may want to consider the economic advantage of the ESOP in determining the appropriate lack of marketability discount. Distributions from the S corporation into the ESOP trust can be earmarked for future repurchase obligation. Or, in the case of the 100 percent S corporation ESOP, cash that would otherwise have been distributed to pay taxes can be held by the company for future repurchase obligation. These facts can be considered with all of the other relevant facts in determining the appropriate discount for lack of marketability.
Repurchases from Plan Participants When the ESOP is a buyer of S corporation shares, it can pay no more than fair market value. As discussed in this chapter, in estimating the fair market value of the S corporation shares, no incremental value should be recognized for the S corporation structure or tax-advantaged status of the ESOP trust. However, analysts do recognize that the investment value of the S corporation stock, once held by the ESOP, may be greater than the concluded fair market value. In the case of a sale by the ESOP of its S corporation stock to an outside party, this may be a significant consideration for the ESOP trustee. It is also important to consider the concepts of investment value and fair market value in light of the annual repurchases from terminated participants. Terminated participants have a put option on their ESOP stock that creates liquidity for their account balance. Either the ESOP or the company may repurchase the shares from the terminated participant. Would it be appropriate for the participant to demand investment value for his/her shares? The answer to this question is no. The ESOP trust is limited by ERISA to buying shares for no more than fair market value. As a result, if the participant demanded a higher price (based on an assumption of investment value due to tax-advantaged structure of the ESOP), the ESOP trust would refuse to purchase the shares. In that case, the company would fulfill the obligation. The company would not pay any price higher than fair market value (i.e., the company would ignore investment value). This is because no other S corporation shareholder benefits from the same tax-exempt status as the ESOP. Therefore, in this case, the ESOP participant has no buyer that would, from an investment perspective, recognize any value other than fair market value. As a result, it is appropriate for the ESOP shares to be repurchased from participants at fair market value.
ESOP Income Tax Shield In a typical C corporation leveraged ESOP, the company enjoys an additional tax deduction (subject to certain limits) on the principal payments associated with the ESOP debt. This is because these payments are made through contributions to the ESOP. This additional tax deduction creates a “tax shield.” Many analysts recognize this tax shield in the post-transaction fair market value of the C corporation stock.
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In an S corporation leveraged ESOP, the same tax deductions apply. However, the S corporation is not a taxable entity. Should the analyst include the same ESOP “tax shield” in the post-transaction estimate of value? In general, if the analyst is applying the conventional method of valuing the S corporation (i.e., as if it was a C corporation), then including the “tax shield” in the value estimate would be both consistent and appropriate. To counter this position, some analysts suggest that there is no benefit at the corporate level. Therefore, the tax shield should not be included. The contributions do reduce the corporation’s income that is passed through to the shareholders and is taxable to the shareholders. In a 100 percent ESOP S corporation, this should still be considered. This is because it (1) is available to all S corporation shareholders and (2) is not affected by the taxexempt status of the ESOP as the sole shareholder. Analysts should evaluate the facts and circumstances of each case to determine whether or not to include the “tax shield.”
Sale of an S Corporation ESOP In the event that the S corporation considers a sale of the company, the ESOP trustee should evaluate the consideration of the proposed transaction. The evaluation of a potential transaction includes consideration of fair market value, fairness (particularly with respect to the proceeds received by non-ESOP shareholders compared to the ESOP Trust), and prudence, among other things. In the case of an S corporation ESOP, the ESOP receives enhanced economic benefits as a result of its tax-exempt status. In the situation where the ESOP owns less than 100 percent of the company, these economic benefits appear in the form of distributions into the trust. These distributions may be used to repay ESOP debt, or, in some cases, to repurchase shares. However, once the ESOP debt is repaid, the ESOP shares benefit from additional investment value (in the form of distributions). This value is not captured in the fair market value of the stock. In the case of a sale of the company, if the ESOP owns a noncontrolling interest, then the issues of (1) the enhanced economic value resulting from the S corporation structure and (2) the tax-exempt status of the ESOP are less significant. This is because the ESOP cannot block the sale or control the company. However, if the ESOP owns a controlling interest, then the question of the significant investment value (potentially greater than the appraised fair market value and the market tender offer for the company) becomes one of financial fairness—and a significant valuation and fiduciary issue. In this situation, the analyst is being asked to determine the fair market value of the company. That standard of value will not incorporate the enhanced investment value, as discussed above. In addition, the analyst may be asked to provide an opinion that the transaction is fair, to the ESOP, from a financial point of view. To form this opinion, the valuation analyst should take into consideration all financial facts at the time of the transaction. There are various reasons why a company would enter into a sale transaction. There may be market, industry, or economic conditions that indicate a sale is the best strategy. In many cases, a synergistic buyer will approach the company. That buyer will provide an offer that incorporates synergies from a business combination that cannot be replicated independently. In these cases, the sale price will, in all likelihood, represent the maximum obtainable value for the stock.
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However, absent these conditions, and in the case of an S corporation ESOP with significant economic benefits to its S corporation ESOP structure, it may be that the maximum financial return for the ESOP shareholders is to continue to hold the stock of the company. The analyst should weigh these considerations carefully, in light of the risks associated with continued ownership. In addition, there are risks to the value of the income tax advantages the ESOP has. For example, the tax laws could change and the ESOP could lose those benefits at any time. For all of these reasons, the sale of an S corporation ESOP company, particularly when the ESOP owns a controlling or 100 percent interest, is a very complex transaction.
S Corporation ESOPs and Step Transactions The implementation of an ESOP is often accomplished in a number of different stages. Typically, the ESOP may purchase an initial block of stock (say, 30 or 40 percent) in a leveraged transaction. Later, as the original ESOP debt is repaid, the ESOP may purchase another significant block of stock to achieve a controlling ownership position. Finally, the ESOP may later purchase the remaining block of stock in order to achieve 100 percent employee ownership. For a C corporation about to elect S corporation status, or for an S corporation, there are significant cash flow benefits to the company when the ESOP achieves 100 percent S corporation ownership. For a company in an industry with significant growth opportunities, the enhanced cash flow in a 100 percent S ESOP company can be deployed in new investments or in acquisition opportunities. One complex issue is whether it would be appropriate for the ESOP to pay a price greater than fair market value in order to capture the economic advantages of the 100 percent ESOP S corporation structure. In the case of the C corporation, the board of directors may determine that the S election and achievement of 100 percent ESOP ownership confers such significant opportunities that the company should tender an offer for the remaining block of shares. This offer could include a price premium to entice shareholders to enter into the transaction. In this case, the ESOP trust could not be a buyer for the shares. This is because that price premium would make the price of the tendered shares greater than fair market value. To structure this transaction, the Company would offer to redeem the shares and retire them into treasury. In this case, the board of directors has a fiduciary duty to all shareholders (including the ESOP) to determine that the price premium paid to redeem the shares (if any) is not in excess of financial benefits to be earned from the S election. Alternatively, the board of directors can advise the shareholders to consider the Section 1042 capital gains deferral if the ESOP purchases the shares at fair market value. In this case, it may preferable for the remaining shareholders (1) to sell to the ESOP at fair market value and elect the 1042 gain deferral rather than (2) to negotiate for a price premium on the shares. In addition, the board of directors would have to consider potential future impact on shareholder value/returns if the S corporation ESOP legislation were to be revoked. The assessment of this legislation risk may offset any potential price premium that could be justified in other ways. The ESOP trustee to a noncontrolling ownership position of a C corporation considering the S corporation election should consider the board of directors’ actions and negotiations. And, the ESOP trustee should consider the impact of any offered price premium on the value of ESOP-owned shares. Of course, as a noncontrolling
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shareholder, the ESOP could not block such a transaction. If the ESOP had a controlling ownership position, the ESOP trustee would consider the financial fairness of such a transaction. And, the trustee would evaluate the potential investment value returns available under the new tax structure. In the case of a current S corporation, the shareholders are not eligible for 1042 capital gains deferral. Therefore, the potential negotiation over a price premium is different. However, the shareholders may have a higher basis in their shares due to undistributed earnings, which would reduce the burden of the capital gains tax. In this case, the board of directors has to evaluate the potential size of any price premium against the economic benefits of being 100 percent ESOP owned. As a shareholder in the S corporation, the ESOP already has a higher investment value for its shares, assuming that the company is profitable. This high investment value is due to the distributions of cash flow to all shareholders in order to pay income taxes. In order to justify any price premium, the potential growth opportunities for the company would have to be greater than the investment value returns already being received by the ESOP. If the ESOP already controls the S corporation, the ESOP trustee may determine that, from a financial fairness perspective, no price premium can be paid. This is because there would be no additional enhancements to the company’s fair market value or to its investment value. In summary, the board of directors of any company (C corporation or S corporation) should carefully evaluate the potential economic benefits of achieving 100 percent ESOP ownership of an S corporation. These benefits should be considered in comparison to any requested price premium on the last block of stock to be purchased in the transaction. The ESOP trustee would have an obligation to evaluate the board’s actions and negotiations. And, in some circumstances, the ESOP trustee may either approve or prohibit any such price premium (as measured in comparison to fair market value).
S Corporation ESOPs in Distress Situations Is the S corporation ESOP different in any way from a comparable C corporation ESOP when the company enters into a period of financial distress? This question is worth examining. When a company becomes financially distressed, it may be because of many different reasons, including economic conditions, a significant debt burden, the loss of a major or significant customer, product obsolescence, poorly timed or executed capacity expansion or acquisitions, or uncontrolled growth. Under these circumstances, the company may (1) divest certain divisions or assets, (2) make significant reductions in headcount, (3) renegotiate its debt financing and/or secure additional capital, or (4) explore selling the company in its entirety. In each of these circumstances, the S corporation ESOP may have either advantages or disadvantages as compared to a similar C corporation. The S corporation ESOP may be at a disadvantage to a comparable C corporation that is in financial distress for two reasons. First, S corporation shareholders cannot utilize net operating loss (NOL) carryforwards for tax purposes as C corporation shareholders can. In a severely distressed company, one of the valuable assets to a potential acquirer of a C corporation may be the level of accrued NOL carryforwards. These NOL carryforwards can be used by the acquirer to shield future taxable income from combined operations. No such value would exist for
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the acquirer of a distressed S corporation. In addition, due to the restrictions for maintaining the S election (specifically with respect to the allowable shareholders), it may be more difficult for the distressed S corporation to obtain new capital. Typically, new investors in a distressed company would require a significant equity position. And, most typical investors would be financial buyout firms or other companies. Such companies are not eligible S corporation shareholders. This may ultimately prevent or limit the S corporation’s ability (1) to secure additional capital and (2) to emerge from the financial distress situation. If the company decides it needs to sell corporate divisions or assets to improve its cash flow or repay debt obligations, the S corporation ESOP may have some significant advantages. When the company sells assets, it reports the gain as taxable income to the corporation. In the case of a 100 percent ESOP S corporation, the company has essentially no tax liability. As a result, all of the proceeds from the sale can be reinvested in the company to either reduce debt or restructure the remaining operations. The comparable C corporation would have to pay taxes on the taxable income generated from the sale of assets. This is true unless the C corporation could offset these asset sale gains by NOL carryforwards or other losses. As a result, the 100 percent S corporation ESOP may be able to emerge from financial distress at a faster rate than a comparable C corporation. If the S corporation is only partially owned by an ESOP, there still may be significant advantages when the company divests assets or divisions. When the S corporation reports the taxable income from the sale, all of the shareholders (including the ESOP) would receive a pro rata portion of the distributions made to shareholders to meet the tax obligation. As mentioned previously, the distributions into the ESOP can be used by the ESOP trust to (1) repay its debt obligation, (2) repurchase shares, or (3) purchase new shares. By using the ESOP distributions for these purposes, the company’s cash flow can be used entirely for restructuring the remaining operations of the company. Because of the enhanced cash flow due to the S corporation ESOP structure, the S corporation ESOP company may be able to emerge from financial distress at a faster rate than the comparable C corporation. In a financial distress situation, the company may have to renegotiate the terms of its debt or secure additional subordinated debt. In these cases, the S corporation ESOP may have advantages and disadvantages compared to an otherwise similar C corporation. When a company becomes financially distressed, it may approach its existing lenders to renegotiate both the interest rate and the repayment terms of the company debt. While the company, in all likelihood, will look for an extension of the terms of the debt, the banks will evaluate the current condition of the company and the ultimate likelihood of repayment. When the company can present a strong case for restructuring and/or a strengthened strategic position, the lenders may agree to an extension of the debt terms. In this case, an S corporation ESOP company that can demonstrate a return to profitability due to strategic reasons may also be able to use the S corporation–enhanced cash flow to repay debt faster than a comparable C corporation could. Alternatively, the financially distressed S corporation ESOP may find it more difficult than a comparable C corporation ESOP to secure additional subordinated capital from new outside investors. The reasons for this may include (1) the additional complexity of an S corporation ESOP that may deter new subordinated investors and (2) the fact that the requirements for maintaining the S election may be too restrictive. As a result, the S corporation ESOP may require a longer time
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period to secure the additional capital, at additional expense, during a period of financial distress. Finally, in the case of a sale of the entire financially distressed company, the S corporation may be at neither an advantage nor a disadvantage. For either the S corporation or the C corporation, the stock held inside the ESOP is held inside a qualified retirement plan. As a result, the ultimate benefit to the participants is in the form of income distributed upon certain events (principally retirement), and taxed as ordinary income. For the shareholders outside of the ESOP, if any, the sale of the stock would result in a capital gain or loss taxed at the capital gains rate. The S corporation non-ESOP shareholders may have a higher basis in their stock (due to undistributed earnings). However, this may be true for the S corporation non-ESOP shareholders regardless of whether or not the company was financially distressed at the time of the sale. In the event that the sale of the entire business is conducted through a sale of its assets, the non-ESOP C corporation shareholders would be at a disadvantage to the non-ESOP S corporation shareholders. This is due to the double taxation of the sale of assets and the distribution of the net sale proceeds.
S Corporation ESOPs and Acquisitions The use of an ESOP in an S corporation also generates significant issues when that S corporation acquires another company. These issues increase in complexity (1) whether the target company is a C corporation or another S corporation, (2) whether the S corporation acquirer is wholly or partially owned by the ESOP, or (3) whether the target has an existing ESOP. These complex issues are worth examining. When an S corporation with an ESOP acquires a C corporation, there are unique issues that have to be considered. First, the target C corporation shareholders may elect Section 1042 capital gains deferral by selling to an ESOP. Second, the target C corporation would become an S corporation as part of the transaction. As a result, the target C corporation would be subject to the same restrictions as any other C corporation converting to an S corporation. Finally, it is important to clarify the appropriate fair market value for the target C corporation. The selling shareholders in the target C corporation would benefit from the Section 1042 capital gains deferral if they can sell to an ESOP. In this case, such a structure can be accomplished through a series of transactions. First, the C corporation could establish an ESOP. The ESOP could purchase the stock of the target company. Second, the C corporation (now wholly owned by the ESOP) could elect S corporation status. Finally, the two ESOP plans could be merged into one plan holding the stock of two subsidiaries. Ultimately, the two subsidiaries can be merged into one S corporation. With this structure, the selling shareholders of the C corporation target can elect Section 1042 capital gains deferral. This structure becomes difficult to accomplish if the S corporation acquirer is only partially owned by the ESOP. In addition, the financing of the transaction may have to be structured in steps to provide for the entire buyout of the C corporation target by the C corporation ESOP. This transaction is easier to accomplish if the C corporation target is already partially owned by an ESOP. When an ESOP-owned S corporation acquires another company, the question of what price the acquiring company can or should pay becomes critical. In this case, the financial advisor should consider only the fair market value of the C corporation. This is true regardless of the future S election or the merger with the
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S corporation acquirer. A knowledgeable C corporation shareholder could attempt to negotiate for the cash flow benefit of becoming part of the S corporation ESOP company. However, this benefit is not relevant in the context of the fair market value test, which governs the ESOP as the acquirer in the transaction. There may be synergistic benefits from the combined operations of the two companies. And, in that case, the value of the synergies can be negotiated between the two parties. However, these synergies should not reflect or include the income tax benefit of the S corporation ESOP structure. Rather, only operational or strategic synergies should be included. When an ESOP-owned S corporation acquires another S corporation, the determination of fair market value is also critical. The target S corporation shareholders are not eligible for Section 1042 capital gains deferral. Therefore, the acquisition can be accomplished with a more straightforward structure of either a cash purchase of stock or assets or a stock-for-stock exchange. However, the target S corporation shareholders may negotiate for an enhanced purchase price due to the S election or the ESOP S corporation benefits. As indicated above, these benefits are not relevant in the context of the fair market value test. Again, the acquiring company can negotiate regarding any operational or strategic synergies that will be created by the combined entities, as long as the unique ESOP income tax benefits are not included. One significant advantage the S corporation ESOP company has in acquisitions is the fact that the S corporation structure (particularly if the S corporation is wholly owned by the ESOP) creates enhanced cash flow, which may result in additional transaction financing capacity. Sophisticated lenders may recognize the enhanced cash flow in the 100 percent ESOP S corporation. This may result in a stronger financing capacity to accomplish an acquisition. Therefore, although the S corporation ESOP acquirer may pay no more than fair market value for a target company, the ability of the S corporation ESOP to finance the acquisition may be stronger than other potential acquirers. As a result, the target company shareholders may prefer to sell to the S corporation ESOP company. This is because they can get a greater portion of the purchase price in cash. Or, this may be because the transaction can be accomplished faster—and with fewer parties involved—than with other acquirers.
Managing Repurchase Obligation in an S Corporation ESOP There are several mechanisms available to manage an ESOP company’s repurchase liability obligation. These mechanisms include the following: • • • • • • •
Funding repurchases from annual cash flow as needed Prefunding the repurchase obligation with the use of a sinking fund Issuing debt as needed to handle repurchases Using corporate owned life insurance (COLI) Creating an internal market for the stock Securing additional investors for the company A combination of the above
The S corporation ESOP has the unique ability to prefund the repurchase obligation liability in a number of different ways. As a result, the S corporation ESOP will likely be more prepared to handle the repurchase obligation as the ESOP matures.
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The use of a sinking fund is a mechanism by which the S corporation ESOP can prefund the repurchase obligation. A sinking fund refers to the systematic accumulation of assets designed to meet a future liability. The primary advantage of prefunding the ESOP repurchase liability is that it allows the company to smooth the unpredictable cash flow requirements associated with share repurchases. In addition, prefunding the repurchase obligation also provides a mechanism for the company to control the retirement benefit expense that it provides to the employees. In this way, the company can evaluate those benefits in the context of competitive market level benefits. Another significant advantage to prefunding the ESOP repurchase obligation is that the company can communicate its methodology to the ESOP participants. This communication enhances the understanding of (1) the benefits of the ESOP and (2) the availability of cash to meet retirees’ repurchases. This may provide the employees with a greater sense of security and greater appreciation of the ultimate benefit of the ESOP. Within the S corporation ESOP, the company has several options to prefund the repurchase liability. The company can use contributions to the ESOP to establish a cash reserve inside the ESOP to handle repurchases. The earnings on the cash funds inside the ESOP are tax-deferred. This is because the ESOP is a qualified retirement plan. As with any contribution to a qualified plan, these contributions would be allocated to employees based on eligible payroll. Therefore, all eligible participants would receive a portion of the cash contribution in their account. Furthermore, the contributions to the ESOP are tax deductible to the company. This is still important in an S corporation that is only partially owned by an ESOP. However, these contributions are subject to the payroll limits under IRC Section 415. And, these contributions have to be included in the payroll limitation test along with any contributions that are made to provide the ESOP with cash to repay the ESOP loan. As a result, prefunding the ESOP repurchase obligation with contributions is typically used only in mature ESOP companies. The S corporation ESOP company can make distributions into the ESOP to establish a sinking fund to handle repurchases of shares from terminated participants. If the S corporation is partially owned by the ESOP, the ESOP will be receiving distributions annually based on its pro rata ownership as the non-ESOP shareholders receive distributions to meet their tax obligations. Since the ESOP trust is a taxexempt entity, the ESOP cash distributions remain inside the trust. The disadvantage of using distributions to prefund the ESOP repurchase liability is that the distributions are not tax deductible to the company, as are contributions to the ESOP. This is particularly disadvantageous if the S corporation is only partially owned by the ESOP. However, because the ESOP is a qualified retirement plan, the distributions are not subject to payroll limits under Section 415, and the earnings on the cash distributions held inside the ESOP trust are tax-deferred. Distributions into the ESOP are typically allocated based on share account balances, rather than based on payroll. As a result, when distributions are made to the ESOP trust, it is typical that the larger account balances receive a larger portion of the distributions. Furthermore, since the distributions are based on share account balances, the benefit may not reach all participants. Over time, this method may magnify a discrepancy in the benefit of the ESOP between participants by favoring those participants that were employees when the ESOP was first established. If these funds are used to repurchase shares, the larger account balances will become even more heavily invested in company stock over time. This may actually magnify the repurchase
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obligation or create very uneven annual needs, depending on the ages of the participants with large account balances. While there are some mechanisms available to alleviate these issues, overall careful planning and professional advice is required. If the S corporation is wholly owned by the ESOP, the company has several choices with respect to prefunding the repurchase obligation. The company may make contributions to the ESOP as before. The S corporation may continue to make distributions to the shareholders—in this case, the ESOP—of an amount similar to the tax obligation of the company. Again, since the ESOP is a tax-exempt entity, the ESOP cash distribution is held inside the ESOP trust for future repurchases. In any case, it is important for the ESOP trustee or the company to establish a cash management and investment policy if a sinking fund is to be established for future repurchase liability. In a more likely scenario, an S corporation that is 100 percent owned by an ESOP would not make any distributions at all. This is because its only shareholder (the ESOP) is a tax-exempt entity. However, the additional annual cash savings the company receives could be set aside in a fund held by the company for future repurchases. This method has several advantages and disadvantages. One of the advantages of this method is that the amount set aside each year is unlimited by payroll contribution levels. This is because there is no contribution to a qualified plan. In addition, the assets would appear on the company’s balance sheet and, thus, would increase the company’s liquidity. And, the company controls the investment choice for the use of the cash. Since the funds are a company asset, the company can pledge the funds as collateral, if necessary, thereby leveraging its balance sheet for additional investments. Finally, the company has control over the decision to redeem or to recirculate the repurchased shares, providing additional control and flexibility over the retirement benefits offered to employees. One disadvantage of this method is that, since the funds are a company asset and not a trust asset, they are not protected from creditors in the event of financial distress. In addition, the earnings on the investment are taxable income to the company. However, this disadvantage is largely eliminated if the company is 100 percent owned by the ESOP.
Conclusion The ability of an S corporation to sponsor an ESOP has created significant opportunities for thousands of employees to experience equity ownership in their employer corporation. There are some significant advantages of the S corporation ESOP structure relating to the structure of the S corporation and the tax-exempt status of the ESOP trust. However, these advantages also create complex legal, valuation, and financial fairness issues. S corporation shareholders that desire to expand the opportunity for ownership through an ESOP should be aware of—and be properly advised on—these complex issues in order to ensure the success of the ESOP. It is apparent that ESOP companies can benefit greatly from the S election. And, S corporations can benefit greatly from the adoption of an ESOP in which the ESOP owns all or nearly all of the corporation’s stock. Not all of the tax incentives available for C corporations that sponsor ESOPs are available for S corporations. However, in most cases, this should not be a substantial deterrent to either an S election for an ESOP-owned C corporation or the adoption of an ESOP by an S corporation.
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New antiabuse rules will deter the use of ESOPs by S corporations with a very small number of employees. These rules will also deter the creation of capital structures in S corporation ESOPs that result in substantial dilution to the ESOP. However, the new rules should not significantly limit the vast majority of legitimate uses of S corporation ESOPs. As with all complex tax planning, the question of whether ESOP companies should make the S election, or whether S corporations should adopt ESOPs, should be analyzed on a case-by-case basis. The answer will depend upon the facts and circumstances affecting each particular company and its owners.
Part II
Business Valuation Special Applications
Chapter 7 The Valuation of Family Limited Partnerships Alex W. Howard and William H. Frazier
Introduction The Partnership Structure Rationale Behind FLPs Internal Revenue Code Chapter 14 Adequate Disclosure The IRS and Valuation Discounts Valuation Parameters FLPs That Own Primarily Marketable Securities FLPs That Own Primarily Real Estate Lack of Marketability Summary Understanding and Interpreting the Partnership Agreement Business Purpose Contributions Management Prerogatives Distributions to the Partners Control and Lack of Control Transferability of Family Limited Partnership Interests Section 754 Dissolution/Liquidation Recent Tax Court Cases Strangi v. Commissioner McCord v. Commissioner Other Relevant Cases Estate of Thompson v. Commissioner Estate of Morton B. Harper v. Commissioner Estate of Kimbell v. United States Church v. United States Knight v. Commissioner Kerr v. Commissioner
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Introduction The family limited partnership (FLP) structure is a commonly used estate planning and intergenerational wealth transfer device. FLP formations are particularly attractive to family-owned business owners and to other high net worth individuals. Unlike the traditional operating business where value is typically driven by profitability, growth, and cash flow, an FLP ordinarily is structured as an asset management vehicle. Accordingly, the value of the FLP is principally based on the value of the underlying constituent assets. Fractional ownership interests are the typical subjects of FLP valuations. It is noteworthy that these fractional interests have no direct claim on the partnership’s assets. Rather, FLP ownership interests are securities representing indirect ownership. The valuation of a fractional FLP interest, then, is premised on a fair and thorough estimation of the underlying asset values on one hand and the legal rights and investment characteristics of the subject partnership interest on the other hand. In many cases, the valuation analyst will find that the lack of control and the lack of marketability of the subject partnership interests involve the application of significant valuation adjustments (in the form of discounts). This chapter will describe the reasons why this is so, the manner in which such valuation discounts should be applied, and the appropriate evidence for the quantification of these valuation discounts. Since 1990, the taxation of intrafamily transfers of equity interests in familyowned entities has been governed by Chapter 14 of the Internal Revenue Code (IRC). One objective of Chapter 14 was to deter abusive estate planning wherein the transferring party retained both the ownership and the enjoyment of the transferred assets. Another objective of Chapter 14 was to provide a uniform set of rules by which legitimate family transfers could be accomplished without fear of adverse tax consequences. There have been, and there continue to be, pitched legal battles between the Internal Revenue Service (IRS) and taxpayers over the interpretation and application of Chapter 14. Generally, the IRS has been unsuccessful in its attempts to thwart the use of FLPs. After more than a decade, the continuing popularity of the FLP as an estate planning device bears testimony to the fact that Chapter 14 has successfully lived up to its intended objectives.
The Partnership Structure The FLP is simply a limited partnership formed with a specific business purpose that suits the long-term goals and objectives of the family forming it. By definition, a limited partnership consists of (1) one or more general partners and (2) one or more limited partners. In any partnership, there are always two or more separate partners. The general partner is responsible for the management of the affairs of the partnership. And, the general partner has unlimited personal liability for all debts and obligations. In the typical FLP structure, the older—or “benefactor”—generation will retain control over the operations of the partnership. This control is accomplished through ownership of the general partnership interest. Often, this ownership interest is not held individually. Rather, it is held through another entity such as a limited liability company. Control of the general partner interest is often a critical factor in the value of an FLP fractional interest.
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Limited partners have no personal liability for the obligations of the partnership. Offsetting this attribute, however, is the prohibition of limited partners to have an active voice in the management of partnership affairs. This prohibition generally includes no participation in either the day-to-day management of partnership assets or the decisions regarding annual distributions. Limited partners typically do have voting rights in the event of significant partnership events such as replacing a general partner, admitting new or substituted limited partners, or liquidating the partnership. Generally, approval of such matters requires a large majority or unanimous approval of the limited partners and, almost always, the consent of the general partner. The partnership agreement, which defines all aspects of the FLP’s governance, is critical to the valuation of the underlying partnership interests. In many FLP situations, the benefactor generation will initially own most of the limited partnership interest. This is because, at the inception of the FLP, it is the assets owned by the benefactor generation that are contributed to form the FLP. Contributions by the younger generations are typically a very small percentage of partnership assets. The younger generation usually receives its interest in the FLP through gifts or sale. Usually, it is this process that gives rise to the need to value the FLP limited partnership interests.
Rationale Behind FLPs There are myriad reasons that explain the attractiveness of the partnership format, particularly with respect to the needs and requirements of family units. Through the creation of an FLP, senior family members have the ability to transfer economic benefits in family-owned assets without losing managerial control over the transferred assets. However, it is critical to recognize that all assets must be managed for the benefit of all partners. The benefactor generation, for example, may not contribute assets to the FLP and continue to use such assets for its own personal benefit. In addition, the possible problems related to direct gifts of securities (i.e., stocks and bonds)—namely, profligacy on the part of children—can be avoided by gifts of limited partnership interests. This is because the senior family members control the distribution of the cash flow generated by the partnership, if any. The ability of the offspring to sell the limited partnership interest gifted to them is also extremely limited, due to the transferability restrictions on the FLP limited partnership interests. A high degree of protection against creditors can be achieved through a partnership structure. Typically, a partner’s creditor is legally unable to gain access to the assets of a partnership. The creditor is also unable to cause distributions to be made to the debtor partner. This would not be the case if the assets in the FLP were owned directly by the debtor (instead of being held within the partnership). Clearly, the partnership form satisfies the objective of keeping the assets in the family. Typically, partnership agreements afford either the partnership or other partners (or both) the opportunity to acquire the ownership interest of a partner wishing to assign his or her interest to a third party. The partnership agreement typically allows the partnership/partners to purchase the ownership interest (1) at the same price and (2) on the same terms as agreed upon with the third party as is typical in a right of first refusal. Typical provisions of partnership agreements also can ensure
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that partnership interests do not stray from family control in instances of divorce, bankruptcy, death, or other such circumstances. Another important advantage relates to the avoidance of problems pertaining to undivided or fractionalized interests in family assets that are not easily subdivided. An example of such an asset would be income-producing real estate. Rather than subdividing the property or gifting undivided interests, the FLP allows the property to be contributed intact to the partnership followed by gifts of limited partnership interests to the younger generation(s). When family-owned assets (e.g., real estate, securities, other partnership interests, interests in family businesses, etc.) are placed in a partnership, the advantages of economies of scale and diversification may also be achieved. The partnership form is extremely flexible. The partnership agreement can provide broad investment and business powers. By agreement of all partners, or as required by the partnership agreement, the agreement can be amended to facilitate the changed objectives and purposes of the partners. In addition, the partners may terminate the partnership, depending on the provisions of the partnership agreement. Because partnerships are pass-through entities, they do not pay entity-level taxes. C corporations on the other hand pay both income and capital gains taxes. Thus, when shareholders of a C corporation receive dividends, this income has already been taxed once at the corporate level. Such dividends are, in turn, taxable to the shareholder—the infamous “double taxation.” One negative to the ownership interest in a pass-through entity is that partnership income gives rise to individual partner tax liability. The partners must pay personal income tax on their share of the partnership income regardless of whether any cash distributions have been made to the partners. While uncommon, there may be significantly adverse consequences to a partner when the taxable income attributable to a partnership interest exceeds the amount of cash distributions paid to that interest. In addition, as previously described, the gifting or transfer of an ownership interest in a limited partnership may be made at a lower value than that interest’s pro rata share of net asset value (NAV). The reason is that the limited partnership interest is noncontrolling and nonmarketable in most cases. Finally, the partnership agreement is likely to require a unanimous vote by all partners to dissolve the partnership and a large majority ownership percentage vote to replace the general partner. As a consequence, the ownership of even a significant percentage of the limited partnership interests in an FLP may be worth no more than the equivalent of a noncontrolling ownership interest in the stock of a corporation. Furthermore, in the context of a sale (actual or hypothetical), a limited partnership interest has only the status of an assignee, regardless of the percentage ownership of the partnership.
Internal Revenue Code Chapter 14 As mentioned earlier, Chapter 14 was enacted in the fall of 1990 as a replacement for the repealed Section 2036(c). The objective of the new statute, however, was the same: to eliminate perceived abuses in the valuation of common or preferred stocks and partnership interests in privately owned entities. Obviously, the valuation
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analyst does not act as an attorney. Therefore, the valuation analyst should not determine the applicability of the provisions of Chapter 14 (or any other statute for that matter). The valuation analyst should rely on guidance from the client’s attorney for direction pertaining to these legal issues. However, the analyst should be familiar with the “whys” and “wherefores” of the legal framework of the valuation, including the pertinent partnership statutes of the state in which the subject FLP is domiciled. The two critical parts of Chapter 14 that relate to valuation considerations are Sections 2703 and 2704. Section 2703 states that the value of the partnership interest will be determined without regard to: 1. Any option agreement, or other right to acquire or use the interest, at a price less than fair market value. 2. Any restriction on the right to sell or to use the interest. However, Section 2703 will not apply to any option, agreement, right, or restriction that meets each of the following requirements: 1. It is a bona fide business arrangement. 2. It is not a device to transfer property to members of the decedent’s family for less than full and adequate consideration. 3. At the time of the inception of the restriction or agreement, its terms are comparable to similar arrangements entered into by persons in an arm’s-length transaction. The thrust of Section 2704 is on lapsing rights, liquidation, and withdrawal rights. This Section states that any provision in the agreement that restricts a partner’s ability to liquidate or withdraw his or her interest is not to be considered when valuing the interest. If the restrictions found in the partnership agreement are no more restrictive than allowed under applicable state statutes, then the restrictions would not be disregarded for valuation purposes. Regardless, the FLP’s attorney may instruct the analyst to disregard Chapter 14 for various legal reasons. The end of this chapter contains a summary of some relevant cases related to FLPs and to Sections 2703 and 2704. Suffice it to say, however, that the various sections of Chapter 14 are complex and require expert legal interpretation based upon the facts and circumstances of each subject interest. Ideally, a skillfully drafted partnership agreement and a well executed estate plan will obviate the need for any consideration of the provisions of Chapter 14. Indeed, the object of such planning is to insure that these provisions do not apply. This is because, if they do, serious valuations consequences can result. For example, forming an FLP with characteristics that are subject to Section 2703 or 2704 can cause various restrictions in the partnership to be ignored for valuation purposes. The analyst should take the time and effort to become acquainted with Chapter 14. While the decision as to whether a provision applies is within the purview of an attorney, the valuation impact if such provisions do apply is the analyst’s responsibility. The analyst may want to include a disclaimer in the valuation opinion letter, stating that (1) the analyst has not considered the provisions of Chapter 14 and (2) such a determination should be made by legal counsel. Valuation analysts should not make legal determinations.
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Adequate Disclosure The Tax Reform Act of 1997 and the Internal Revenue Service Restructuring and Reform Act of 1998 added adequate disclosure requirements. For these requirements, the IRS issued proposed regulations regarding the valuation of prior gifts for estate and gift tax purposes. These proposed regulations became final regulations in 2003 (Reg. 301.650(c)-1). If valuation factors are adequately disclosed, these new rules preclude the revaluation of (1) any gift if the donor did not actually pay gift tax or (2) any gift made for the purpose of computing the donor’s estate tax after a gift had been made. Since it is generally advantageous for taxpayers to start the clock ticking on the statute of limitations, analysts should be familiar with these requirements in order to avoid revaluations. The thrust of these adequate disclosure regulations is that information should be provided to the IRS in an adequate manner. This disclosure allows the IRS to be apprised of the nature of the gift and the basis for the value reported. This requirement argues for a comprehensive and well documented valuation report. Such a report would allow evaluation by the IRS without recourse to significant additional information or questions. Transfers are considered adequately disclosed if the following information is provided: 1. The transferred property and any consideration received is fully described. 2. The identity of, and relationship between, the transferor and transferee is provided. 3. The property is transferred in trust; the trust tax identification number and a brief description of the terms of the trust or a copy of the trust instrument is included. 4. There should be a detailed description of the method used to determine the fair market value of the transferred property including (a) any financial data used in determining value, (b) restrictions on the transferred property that were considered, and (c) a description of any discounts (such as discounts for blockage, noncontrolling or fractional ownership interests, and lack of marketability) claimed and included in the value of the property. 5. In the case of the transfer of an interest in an entity such as a corporation or partnership that is not actively traded, a description should be provided of any discount claimed in valuing an interest in the entity or any assets owned by that entity. If the value of the entity or interests is properly determined based on net asset value, a statement should be provided regarding (a) the fair market value of 100 percent of the entity, (b) the pro rata portion of the entity subject to the transfer, and (c) the fair market value of the transferred interest as reported on the return. If an asset held by that entity is itself nonactively traded, then adequate disclosure should be provided for each entity, if the information is relevant and material in determining the value of the interest. 6. A statement describing any position taken contrary to any proposed temporary or final treasury regulations or revenue rulings published at the time of the transfer should be included. The following paragraphs describe the requirements for a valuation opinion report related to the appraisal of transferred property.
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The appraisal should be prepared by an individual who (1) performs appraisals on a regular basis, (2) can show through qualifications described in the appraisal report that he or she is qualified to make appraisals of the type of property being valued, and (3) is not a party to the transaction, a family member, or employed by the donor, the donee, or a member of the family of either. The appraisal should contain (1) the date of transfer, valuation date, and purpose of the valuation; (2) a description of the property and a description of the valuation process employed; (3) a description of the assumptions, hypothetical conditions, and any limiting conditions and restrictions on the transferred property that affect the analysis, opinions, and conclusions; (4) the information considered in the value conclusion, including all financial data used in determining value; (5) information that is sufficiently detailed so that another person can replicate the process and arrive at the value conclusion; (6) a detailed description of the valuation procedures and the reasoning to support the procedures; (7) a description of the valuation method used and rationale for the valuation method; and (8) the specific basis for the valuation, such as specific guideline sale or other transactions, sales of similar interests, assetbased approach analysis, merger/acquisition transactions, and so forth. These requirements indicate that a detailed valuation report prepared by a qualified individual is necessary in order to fulfill the “adequate disclosure” requirements. Valuation reports that are not fully documented and do not fully explain the methodology and guideline transactions used will not comply with this requirement. Failure of the valuation report to meet the adequate disclosure requirement will leave the door open for revaluation by the IRS. This would be a disservice to the client. In the past few years, there have been many challenges to the validity and valuation of FLPs. For a long period of time, the challenges have been principally of a legal nature, dealing with (1) the legitimacy of the business purpose, (2) the applicability of restrictions contained in the partnership agreement, and (3) what one could call “death bed planning” issues. For the most part, these IRS challenges have not been successful if the FLP is not abusive in nature. Relevant cases in the limited partnership area are contained at the end of this chapter. It seems clear from these cases that it is extremely important to: 1. Properly document the intentions of the parties to the formation of the partnership agreement 2. See that the assets are properly transferred to the partnership and that the partnership has been funded before any transaction occurs 3. Not have partnership agreement provisions that deviate significantly from state law 4. Ensure that the partnership is run as a business entity and not out of the pocketbook of the senior family member The biggest issue relating to partnerships, at the time of this writing, is in IRC Section 2036(a). Section 2036(a) relates to a retained interest in property transferred. Section 2036(a) states: The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in the case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without
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reference to his death or for any period which does not in fact end before his death— 1. the possession or enjoyment of, or the right to the income from, the property, or 2. the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom. When the donor retains a degree of control and economic benefit (1) the formation of an FLP may be disregarded and (2) the contributed assets of the FLP, rather than the decedent’s partnership interest, may be included in the decedent’s gross estate. Issues that may support the application of Section 2036(a) include (1) disproportionate distributions, (2) commingling of funds, (3) delay in transferring assets to the FLP, (4) failure to follow partnership rules, and (5) subsequent use of the transferred property that indicates that the partner retained economic benefit of the transferred property. Estate planning attorneys have indicated great concern about how Section 2036(a) should be interpreted. One way to significantly alleviate this problem is to reduce the general partner (i.e., the senior family member) to an ownership interest in the general partner entity to less than a controlling interest in the FLP. This is not a significant problem in community property states where husband and wife jointly own property. This issue can be a problem in states where community property rules are not followed. And, it can be a problem where the senior family member is also the sole or controlling general partner.
The IRS and Valuation Discounts An important event in facilitating the use of an FLP in estate planning programs was the reversal of the IRS position with regard to “family attribution.” Prior to February 1993, the IRS aggregated ownership interests of family members in an entity (e.g., a privately owned corporation or partnership) in arriving at the noncontrolling or controlling ownership status of an interest. For instance, if the patriarch and sole owner of a family business gifted 20 percent interests in his company’s stock to each of his five children, the gift was viewed as one gift of 100 percent. Therefore, the value of each gift was its pro rata share of the value of 100 percent of the common stock of the company. Neither discounts for lack of ownership control nor discounts for lack of marketability were allowed. However, the IRS was often unsuccessful in arguing this position in Tax Court, culminating with the Bright case.1 After the Bright case, the IRS reaffirmed its intent to continue to pursue the family attribution policy. However, in 1993, the IRS issued Revenue Ruling 93-12 explicitly abrogating this position. Revenue Ruling 93-12 acknowledged that the fair market value standard assumes (1) a transaction between a hypothetical buyer and a hypothetical seller and (2) the specific identity of either party is irrelevant. Therefore, valuations for gift and estate tax purposes are now based on the property actually transferred without regard (1) to the identity of the buyer of the property 1 Estate
of Mary Frances Smith Bright v. United States, 658 F.2d 999 (5th Cir. 1981).
7 / The Valuation of Family Limited Partnership
179
or (2) to his or her relationship to the seller. Under this interpretation, gifting a 20 percent stock interest in a company to each of five children is not treated as a single gift of 100 percent but rather as a gift of five separate 20 percent interests. Accordingly, the value of the transferred interests would typically be subject to discounts to reflect lack of control and lack of marketability. Clearly, this reversal of policy has profound implications for the gifting or other transfer of both fractional limited partnerships interests and noncontrolling interests in the common stock of privately owned companies. This is because the value of the partnership interests (and the closely held stock) should reflect the appropriate discounts for lack of control and lack of marketability. This conclusion is not to suggest that the subject of valuation discounts has been resolved—far from it. In many cases, the IRS has challenged discounts that seem to be warranted based upon the facts surrounding the subject transferred interest and the objective evidence of the marketplace. Most discount-related IRS disputes are settled through negotiation before reaching the Tax Court, but there have been several recent FLP valuation cases. Three of these cases are discussed at the end of this chapter.
Valuation Parameters In the typical FLP valuation assignment, the analyst’s objective is to estimate the fair market value of a fractional limited partnership interest. Accordingly, it is important to first explore the concepts embodied in the term “fair market value.” Fair market value is, after all, the standard of value on which most tax-related valuations are based. For federal taxation purposes, fair market value is typically defined as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.”2 When valuing partnership interests, it is important for the analyst to understand that the “property” being valued is not the underlying assets of the partnership. Rather, the valuation subject is a security that represents an indirect ownership interest in the underlying assets of the partnership. The fair market value standard assumes a hypothetical willing seller and a hypothetical willing buyer. Accordingly, the identity, intentions, and desires of any particular buyer or seller are entirely irrelevant in a fair market value analysis. Another important consideration in the fair market value standard is that the analysis should give equal consideration to the motives of both the hypothetical willing seller and the hypothetical willing buyer. Furthermore, even though the fair market value transaction is hypothetical, it does not mean it is presumed to take place in a vacuum. For example, the analyst should assume that the willing seller and the willing buyer have knowledge of all relevant facts. Therefore, the valuation analysis should emulate the behavior of actual (although unidentified) investors and take into account all the factors that actual investors would be expected to consider. In making valuation judgments, analysts look to reliable, empirical evidence from the public markets. The markets for publicly traded equity securities [e.g.,
2 Treasury
Reg. Sec. 20.2031-1(b)
180
II / Business Valuation Special Applications
New York Stock Exchange (NYSE), Nasdaq] often provide such an empirical source of data for the analyst valuing the stock of a privately owned company. Based on a combination of (1) the operating performance of the subject private company (relative to the guideline publicly traded companies) and (2) the valuation pricing parameters observed in the public market, the valuation analyst is able to estimate a value for the subject private company stock as if it were publicly traded. In the same fashion, the analyst should look for an objective, market-derived basis on which to conclude an FLP value opinion. An FLP can contain any type of tangible or intangible asset (e.g., an operating business, farmland, timberland, mineral interests, and intangible assets). Nonetheless, the majority of FLPs contain two primary types of assets: (1) marketable securities and/or (2) real estate. In many cases, an FLP will contain both types of assets. The following discussions will focus separately on the valuation of FLPs owning marketable securities and real estate.
FLPs That Own Primarily Marketable Securities FLPs that own publicly traded securities are clearly asset-oriented. The analyst has merely to obtain a price for each security in the portfolio, sum the totals, and deduct any liabilities in order to determine the FLP net asset value. The NAV allocable to an individual limited partner’s share of the partnership is referred to as “pro rata NAV.” This pro rata NAV represents that partner’s mathematical (but indirect) share of the market value of the FLP net assets. However, the pro rata NAV does not represent the fair market value of that partner’s ownership interest. This disparity is due to (1) the restrictions on a limited partner’s ability to participate in decisions affecting the partnership and (2) the relatively limited marketability of the subject ownership interest. Without access to the underlying assets (or, at least, without control over the use of the assets), a hypothetical investor would not pay the same price for the subject ownership interest as he or she would pay for direct ownership of the underlying assets. That is, the economic benefits to a limited partner are significantly less than the economic benefits to the direct owner of the underlying assets. After determining the pro rata NAV, the next step in the valuation process is to estimate the marketable, noncontrolling interest value (MNIV) of the subject partnership interest. The valuation analyst should carefully review the partnership agreement in order to determine the specific rights and powers of the subject FLP interest. Frequently, there is significant voting power only if the subject FLP interest represents a very large percentage of the partnership. Furthermore, on the advice of the client’s attorney, an analyst may be instructed to value the FLP interest as an “assignee interest.” (This concept will be discussed later). However, an assignee interest has no vote whatsoever in any circumstance. Regardless of the size of the FLP interest, unless significant voting powers exist, the FLP interest will generally be treated as a noncontrolling ownership interest. In many respects, a limited partnership—or an assignee—interest is very similar to a noncontrolling interest in the common stock of a corporation. The noncontrolling shareholder can exercise little or no control over the operations of the corporation, including the following: 1. The basic policies applied to the business or the direction in which the business is guided 2. The daily operations of the company
7 / The Valuation of Family Limited Partnership
181
3. The compensation and benefits received by management of the entity 4. The legal framework under which the corporation operates (e.g., articles of incorporation and the bylaws) 5. The disposition or acquisition of the assets of the corporation or the acquisition of other assets of the business 6. The selection of the members of management 7. The sale, liquidation, merger, or dissolution of the company 8. The declaration and payment of dividends To reflect the MNIV of an ownership interest in a marketable securities-oriented FLP, a good reference point is the universe of publicly traded, closed-end investment companies. Analysts typically study closed-end investment companies that hold publicly traded securities akin to the types of securities held by the FLP. These types of securities may include domestic stocks, foreign stocks, municipal bonds, corporate bonds, or government bonds. Typically, closed-end funds have sold at prices that are lower than their net asset values per share. However, not all closed-end funds sell at a price discount all of the time. Explanations for the price discount range from expense-related reasons to the capital gains tax liability imbedded in some funds. Statistical efforts (e.g., regression and similar analysis) have not provided a definitive explanation for the closedend fund price discount. Regarding the imbedded capital gains liability, many closed-end funds sell at large price discounts from net asset value regardless of whether they have small tax liabilities or large tax liabilities. In most instances, it appears that the magnitude of the discount in a closed-end fund is related to the performance of the fund. The better a fund is perceived by the investing public to perform, the more in demand it becomes. This serves to drive up the price of the fund, consequently lowering the discount. The reverse is true, as well. The poorer a fund is perceived to perform, the lower its price and the higher its discount. Performance is expressed by the fund’s historical economic returns, which can be either a dividend yield, capital appreciation, or both. The ranked profile of price discounts/premiums (i.e., the investment company discount/premium) in relation to NAV observed in the public market often serves as a proxy for the discount for lack of control. Exhibits 7.1 and 7.2 present ranked price discounts—and premiums—to NAV for groups of closed-end stock and corporate bond funds. Exhibits 7.1 and 7.2 also indicate the financial data about each closed-end fund in each grouping. For the closed-end stock funds, the data include (1) NAV, (2) market prices, (3) the indicated dividend rates, (4) yield based both on NAV and market prices, (5) net assets, (6) total rates of return, (7) manager tenure, (8) Morningstar rating, and (9) built-in capital gains. The information provided for the closed-end municipal bond funds is very similar. For the municipal bond funds, the average S&P credit rating and the average maturity are also presented. An important consideration for the analyst is how the security portfolio owned by the subject FLP compares to the portfolios managed by the closed-end funds. The following discussion provides guidance as to various characteristics of a securities portfolio that increase or decrease the investment company discount: 1. An important difference is likely to be that the securities portfolio owned by the FLP is not professionally managed. The securities portfolio owned by a closedend fund, on the other hand, is professionally managed. If the FLP portfolio is professionally managed, then (all other things being equal) the price discount
182 USA BLU
Large Blend Large Value
Large Growth
Large Blend
Liberty All Star Equity Blue Chip Value
Alliance All-Mkt Advantagee
Liberty All Star Growth
(10.3)% (4.4)% 1.3%
25th percentile
3.0
2.3
75th percentile Median
$16.70 $6.55
1.1 1.8
(7.9) (6.4) (2.3) 0.0
(9.8)
(12.1) (11.9)
(13.1)%
(Discount)
(4.6)%
$16.33 $6.36
$8.58 $6.10
$16.40 $6.30 $16.55
$9.99 $27.70
$16.10 $12.26
$10.64
Price
Market
Average
ASG
AMO
$8.49 $5.99
$16.55
$11.08 $30.08 $17.52 $6.45
$18.31 $13.91
$12.24
NAV
6/28/2002
Percentage Premium
0.0 1.6 0.8 10.0 9.1 10.0 10.0
0.00 0.47 0.14 0.65 f 1.51g 0.85 f 0.60h
1.4 %
10.0 % 5.5 %
6.0 %
12.6
1.5 1.9
0.28 0.26
13.6
0.8%
$0.10
0.80 f
NAV
Ratea
2.22i
Rate/
Indicated
Indicated
1.5%
10.0% 5.6%
6.0%
12.2
13.3
9.9 9.8
9.1
0.0 1.7 0.9 10.2
1.7 2.1
0.9%
Yieldb
$170
$1203 $697
$970
163
167
1133 171
666
728
227
1036
107
3953 1410
$1877
(Millions)
Assets
Net
(17.4)%
(12.2)% (15.1)%
(14.4)%
(22.2)
(16.2)
(20.1) (10.9)
(2.4) (23.3) (5.7)
(13.1) (16.0)
(16.5) (12.7)
(14.2)%
Return
Total
3-Month Market
(27.7)%
(17.6)% (24.2)%
(19.4)%
(24.8)
(32.4)
(28.2) (15.7)
2.2 (30.0) 11.6
(21.5)
(18.3)
(25.0) (23.6)
(27.5)%
Return
Total
1-Year Market
(8.5)%
8.1% (4.5)%
(0.8)%
(4.8)
(14.0)
(4.3) (2.7)
14.8 (8.3) 17.9
7.5 9.7
(9.0) (6.3)
(9.8)%
Total Return
Market
3-Year Annualized
b
3.4 %
7.6 % 4.7 %
6.0 %
1.1
5.7
3.7 5.0
(3.0) 14.9
7.3
18.4
8.6
2.5 3.8
4.5%
Total Return
Market
5-Year Annualized
May include capital gains. Indicated rate divided by market price. c Data taken from Morningstar Principia Pro; defined as the potential capital gains exposure as a percentage of net assets. d Over the past 90 calendar days. e Classified as a nondiversified fund. f Distributes 2.5% of NAV quarterly. g Distributes at annual rate of 9% of rolling average of prior 4 calendar quarter-end NAVs of the fund’s common stock. h Distributes 10% of NAV annually. i Distributes 2.5% of NAV per quarter for first three quarters; fourth quarter distributions are at least 2.5% of NAV. SOURCE: Bloomberg; Morningstar Principia Pro, June 30, 2002; Standard & Poor’s Stock Guide, July 2002.
a
ZF RVT
Large Value Small Value
Zweig Royce Value Trust
Boulder Total Returne
MGC GAM BTF
Small Growth Large Blend Mid Cap Value
Morgan Grenfell Smallcap General American Investors
TY ADX
Large Blend Large Blend
SBF
Large Value
Symbol
Exchange
Tri-Continental Adams Express
Category
Morningstar
6/28/2002
8.1 %
11.3 % 10.4 %
9.8 %
NA 6.1
9.9 11.2
3.3 14.3
NA
11.0 14.0
7.7 9.2
11.3%
Total Return
Market
10-Year Annualized
(29)%
20% (14)%
(9)%
(42)
(61)
(17) (19)
32 26 (52) 29
18
(24) 15
(10)%
(% of NAV)c
Gains
Built-in Capital
8 NA 9 11 8 6
86,037 110,826 92,055 26,258
9 2
5 7 9 12 16
6 16
4
(Years)
Tenure
Manager
7,348 28,697
204,681 95,827
110,134
18,939 29,514 13,542 226,755
93,886 90,223
112,903
Volumed
Trading
Avg. Daily
Closed-End Funds—Domestic Equity Portfolios as of June 28, 2002, Ranked by Percentage Premium/(Discount)
Salomon Bros
Company
Exhibit 7.1
2
3 3
3
1
1
3 3
4 4 1 4
3
2 3
3
(# of stars)
Rating
Morningstar
0.8 %
1.6 % 1.1 %
1.2 %
1.2
2.4
1.0 0.9
1.6
1.6 1.0 2.0 1.1
0.6 0.3
0.6%
Ratio
Expense
183
11.85 18.50 18.93 6.12 13.75
15.83 14.45 12.29 18.84 19.05 6.13 13.17
JHS
HAT
MUO
VBF
MTS
VIN
VES
John Hancock Income Securities
Hatteras Income Securities
Pioneer Interest Shares
Van Kampen Bond
Montgomery Street Income Sec
Van Kampen Income
Vestaur Securities
(5.9)% (3.6)% (0.6)%
75th percentile
Median
25th percentile
0.96
0.46
1.36
1.32
0.84
0.96
0.96
1.26
0.61
0.96
Rate*
Indicated
6.1%
6.8%
7.1%
6.7%
7.3
7.4
7.1
7.0
6.8
6.6
6.1
6.1
5.8
5.3
NAV
Rate/
Indicated
6.5%
7.0%
7.1%
6.9%
7.0
7.5
7.2
7.1
7.1
6.9
6.4
6.5
6.3
5.8
Yield†
$102
$111
$176
$137
97
111
210
218
102
53
176
168
102
91
(Millions)
Assets
Net
3.2%
3.7%
4.5%
3.9%
3.6
0.8
5.6
4.5
6.3
3.7
4.3
3.2
3.2
1.3
Total Return
Market
3-Month
† Indicated
3.5%
5.6%
6.4%
4.0%
6.4
(5.9)
7.8
3.5
8.8
6.0
5.6
4.3
(0.2)
6.0%
Total Return
Market
1-Year Total
May include capital gains. rate divided by market price. ‡ For the 3-month period ended June 28, 2002. SOURCE: Bloomberg; Morningstar Principia, June 30, 2002; Closed-End Fund Association.
*
(2.8)%
4.4
(0.2)
(0.6)
(1.8)
(3.6)
(3.8)
(5.9)
(6.2)
Average
13.90
14.90
19.39
20.68
JHI
(7.5)
John Hankcock Investors
(8.9)
9.68
(Discount)
Premium
Percentage
16.48
10.46
CIGNA Investment Securities
18.09
Price
IIS
NAV
Symbol
Market
ALM
6/28/2002
Exchange
6/28/2002
8.1%
9.0%
9.5%
8.4%
9.5
4.6
10.2
8.1
9.0
8.8
9.9
9.4
6.2
9.4
Total Return
Market
Annualized
3-Year Total
6.1%
6.3%
7.6%
6.7%
8.1
4.1
8.8
6.3
5.8
7.6
6.9
6.1
6.2
7.9
Total Return
Market
Annualized
5-Year Total
6.2%
6.4%
7.1%
6.6%
7.5
6.2
7.3
7.1
5.9
5.9
6.9
6.3
6.4
6.6
Total Return
Market
Annualized
10-Year Total
13 6 9 4 3
8,942 12,083 8,008 5,989
1
3 4,906
15,402
8,008
1
9
6,617 12,083
11
4
4
8
11
(Years)
Tenure
Manager
3,523
12,978
5,989
10,969
5,266
Volume‡
Trading
Avg. Daily
5.2
5.3
5.7
5.3
5.4
5.2
5.7
5.7
5.3
4.4
5.2
5.2
6.0
6.1
Duration
Effective
Average
BBB
BBB
A
BBB
BBB
A
AA
A
A
A
A
A
A
AA
Quality
Credit
Average
Closed-End Funds—Corporate Bond Portfolios as of June 28, 2002, Ranked by Percentage Premium/(Discount)
Allmerica Securities Trust
Company
Exhibit 7.2
4
4
4
4
4
3
4
4
3
4
5
4
4
4
(# of stars)
Rating
Morningstar
0.8%
0.9%
1.0%
0.9%
1.0
1.0
0.8
0.6
0.9
0.9
0.8
0.8
1.3
0.9
Ratio
Expense
184
II / Business Valuation Special Applications
2.
3.
4.
5.
6.
from NAV may approximate the median discount for the closed-end fund grouping. The absence of professional management would tend to increase the discount because of concerns over performance. The investor in the closed-end fund benefits from stringent regulation imposed by the U.S. Securities and Exchange Commission (SEC). The limited partner in the securities-oriented FLP is afforded no such regulatory protection. The portfolio owned by the FLP may be relatively undiversified when compared to the portfolio owned by the closed-end fund. As such, the assets of the FLP portfolio may be concentrated in a relatively few investments. Though there may be numerous securities in the subject FLP portfolio, some ownership positions may be outsized relative to others. Again, this is a performancebased concern. A closed-end fund may be subject to specific investment objectives and may be limited to investing in particular investment vehicles. On the other hand, the FLP portfolio may reflect no defined investment policy, discipline, or objective. This condition is a function of the lack of professional management of the FLP portfolio. The FLP portfolio may simply represent a hodgepodge of miscellaneous securities. The FLP portfolio may have no definable investment character or philosophy. The quality of the investments in the FLP portfolio (e.g., speculative versus investment grade) is another dimension that would affect where the portfolio should be placed in the range of ranked discounts from NAV. With regard to fixed income portfolios, all the aforementioned criteria would also apply in distinguishing the FLP portfolio from the closed-end fund grouping. In addition, the average maturity of the bond portfolio is a significant factor. The longer the average maturity (or duration), the greater the price volatility and investment risk. Another important factor is the return on the FLP portfolio (i.e., the yield) compared to the return on the closed-end fund portfolio.
The valuation analyst should consider this public market information with regard to the closed-end funds. In addition, the valuation analyst should discuss with the managing partner the future asset allocation, distribution policy, reinvestment, and likely duration of the partnership. As a result, the valuation analyst is prepared to make discerning judgments as to the size of the appropriate discounts from the aggregate NAV of the FLP. Again, the investment company discount is a proxy— or a substitute—for the discount for lack of control applicable to the FLP interest value. This discount is separate from (and is applied in addition to) the discount for lack of marketability.
FLPs That Own Primarily Real Estate Real estate is a broadly defined asset. It can include unimproved land, office buildings, shopping centers, residential properties, warehouses, and agricultural land. Real estate can be further subdivided between income-producing property and nonincome-producing property. An important factor is whether the owned property generates enough cash flow to make distributions to the FLP partners. The important considerations with regard to surplus cash flow distributions include capital requirements and debt service. The valuation process for a simple real estate–oriented FLP is similar to that for any FLP. The valuation process begins with the determination of the underlying NAV.
7 / The Valuation of Family Limited Partnership
185
For a simple real estate–oriented FLP, the analyst will typically obtain current property appraisals performed by qualified real estate appraisers. After this procedure is performed, the task of determining the FLP MNIV begins. Historically, analysts did not have many benchmarks to use as valuation reference points for FLP ownership interests. This was particularly true with regard to real estate–oriented partnerships. Typically, NAV was estimated and then was discounted as appropriate to reflect the (1) lack of control and (2) lack of marketability. These discounts were derived from the studies conducted regarding nonmarketable, noncontrolling ownership interests in corporations (but not in partnerships). Around 1980, an informal market (ultimately known as the secondary market for limited partnerships) developed. As is frequently the case, entrepreneurs are constantly on the lookout for new opportunities, identifying situations where a void needs to be filled. The secondary market developed as a response to the enormous number of offerings of publicly syndicated partnerships in the late 1970s and early 1980s. No provisions were made to enable unit holders to buy or sell interests in the respective partnerships. It was this liquidity void that the creators of the secondary market attempted to fill. The secondary market is comprised of three different types of participants. The first group operates as market makers (i.e., over-the-counter dealers). There are several firms that regularly conduct transactions in limited partnership units. These firms operate on either a principal or an agency basis. The second group of firms refers to themselves as “exchanges.” In reality, however, these firms simply operate a service through various brokerage firms—in an attempt to match prospective buyers and sellers. The third group is composed of firms that buy and sell for their own account or for partnerships created to own interests in publicly syndicated partnerships. The participants in this market have a strong preference for partnership units in publicly syndicated deals (as opposed to privately syndicated partnerships). They prefer real estate–oriented partnership units, “seasoned” partnerships (i.e., those in existence for many years with established track records), as well as income-producing, cash flow–producing, and cash-distributing partnerships. It is noteworthy that the great majority of partnerships trading in this secondary market are real estate–related. During the early years of the secondary markets existence, information was limited regarding the basis on which partnership units were priced. Several studies on pricing in the secondary market over a multiyear period, from the late 1980s to the early 1990s were undertaken. These studies were based on interviews with market makers, “exchange” executives, and individuals managing their own accounts. The typical range of price discounts from NAV was 20–40 percent in 1987, 20– 40 percent in 1990, and 30–50 percent in 1993. Just as the secondary market was developed as a result of a need to fill the liquidity void for partnership units, the information void was filled by another entrepreneur. In 1990, Partnership Profiles, Inc. (PP) was created. PP issues a bimonthly publication, Partnership Spectrum.3 This publication offers general commentary about what is happening in the secondary market for limited partnership interests. It (1) reports on developments in a vast number of specific partnerships and (2) provides trading information on a large number of partnerships. These partnerships are divided into categories (e.g., unimproved land, conventional, triple-net 3 Partnership Spectrum, published on a bimonthly basis, is available from Partnership Profiles, Inc. (800) 634-4614, www. partnershipprofiles.com.
186
II / Business Valuation Special Applications
lease, oil and gas, equipment leasing). The reported information for these partnership units for each 2-month period includes (1) the range of trading prices, (2) the number of trades and total number of units traded, (3) the current yield, and (4) the unit values (i.e., the NAV). The publication Partnership Profiles4 is also a valuable resource to FLP analysts. This publication provides fundamental operating and financial information on hundreds of partnerships, derived from SEC filings. Partnership operating data for the last 5 years are provided. These data include the cost basis of properties owned, percentage leverage, gross revenues, net income, cash flow, working capital, and the history of distributions to partners. In addition, there are descriptions of properties and property dispositions. Also, the publication provides substantial commentary regarding fundamental information about the partnership properties and explanations about their financial statements. As a result of the increased availability of operating and financial information about publicly traded partnership units, FLP analysis may be performed much like stock and bond market investment analysis. In other words, FLP analysts can evaluate and assess the relative merits of investments on the same basis that stock market analysts do—that is, using the wealth of information available on publicly traded securities. From the aforementioned operating, financial, and market data, analysts are able to calculate various valuation pricing parameters for secondary market partnerships that are similar to the subject FLP. Such valuation pricing parameters include (1) price to NAV, (2) price to cash flow, (3) distribution yield, (4) degree of leverage, and (5) percentage of cash flow paid out as distributions to partners. From these secondary market data, several conclusions may be reached regarding the basis for pricing of limited partnership units in the secondary market. The most significant driver of partnership unit pricing in the secondary market is cash distributions (and, therefore, yield). Other factors that influence partnership unit pricing in the secondary market (not necessarily ranked in order of influence) include the following: 1. 2. 3. 4. 5.
The type of real estate (or other) assets owned by the partnership. The amount of financial leverage inherent in the partnership capital structure. The underlying cash flow coverage of yearly distributions made to partners. The cash flow return as a percentage of NAV. The caliber of the information flow from the partnership and from the general partner. 6. Whether the assets of the partnership are well diversified. 7. The reputation, integrity, and perceived competence of the management/general partner. 8. Liquidity factors such as: a. How often a partnership interest trades b. The number of investors in the partnership c. The expected time period until liquidation d. The universe of interested buyers e. Whether the partnership is publicly or privately syndicated f. The presence of rights of first refusal
4 Partnership Profiles, published twice a year, is available from Partnership Profiles, Inc. (800) 634-4614, www.partnershipprofiles.com.
7 / The Valuation of Family Limited Partnership
187
Periodic reviews of the pricing of both distributing and nondistributing equity partnerships indicate that nondistributing partnerships generally sell at higher price discounts than do distributing partnerships. In addition, nondistributing partnerships are characterized by a higher degree of leverage than is the case with distributing partnerships. Exhibits 7.3 and 7.4 present various valuation parameters for both vacant land partnerships and distributing equity partnership units trading in the secondary market. A summary of the average discount and distribution yield (as reported in the May/June 2002 issue of the Partnership Spectrum) for six different categories of secondary market partnerships is presented in Exhibit 7.5. The distributing equity partnerships (with low debt) traded at the lowest average discount of 16 percent. The distributing equity partnerships (with high debt) traded at an average discount of 26 percent. The nondistributing equity partnerships, which are typically unable to pay operating distributions due to high debt loads and/or property improvement funding needs, traded at an average discount of 32 percent. The vacant land partnerships traded at the highest average discount of 35 percent. These partnerships do not pay regular operating distributions. Rather, the vacant land partnerships periodically pay cash distributions as parcels are sold. As indicated in the chart in Exhibit 7.5, the more steady, safe, and predictable the cash distribution level, the lower the discount from NAV required by investors. Those partnerships with lower discounts tend to trade on a yield basis. When cash flow is not distributed regularly, investors demand higher discounts from NAV. It is noteworthy that the preceding exhibits describe pricing information as of a particular date for illustration purposes only. Since prices and asset values change over time, the underlying data used in the valuation analysis must be as of a date as close to the valuation date as possible. The secondary market serves as a reference point for the valuation of privately owned FLPs, just as the publicly traded common stock market is a reference point for the valuation of common stocks of privately owned companies. The primary difference between the secondary market and the public equity markets (the NYSE, Nasdaq, and the like) is the more limited liquidity of the secondary market. Accordingly, in order to price a privately owned limited partnership interest based upon the NAV discounts observed in the secondary market, such discounts should be modified. The general conclusion of the Partnership Spectrum is that the majority of the total NAV discount is related to lack of control: Although it is not possible to precisely quantify the amount of discount attributable to marketability versus lack of control considerations, it is the opinion of The Partnership Spectrum, along with many appraisers, that most of this discount is due to lack of control issues. While the partnership secondary market is certainly not a recognized securities exchange, it is a market where there are usually multiple bidders who stand ready to purchase the units of virtually any publicly-registered partnership that has value. . . . it is typically not a matter of whether the units can be sold, but a matter of how long it takes to get the net sale proceeds in the hands of the seller. It therefore seems that most of the overall price-to-value discount inherent in the pricing of partnership interests changing hands in the secondary market is due to lack of control considerations. . . .
188 $29.13 18.70 32.11 111.51 0.66 1.21 2.04 0.68 154.33 29.30 0.72 0.92 0.64 26.12 31.88 0.90 0.85 54.74 0.88 0.95 0.92
CF per Unitc
10.4 8.9 6.9
8.6
8.2 4.1 5.3 12.9 6.2 8.0 9.7 7.2 10.5 6.9 8.3 5.9 5.7 8.9 11.2 9.7 9.4 10.5 10.4 11.3 10.2
CF/ NAV (%)
11.2× 9.2× 8.1×
9.8×
7.7× 15.5× 12.1× 5.4× 11.2x 8.8× 7.8× 11.0× 7.5× 11.5× 9.6× 13.5× 14.5× 9.5× 7.8× 9.1× 9.4× 8.4× 8.7× 8.1× 9.2×
Avg. CF Mult $10.00 11.48 12.00 30.14 0.28 0.88 1.50 0.76 132.00 10.08 0.72 0.60 0.56 16.00 5.60 0.96 0.80 40.00 0.84 0.84 0.92
Distrib. Rated
10.4 8.3 4.4
7.4
4.4 4.0 3.1 5.0 3.8 8.3 9.4 10.2 11.4 3.0 10.4 4.8 6.0 6.4 2.2 11.8 10.0 8.7 11.0 10.9 10.9
Yield (%)
94.1 73.1 42.4
70.0
34.3 61.4 37.4 27.0 42.4 73.0 73.5 111.8 85.5 34.4 100.3 65.2 87.5 61.3 17.6 106.7 94.1 73.1 95.7 88.4 100.0
Payout Ratio (%)
b Average
NAV unit values taken from the May/June 2002 Partnership Spectrum, except as otherwise noted. prices for trades between April 1, 2002 and May 31, 2002, except as otherwise noted. c Cash flow per unit before capital expenditures. d Latest annualized cash distribution rate from Spring 2002 Partnership Profiles, unless otherwise noted. e Calculated as NAV multiplied by the number of units outstanding. f Data obtained from Spring 2002 Partnership Profiles. g Total units traded between April 1, 2002 and May 31, 2002, except as otherwise noted. h Data taken from March/April 2002 Partnership Spectrum. SOURCE: Partnership Spectrum, March/April 2002 and May/June 2002, and Partnership Profiles, Spring 2002.
a
29.4 20.1 12.2
37.0 37.0 35.8 30.4 30.4 29.4 23.8 21.4 21.2 20.4 20.1 19.9 17.2 15.2 12.3 12.2 11.3 11.3 9.1 8.2 5.8
75th percentile Median 25th percentile
$225.00 290.00 388.25 600.00 7.40 10.60 16.00 7.47 1162.00 338.29 6.92 12.42 9.31 248.61 250.00 8.17 8.00 461.22 7.65 7.74 8.46
Discount from NAV (%)
20.4
$357.00 460.00 605.00 862.00 10.63 15.01 21.00 9.50 1475.00 425.00 8.66 15.50 11.25 293.00 285.00 9.31 9.02 520.00 8.42 8.43 8.98
Rancon Income Fund I Rancon Realty Fund IV Uniprop MHC Income Fund I Oxford Residential Properties I Realty Parking Properties II Uniprop MHC Income Fund II Brown-Benchmark Properties Wells Real Estate Fund IV-A Public Storage Properties IV ChrisKen Partners Cash Income Fund Wells Real Estate Fund V-A Corporate Realty Income Fund I Realty Parking Properties LP First Capital Income Properties XI ChrisKen Growth & Income II Wells Real Estate Fund VIII-A Wells Real Estate Fund VI-A DSI Realty Income Fund IX Wells Real Estate Fund VII-A Wells Real Estate Fund X-A Wells Real Estate Fund IX-A
Average Priceb
Average
NAV
a
3 11 4 4 5 9 3 4 17 2 5 6 8 1 1 8 8 6 8 7 9 6 8 6 4
Leverage f (%) 0 24 105 43 0 45 53 0 0 0 0 47 0 0 57 0 0 78 0 0 0 22 45 0 0
Total NAVe (000s) $4,841 34,056 18,150 20,307 14,805 49,584 10,500 12,568 59,000 15,285 13,565 46,245 21,478 16,883 3,281 26,129 20,172 15,960 17,404 19,529 28,165 $22,281 $26,129 $18,150 $14,805
# of Props f
5 4 2
4
1 1 3 4 4 4 1 3 2 2 4 5 8 1 1 7 5 4 4 5 7
# of States f
Equity Real Estate Partnerships—Distributing as of May/June 2002, Ranked by Discount from NAV
Partnership
Exhibit 7.3
1448 210 28
1177
30 28 31 5 3000 h 4261 1200 550 130 210 2500 960 1448 180 14 8000 400 h 7 1700 28 26
Total Units Traded g
71.7% 29.8% 22.3%
43.6%
(0.8%) 29.8% 100.0% 73.9% 31.8% 68.2% 100.0% 28.6% 73.2% 31.3% 24.1% 12.4% 18.6% 54.3% 91.6% 26.2% 27.2% 71.7% 22.3% 11.9% 20.0%
Capital Gains as % of NAV
189
$14.73 9.83 1.56
CF per Unit a ,c
1.0 0.9 0.5
0.7
1.1 0.9 0.1
CF/ NAV (%)
Total NAVa ,d (000s) $66,142 32,256 36,573 $44,991 $51,358 $36,573 $34,415
Avg. CF Multiple 50.2× 74.9× 505.4× 210.2× 290.1× 74.9× 62.6×
b Average
taken from the May/June 2002 Partnership Spectrum. prices for trades between April 1, 2002 and May 31, 2002, except as otherwise noted. c Cash flow per unit is before capital expenditures. d NAV multiplied by the number of units outstanding. e Data obtained from Spring 2002 Partnership Profiles. f Total units traded between April 1, 2002 and May 31, 2002. SOURCE: Partnership Spectrum, May/June 2002, and Partnership Profiles, Spring 2002.
a Value
38.2 32.5 31.4
44.0 32.5 30.3
75th percentile Median 25th percentile
$740.00 735.96 788.41 35.6
$1321.00 1090.00 1131.00
NAVa
Discount from NAV (%)
Average
Inland Land Appreciation Fund II Inland Land Appreciation Fund InLand Capital Fund
Partnership
Average Priceb
9 0 0
6
0 18 0
Leveragee (%)
17 16 14
15
18 16 12
# of Propertiese
1 1 1
1
1 1 1
# of States e
16 6 6
12
5 26 6
Total Units Traded f
43 40 36
40
46 32 40
Capital Gains as % of NAV
Equity Real Estate Partnerships—Undeveloped Land Partnerships as of May/June 2002, Ranked by Percentage Discount
Exhibit 7.4
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Exhibit 7.5
Summary of Partnership Resale Discounts Partnership Category
No. of Partnerships
Average Discount
Average Yield
18 23 7 14 5 3
16% 19% 19% 26% 32% 35%
8.6% 10.5% 13.6% 6.5% 0.0% 0.0%
Equity—Distributing (Low debt)* Triple-Net-Lease Insured Mortgages Equity—Distributing (High debt)† Equity—Nondistributing Undeveloped Land
Summary of Discounts by Partnership Category 40% 35%
Discount
30% 25% 20% 15% 10% 5% 0%
Equity Triple-NetDistributing Lease (Low debt)*
Insured Mortgages
Equity Equity - Undeveloped Distributing NonLand (High debt)† distributing
Partnership Category
* Low to no debt. † Moderate to high debt. SOURCE: Partnership Spectrum, May/June 2002.
It is common practice for appraisers using the discount data reported in this study when valuing a minority interest in a Family Limited Partnership or some other highly illiquid investment involving real estate to adjust these discounts upward to account for the fact that the subject of their valuation is less marketable than the partnership interests included in this study.5
Lack of Marketability A detailed discussion of the methods used to estimate a discount for lack of marketability is beyond the scope of this chapter. Typically, there are several provisions in FLP agreements that limit or impede the transferability of the partnership interest.
5 “Partnership
Re-Sale Discounts Holding Up,” Partnership Spectrum, May/June 2003, p. 9.
7 / The Valuation of Family Limited Partnership
191
These FLP agreement provisions typically include the following: 1. Any disposition of any partnership interest would, unless the transferee becomes a substituted limited partner, be effective only to give the transferee the right of an “assignee.” An assignee is only entitled to economic participation in the partnership. No person can become a substituted limited partner without the consent (a) of the general partners and, often, (b) of all of the limited partners. 2. With limited exceptions, partners cannot transfer all or any part of their partnership interest without the prior written consent of the general partner. Usually a right of first refusal exists whereby the partnership and partners have the right to purchase the offered interest at the offered price before the interest can be sold to a third party. 3. The agreements usually severely restrict events that would cause the dissolution and liquidation of the partnership. 4. The limited partners cannot withdraw from the partnership; commonly, they are not obligated to make capital calls; and, the partnership can only be liquidated with the consent of all the partners. Many analysts use restricted stock studies such as those summarized in Exhibits 7.6 through 7.10 to quantify a discount for lack of marketability. In determining the appropriate discount for lack of marketability for an FLP, it is important to note that none of these studies include entities that are primarily asset holding vehicles (as opposed to operating businesses). Therefore, the analyst should evaluate the subject FLP as related to the benchmark studies, based on (1) the liquidity and volatility of its underlying assets, (2) its income potential and distribution policy, (3) the management of the assets of the partnership, and (4) the term of the partnership agreement. In addition, if the lower degree of liquidity of the secondary market partnership studies has not been incorporated when determining the discount for lack of control, then that factor should be taken into account when evaluating the appropriate discount for lack of marketability. Some valuation analysts use a quantitative analysis (in contrast with the empirical analysis described above) in the estimation of the lack of marketability discount. While some analysts use this quantitative analysis as a primary methodology, most use it as an additional or corroborative methodology. This quantitative analysis may be performed in a variety of ways. One example of such a method is the Quantitative Marketability Discount Model (QMDM).6 This discount for lack of marketability methodology is based on a rate of return analysis using (1) an assumed growth rate, (2) assumed income generation of the FLP’s assets, and (3) an expected duration or holding period. If the quantitative analysis is used to corroborate a primary discount estimate based on empirical restricted stocks studies, the fair market value of the FLP interest is assumed to be the “investment amount” in an internal rate of return analysis. To provide reasonable corroboration, the rate of return concluded by this procedure should be reasonable in light of (1) the underlying asset returns of the FLP and (2) the lack of marketability characteristics of the subject ownership interest.
6 This
LP, 1997).
method is described in Z. Christopher Mercer, Quantifying Marketability Discounts (Memphis, TN: Peabody Publishing,
192 34,682
52,338
2,497 15,112 15,850 13,614 5,266
85
9 2 3 47 17 7 927
1396 1939 765 271 2146 1548
Discount 0.1 to 10.0% No. of Avg. Size of Trans- Transaction actions ($000s)
67
2 13 4 39 9
Discount 0.1 to 10.0% No. of Value of TransPurchases actions ($000s)
102,965
205 24,504 14,549 38,585 25,122
69
6 1 10 24 18 10 1323
2045 1019 935 893 1235 2496
Discount 10.1 to 20.0% No. of Avg. Size of TransTransaction actions ($000s)
78
1 13 11 35 18
Discount 10.1 to 20.0% No. of Value of TransPurchases actions ($000s)
68
16 1 15 25 8 3
67
2 3 7 30 25 123,622
3,332 11,103 21,074 58,689 29,424
Discount 30.1 to 40.0% No. of Value of TransPurchases actions ($000s)
1022
762 500 658 1090 1477 2635 50
17 0 12 13 6 2 1397
1155 890 1999 1917 1025
Discount 30.1 to 40.0% No. of Avg. Size of TransTransaction actions ($000s)
Discount by Sales of Issuer†
110,864
17,954 46,201 35,480 11,229
Discount 20.1 to 30.0% No. of Avg. Size of Trans- Transaction actions ($000s)
77
10 20 30 17
Discount 20.1 to 30.0% No. of Value of TransPurchases actions ($000s)
22,106
1,400 44 9,284 11,377 48
1 4 4 21 18 33,569
1,260 5,005 4,802 8,996 13,506
Discount 50.1 to 80.0% No. of Value of TransPurchases actions ($000s)
29
7 2 13 4 3 0
602
365 611 629 287 1458 -
37
11 7 8 6 3 2
324
263 68 576 270 202 903
Discount Discount 40.1 to 50.0% 50.1% or More No. of Avg. Size of No. of Avg. Size of Trans- Transaction Trans- Transaction actions ($000s) actions ($000s)
35
1 1 13 20
Discount 40.1 to 50.0% No. of Value of TransPurchases actions ($000s)
Discount by Trading Market∗
SEC Institutional Investor Study
480,146
8,794 78,838 109,783 178,477 104,253
338
66 13 61 119 55 24
1,003
62,122 7,091 44,964 90,183 87,009 47,551
Total No. of Size of Trans- Transactions actions ($000s)
398
7 51 49 179 112
Total No. of Value of TransPurchases actions ($000s)
20.1–30.0%
30.1–40.0% 10.1–20.0% 20.1–30.0% 20.1–30.0% 30.1–40.0%
20.1–30.0%
30.1–40.0% 50.1% + 30.1–40.0% 10.1–20.0% 10.1–20.0% 10.1–20.0%
10.1–20.0%
20.1–30.0% 0.1–10.0% 30.1–40.0% 20.1–30.0% 10.1–20.0% 10.1–20.0%
Implied Discount Range‡ No. of Size of TransTransactions actions (Dollars)
20.1–30.0%
10.1–20.0% 10.1–20.0% 20.1–30.0% 20.1–30.0% 30.1–40.0%
Implied Discount Range‡ No. of Value of TransPurchases actions (Dollars)
†
Table XIV-45 of SEC Institutional Investor Study. Table XIV-47 of SEC Institutional Investor Study. ‡ Calculated by HFBE. Represents the discount level for the median transaction in each grouping. For example, there were 66 transactions involving companies with sales less than $100,000. If the 66 transactions were sorted by discount, the median discount (representing the 33rd transaction) would have fallen into the 30.1–40% range; the first 18 (11+7) transactions had discounts of 40% or more, while the last 15 (6+9) transactions had discounts of 20% or less. § Reporting companies. ¶ Nonreporting companies. SOURCE: “Discounts Involved in Purchases of Common Stock (1966–1969),” Institutional Investor Study Report of the Securities and Exchange Commission, H.R. Doc. No. 64, Part 5, 92nd Cong. 1st Session 1971, pp. 2444–2456.
*
Total
Less than $100 $100 - $999 $1,000 - $4,999 $5,000 - $19,999 $20,000 - $99,999 $100,000 or More
Sales of Issuer (000s)
26
Unknown New York Stock Exch. American Stock Exch. OTC - Reporting§ OTC - Non-reporting¶
Total
1 7 2 11 5
Trading Market 1,500 3,761 7,263 13,829 8,329
Discount −15.0 to 0.0% No. of Value of Trans- Purchases actions ($000s)
Exhibit 7.6
7 / The Valuation of Family Limited Partnership
193
Exhibit 7.7
The Silber Study Sample Characteristics
Sample characteristics Percentage discounta Dollar size of issue (millions)b Restricted/totalc Earnings (thousands)d Revenues (millions)e Market capitalization (millions)f
Number of companies Discount Sample characteristics—mean values Percentage discounta Dollar size of issue (millions)b Restricted/totalc Earnings (thousands)d Revenues (millions)e Market capitalization (millions)f
Mean
Maximum
Minimum
33.75% $4.3 13.6% $912 $40 $54.0
84% $40 56.0% $65,039 $595 $532.0
(12.7%) $0.17 1.0% ($8863) $0 $4.4
Group I
Group II
34 >35%
35 <35%
53.9%g $2.7 16.3% ($1,440) $13.9 $33.8
14.1%h $5.8 10.9% $3198 $65.4 $74.6
Percentage discount = [1 − p*/p] *100, where p* is the price per share of the restricted stock and p is the closing price of common stock on the placement date; median discount for all companies in study = 35% and standard deviation = 23.7%. b Dollar size of issue = p* times number of restricted shares. c Restricted/total = number of restricted shares divided by total common stock including restricted stock. d Earnings = total earnings for fiscal year prior to placement date. e Revenues = total revenues for fiscal year prior to placement date. f Market capitalization = p times number of shares outstanding prior to placement date. g Standard deviation = 13.3%. h Standard deviation = 12.6%. SOURCE: William L. Silber, “Discounts on Restricted Stock: The Impact of Illiquidity on Stock Prices,” Financial Analysts Journal, July–August 1991, pp. 60–64. a
Exhibit 7.8
Columbia Financial Advisors, Inc., Restricted Stock Study
Number of transactions Range of discounts Average discount Median discount
Pre-Rule 144 Change*
Post-Rule 144 Change†
23 1–68% 21% 14%
15 0–30% 13% 9%
* Prior to SEC Rule 144 change in holding period from 2 years to 1 year; study covers the period January 1, 1996 through April 30, 1997. † After SEC Rule 144 change in holding period from 2 years to 1 year; study covers the period January 1, 1997 through December 31, 1998. SOURCE: Kathryn Aschwald, “Restricted Stock Discounts Decline as a Result of 1-Year Holding Period,” Shannon Pratt’s Business Valuation Update, May 2000, pp. 1–5. (This study focuses on the change in discounts as a result of the holding period reduction from 2 years to 1 year.) Used with permission.
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Exhibit 7.9
Summary of Restricted Stock Studies Study SEC Overall Averagea SEC Nonreporting OTC Companiesa Gelmanb Troutc Moroneyd Mahere Standard Research Consultants f Willamette Management Associates, Inc.g Silber j FMV Opinions, Inc.k Management Planning, Inc.l Bruce Johnsonm Columbia Financial Advisorsn Columbia Financial Advisorsn
Years Covered in Study
Average Discount (%)
1966–1969 1966–1969 1968–1970 1968–1972
25.8 32.6 33.0 33.5i 35.6 35.4 45.0 i 31.2 i 33.8 23.0 27.1 20.0 21.0 13.0
h
1969–1973 1978–1982 1981–1984 1981–1988 1979–April 1992 1980–1996 1991–1995 1996–Feb. 1997 May 1997–1998
a
From “Discounts Involved in Purchases of Common Stock (1966–1969),” Institutional Investor Study Report of the Securities and Exchange Commission, H.R. Doc No. 64, Part 5, 92nd Cong. 1st Session. 1971, pp. 2444–2456. b From Milton Gelman, “An Economist-Financial Analyst’s Approach to Valuing Stock of a Closely-Held Company,” Journal of Taxation, June 1972, pp. 353–354. c From Robert R. Trout, “Estimation of the Discount Associated with the Transfer of Restricted Securities,” Taxes, June 1977, pp. 381–385. d From Robert E. Moroney, “Most Courts Overvalue Closely-Held Stocks,” Taxes, March 1973, pp. 144–154. e From J. Michael Maher, “Discounts for Lack of Marketability for Closely-Held Business Interest,” Taxes, September 1976, pp. 562–571. f From “Revenue Ruling 77–287 Revisited,” SRC Quarterly Reports, Spring 1983. pp. 1–3. g From Willamette Management Associates study (unpublished). h The years covered in this study are likely 1969–1972, although no specific years were given in the published account. i Median discounts. j From William Silber, “Discounts on Restricted Stock: The Impact of Illiquidity on Stock Prices,” Finanical Analysts Journal, July–August 1991, pp. 60–64. k From Lance S. Hall and Timothy C. Polacek, “Strategies for Obtaining the Largest Valuation Discounts,” Estate Planning, January/ February 1994, pp. 38–44. l Robert P. Oliver and Roy H. Meyers, “Discounts Seen in Private Placements of Restricted Stock: The Management Planning, Inc., LongTerm Study (1980–1996),” Chapter 5 of Robert F. Reilly and Robert P. Schweihs, eds., The Handbook of Advanced Business Valuation (New York: McGraw-Hill, 2000). m Bruce Johnson, “Restricted Stock Discounts, 1991–1995,” Shannon Pratt's Business Valuation Update, March 1999, pp. 1–3. n Kathryn Aschwald, “Restricted Stock Discounts Decline as a Result of 1-Year Holding Period,” Shannon Pratt’s Business Valuation Update, May 2000, pp. 1–5. (This study focuses on the change in discounts as a result of the holding period reduction from 2 years to 1 year.) SOURCE: Jay E. Fishman, Shannon P. Pratt, et al., Guide to Business Valuations, 13th ed. (Fort Worth, TX: Practitioners Publishing Co., 2003). pp. 8–28.
Summary If properly designed and implemented, an FLP can be an effective estate planning and charitable planning vehicle. By carefully analyzing and applying the available valuation benchmarks and concepts, the valuation analyst is able to develop credible, defensible values for FLP interests.
7 / The Valuation of Family Limited Partnership
195
Exhibit 7.10
Willamette Management Associates Studies Summary of Discounts for Private Transaction P/E Multiples*
Time Period
Number of Companies Analyzed
1975–1978 1979 1980–1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Overall average
17 9 58 85 20 18 47 25 13 9 17 27 36 51 31 42 17 34 14 22 13
Number of Transactions Analyzed 31 17 113 214 33 25 74 40 19 19 23 34 75 110 48 66 22 44 21 28 15
Median Discount (%) 52.5 62.7 56.5 60.7 73.1 42.6 47.4 43.8 51.8 50.3 48.5 31.8 51.7 53.3 42.0 58.7 44.3 35.2 49.4 27.7 31.9 48.4
* Based on price/earnings relationships indicated in private transactions compared to initial public offerings adjusted for changes in industry P/E pricing multiples. SOURCE: Willamette Management Associates.
Understanding and Interpreting the Partnership Agreement Exhibit 7.11 provides a checklist of documents and information that the analyst should have in order to perform the FLP ownership interest valuation assignment. The beginning point in valuing an FLP interest is the critical review of the partnership agreement (the Agreement). The interpretation of the provisions of the Agreement, in conjunction with the state partnership statutes and the FLP characteristics (e.g., its rights, lack of rights, and limitations), are important considerations for the valuation analyst when estimating the appropriate discount to the partnership pro rata NAV.
Business Purpose The partnership will fail the tests put forth in Section 2703 if the stated business purpose is not valid. Clearly, describing the valid business purpose is the responsibility of the attorney who draws up the Agreement. However, the analyst may question
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Exhibit 7.11
FLP Document Checklist For a Partnership That Is Just Being Formed: 1. The final or proposed partnership agreement. 2. Documentation of the assets being contributed to the partnership. 3. Valuations of real estate and similar assets. The analyst should obtain market values of publicly traded securities that are being contributed. 4. Determination of whether certain assets (e.g., other partnership interests, stock in a privately owned company) to be contributed to the partnership need to be valued separately and prior to the formation of the partnership. The analyst should request the information necessary to make each of those valuations. 5. Balance sheet as of the valuation date. 6. Income statement for the stub period through the valuation date. 7. Pro forma income and expense statement for the partnership once it is effective. 8. The general partner’s anticipated policies regarding: a. Prospective distributions to the partners and distribution policy. b. The Section 754 election. For a Partnership That Is Ongoing: 1. 2. 3. 4.
The same information requested for a partnership that is just being formed. Partnership income tax returns for a reasonable period of time or for the life of the partnership, if its history is short. The history of distributions made to the partners. Information regarding any transfers of partnership interests.
the FLP business purpose. Various Tax Court cases have eliminated the claim that a gift had been made because no business purpose for the FLP was established. However, adequate documentation of the FLP business purpose should be maintained in order to support the FLP planning and business goals.
Contributions The valuation analyst should understand how the partnership is capitalized. In particular, the analyst should be aware of the circumstances in which additional capital contributions (i.e., cash calls) may be required.
Management Prerogatives The Agreement should articulate management responsibilities and authority. These responsibilities are typically granted exclusively to the general partner. The agreement should also disclose (1) the limitations placed on the general partner and (2) the basis upon which he or she can be removed, if any. Most important, the Agreement should speak to the inherent characteristics of the limited partnership interests. Ordinarily, the limited partners have (1) no liability (beyond the requirements of the Agreement) to provide additional capital, (2) no role in the management of the partnership, and (3) no ability to unilaterally dissolve the partnership.
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Distributions to the Partners Typically, partnership distributions will be at the sole discretion of the general partner. However, there may be language in the Agreement that defines “cash flow” and that indicates the general partner may establish reserves for current or future needs of the partnership. Typically, the general partner will base any distribution decision on the partnership’s “net cash flow.”
Control and Lack of Control The percentage ownership of the corporation that gives an owner the right to unilaterally sell, merge, liquidate, or effect similar transactions is called a supermajority interest. In some states, a simple majority is all it takes to exercise corporate control. Other states require two-thirds or an even greater percentage to exercise control. If the supermajority owner sells his or her stock to another person, that buyer will stand in the same shoes as the previous owner. He or she will have the same ability as the previous owner to determine operating policies, establish his or her own salary, set dividend payouts, hire and fire employees, and the like. The new owner will also have the same ability to unilaterally sell, merge, or liquidate the corporation as did the former owner. If the same supermajority ownership in an FLP represents control because of various Agreement provisions, the situation is dramatically different. The owner of the FLP interest cannot generally pass on his or her controlling attributes to another party through sale or other means of transfer, for the reason explained earlier. An owner of a partnership interest cannot actually sell his or her partnership interest. The owner can only transfer an assignee interest to another. This is because the partner cannot pass partner status to anyone. In the context of an FLP in which all the partners are family members, it is reasonable to assume that the hypothetical, nonfamily assignee will remain an assignee. It is possible for an Agreement to provide that a supermajority ownership position would enable the holder to dissolve the partnership, replace the general partner, and/or determine distributions. However, such Agreement provisions would be at cross-purposes with the objectives of the typical FLP. In normal circumstances, the general partner of an FLP will unilaterally control all partnership operations.
Transferability of Family Limited Partnership Interests There is normally a provision in the Agreement (possibly in the form of a right of first refusal to the partnership and to the individual partners) restricting transfer of an FLP interest to anyone other than a family member. The important consideration is that a partner cannot sell or transfer a partnership interest. The partner can only sell a transferee/assignee interest. The reason for this is that no one can force another party to be one’s partner. In essence, the analyst is valuing an assignee interest. An assignee has no voting rights whatsoever. The assignee has only an economic interest (i.e., the right to receive the pro rata share of distributions made to all the partners).
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Section 754 The Agreement may be silent regarding the Section 754 election, which gives the acquiring partner the advantage of increasing his or her tax basis in the partnership to the purchase price. Alternatively, the Agreement may say that the availability of the election is strictly at the discretion of the general partner or the tax matters partner. The Agreement may state that if a partner or assignee requests a Section 754 election, the general partner is obligated to honor the request. If the Agreement is silent, there is a default to the applicable state law.
Dissolution/Liquidation The partnership agreement is likely to specify several events that will cause the dissolution of the partnership, such as: 1. Reaching the designated term (i.e., the date at which the partnership is to be liquidated as indicated in the agreement). 2. Upon the death, bankruptcy, or other demise of the general partner. However, the limited partners normally can vote to reconstitute and continue the partnership under certain conditions. 3. By vote of a prescribed percentage of the partners. 4. The occurrence of any circumstance that, by law, would require that the partnership be dissolved. Clearly, the terms of a typical partnership agreement (along with the fundamental characteristics of a limited partnership interest as defined in state partnership statutes) serve to: 1. Exclude the limited partners from participation in the management of the partnership, including decisions pertaining to distributions to be made to the partners. 2. Restrict the transferability of a limited partnership interest. 3. Provide the general partner with exclusive managerial power to operate and manage the partnership. 4. Distance the limited partners from the assets of the partnership, thereby preventing the limited partners from having access either to partnership assets or to their own capital contributions.
Recent Tax Court Cases Four recent noteworthy FLP valuation cases will be discussed in this chapter: Strangi, McCord, Lappo, and Peracchio. Strangi7 is important because the IRS successfully challenged the validity of the partnership itself based on how the integrity of the partnership entity was (or was not) respected after formation. The Tax Court clearly agreed with the IRS that the
7 Estate
of Albert Strangi, et al. v. Commissioner, T.C. Memo 2003-145 (May 20, 2003).
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Strangi FLP operated in violation of the basic rules defining a retained interest. This case is currently on appeal, for the second time, at the Fifth Circuit. McCord,8 Lappo,9 and Peracchio10 are three FLP valuation cases with significant valuation implications. We only review the McCord case here, since Lappo and Perrachio are very similar in nature and result. The discussion of McCord is intended to be a purely factual one. We do not agree with many of the findings of the Tax Court in these three cases. Nevertheless, analysts should be familiar with the arguments presented by both the IRS and the taxpayers in these cases. It may be more than coincidence that the Tax Court exactly split the difference between the two sides in all three cases.
Strangi v. Commissioner In the Strangi decision, the Tax Court held that: 1. The partnership was valid under state law and would be recognized for estate tax purposes. The Tax Court was skeptical of the estate’s claims about the nontax motives of forming the partnership. The Tax Court concluded, however, that the partnership was validly formed under state law. “Regardless of subjective intentions, the partnership had sufficient substance to be recognized for tax purposes. Its existence would not be disregarded by potential purchasers of decedent’s assets, and we do not disregard it in this case.” 2. Section 2703(a) did not apply to the partnership agreement. The Tax Court held that the property included in the decedent’s estate was a limited partnership interest. The property was an interest in the corporate general partner rather than in the underlying assets of the partnership. The Tax Court concluded that “Congress did not intend, by the enactment of Section 2703, to treat partnership assets as if they were assets of the estate where the legal interest owned by the decedent at the time of death was a limited partnership or corporate interest.” 3. The transfer of assets to the partnership was not a taxable gift. The Tax Court held that “the disparity between the value of the assets in the hands of the decedent and the alleged value of his partnership interest reflects on the credibility of the claimed discount applicable to the partnership interest. It does not reflect a taxable gift.” 4. The discounts proposed by the IRS expert were accepted. The Tax Court did not find persuasive evidence that a hypothetical seller would not market, as a unit, (a) the decedent’s limited partnership interest in the partnership and (b) the decedent’s interest in the corporate general partner of the partnership. The Tax Court held that “the entities were created as a unit and operated as a unit and were functionally inseparable.” In the initial Strangi decision, the Tax Court did not consider Section 2036. This was because the government did not assert or tender the issue until shortly before trial. In June 2002, The Fifth Circuit Court of Appeals found no obvious reason for the Tax Court to deny the government’s motion to add the Section 2036 claim. The Fifth Circuit concluded that the denial of the government’s motion was an abuse of discretion on the part of the Tax Court. 8 Charles
T. McCord, Jr. and Mary S. McCord, Donors v. Commissioner, 120 T.C. 13 (2003). Lappo v. Commissioner, T.C. Memo 2003-258 (Sept. 3, 2003). 10 Peter S. Peracchio v. Commissioner, T.C. Memo 2003-258 (Sept. 25, 2003). 9 Clarissa W.
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Therefore, the Fifth Circuit reversed the Tax Court’s decision and remanded the case for consideration of the Section 2036 claim. The Fifth Circuit affirmed the Tax Court on all other conclusions. The Fifth Circuit did state, however, that the issue of value of the decedent’s interest may be revisited after considering the Section 2036 claim. The Tax Court, on remand from the Fifth Circuit Court of Appeals, concluded that Section 2036(a) applied and that the estate must include the full value of the assets transferred by the decedent to the partnership in his gross estate. The Tax Court found that there was an implied agreement for Mr. Strangi to retain possession, enjoyment, or the right to income of the assets transferred as contemplated under Section 2036(a)(1). The Tax Court concluded that “the preponderance of the evidence shows that the decedent as a practical matter retained the same relationship to his assets that he had before formation of SFLP and Stranco.” The factors cited by the Tax Court in support of this conclusion included: (1) transfer of approximately 98 percent of decedent’s wealth to the partnership arrangement; (2) continued physical possession of his residence after its transfer to the partnership; and (3) several instances where the partnership distributed funds in response to a need of the decedent or his estate, including expenses to cover back surgery and nursing services. The Tax Court also concluded that decedent retained the right to designate who could enjoy property and income from the partnership as contemplated under Section 2036(a)(2). Finally, the Tax Court concluded that there was no exception for a “bona fide sale for an adequate and full consideration in money or money’s worth,” because the Tax Court did not find that an arm’s-length transaction occurred or that full and adequate consideration existed, since there was a mere “recycling” of value.
McCord v. Commissioner The two key issues in this case are (1) whether transfers of interests in the partnership made by petitioners included all of their rights as class B limited partners or only their economic rights with respect to the partnership and (2) the fair market value of the gifted interests. With respect to the first issue, the Tax Court concluded that the taxpayers assigned only economic rights with respect to the partnership, and such assignments did not confer partner status on the assignees. The Tax Court found no evidence that the partners consented to the admission of the assignees as partners in the partnership; such consent is required by the terms of the partnership agreement. In reaching its conclusion, the Tax Court noted distinctions between the issues in this case and the factors in the Kerr case (in which the Court found that full partnership interests had been transferred). Unlike the circumstances of the Kerr case, the McCord taxpayers consistently followed the provisions of the agreement with regard to transfers. The Tax Court noted that when the petitioners previously transferred their class A partnership interests, each of the partners (1) followed the provisions of the agreement and (2) consented in writing to the admission of the charity as a class A limited partner. The Tax Court also noted that the petitioners could not unilaterally admit the assignees as partners in the partnership. This was because such admission required the consent of all partners, including an unrelated third party. Since both parties agreed on the net asset value of the partnership, the Tax Court’s determination of the fair market value of the gifted interests primarily focused on the appropriate discount for lack of control and discount for lack of marketability to be applied to the net asset value of the partnership.
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Discount for Lack of Control Marketable Securities Portfolios (Equity and Municipal Bonds). Both the expert for the taxpayer and for the IRS referenced the discounts at which shares of closedend funds trade relative to their pro rata share of net asset value in their estimation of an appropriate discount for lack of control for these asset classes. The experts differed, however, with respect to measurement dates, sample funds, and representative discounts within the range of sample funds. With regard to the selection of guideline portfolios, the taxpayer’s expert selected a smaller sample of closed-end funds that he considered to have similar characteristics to the partnership’s assets. The IRS expert selected a larger sample of guideline closed-end funds. Absent any direct objections to specific funds (such as scheduled liquidation dates) in the study, the Tax Court favored using a larger sample. The Tax Court selected its own guideline portfolios, including funds from both experts’ studies. With regard to the magnitude of the discount for lack of control, the taxpayer’s expert selected a discount higher than the average discount of the guideline funds. The IRS expert selected a discount below the average discount of the guideline funds. The Tax Court was not persuaded by either expert’s arguments for higher or lower than average discounts, so the Tax Court effectively split the difference and applied the average discount from its selected sample of guideline funds. Real Estate Partnerships. The experts in this case disagreed with regard to the general type of publicly traded entity from which to extrapolate the minority interest discount for lack of control for the partnership’s real estate partnership investments. The IRS expert selected real estate investment trusts (REITs) as guideline investments and presented a sample of 62 companies. The taxpayer’s expert, on the other hand, selected publicly traded real estate operating companies as guideline investments and presented a sample of 5 companies. The Tax Court concluded that the sample selected by the taxpayer’s expert was not sufficiently similar to the partnership to justify the use of such a small sample. The Tax Court used the REIT study presented by the IRS expert in its determination of the appropriate discount for lack of control to apply to the partnership’s real estate investments. However, the Tax Court applied its own discount for lack of marketability of 18 percent (rather than the 7 percent selected by the IRS expert) in calculating the implied liquidity premium in the REIT universe. The resulting real estate discount for lack of control was 23 percent—compared to the 9 percent estimated by the IRS expert and the 40 percent estimated by the taxpayer’s expert. Other Assets. The IRS expert was instructed to use the discounts for lack of control selected by the taxpayer’s expert for the partnership’s direct real estate holdings and oil and gas interests. Discount for Lack of Marketability. The experts in this case disagreed as to the appropriate studies to use to estimate the discount for lack of marketability to apply to the partnership on an entity-wide basis. The taxpayer’s expert relied on data from empirical studies of restricted stock transactions and also cited the pre-IPO studies to support the estimated discount. The IRS expert relied on a variation of the empirical restricted stock study analysis, which is referred to by the Court as the private placement approach. The Tax Court was persuaded by the IRS expert’s argument that the pre-IPO study analysis was flawed because it “may reflect more than just the availability of a ready market.” This is because (1) a purchaser may seek a lower price in order to compensate for the risk that the IPO may not occur and (2) the
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buyers of shares of the IPO may be insiders who receive a bargain price. The Tax Court rejected the use of the pre-IPO study analysis in determining the appropriate lack of marketability discount. The Tax Court noted flaws with the taxpayer’s support for the discount estimated from the restricted stock studies. Therefore, the Court gave little weight to the restricted stock study analysis of the taxpayer’s expert. The IRS expert’s study included both registered and unregistered private placements. The IRS expert contended that discounts implied in the restricted stock studies include factors other than impaired marketability, such as assessment and monitoring costs. The IRS expert noted that both the registered and unregistered shares traded at discounts. He believed that this fact indicated that the discounts were not attributable solely to impaired marketability, because the registered shares could be sold in the public market. While the Tax Court used the data from the private placement study compiled by the IRS expert, the Court rejected the analysis and estimation of the discount for lack of marketability presented by the IRS expert. The Tax Court noted the IRS expert’s focus on the liquidity aspect of the lack of marketability discount and his lack of conclusion regarding whether or not other factors may contribute to the discount. The Tax Court looked to the “middle” group of private placements in the IRS expert’s study to determine the lack of marketability discount for the partnership. The Tax Court excluded the “low” and “high” categories, because the court determined they were less comparable to the partnership. The impaired marketability of the “low” group (which was dominated by registered private placements) was not as severe as that experienced by the partnership. And, the “high” group (which was dominated by unregistered private placements) had a substantial level of assessment and monitoring costs. Therefore, the Tax Court selected the average discount from the “middle” group, or 20 percent. This discount for lack of marketability was close to the average of the discounts estimated by the taxpayer’s expert (i.e., 35 percent) and by the IRS expert (i.e., 7 percent).
Other Relevant Cases In this section, we review a number of court opinions with particular relevance to the valuation of FLP interests. These cases can provide the valuation analyst with important guidance as to how certain key valuation issues have been viewed by the Tax Court and other relevant courts. However, it is important for the analyst to consider these issues from an economic perspective, considering the facts and circumstances of the subject FLP interest.
Estate of Thompson v. Commissioner11 In this case, the Tax Court ruled that: 1. The FLPs were validly formed pursuant to state laws and potential purchasers of the decedent’s assets would not disregard the FLPs. Therefore, the FLPs had sufficient substance to be recognized for estate tax purposes. 11 Estate
of Thompson v. Commissioner, T.C. Memo. 2002-246 (September 26, 2002).
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2. The decedent retained economic benefit and control of transferred assets. Therefore, Section 2036(a) (pertaining to transfers with a retained life estate) applied. And, the date-of-death value of the assets transferred by the decedent to the FLPs should be included in the decedent’s estate. 3. The transfer of assets by the decedent to the FLPs was only a vehicle for changing the form in which the decedent held his property—a mere “recycling of value.” Therefore, the transfer did not constitute a bona fide sale for full and adequate consideration. The Tax Court noted the following circumstances surrounding (1) the establishment of the FLPs, (2) the transfer of assets to the FLPs, and (3) the subsequent use of the assets. These circumstances support the Court’s conclusion that there was an “implied agreement or understanding that decedent would retain the enjoyment and economic benefit of the property he had transferred”: 1. Before forming the FLPs, the decedent and his children (i.e., the other partners of the FLPs and the corporate general partners) agreed that the decedent would be taken care of financially. 2. At the formation of the FLPs, the decedent transferred nearly all of his wealth to the FLPs. 3. The FLPs made cash distributions to the decedent so he could continue to make annual Christmas gifts to his children and grandchildren. 4. The FLPs distributed funds to the decedent to cover his personal expenses. The Tax Court concluded: “Decedent continued to be the principal economic beneficiary of the contributed property after the partnerships were created. Based on these facts, we conclude that nothing but legal title changed in the decedent’s relationship to his assets after he transferred them to the partnerships.”
Estate of Morton B. Harper v. Commissioner12 The Tax Court concluded that during his lifetime the decedent retained economic benefit of the assets he transferred to the partnership. Therefore, the property contributed to the partnership was includable in his gross estate. In support of its conclusion that there existed an implied agreement that the decedent would retain economic benefit of the assets transferred to the FLP, the Court focused on the following areas: 1. Commingling of funds. A separate bank account for the FLP was not set up until 3 months after the FLP was formed. And, partnership income was deposited in the decedent’s trust account until the separate FLP bank account was established. 2. Delay in transferring assets. There was a delay from the date of formation of the FLP to the formal transfer of assets into the FLP. During that time, the decedent’s trust retained title to the underlying assets and was issued dividend and interest income generated by those assets. 3. History of disproportionate distributions. Distributions made by the managing general partner were heavily weighted to the decedent. And, certain distributions made to the decedent’s trust were linked to expenses of the decedent personally or of his estate.
12 Estate
of Morton B. Harper v. Commissioner, T.C. Memo. 2002-121 (May 15, 2002).
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4. Testamentary characteristics of arrangement. The partnership was principally created as an alternate testamentary vehicle to the trust. The Tax Court noted that the contributed property constituted the majority of the decedent’s assets. The Tax Court also noted the decedent’s advanced age, serious health conditions, and experience as an attorney. The Tax Court found that there was “indifference by those involved toward the formal structure of the partnership arrangement and, as a corollary, toward the degree of separation that the agreement facially purports to establish.” The Tax Court also found that the partnership’s formation fell short of meeting the bona fide sale requirement. This was because the decedent didn’t receive any consideration from his children or the partnership as a result of the property he contributed. The Tax Court concluded that the decedent “essentially stood on both sides of the transaction and conducted the partnership’s formation in absence of any bargaining or negotiating whatsoever.” Therefore, the Tax Court held that the transaction was not of an arm’s-length nature. The Tax Court further noted that there was no transfer for consideration. This was because the transaction (1) involved only value “recycling” and (2) did not appear motivated by primarily legitimate business concerns.
Estate of Kimbell v. United States13 The U.S. District Court held that the value of the assets contributed to an FLP must be included in the decedent’s estate. This was because the property interest did not qualify for either one of the two exceptions to the general rule of inclusion of Section 2036(a): 1. Bona fide sale exception. The Court did not find credible evidence that the formation of the partnership qualified as a bona fide sale (arm’s-length transaction) for full and adequate consideration. The trust, which was wholly owned by the decedent, held the 99 percent limited partnership interest of the partnership. And, the trust owned 50 percent of the LLC that held the 1 percent general partnership interest of the partnership. The Court found that the “Decedent not only ‘stood on both sides of the transaction,’ but, for all intensive purposes, was both sides of the transaction.” The Court also sited the Harper case, stating that there was “only a recycling of value and not a transfer of consideration.” 2. Retained income or rights exception. The Court noted several provisions in the partnership agreement that allowed the decedent (a) to retain the right to either personally benefit from the income of the partnership or (b) to designate the persons who will benefit from the income of the partnership. The partnership agreement stated that 70 percent in interest of the limited partners had the right to remove the general partner. And, a majority in interest of the limited partners could elect one or more new general partners if a general partner ceased to serve for any reason. The partnership agreement also specified that the general partner had the sole discretion to decide on distributions of income from the partnership. Since the decedent owned the 99 percent limited partnership interest,
13 Estate
of Kimbell v. United States, 2003 U.S. Dist. LEXIS 523 (N.D. Tex. Jan. 15, 2003).
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the decedent had the power to remove the general partner and appoint herself as the general partner. And, as general partner, the decedent could decide on distributions of income from the partnership.
Church v. United States14 This case was the first FLP case to be tried in U.S. District Court. The U.S. District Court for the Western District of Texas ruled (1) that the decedent entered into a valid Texas limited partnership and (2) that the decedent did not make a gift to the other limited partners. The Court found that the partnership had a bona fide business purpose and was not formed solely to reduce estate taxes. The following is a list of some of the findings by the Court that led to that conclusion. 1. The Court found that “the primary purpose of the partners in forming the partnership was a desire to preserve the family ranching enterprise for themselves and their decedents.” 2. The Court noted that it was the intention of the partnership to purchase the remaining undivided interests in the ranch when sufficient capital accumulated in the partnership. The capital needed to purchase the remaining interests in the ranch would most likely come from the income related to the securities. 3. “The character of the interests owning a majority of the Ranch changed dramatically as a result of the Partnership.” The formation of the partnership eliminated the decedent’s right to use and enjoy the property, or force a partition or possible sale. 4. The decedent did not have the power to alter, amend, revoke, or terminate the partnership agreement. 5. The Court found that there was no express or implied agreement between the decedent and the other partners of the partnership allowing the decedent to retain the possession or enjoyment of, or the right to the income from, the partnership property within the meaning of Section 2036. 6. The terms and restrictions of the partnership agreement were comparable to similar arrangements entered into by persons in arm’s-length transactions. The Court also ruled that there was no gift by the decedent to the other partners at formation. This was because the decedent received adequate consideration for the assets contributed to the partnership. The partnership interests received by each partner were directly proportionate to the contributions made by each partner at formation. The decedent was allocated 62 percent of the profit, loss, and income from the ranch and 99 percent of the profit, loss, and income from the securities. This allocation was based on the decedent’s initial capital contribution percentages. No partner received an economic benefit from the contribution of another. The Court rejected the government’s contention that the term “property” in Section 2703 (pertaining to certain rights and restrictions disregarded) refers to the assets contributed to the partnership by the decedent prior to her death. The Court concluded that the decedent “did not own the assets she contributed to the Partner-
14 Church
v. United States, No. SA-97-CA-0774-OG, 2000 U.S. Dist. LEXIS 714 (W.D. Tex. Jan. 18, 2000), aff’d No. 00-50386 U.S. App. (5th Cir. July 18, 2001).
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ship on the date of her death; she owned a Partnership interest.” Therefore, the estate tax should be imposed on the value of the partnership interest owned by the decedent, not on the underlying assets contributed by the decedent. The Court also rejected the government’s contention that the partnership agreement should be disregarded under Section 2703. “By its very nature, a partnership is a voluntary association of those who wish to engage in business together, and upon whom the law imposes fiduciary duties. Term restrictions, or those on the sale or assignment of a partnership interest that preclude partnership status for a buyer, are part and parcel of the property interest created by state law. These are not the agreements or restrictions Congress intended to reach in passing I.R.C. Section 2703.” The Court rejected the government’s argument that the decedent did not effectively convey the securities to the partnership before her death. The Court noted that “under well-established principles of Texas law, ownership of property intended to be a partnership property is not determined by legal title, but rather by the intention of the parties.” The decedent’s execution of the partnership agreement conveyed her intent to relinquish her beneficial interest in the securities.
Knight v. Commissioner15 In the Knight decision, the Tax Court held that: 1. The partnership would be recognized for gift tax purposes. The steps followed in the creation of the partnership complied with state law. And, the partnership had continued to be a limited partnership under state law since its formation. The Tax Court concluded, “We do not disregard the partnership because we have no reason to conclude from this record that a hypothetical buyer or seller would disregard it.” 2. Section 2704(b) (pertaining to treatment of certain lapsing rights and restrictions) did not apply to the transaction. The Tax Court cited its opinion in the Kerr case. In Kerr, the Tax Court concluded that the restrictions in the partnership agreement (50-year term or dissolution by agreement of all partners and the lack of withdrawal rights of limited partners) were not more restrictive than the limitations that would generally apply under state law. 3. Discounts totaling 15 percent for lack of control and lack of marketability should be applied to the partnership pro rata NAV. The Tax Court did not apply a portfolio discount. This was because the Tax Court did not find convincing evidence that the partnership’s mix of assets would be unattractive to a buyer. The Tax Court found the petitioners’ expert “was acting as an advocate and that his testimony was not objective.” The Tax Court did not agree with the petitioners’ expert’s conclusion of a 10 percent minority interest discount. This was because the selected closed-end bond funds were not comparable to the partnership. However, the Tax Court did believe that “some discount is appropriate based on an analogy to a closed-end fund.” In addition, the Tax Court rejected the petitioners’ claim that, since transfer documents for the gifts stated that the petitioners transferred the number of limited partnership units which equal $300,000 in value, the gifts could not be worth more
15 Knight
v. Commissioner, 115 T.C. 36 (2000).
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than $300,000. The Tax Court disregarded the stated $300,000 gift for two primary reasons: (1) the petitioners reported on their gift tax returns that they gifted a 22.3 percent interest in the partnership rather than reporting they had gifted partnership interests worth $300,000 and (2) petitioners offered expert testimony contending that each gift was worth less than $300,000. The Tax Court concluded, “We find petitioners’ contentions to be at best inconsistent. We treat petitioners’ contention and offer of evidence that the gifts were worth less than $300,000 as opening the door to our consideration of respondent’s argument that the gifts were worth more than $300,000.”
Kerr v. Commissioner16 In the Kerr decision, the Tax Court held that the plaintiffs transferred limited partnership interests in both form and substance rather than assignee interests as the plaintiffs contended. The Tax Court noted that “the doctrine that the substance of a transaction will prevail over its form has been applied in Federal estate and gift tax cases.” The Tax Court found that the petitioners in both substance and form had transferred limited partnership interests based upon the failure to comply with the partnership agreement. In addition, transfer documents stated that petitioners were transferring units of limited partnership interests. The Tax Court also found that the differences between the rights under the partnership agreement of a limited partnership interest versus an assignee interest were not significant. “To characterize the interests that petitioners transferred to the GRAT’s trustees as assignee interests ignores the objective economic reality that there was no meaningful difference between the transfer of an assignee interest as opposed to a limited partnership interest.” 1. The Tax Court rejected the petitioners’ argument that the transfers should be valued as assignee interests under the hypothetical willing buyer/willing seller provisions of Regs. Section 25.2512-1. The Tax Court stated that petitioners had attempted to expand Section 25.2512-1 beyond its original scope by using the provisions to redefine the character of the interests as assignee interests. As the Tax Court had already determined that limited partnership interests had been transferred, and as petitioners had admitted that they had transferred limited partnership interests to their children and the GRATs, this issue was moot. 2. The restrictions on transfer set forth in the partnership agreements did not constitute “applicable restrictions” within the meaning of Section 2704(b). The Tax Court concluded that “the restrictions contained in section 10.01 of the partnership agreements are no more restrictive than the limitations that generally would apply to the partnership under Texas law.” Section 10.01 of the partnership agreements provided that the partnerships will dissolve and liquidate upon the earlier of the December 31, 2043 (the term of the partnership), or by agreement of all partners. Section 7.04 of the Texas Revised Limited Partnership Act (TRLPA) provided that a Texas limited partnership will be dissolved on the earlier of (a) the events specified in the agreement, (b) the written consent of all partners, (c) the withdrawal of a general partner, or (d) entry of judicial dissolution. 16 Kerr
v. Commissioner, 113 T.C. 30 (1999), aff’d No. 00-60903 U.S. App. (5th Cir. June 10, 2002).
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The Tax Court concluded, “In sum, we hold that petitioners transferred limited partnership interests to the GRAT’s trustees. However, consistent with the preceding discussion, we conclude that Section 10.01 of the partnership agreements does not contain an ‘applicable restriction’ within the meaning of Section 2704(b). Accordingly, we will grant petitioners’ motion for partial summary judgment as it pertains to this issue.” In June 2002, the Fifth Circuit of the U.S. Court of Appeals affirmed the Tax Court judgment that restrictions in the partnership agreements were not “applicable restrictions” under Section 2704(b). The Court of Appeals stated that the three defining features of an “applicable restriction” are that it (1) effectively limits the ability of the partnership to liquidate, (2) lapses or can be removed by the family after transfer, and (3) is more restrictive than state law. The Court of Appeals addressed the question of the ability to remove the restrictions. This was the only issue under Section 2704(b) not directly addressed by the Tax Court. The IRS argued that restrictions in the Kerr partnership agreements were removable by the family after the gifting, as there was evidence that the University of Texas (the only nonfamily partner) would not oppose the removal of restrictions if this was proposed by the Kerr family. The Court of Appeals disagreed. This was because the probable consent of a nonfamily member (University of Texas) cannot fulfill the requirement that the family alone be able to remove the restriction.
Chapter 8 Fairness Opinions: Common Errors and Omissions Gilbert E. Matthews
Introduction Calculation and Miscalculation of Aggregate Market Value Diluted Shares Long-Term and Short-Term Debt Preferred Stock and Minority Interests Cash Selection and Use of Guideline Companies and Guideline Acquisitions Acquisition Price Premiums Overstating Averages by Using the Arithmetic Mean Irrational Pricing Multiples Limitations of the Application of the Discounted Cash Flow Method Unreliability of Financial Projections Sensitivity to the Present Value Discount Rate Sensitivity to Terminal Value Depreciation and Capital Expenditures Asset Value Proper Standards of Value Stock-for-Stock Consideration to Other Class Members High-Vote versus Low-Vote Shares Structural Fairness Presentation of Fairness Opinions Updating Fairness Opinions Conclusion
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Introduction Fairness opinions almost always involve an assessment of the value of a company. The question in most fairness opinions is whether a merger or acquisition offer is within an objectively determined range of values for the company or for its shares. In evaluating the fairness of an offer, the analyst is required by law to use valuation methods that are generally accepted. The analyst providing a fairness opinion must expect that the opinion will be scrutinized by the parties to whom it is addressed and will perhaps even be tested in the crucible of litigation. This chapter discusses numerous issues and problems in fairness opinions and valuations, which the author has observed in more than 40 years as an investment banker. The issues range from simple mathematical errors to methodological flaws to broad conceptual issues. Errors that can be laid at the door of the analyst include (1) misinterpretation or misuse of data, (2) failure to recognize mathematical inconsistencies in the data used, and (3) misapplication of generally accepted methods. Some errors, however, derive from flaws in methodologies that have been generally accepted by investment bankers and valuation practitioners. Since analytical methods continue to evolve, it is necessary to be aware of current thinking, to recognize the strengths and weaknesses of various approaches, and to understand when traditional methods need to be reexamined. When an approach is flawed, these flaws should be recognized and corrected. When a concept or method is demonstrably incorrect, either statistically or conceptually, it should be rejected. This chapter points out several areas in which widely used approaches to valuation and to determining fairness should be subjected to critical examination. Some of the broader issues that this chapter will examine include the scope of fairness opinions, the updating of fairness opinions, and the relationship between fairness opinions and the fiduciary duties of directors and control parties. Fairness opinions are normally rendered to assist corporate directors in performing their duties. The increased focus on the duties and responsibilities of corporate directors is likely to engender greater scrutiny of the quality and scope of fairness opinions. Corporate directors should examine not only the financial aspects of fairness, but also the nonfinancial aspects. In addition, both corporate directors and analysts should also give greater attention to the question of when it is appropriate to update fairness opinions.
Calculation and Miscalculation of Aggregate Market Value An approach to valuing companies is to use pricing multiples of EBIT (earnings before interest and taxes) and EBITDA (earnings before interest, taxes, depreciation, and amortization). For computing multiples of EBIT and EBITDA, the numerator is the aggregate value of the company’s capital structure. This numerator can be described in numerous ways, including aggregate market value (AMV), market capitalization, total value of invested capital (TVIC), enterprise value, and market value of invested capital (MVIC). Regardless of the name used for this level of corporate value, the concept is the same.
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AMV is defined as follows: times: plus: plus: plus: plus: less: equals:
Market price of common stock Number of diluted shares Long-term debt Short-term debt Preferred stock (if any) Minority interest (if any) Cash and cash equivalents (excluding any restricted cash) Aggregate market value
In a fairness opinion analysis, each of these components of AMV should be carefully considered. These components are discussed below.
Diluted Shares Public companies report the number of diluted shares using the “treasury stock” method. This method assumes the exercise of “in-the-money” options and warrants and also assumes that the proceeds from exercise are used to buy shares in the market. If the market price of the stock has changed materially since the latest available quarterly financial statement, it may be necessary to recalculate the number of diluted shares outstanding. Furthermore, the prospective transaction price for the subject company, not the stock market price, should be used in this calculation. Also, the analyst should consider if it is appropriate to use (1) the treasury stock method (assuming repurchase of shares in the market) or (2) the maximum dilutive effect (assuming that additional shares are added to outstanding shares with no repurchase). If the maximum dilutive effect is used, the incremental cash to be received upon the stock option exercise must be added to cash, thereby reducing net debt. An occasional error in computing AMV is double-counting “in-the-money” convertible securities. The calculation of diluted earnings per share assumes conversion of these securities. To the extent that diluted shares assume conversion of debt or preferred stock, the convertible senior securities should be excluded in the AMV calculation.
Long-Term and Short-Term Debt Conceptually, debt should be valued at its current market value. However, unless the debt pays interest at a rate materially different from the current market level for comparable quality debt, debt is usually valued at par value in the AMV computation. Zero coupon debt normally should be included at its accreted value, because the accreted value is the present value of the commitment to pay the principal at maturity. Capitalized lease obligations should be included as debt, because they are functionally equivalent to debt. Analysts sometimes calculate AMV of leveraged companies by using the market price of debt that is selling below par. This procedure often results in an overvaluation of the equity. To the extent that debt is selling in the market at substantially below par value because of a below-market coupon, the low market value of the debt does accrue to the value of the equity. Alternatively, if the low price of the debt reflects an issuer’s poor credit standing rather than simply a below-market coupon,
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the issuer is nonetheless obligated to pay the debt in full when due, and it is unlikely that the issuer would be able to repurchase the debt without paying a premium above the market price. The corporation’s shareholders, as residual owners of the company, do not fully benefit from the low market price of its debt in this circumstance. In calculating AMV, it is reasonable to exclude debt that reflects seasonal borrowings for a company with seasonal financing peaks. For example, the temporary financings of a toy company prior to the Christmas season or of an agricultural company prior to harvesting are not part of permanent capital. The analyst should consider whether or not the incremental debt is effectively part of permanent capital. If the seasonal debt is excluded from the AMV calculation, the exclusion should be appropriately noted.
Preferred Stock and Minority Interests A common error in the AMV calculation is to include preferred stock at the nominal value shown on a company’s balance sheet. The analyst should value preferred stock at its economic market value, reflecting its repurchase value, liquidation value, or call value, as appropriate. In theory, a minority interest should be valued at its economic or fair market value. However, this information is rarely available. Since minority interests are normally a very small percentage of AMV, a minority interest is usually included in the AMV calculation at book value. In the rare situation where a minority interest is material, the analyst should, if possible, obtain data to enable him or her to value the investment.
Cash A point on which some analysts disagree is whether or not cash should be deducted in computing AMV. The argument against deducting cash from debt is based on the fact that some or all of the cash is needed for operations. The problem with including cash in the analysis is the difficulty of determining the amount of cash needed (1) for the operations of the subject company and (2) for the operations of each of the guideline companies. To the extent that companies are treated in a similar manner and their balance sheet dates are reasonably close, some analysts conclude that it does not matter if cash is deducted. The procedure of not deducting cash does not stand up to scrutiny, however. The necessity of deducting cash becomes clear when one considers the impact on AMV of a large debt financing. For example, consider a company with an equity market value of $100 million, debt of $75 million, and cash of $50 million. Assume that its AMV would be $125 million if cash were deducted from debt and $175 million if cash were not deducted. If we then assume that this company uses half its cash to repay debt, its AMV would still be $125 million if cash were deducted from debt. However, the AMV would decrease to $150 million if cash were not deducted. Alternatively, if we assume that the company borrowed an additional $50 million, its AMV would still be $125 million if cash were deducted. However, the AMV would increase to $225 million if cash were not deducted. The experienced analyst will recognize that a company does not reduce its value simply by paying off debt or increase its value by borrowing.
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Generally, the more logical analytical result is reached by deducting cash from debt rather than including cash in the computation of AMV.
Selection and Use of Guideline Companies and Guideline Acquisitions In selecting guideline companies (sometimes called comparable companies), the objective is to find publicly traded companies with market multiples that can provide the analyst with guidance in valuing the subject business. Guideline companies, of course, will never be twins of the subject company. There are a few situations where numerous guideline companies are available, such as regional banks or supermarkets. Usually, however, the choice of guideline companies is limited. It is not uncommon for the analyst to be faced with situations in which there are no adequate guideline companies. When choices are limited, companies that have similar secondary characteristics should be considered. Companies that (1) supply the same end-markets or (2) produce dissimilar products but use similar manufacturing processes may be useful as guideline companies to the extent that they are subject to similar market forces. For example, there are important similarities between manufacturers of different products that are supplied to the automobile industry, because the prospects of the various manufacturers are all dependent on the prospects for the automobile industry. The fact that companies are in the same general industry category or have the same SIC code does not necessarily make them relevant guideline companies. If possible, guideline companies should have characteristics that make them similar from the perspective of investors. Companies in the electronics, computer, and semiconductor sectors include innovative, fast-growing companies with strong intellectual property and market positions. However, these sectors also include manufacturers of commodity-type products, such as electrical connectors and memory chips. Stock market pricing multiples are greatly influenced by a company’s growth prospects. It is preferable to have a reasonably large sample of guideline companies. However, there are occasions where one or two entities may clearly provide the best available guideline companies. However, even when one or two appear to be the best, it is also helpful to consider companies that have secondary characteristics that are similar to the subject company. It would be appropriate, then, to accord lesser weight in the guideline publicly traded company value analysis to the companies with the similar secondary characteristics. The selection of the guideline company pricing multiples is as much an art as a science. This selection necessarily depends on the judgment and experience of the analyst. Simply applying an average of the guideline company multiples in the valuation fails to reflect whether the subject company’s characteristics merit a higher or lower multiple than the average, which is typically the case. Smaller companies may have greater growth prospects than their larger competitors. However, it is not unusual to find such smaller companies valued at lower multiples. This may be because of the greater risks perceived by market participants for companies with (1) less financial strength and (2) thin management. For example, Exhibit 8.1 presents the relationship between the number of subscribers of cable television businesses and the multiple of operating cash at which they were acquired.
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Exhibit 8.1
Cable Acquisitions October 1998–March 1999 15.0×
Multiple of Operating Cash Flow
14.0× 13.0× 12.0× 11.0× 10.0× 9.0× 8.0× 7.0× 6.0× 5.0× 4.0× 100
1,000
10,000
100,000
1,000,000
10,000,000
100,000,000
Basic Subscribers
Generally, cable companies with fewer subscribers received lower multiples of operating cash flow. A guideline (or comparable) merged or acquired company transaction takes place as of a given date and the terms of the deal reflect economic and industry conditions as of that date. A common error is the failure of the analyst to take into consideration, either quantitatively or qualitatively, any changes in market conditions, economic conditions, and/or industry conditions that occurred between the date of the guideline transaction and the date of the fairness analysis. For example, AMV multiples paid in the Internet industry in the euphoria of 1999 would have limited applicability to transactions in the Internet industry in the bear market of 2002. The selection process for public and private guideline transactions is similar to the selection process for publicly traded guideline companies. However, data on most acquisitions of private companies, as well as on many acquisitions of divisions of public companies, are often quite limited. Even when data are available, it is usually in much less detail than the data for companies that file U.S. Securities and Exchange Commission (SEC) annual and quarterly reports.
Acquisition Price Premiums The term “control premium” is used inconsistently among valuation practitioners. Many analysts, in describing “levels of value,” define a “control premium” as the difference between (1) the value of a company as a stand-alone business and (2) the value of that company to an acquirer.
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However, the same term is also frequently applied to the price premium over market price paid by an acquirer. This price premium is the difference between the price paid for control and the market price of publicly traded shares. The price premium over the publicly traded market price is more accurately called an “acquisition premium.” The acquisition premium is commonly used by analysts in reviewing transactions. A comparison of the acquisition price premium in the subject transaction to the average historical acquisition price premium is sometimes used as a test of a transaction’s fairness. This approach is flawed, however, because the average price premium paid in acquisitions is upwardly biased. It only includes the prices paid for companies that buyers viewed as being undervalued and, therefore, as attractive targets. The average price premium in acquisitions necessarily excludes companies that acquirers considered overpriced or fairly priced in the marketplace. In any given year, only a small percentage of public companies are acquired. Moreover, market prices fluctuate regularly. For example, one company’s share price may increase only because a competitor was acquired. A rational buyer does not simply determine a price premium and apply it to a fluctuating market price. A premium depends on the specific factors of each transaction. Assume there are two virtually identical companies trading in the market at a price of $50 per share, and that one is acquired at a price of $80 per share, a price premium of 60 percent. In this case, the stock price of the second company could react by rising to $60 or more. It would be illogical to argue that fairness would require a $96 price, a 60 percent price premium over a $60 price per share, for the second company. The price premium in a prior transaction does not determine fairness in a subsequent transaction. Relative pricing multiples are the appropriate measure of the price premium paid in acquisitions. If the multiples paid in acquisitions are higher than the multiples in the market, this becomes a reasonable approach for determining a fair acquisition premium. Exhibit 8.2 presents the multiples calculated for a study of supermarket chains as of late 1997. Faced with evidence like this, which shows that the acquisition multiples in contemporaneous transactions are at the same level as the market multiples, it makes sense for the analyst to conclude that no acquisition price premium is warranted.
Exhibit 8.2
Multiples of Comparable Companies, Supermarket Chain Example Ratio of AMV
Price/Earnings Ratio
LTM Sales
LTM EBITDA
LTM EBIT
LTM EPS
Estimated EPS
Estimated EPS–Year 2
0.35× 0.45×
6.7× 7.6×
11.7× 11.9×
20.5× 20.2×
17.7× 19.0×
14.6× 17.1×
0.36× 0.36×
7.5× 7.9×
12.6× 12.9×
22.3× 20.1×
19.0× 18.5×
16.3× 16.9×
Multiples of Comparable Companies Harmonic mean Median Multiples of Comparable Acquisitions Harmonic mean Median
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Many companies are already fully priced in the market and do not merit acquisition price premiums. In a situation where there had been no acquisitions in the previous 3 years, despite a large number of public companies in the industry, an expert witness appropriately testified that no acquisition premium was applicable. In the late 1990s, shares of most “dot-com” companies were selling in the market at far higher prices than any acquirer would be expected to pay in cash for the entire company, although some acquisitions were made using shares of similar companies. It is also erroneous to apply a price premium for control to a discounted cash flow (DCF) calculation that is based on estimated cash flow of the target corporation after its acquisition.1 A typical DCF calculation values the cash flow of an entire company. If the present value of the future cash flows of a company is worth $50 million, why would any rational buyer pay a price premium above $50 million? A buyer may pay more for the potential incremental cash flow from synergistic or similar benefits. However, an acquirer will rarely pay for benefits that are unique to a specific buyer and that cannot be obtained by another buyer. The incremental value stems from the higher potential cash flow embedded in the projected cash flow, not from an arbitrary control price premium based on other transactions.
Overstating Averages by Using the Arithmetic Mean Everyone is familiar with the calculation of the arithmetic mean: the arithmetic mean of 2, 4, 6 and 8 is 5. The student of statistics learns, however, that there are other methods of averaging numbers. These methods include the geometric mean (the nth root of the product of the numbers) and the harmonic mean (the reciprocal of the arithmetic mean of the reciprocals of the numbers). The geometric mean of 2, 4, 6 and 8 is 4.45, and the harmonic mean is 3.84.2 The customary (but incorrect) manner in which analysts calculate central tendency for pricing multiples such as AMV/EBITDA and P/E is to calculate the arithmetic mean. The median is also widely used and is useful if the sample is sufficiently large. Using the arithmetic mean as a measure of the average pricing multiple is statistically incorrect, because it results in an incorrectly weighted average. The fact is that the arithmetic mean of any ratio with price in the numerator, such as AMV/EBITDA and P/E, always gives greater weight to higher multiples in the sample and lesser weight to lower multiples. The median—the midpoint of the group—is a better measure of central tendency. However, the median effectively eliminates the information in the remaining multiples.3 Statistically, the harmonic mean is a superior measure, because it does not suffer from the flaw of misweighting the data points. The arithmetic mean weights the multiples in proportion to the
1 See
Lippe v. Bairnco, 288 B.R. 678 (S.D.N.Y. 2003), which stated that “the addition of a control premium to a DCF analysis is not consistent with proper and usual valuation practice.” The decision criticized (and disqualified) two expert witnesses who had arbitrarily applied control premiums to their valuations based on guideline companies as well. As a result of the disqualifications of its experts, the plaintiff was unable to support its claims of undervaluation, and the defendants were granted summary judgment. Lippe v. Bairnco, 249 F.Supp.2d 357 (S.D.N.Y. 2003). 2 The geometric mean is always lower than the arithmetic mean and higher than the harmonic mean. 3 The medians of large samples of multiples are normally close to the harmonic mean and are almost always lower than the arithmetic mean.
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magnitude of each multiple. The harmonic mean gives equal weight to an equal dollar investment in each comparable company. Thereby, the arithmetic mean gives a multiple of 30× a weight three times higher than the weight given to a multiple of 10×. The effective weighting can be demonstrated by taking the means of the multiples of two hypothetical companies selling at $40 per share. In this example, we assume that Company A has earnings of $1.00 per share, and Company B has earnings of $4.00 per share. The P/E multiples of the two companies are 40× and 10×, respectively, so that the arithmetic mean multiple is 25×. The harmonic mean is calculated by taking the reciprocals of 40× and 10× (0.025 and 0.1), averaging the reciprocals (0.0625), and then taking the reciprocal of 0.0625 to get a harmonic mean P/E multiple of 16×. Why is the harmonic mean a preferable measure? Assume that an investor buys 100 shares of each stock at $40, for a total investment of $8000. What would the P/E multiple of the portfolio be? The 100 shares of Company A would have aggregate earnings of $100, and the 100 shares of Company B would have aggregate earnings of $400. With a purchase price of $8000 and $500 in total earnings, the P/E multiple of the investor’s portfolio would be 16×, the same as the harmonic mean. If, instead, the investor wished to purchase $400 of earnings of each company, he or she would still buy 100 shares of Company B for $4000. However, the investor would have to spend $16,000 to buy 400 shares of Company B. The total cost of the portfolio would be $20,000 for $800 in earnings. The P/E multiple of this portfolio would be 25×, the same as the arithmetic mean. This demonstrates the greater weight given to stocks with higher P/E multiples by the arithmetic mean. In fact, it would be a rare (and irrational) investor who would build a portfolio using the arithmetic mean. Although analysts commonly use arithmetic means, they are upwardly biased. The harmonic mean is a statistically preferable measure of averaging multiples.
Irrational Pricing Multiples There should be a rational connection between the numerator and the denominator when applying market-derived pricing multiples. Sometimes, analysts apply multiples without having given adequate consideration to the appropriate relationship between the variables in a market approach analysis. Some analysts calculate EBITDA per share and then compare it to the market price per share. This is an example of an irrational pricing multiple. The “I” in EBITDA represents the company’s interest expense. Accordingly, it is inappropriate to use EBITDA in the denominator without including the company’s debt in the numerator. The same criticism applies to such multiples as (1) price/revenues per share and (2) price/EBIT per share. These multiples typically overvalue companies with substantial leverage and undervalue companies with little leverage. If a company doubles its level of EBIT (for example) by making an acquisition with borrowed money, the incremental earnings that are used to make interest payments on the new debt are not available to shareholders. In the application of multiples of revenues, multiples of EBITDA, or multiples of EBIT, the appropriate numerator is not equity value alone. The numerator for these multiples should be AMV—the capitalization of the entire business. If a company incurs substantial debt to finance an acquisition, its revenues per share increase. This transaction directly reduces the equity price/revenues multiple. The equity
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price/revenues multiple does not take into account the impact on earning power of the financing cost. Normally, the equity of the company will not increase in value in proportion to the incremental revenues. However, there is a rational relationship between AMV as the numerator and either EBITDA or EBIT as the denominator, because EBITDA and EBIT include interest expense and AMV includes the amount of debt on which that interest expense is paid. A pricing multiple that is used by some analysts for companies with high rental payments (such as airlines), is AMV/EBITDAR (EBITDA plus rent expense). This approach is intended to level the playing field for comparisons of (1) companies that own most of their assets with (2) companies that rely primarily on leased assets. Analysts usually calculate the AMV/EBITDAR multiple by adding rent expense to EBITDA, but without a corresponding adjustment to AMV. However, this procedure is conceptually incorrect. Rent expense, in many situations, is similar to capitalized lease payments. Accordingly, rent expense is composed of an interest component and a principal payment component. The denominator—EBITDAR—should include only the portion of the annual rent expense payments that is substantively equivalent to interest—and not to the entire rent expense payment. The numerator—AMV—should be increased by the present value of the portion of future rent expense payments that are substantively equivalent to the principal payments.4
Limitations of the Application of the Discounted Cash Flow Method The DCF method is conceptually useful, but it has significant application limitations. The method is based on the premise that the value of a business is the present value of its future net cash flow. Projected net cash flow is discounted to present value using a cost of capital that is intended to reflect the risks of the business. Because cash flow projections are made for only a limited period, the value of a business at the end of the discrete projection period is calculated. This value at the end of a discrete projection period is typically called the “terminal value.” The terminal value is typically estimated (1) by capitalizing the projected cash flow for the final year of the projection, (2) by discounting the terminal value to its present value, and (3) by adding the present value of the terminal value to the present value of the discrete period net cash flows. The theory of a DCF analysis assumes the validity of the financial projections, but financial projection accuracy is a simplifying assumption that does not often comport with the real world. Moreover, a DCF analysis is also highly dependent on the selected discount rate, as well as the methodology used for estimating the terminal value. Often, the terminal value is based on the projected financial results for the year after the discrete projection period. Terminal value is based on the final year of a projection, which is necessarily far less predictable than projections for earlier years. The driving factor in a calculated DCF value is terminal value, so that the final year of the forecast is by far the dominant factor in the result. 4 For a method of determining the value of scheduled future principal and interest payments embedded in rentals, see Sidney Cottle, Roger F. Murray, and Frank E. Block, Graham & Dodd’s Security Analysis, 5th ed. (New York: McGraw-Hill, 1988), pp. 305–310.
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Unreliability of Financial Projections The quality of financial projections and the likelihood that a company will achieve those projections are factors that affect the reliability of a valuation calculated using the DCF method. Accordingly, the DCF method is most useful for companies with revenues that can be reasonably projected based on an existing nucleus of continuing customers, such as regulated utilities and cable television companies. For most businesses, projecting financial performance several years into the future is a difficult, if not impossible, task. Rapidly changing economic conditions and competitive pressures often make it difficult even to project next year’s earnings with confidence. How far into the future can a high-tech company make a supportable financial projection? This question is difficult to answer when the company often does not even know what products it will be producing in 2 years. Changes in the competitive condition within some traditional industries have made earnings projections more speculative than they were in the past. Moreover, even in cyclical industries with volatile earnings, company managements seldom include significant downturns in their projections of future revenues and earnings. The analyst preparing a fairness opinion rarely has sufficient knowledge of the company to prepare reliable independent projections. Financial projections prepared by company management should be provided to the analyst, because management is most familiar with the company and with its prospects. Furthermore, when financial projections are used in a fairness opinion analysis, projections that have been developed in the ordinary course of business are preferable to projections prepared specifically solely for the transaction itself. When possible, the analyst should consider several sets of financial projections for the subject company. Typically, alternative financial projections will take into account alternative economic scenarios regarding both the company and its industry. With this information, the analyst could then (1) compute a DCF value estimate for each scenario, (2) consider the relative probability of each alternative, and (3) calculate value using a weighted average based on the relative probabilities.
Sensitivity to the Present Value Discount Rate It is intuitively obvious that the selected discount rate can greatly affect a DCF method valuation. However, many analysts underestimate the impact that small changes in the discount rate have on calculated values. Exhibit 8.3 presents the range of calculated AMVs and equity values of a hypothetical company, using the following assumptions: • • • • • • • •
Revenues of $100 million Depreciation expense of $5 million Net debt of $50 million Capital expenditures of $6 million in the first year of a 5-year forecast A 20 percent EBITDA margin A 10 percent annual long-term growth rate A 40 percent income tax rate A terminal value estimated using a multiple of 8× EBITDA
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Exhibit 8.3
Range of Calculated AMVs and Equity Values for Hypothetical Company Discount Rate (%) 10 12 14 16 18
AMV ($ million)
Equity Value ($ million)
187 172 159 148 137
137 122 109 98 87
Exhibit 8.3 shows that the calculated equity value, after net debt of $50 million, is $137 million using a 10 percent discount rate, 57 percent higher than the $87 million calculated using an 18 percent discount rate. It should be noted that the impact of the selected discount rate is far more pronounced if the terminal value is computed using the Gordon growth model. The Gordon growth model computes a terminal value by (1) projecting a constant growth in long-term future net cash flow and (2) using the cash flow in the final year of the projection period as a base. The capitalization rate used to calculate terminal value is a function of the difference between the present value discount rate being applied in the computation and the company’s expected long-term growth rate. Exhibit 8.4 is based on the same assumptions as presented above. However, in Exhibit 8.4, the terminal value is computed using the Gordon growth model, assuming a 5 percent expected long-term growth rate. Exhibit 8.4 shows that the AMV of $83 million calculated using a 10 percent discount rate is more than 160 percent higher than the AMV of $218 million calculated using an 18 percent discount rate. To emphasize the sensitivity of the Gordon growth model to both the assumed discount rate and the assumed growth rate, the equity value of $168 million computed using a 10 percent discount rate is more than 400 percent higher than the equity value of $33 million computed using an 18 percent discount rate. The method most commonly taught in business schools to estimate the cost of equity capital is the capital asset pricing model (CAPM). The CAPM is typically used as a component in the calculation of the weighted average cost of capital (WACC). The standard WACC methodology used is to determine a company’s after-tax costs of debt capital and equity capital and then to weight these costs based on an appropriate Exhibit 8.4
Range of Calculated AMVs and Equity Values Using Gordon Growth Model for Hypothetical Company Discount Rate (%) 10 12 14 16 18
AMV ($ million)
Equity Value ($ million)
218 155 120 98 83
168 105 70 48 33
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debt/equity capital structure mix. Ultimately, the calculated discount rate (i.e., the after-tax WACC) is applied to the company’s projected net (after-tax) cash flow in order to arrive at a value estimate. Under the CAPM, a company’s cost of equity is determined by adding the riskfree rate of return (typically, the yield on 20-year U.S. Treasury bonds) to a measure of the equity risk premium.5 A company’s equity risk premium is calculated by multiplying the equity risk premium for the market as a whole by a factor called beta (b). Beta is a measure of the volatility of an individual security’s return relative to the total market return. Where appropriate, a company’s cost of equity may be increased (1) by a company-specific equity risk premium and/or (2) by a small stock (or size adjustment) premium. The CAPM is widely accepted for financial analysis, portfolio management, corporate planning, and other applications. However, its reliability in calculating the appropriate discount rate for an individual company is subject to question. Many of the factors used in estimating the discount rate, such as beta, the company-specific risk premium, and the small company/size adjustment risk premium, are subject to the judgment of the analyst. Ideally, valuation analysts should use a forward-looking beta. In practice, though, historical betas are commonly used because projected betas are not readily available. However, it can sometimes be difficult to determine a specific company’s historical beta. Several financial reporting sources can be used to estimate the beta for a company’s publicly traded stock, but these sources rarely report the same beta for the same company. In addition, a company’s beta can vary widely at different points in time. A company’s beta, therefore, can fluctuate depending on when it is calculated. Moreover, there is significant disagreement in the academic community over the relevance of beta in the cost of capital estimation.6 The estimation of the company-specific equity risk premium is a matter of professional judgment in many situations. Although the company-specific equity risk premium does not lend itself to mathematical determination, it is important for analysts to consider this factor when estimating the cost of equity capital. The estimation of the small company (size adjustment) equity risk premium also requires judgment on the part of the analyst. The general practice, at least in academic theory, is to apply the small company equity risk premium based solely upon the equity value of the subject company, with no regard to the size of its industry. However, the small company equity risk premium should be influenced, at least in part, on the company’s size relative to the size of other entities in its industry. The relative performance of small companies in the recent bull market has caused some analysts to question whether a small company equity risk premium should be applied at all. However, the subsequent decline in the prices of Nasdaq equities (typically smaller companies) has helped to rebut this position.7 Another factor that affects the estimation of a discount rate is the impact of leverage on the company’s capital structure. When a corporation increases its leverage, its cost of equity typically increases, because the corporation’s equity risk increases as its amount of outstanding debt increases. However, this leverage-related 5 The standard source for the equity risk premium for the general stock market is Stocks, Bonds, Bills, and Inflation, published annu-
ally by Ibbotson Associates, www.ibbotson.com. Also, see Chap. 1 of this book. 6 For example, see Eugene F. Fama and Kenneth R. French, Industry Cost of Equity, Journal of Financial Economics, February 1997, p. 153ff. 7 For more on estimating the equity risk premium, see Chap. 1.
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increase in the cost of equity is not linear. An increase from a 10 percent debt/equity ratio to a 25 percent debt/equity ratio will impact the cost of equity far less than an increase from a 75 percent debt/equity ratio to a 90 percent debt/equity ratio. In addition, the interest rate that an issuer pays on its new or refinanced debt increases because the quality of the debt declines. The cost of debt is a function of the capital structure, because the cost of debt typically increases as the company’s amount of outstanding debt increases. An analyst should test the reasonableness of the calculated cost of capital, based on the analyst’s professional judgment and experience as to the rates of return required in the marketplace. The CAPM may produce a different discount rate than would be acceptable to investors in the market. As a result, analysts should be aware of the rates of returns expected by acquirers in merger and acquisition transactions, as well as the rates of return targeted by venture capital investors and leveragedbuyout funds. Rather than relying solely on the theoretical application of CAPM, analysts should also use their experience and knowledge of rates of return required in actual transactions.
Sensitivity to Terminal Value In any DCF analysis, the cash flow projection for the final year necessarily has a larger margin of error than the cash flow projection made in earlier periods. Nevertheless, a small change in the final year projection will affect the value estimate far more than a similar change to the cash flow projection in any earlier year. In the typical DCF analysis, it is not uncommon for the present value of the terminal value to represent 75 percent or more of the total value estimate. The sensitivity of the DCF analysis to the terminal year cash flow projection is a procedural weakness of the DCF method. When such a large percentage of the total value is derived from the terminal value (rather than from the discrete period cash flows), it is arguably a misnomer to call this method discounted “cash flow.” When the terminal value is the dominant component of a calculated DCF value, it is not accurate to describe the calculated number as the present value of future cash flow. Instead, the calculated number is essentially the present value of the capitalized earnings at the end of the projection period. Investment bankers customarily estimate a terminal value by applying a multiple to EBIT or EBITDA in the final year of a projection. The common practice is to select the pricing multiple by reference to the current multiples of comparable or guideline companies. However, the application of a multiple based on current market conditions to terminal year data may not be appropriate. A downward adjustment to the multiple may be necessary. Current multiples reflect current expected growth rates, and expected growth rates may decline over time as an industry matures. Therefore, it is often appropriate to apply a lower multiple to calculate terminal value. The academic approach is to estimate a terminal value by applying a constant growth model, usually the Gordon growth model. An advantage of this approach is that it avoids mixing income approach and market approach valuation procedures. The constant growth model is not always appropriate, however, because the subject company may not be mature—or in a steady growth rate state—at the end of the projection period. The analyst should consider using a multi-stage model in which higher growth rates are used for a discrete period, followed by a lower discount rate in later years.
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A terminal value estimate based on the Gordon growth model is highly sensitive to both (1) the expected long-term growth rate and (2) the discount rate (see Exhibit 8.4). The Gordon growth model will produce a nonmeaningful value estimate when the expected growth rate is close to the discount rate. In fact, if the discount rate equals the expected growth rate, the model produces an infinite terminal value. If the expected growth rate is 2 percent lower than the discount rate, the model values a company at 50× terminal year cash flow. The terminal value estimated using the Gordon growth model can be checked for reasonableness by comparing the estimated terminal value to the projected terminal year EBITDA, EBIT, and net income. If the estimated terminal value implies multiples of EBIT, EBITDA, or net income that are materially inconsistent with current pricing multiples, then the analyst should reexamine the assumptions used in applying the Gordon model.
Depreciation and Capital Expenditures Analysts sometimes make the mistake of applying the Gordon growth model to a terminal year cash flow that includes projected depreciation expense substantially in excess of projected capital expenditures. This phenomenon is clearly impossible in a perpetuity model. The common practice of setting depreciation equal to capital expenditures is similarly incorrect, except in nongrowth situations. If the company is growing, or if prices are expected to increase, then normalized capital expenditures must exceed projected depreciation expense. Assume that a company depreciates its fixed assets over 10 years on a straightline basis, and assume that it increases its annual capital expenditures by 3 percent each year. Exhibit 8.5 calculates the company’s annual depreciation expense in
Exhibit 8.5
Three Percent Growth, 10-Year Straight-Line Depreciation Year
Capital Expenditures
Depreciation Rate (%)
Depreciation in 2013
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
1000 1030 1061 1093 1126 1159 1194 1230 1267 1305 1344
5 10 10 10 10 10 10 10 10 10 5
50.0 103.0 106.1 109.3 112.6 115.9 119.4 123.0 126.7 130.5 67.2
Total depreciation in 2013
1164
Capital expenditures in 2013
1344
Difference % Difference
180 15.5%
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Exhibit 8.6
Excess of Capital Expenditures over Depreciation Growth Rate Life (year)
Method
2%
3%
4%
5%
10 15 10 15
Double declining Double declining Straight line Straight line
7.7 11.9 10.2 15.6
11.6 18.0 15.5 23.8
15.5 24.2 20.9 32.3
19.4 30.3 26.3 41.0
Exhibit 8.7
Depreciation as Percent of Capital Expenditures Growth Rate Life (year)
Method
2%
3%
4%
5%
10 15 10 15
Double declining Double declining Straight line Straight line
92.8 89.3 90.7 86.5
89.6 84.7 86.6 80.8
86.6 80.5 82.7 75.6
83.7 76.7 79.1 70.9
the 11th year. This example demonstrates that, using these specific assumptions, capital expenditure levels would be 15.5 percent higher than long-term depreciation expense. If a company uses an accelerated depreciation method, such as the double declining balance method or the sum-of-the-digits method, the difference between terminal capital expenditures and terminal depreciation expense will be smaller. However, this difference can still be meaningful. Exhibit 8.6 shows the excess of capital expenditures over depreciation expense at various growth rates and depreciation periods, using both double declining balance depreciation and straightline depreciation. Exhibit 8.7 presents the calculation of depreciation expense as a percentage of capital expenditures, using the same assumptions as presented in Exhibit 8.6.
Asset Value If a company has nonearning (nonoperating or excess) or low-earning (underutilized) assets that have a market value greater than their earnings-based value, the company should not be valued solely in relation to its earnings power. The independent market values of these nonoperating, excess, or underutilized assets should be added to the value of the company estimated using other valuation methods.
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Vacant land, facilities of discontinued operations, and works of art are examples of idle or excess assets that have independent value but that do not contribute to earnings. The estimated market value of these assets (net of selling expenses and any taxes due on the sale of the asset) is added to the earnings-based company valuation. If such an adjustment is made, it would be appropriate to adjust projected earnings and cash flow for the carrying costs (such as property taxes) on the nonearning assets. Underutilized assets could include timber properties or farmland. These assets may have minimal earnings, or even be operating at a loss, and could be worth materially more if the timberland or farmland were to be developed to its highest and best use. Income statements and projections should be adjusted to reflect any contribution, positive or negative, of the underutilized assets to the company’s earning power. The analyst should consider whether operations that are being discontinued but are still operating should be treated in a similar manner. The liquidation value of a company’s assets can be a relevant factor in assessing whether a transaction is fair. If the company’s liquidation value is higher than its going-concern value based on the market approach or the income approach, liquidation value sets a floor on a company’s value for a fairness opinion.
Proper Standards of Value The standards for determining transaction fairness and the related appraisal standards are matters of state law. Analysts who render fairness opinions should be familiar with the standards applicable in the subject company’s state of incorporation and should obtain the advice of legal counsel, if necessary. A transaction cannot be fair if the company’s shareholders are entitled to a statutory appraisal in which a court is likely to award greater consideration. The problem for the analyst is that it is not possible to know what a court may do at a later date. However, it is important for the analyst to understand the relevant state standards: the allowable application of a discount for lack of marketability, a discount for lack of control, and a premium for control vary significantly by state. In Delaware, premiums for control and discounts for lack of control and for lack of marketability may not be considered when determining the value of shares in appraisal actions. In rendering a fairness opinion with respect to a Delaware corporation, the analyst should consider the impact of this appraisal standard. A transaction (other than a stock-for-stock transaction) cannot be fair if the transaction consideration is materially lower than the price that likely would be awarded in an appraisal action. Some states have long taken the same position as Delaware with respect to the application of valuation discounts in a statutory appraisal, and several other states have adopted the Delaware position in recent years. These states have sometimes reversed long-standing judicial precedent. There are states in which case law still permits the application of a discount for lack of marketability or a discount for lack of control (or both). Some states have no legal precedent with respect to the application of discounts in shareholder appraisal rights cases. The least shareholderfriendly standard is that followed in Ohio, which awards only the fair market value of the shares before the transaction—generally the public market price of the shares if there was a broad market.
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Stock-for-Stock Investors sometimes prefer stock-for-stock transactions. Unlike transactions in which cash or debt is paid, the stock-for-stock transaction typically can be structured to be tax-free (or, more precisely, tax-deferred). The principal legal standard for fairness in a stock-for-stock transaction is not the absolute price of the shares being received. Rather, fairness is determined on a relative basis. Mergers in which shareholders receive common stock of another company are viewed differently from acquisitions of stock for cash or debt because, in a merger, the shareholders receive a continuing economic interest in the acquiring company. In analyzing the fairness of a stock-for-stock transaction, the analyst should perform a “has-gets” analysis. In this analysis, the analyst compares what a shareholder “has” on a per share basis before the proposed transaction with what the shareholder “gets” on a pro forma basis if the merger is consummated. The pro forma data should be adjusted to take into account any synergistic benefits expected to result from the merger. The analyst should consider quantitative factors, such as earnings, dividends, and asset values. In addition, the analyst should consider any qualitative factors, such as relative growth rates, relative market position, and the quality of management. If there is no competing offer, a board of directors may exercise its business judgment to conclude that even though the value of the shares to be received is less than the amount that might be received in a cash transaction, the shareholders would prefer a nontaxable stock-for-stock transaction. However, if there is a genuine cash offer that is materially higher in value than a stock offer, or if the market value of shares to be received is materially lower than the market value of the same shares before the transaction, then it may become difficult, or even impossible, to render a fairness opinion on the stock-for-stock proposal. Delaware case law distinguishes between situations that would result in a change of control and those that do not result in a change of control. Where there would be a change of ownership control, a board of directors is required (1) to quantify noncash consideration and (2) to objectively compare the noncash offer to a cash offer.8 However, if there is no change of ownership control, the board may favor a transaction that it believes to be consistent with its long-range strategic objectives.9
Consideration to Other Class Members A minimum standard of fairness is the direct impact on the shareholders who are addressed in the opinion. The shareholder should be at least as well off after a transaction as before it. An additional standard, however, is that the control shareholders should not receive a materially disproportionate economic benefit as a result of the transaction.
8
Paramount Communications v. QVC Network, 637 A.2d 34 (Del. 1994). Communications v. Time Inc., 571 A.2d 1140 (Del. 1990).
9 Paramount
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There are transactions in which different forms of consideration are offered to different shareholders, even though all of the company’s shares have identical rights. For example, stock of the acquiring company may be given to the seller’s management and to other control shareholders, while cash is offered to public shareholders. In judging the fairness of this transaction structure, the analyst should review the relative value of these alternative forms of consideration. The alternative forms of consideration do not have to be of precisely equal value. However, any value difference should not be material. In considering the amounts payable to management, it may be necessary to distinguish between the consideration paid directly for the purchase of management-owned shares and any incremental amount that is attributable to present or future services. Shareholders are sometimes given the right to receive cash, stock, or a combination of both. In this situation, fairness should be judged in relation to the blended value of the consideration. The analyst should carefully review any incremental consideration being paid to any control shareholder (or group of shareholders) above what is being offered to noncontrol shareholders. When a control shareholder negotiates a transaction where the control block is to be paid greater consideration per share than other shareholders, the fairness of the transaction to the other shareholders should be questioned. This is true even if such a price differential is permissible under the applicable state law. In a management buyout or other going-private transaction, certain insiders may be granted an equity interest or option in the continuing enterprise, while other shareholders receive cash. It is often difficult to value the equity interests to be received by the insiders in a new entity, which may be highly leveraged. The test of fairness to the shareholders of the selling company in these situations is necessarily determined principally by the value of the consideration paid to the exiting shareholders for their proportionate interest in the company.
High-Vote versus Low-Vote Shares If a company has two classes of shares with different voting rights, an important issue to consider is whether the holders of high-vote shares have the ability to transfer their control position. In a majority of publicly traded companies with two classes of stock, the value of high-vote shares is restricted by a binding provision that prohibits the sale of control at a premium over the price received by other shareholders. For example, there may be an agreement (usually dating back to an initial public offering) that the holders of high-vote shares cannot sell control of the company unless all shareholders receive the same consideration. Also, there may be a provision in the company’s charter or by-laws that high-vote shares cannot be transferred outside the control group unless they are converted into low-vote shares. The public market for high-vote shares does not provide a valid measure of the value of control. The relative market price of low-vote and high-vote shares of the same issuer depends on several factors. These factors include liquidity, dividend expectations, restrictions on the rights and/or transferability of the high-vote shares, and the possibility of a transaction in which high-vote shares may receive a price premium. In cases where both high-vote shares and low-vote shares are publicly traded, the publicly traded high-vote shares seldom collectively represent voting control.
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When the majority of the high-vote shares are closely held, control cannot be affected by all of the publicly traded high-vote shares put together. The high-vote shares, therefore, trade at little or no premium. Without acquiring shares owned by insiders in this situation, purchasers of high-vote shares in the market cannot acquire voting control. Therefore, the market price of high-vote shares is not a function of the voting power of the shares owned by public shareholders. The price premium for voting control should not be calculated on a per share basis. Instead, this premium should be determined by allocating a percentage of the value of the entire company to the class of high-vote shares. There have been a limited number of transactions in which premiums have been paid to holders of highvote shares with voting control. Reviewing these transactions may be helpful to the analyst in assessing the appropriate premium for an entire voting class. It seems obvious that a fairness opinion requested by a special committee of a board of directors should consider the relative fairness of the consideration to be received by the low-vote class compared to the consideration to be received by the high-vote class. However, that is not always the case. Consider a recent proposed recapitalization that would have eliminated a two-class structure in return for cash or additional shares to high-vote shareholders. In that case, the investment banking firm qualified its fairness opinion by explicitly excluding the relative fairness to holders of low-vote shares compared to holders of high-vote shares. The Delaware Supreme Court enjoined the transaction. The Court ruled (1) that the opinion had not addressed fairness to the low-vote shares and (2) that the directors did not have sufficient information as to the impact on the low-vote shareholders.10
Structural Fairness The general practice for fairness opinions is to address the fairness of the consideration being paid in a transaction. However, fairness from a financial point of view may depend on other factors in addition to the consideration received by noncontrol shareholders. Even if the consideration itself is fair to noncontrol shareholders, a transaction may be structurally unfair for other financial reasons. This structural unfairness could occur, for example, if control shareholders were to receive greater consideration than noncontrol shareholders. It is often necessary to weigh (1) the relative consideration received by various parties, (2) other financial terms of the transaction, and (3) any financial alternatives that may be available to shareholders. If a transaction, taken as a whole, is not fair from any of these perspectives, the fairness opinion should not be rendered, even if the consideration offered to noncontrol shareholders is adequate. Ideally, a fairness opinion should not be limited to the fairness of the consideration, and a fairness opinion should state that the entire transaction is fair. In 2000, the Delaware Supreme Court decided that a transaction was not fair, even though the controlling shareholder and the noncontrolling public shareholders received identical cash consideration per share.11 The plaintiff asserted that the directors had failed to determine the value of the company as a going concern. 10 Levco
Alternative Fund v. Reader’s Digest Assn., 803 A.2d 428 (Del. 2002). v. Beran, 765 A.2d 910 (Del. 2000).
11 McMullin
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229
The plaintiff also asserted that the control shareholder had restricted bidders by limiting them to an all-cash deal. The Court agreed with these claims.
Presentation of Fairness Opinions A fairness opinion is normally a two- or three-page document that briefly describes the transaction and the scope of the opinion. The opinion normally includes (1) a description of the procedures used and the factors considered, (2) a discussion of the assumptions and limitations, and (3) the opinion conclusion. The opinion typically does not describe the methodologies used, the details of any analyses, or the reasoning behind the conclusion. Because the typical fairness opinion does not describe the reasoning or the analyses, it is customary and advisable for the board of directors to be given a detailed oral presentation. The detailed oral presentation explaining the reasoning behind the opinion is normally accompanied by a written summary. In the written summary, the analyses underlying the opinion are summarized. The detailed presentation is typically delivered at a formal board meeting at which the directors can ask questions. These meetings can serve to protect both the directors and the opiniongiver in the event of litigation. This is especially true if the presentation is thorough and is clearly understood by the directors. The detailed presentation should accurately reflect the views of the fairness opinion presenter and his/her firm. The board is usually not given the detailed calculations underlying the fairness opinion. The backup data in the analyst’s files or computers should support the analysis and should be retained until any litigation is settled and no further litigation is likely. For a defensive transaction in the face of a hostile bid, a major investment bank advised its client that the prices of options to buy two operating businesses were “within the range of fairness.” Unfortunately for the client, the record did not show that the investment bank’s presentation had supported its conclusions. It was proved at trial that the investment bankers had never actually determined the range of fairness for either business. The Court overturned the defensive measures, and the hostile bidder acquired the target.12 For companies registered with the SEC, a summary of the presentation to the board of directors is often included in a registration, proxy, or information statement sent to shareholders in connection with the transaction. Also, a copy of the written presentation is usually filed supplementally with the SEC and normally is available to the public. The opinion-giver should play a role in preparation of the SEC filing. Because legal counsel is often not fully conversant with the details of the fairness analysis, it is preferable that the text to be used in the filing of the description of the opinion and the presentation be prepared by the opinion-giver, working with counsel. The statement filed with the SEC also includes a summary of the history of the transaction, which should be reviewed by the analyst for accuracy.
12 Hanson
Trust v. ML/SCM Acquisition, 781 F.2d 264 (2nd Cir. 1986).
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When the opinion-giver is retained by a special committee of the board in a related-party transaction, such as going private, there are normally one or more earlier meetings with the special committee. The SEC requires that these meetings be described in the public filing. This disclosure requirement can have the unfortunate effect of restricting communications between the analyst and the special committee. If an analyst thinks that a proposal is within a range of fairness but that a higher price may be negotiable, it is frequently not advisable for the analyst to inform the special committee of the specific fairness range, because that information would subsequently require public disclosure. The analyst is then in the unfortunate position where his or her preferable course of action is to advise the special committee to negotiate, without giving the committee the valuation analysis. Although the SEC’s desire for full disclosure is understandable, it is not always in the best interests of corporate shareholders.
Updating Fairness Opinions The mailing date of the proxy statement, merger prospectus, or similar document sent to shareholders is usually several weeks (or perhaps several months) after the opinion was originally rendered. Numerous factors could cause a transaction that had been fair at an earlier date to become unfair by the mailing date, including changes in market conditions, industry conditions, or the company’s recent operations or its prospects. In common practice, a fairness opinion is dated as of the day that it is delivered to a board of directors, and the opinion that is included in the transaction document mailing is often not updated. However, when the fairness opinion is included in the transaction document sent to shareholders, there is an implication that the opinion is still valid at the mailing date. A fairness opinion protects directors who have a duty to protect the interests of shareholders. It would be beneficial both to directors and to shareholders to have an opinion letter updated prior to the document mailing. In the absence of such an updated opinion, directors would be well advised to ascertain whether the firm that rendered the opinion continues to believe that the transaction is fair. This is particularly important in related-party transactions. Special committees of independent directors (1) should insist that their initial approval of a transaction with a control shareholder be subject to later review and (2) should condition their decision on a timely fairness opinion update. Some firms continue to monitor the fairness of transactions until the shareholders have voted, and some will withdraw an opinion if material changes occur. For example, in 1984, Bear, Stearns & Co. withdrew a fairness opinion it had previously given to Far West Financial Corporation in connection with a buyout of its publicly held shares. Far West had a substantial investment in Gulf Oil Company. A takeover battle caused a material increase in value of the Gulf Oil investment (and therefore in the Far West value) after the proxy statement had been mailed but before the shareholders’ vote. As a result of the withdrawal of the fairness opinion, the stockholders’ meeting was canceled, and the transaction was aborted. No judicial precedent has yet established (1) that an investment banker has an obligation to update a fairness opinion or (2) that a board of directors has an obligation to request such an update. The Delaware Court of Chancery has declined to
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rule that a board’s failure to obtain an update of a fairness opinion represented a breach of its duty except when the Court ultimately determined that the transaction itself was unfair. It remains to be seen how the Chancery Court would rule in a case in which it determines that a transaction had become unfair prior to mailing of the transaction document. A recent Delaware Supreme Court decision13 held that the directors of a target company breached their fiduciary duties by agreeing to a lock-up and to a provision requiring that the proposed transaction be presented to shareholders for a vote. The approval of the transaction was assured because two shareholders owning a majority of the shares had already committed to voting in favor of the merger. The Court concluded that the absence of a “fiduciary out” provision prevented directors from exercising their fiduciary obligations when another bidder emerged. The emphasis on the continuing responsibility of directors after an agreement is signed could, by analogy, lead directors to request an updated fairness opinion when there are indications that the original opinion could be questioned. Factors signaling that a fairness opinion update may be appropriate include (1) unanticipated changes in reported earnings or future prospects of the target, (2) a market price of the company’s shares that has become inconsistent with the terms of the pending transaction, and (3) public criticism of the transaction. Fairness opinions should be updated to help protect directors and investment bankers against potential liability. Shareholders should have full and current information in order to decide how to vote and, if relevant, whether to consider dissenting from the proposed transaction and requesting a statutory appraisal.
Conclusion Business valuation methodology continues to evolve over time. For example, a century ago, the most common business valuation methods related to asset values and dividend yields. These business valuation methods are given far less weight today. A half-century ago, the price/earnings multiple and the multiple of price to cash flow per share were important business valuation components. While the price/earnings multiple continues to be an important valuation component, the price/cash flow multiple is no longer generally accepted. More recently, other multiples—such as AMV/EBITDA—have gained wide acceptance as valuation benchmarks. In addition, the DCF method has become a widely used business valuation method. When an analyst uses any method, it is important to consider the method’s relevance to the specific assignment and to apply the method thoughtfully, not mechanically. Mathematical averages should be used with caution, and valuation premiums and discounts should be applied only when there is a sound basis. The use of any valuation approach or method is subject to the exercise of the analyst’s professional judgment. The fact that the DCF method is an accepted valuation method does not mean that it should always be used. Without reliable financial projections, a DCF calculation cannot be analytically useful. Likewise, the guideline transaction method cannot be reliably applied if the guideline transactions are outdated or are not sufficiently similar to the subject company.
13 Omnicare
v. NCS Healthcare, 818 A.2d 914 (Del. 2003).
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Any conclusion as to the fairness of a transaction must weigh all relevant facts. Valuation is an important consideration, but the decision makers should also consider the structural fairness of the transaction and other factors. A fairness conclusion rendered to the board of directors should weigh the overall impact of a transaction on shareholders. An analyst rendering a fairness opinion should recognize that shareholders are the ultimate beneficiaries of the fairness conclusion and that the shareholders will be considering the fairness opinion in arriving at their transaction decisions. The heightened emphasis on the ethical responsibilities of corporate directors increases their duty to be diligent. This emphasis, in turn, heightens directors’ dependence on professional fairness opinions, and thus the responsibility of analysts is increased.14
14 The
author would like to thank Mark M. Lee and Dr. Michelle Patterson for their assistance in reviewing this chapter.
Chapter 9 Valuing a Canadian Business for a U.S. Purchaser: Canadian Laws to Be Considered Richard M. Wise and Sheri-Anne Doyle
Introduction Foreign Ownership Considerations Acquisition of a Canadian Corporation—Income Tax Considerations Acquisition of a Small Business Canadian Withholding Taxes Other Business Corporations Acts—Shareholder Rights Dissent and Oppression Remedies Take-Over Bids and Follow-Up Offers Canadian Publicly Traded Securities Formal Valuations—Ontario Securities Commission Environmental Laws Intellectual Property Conclusion
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Introduction U.S.-based acquirers top the list of foreign-based companies buying Canadian businesses, with 78 announced transactions in 2002. These 78 transactions had a total value of Cdn. $6.9 billion. This amount compares with 101 foreign-based acquisitions of Canadian companies in 2001, representing a value of Cdn. $37.4 billion. This change was largely due to a drop in 2002 in the number of mega-deals. A summary of these acquisition data is presented in Exhibit 9.1. As an acquirer seeks to maximize the economic benefits of a cross-border acquisition, an evaluation of the various factors that may affect the quantum, timing, and receipt of these benefits is critical. Accordingly, this chapter outlines a number of Canadian laws that a U.S. valuation analyst should be aware of when pricing/valuing a Canadian business. The following comments are not exhaustive, and they do not deal with each and every legal/valuation consideration. However, this chapter should serve as a useful checklist for American analysts advising acquirers of Canadian companies.1
Foreign Ownership Considerations In valuing a Canadian business and, in particular, when considering the market for the business (or for the shares of the enterprise), a U.S. analyst should be aware of restrictions on foreign investment imposed in certain cases by the Canadian government. The American analyst should also be aware of the potential adverse income tax consequences in some acquisitive situations. The Investment Canada Act permits the Canadian federal government, through Industry Canada, to screen proposed foreign investments. The purpose of the screening process is to ensure that a proposed foreign investment is likely to produce a “net benefit to Canada.” Industry Canada administers “notifications” of new investments and applications for foreign investment approval. There are government approval requirements related to new investments by nonresidents that would have a significant effect (1) on the Canadian public interest, (2) the “national identity,” or (3) the “cultural heritage” (e.g., foreign investments, publishing, filmmaking, videos, and music investments). Otherwise, new business ventures by a U.S. or other non-Canadian investor are subject to either a government “review” or a “notification” requirement, depending on the size and degree of control of the investment. The foreign acquirer must inform Industry Canada of the new investment within 30 days of the transaction, but no further information is required. This is true except for the foreign acquisition of an existing business that exceeds the specific size and percentage-of-control thresholds noted below. U.S. investors are exempt from these requirements in a number of situations because of the North American Free Trade Agreement (NAFTA). Also, to limit the growth of foreign-controlled businesses in specified Canadian industries, foreign control is restricted in the banking, media, airline, insurance, trust, and loan industries.
1 See, for example, Richard M. Wise, “More Laws—More Valuations,” CA Magazine, Canadian Institute of Chartered Accountants, October 1987, p. 52.
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Exhibit 9.1
Cross-Border Transactions 2002
2001
2000
Number of Deals
Value ($ billions)
Number of Deals
Value ($ billions)
Number of Deals
Value ($ billions)
108 27 135
9.8 4.7 14.5
136 43 179
41.2 11.6 52.7
223 64 287
101.8 12.0 113.8
78
6.9
101
37.4
140
20.4
Foreigners Acquiring Canadian companies Foreign companies from Canadians Total Top Foreign Acquirer of Canadian Located Companies United States
SOURCE: Mergers & Acquisitions in Canada, 2002 Annual Directory (Toronto: Crosbie & Company Inc., 2003), p. 4. Used with permission. All rights reserved.
Transactions involving the following are exempt from these government review and notification provisions: • • • • • • • • • • •
Securities dealers and venture capitalists acting in the ordinary course of business Government vendors Tax-exempt vendors Banks The acquisition of government-owned or government-controlled businesses Involuntary acquisitions The temporary acquisition of securities in connection with the facilitation of financing arrangements The acquisition of a business in connection with the realization of security Corporate reorganizations The acquisition of a business, the revenue of which is generated from farming carried out on real property acquired in the same transaction The acquisition of insurance company portfolios2
Excluding the exceptions, the Canadian government will perform an investment “review” when a foreign entity acquires control of an existing Canadian business and either of the following two conditions exists:3 1. The business is being acquired directly (rather than indirectly through the acquisition of the non-Canadian parent of the Canadian business) and the business assets have a value of at least Cdn. $5 million. 2. The business is being acquired indirectly (through the acquisition of the nonCanadian parent of the Canadian business) and the Canadian business assets have a value of at least Cdn. $50 million. Any direct and indirect investments by non-Canadians that exceed the abovenoted thresholds will be reviewed by Industry Canada for purposes of assessing the 2 There
may be other legislation that could apply to some of these transactions. a mere notification of the acquisition is required.
3 Otherwise,
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net benefit to the country. If the acquisition of a Canadian business (see below) has implications regarding Canada’s national identity or cultural heritage, the acquisition will be subject to review by Industry Canada, whether or not the above-mentioned thresholds apply. A “cultural business” is one that carries on any of the following activities: •
• • • •
Publishes, distributes, or sells books, magazines, periodicals, newspapers, or music in print or in machine-readable form, unless all that it does is print or typeset books, magazines, periodicals, or newspapers. Produces, distributes, sells, or exhibits audio, film, video, or music-video recordings. Broadcasts through the medium of radio, television, or cable television. Provides satellite programming or broadcast network services. Engages in radio communication, other than broadcasting, in which the transmissions are intended for direct reception by the general public.4
Industry Canada considers a number of specific factors when assessing the net benefit of an acquisition to Canada. These factors are intended to ensure that no detriment to Canada will result from the transaction.5 These factors include, for example (1) the effects on competition within Canadian industries, (2) the compatibility of the activities of the acquiree with the industrial, economic, and cultural policies of the federal and provincial governments concerned, and (3) the effect of the investment on Canada’s competitive position in world markets. Therefore, particularly when considering the market for the target business, the American analyst should consider each of these factors. A Canadian valuation analyst should also consider these factors. This is because the market for a Canadian business is generally not limited to Canadian purchasers. For example, this issue affected the valuation of Canadian Regional Airlines (a regional, feeder airline) during arbitration hearings in 2001.6 These arbitration hearings were between Air Canada and the Federal Competition Bureau in Ottawa. This issue was relevant because the voting shares of domestic airlines in Canada may not be more than 25 percent foreign-owned. The Investment Canada Act provides that a business is “acquired” if control of that business is acquired. The act contains the following provisions: •
•
•
Corporations—A corporation carrying on business in Canada may be acquired through either a share purchase or an asset purchase. In a share transaction, the non-Canadian must acquire the majority of the company’s voting shares.7 In an asset purchase, control is acquired if all or substantially all of the corporation’s assets are acquired by the non-Canadian. Noncorporations—In the case of unincorporated businesses, all transactions in which the majority of voting interests is acquired are considered an acquisition of control. Indirect Acquisitions—These would include acquisitions by nonresidents of nonCanadian businesses that control Canadian businesses. If a parent corporation
4 The federal minister responsible for reviewing proposed acquisitions of “cultural businesses” is the Minister of Canadian Heritage. 5 Since the enactment of the Investment Canada Act (1985), only one investment by a nonresident of Canada has been rejected under this process. 6 Proceedings before Attorney Charles A. Hunnicutt of Washington, D.C. (former U.S. Assistant Secretary of Transportation). 7 There is a presumption that, if at least one-third, but less than one-half, of the corporation’s voting shares are acquired, there is an acquisition of control. Such a presumption is rebuttable by demonstrating that there is no control in fact.
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controls a subsidiary, the parent is deemed to indirectly control any entities that are controlled, whether directly or indirectly, by that subsidiary.
Acquisition of a Canadian Corporation—Income Tax Considerations Consideration of income taxes is, of course, important in developing the rate of return and, ultimately, the price to pay for a target business. One important indication of the value of a company’s shares to a purchaser is the present value of the expected after-tax cash flows accruing to the purchaser, discounted at the purchaser’s required rate of return. Accordingly, when a U.S. purchaser acquires a Canadian business, both the U.S. and Canadian income taxes should be carefully considered. An actual cross-border transaction would typically involve both U.S. and Canadian tax specialists who, working with other counsel, would structure the deal in order to minimize taxes on the future repatriation of funds from Canada to the United States. Similarly, a notional fair market value determination should consider the relevant income tax implications. Analysts would typically assume that the parties to a transaction would conduct appropriate tax planning so as to minimize taxes overall. Some examples of transaction-related income tax considerations are provided below. The deductibility of tax loss carryovers, which reduce future taxes and increase future cash flow, may be affected by a purchase of shares. The Canadian Income Tax Act (ITA)8 allows a corporation in which there has been a change of control of shares to deduct “noncapital losses” (business and property losses). However, this is only true if the business in which the losses were incurred continues to be carried on following the change in control.9 Therefore, a share purchase rather than an asset purchase may be preferable. This is because, with a share purchase, a portion of the target company’s future cash flow can be sheltered from income taxes. The valuation analyst should consider transaction structuring in the valuation, since a knowledgeable purchaser would be expected to structure a transaction so as to minimize income taxes. In any event, as in the United States, the economic and legal aspects of an asset transaction versus a share transaction should be considered in the analysis. It is beyond the scope of this chapter to delve into the myriad income tax aspects that would be considered in a cross-border acquisition. However, some of the common issues that give rise to different income tax consequences include the following: 1. 2. 3. 4. 5.
8 ITA,
Whether the U.S. purchaser is publicly traded. Whether the Canadian target corporation is publicly traded. How the transaction is structured (e.g., is it a purchase or a merger?).10 How the acquisition is financed (by cash, debt, shares, or a combination thereof?). Whether a Canadian holding company would be interposed between the U.S. purchaser and the Canadian target corporation.
subsection 111(5). there is a change in control, net capital losses may not be carried over. 10 Under Canadian corporate and securities laws, there are no provisions for a straight, formal cross-border amalgamation or merger between a domestic and foreign corporation (except for a company incorporated under the laws of Alberta and, in the United States, under Delaware and Texas). Canadian company law restricts amalgamations (other than in Alberta) to companies formed under the same company law statute. 9 If
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Another factor in cross-border transactions is that the Canadian seller will typically consider what portion of the company’s value can be “stripped out” on a taxfree basis prior to the company sale. The Canadian seller will consider this factor in the overall analysis as to whether a sale of shares or a sale of assets is the preferable transaction structure. This transaction structuring analysis will necessarily involve income tax calculations. And, these income tax calculations will consider that dividends from a Canadian corporation can generally be paid on a tax-free basis to another Canadian corporation, subject to certain “safe income” rules.11
Acquisition of a Small Business If a U.S. corporation acquires the shares of a closely held Canadian corporation that qualifies as a Canadian-controlled private corporation (CCPC) under the ITA, the target will lose its favorable “small business deduction.”12 This means that the target will pay income taxes at a higher rate on its profits and not benefit from the lower income tax rates otherwise enjoyed by small businesses. Also, Canada imposes full income tax rates on investment income (other than on dividends, which are taxed at a special, lower flat rate). A portion of this tax is a permanent tax cost to the CCPC. The other portion of this tax is refundable if and when the CCPC subsequently pays taxable dividends to its shareholders. A CCPC could have large amounts of refundable dividend tax accumulated. This is because the CCPC owner is waiting for a propitious time to pay out dividends, thus triggering the income tax refund. However, if control of the CCPC is acquired by a U.S. buyer, any refundable tax balance will be lost. As with the foreign-control issue outlined earlier, a valuation analyst should consider this income tax consequence as well.
Canadian Withholding Taxes Management fees, royalties, interest, dividends, and capital-dividend payments to the U.S. purchaser will be subject to Canadian withholding tax. As such, withholding taxes will result in a cash outflow earlier than what otherwise would be the case. The Canadian thin-capitalization rules may serve to reduce the deductibility of interest paid to a U.S. parent company.13 The rules apply with respect to interest-bearing debt owed by a Canadian resident corporation (1) to a “specified nonresident shareholder”14 or (2) to a nonresident person that does not deal at arm’s length with that shareholder. Dividends received by a nonresident shareholder are generally subject to Canadian income tax at the rate of 25 percent.15 However, under Article X of the CanadaU.S. Income Tax Treaty, the withholding tax rate is limited to 15 percent. This withholding tax rate is reduced to 10 percent if a U.S. resident corporation is the beneficial owner of at least 10 percent of the Canadian company’s voting shares.
11 ITA,
subsection 55(2). Section 125 of the ITA, a CCPC pays a lower rate of income tax on the first $300,000 of “active business income.” 13 ITA, subsection 18(4). 14 ITA, subsection 18(5). 15 ITA, subsection 212(2). 12 Under
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The Canadian ITA permits the repayment of paid-up capital free of income tax (and, hence, withholding tax). If shares of a Canadian corporation are redeemed, only the amount paid that is in excess of the paid-up capital is considered to be a dividend.16 A U.S. purchaser of a Canadian company would, of course, prefer to repatriate the purchase price for the Canadian company’s shares on a withholding-tax-free basis. If, however, the “paid-up capital” of the shares is less than the price paid by the U.S. purchaser, payments by the Canadian company in excess of such paid-up capital would trigger a deemed dividend. That deemed dividend would be subject to Canadian withholding tax. In effect, where a purchaser acquires the shares of a target company, even though the purchase price may exceed the paid-up capital of the shares, the paid-up capital nonetheless remains the same. Acquisition by Using a Canadian Holding Company. In order to avoid the adverse tax consequences (i.e., Canadian withholding taxes on the excess of the redemption amount over the paid-up capital of the shares),17 the U.S. acquirer can incorporate a new Canadian company. These new company shares would have a paid-up capital18 equal to their issue price, which would be equal to the purchase price paid for the Canadian target business. The newly formed Canadian company would then acquire the target company. And, the target company would then become a subsidiary of the new company. In the future, the U.S. corporation could repatriate its purchase price free of Canadian withholding tax simply by redeeming the shares of the holding company. Also, if the holding company and the target company were to be amalgamated, the shares held by the U.S. parent would continue to have a high paid-up capital. Therefore, the amount equivalent to the purchase price could be returned to the U.S. purchaser free of Canadian withholding taxes. For example, if the historical paid-up capital of the shares is $1000 and the purchaser pays $1,000,000 for the shares, the paid-up capital of the shares nonetheless remains at $1000. Therefore, if a U.S. resident acquires the shares, it will be permitted to repatriate only $1000 from the Canadian target. The remaining amount would be considered a dividend for Canadian income tax purposes19 and subject to withholding tax. If the U.S. purchaser eventually elects to dispose of the shares of the Canadian company to a Canadian buyer with which the U.S. parent does not deal at arm’s length, the U.S. purchaser will be precluded from receiving (without Canadian withholding tax) an amount exceeding the paid-up capital of the shares. If the U.S. parent company sells the shares of the Canadian target to a non-arm’s-length purchaser, that purchaser could only pay nonshare consideration up to $1000, the excess being a deemed dividend, as noted earlier. The valuation analyst will typically assume that reasonable tax planning procedures will be performed so that the buyer will structure the acquisition, as well as the ongoing operations, on a basis that would be tax-efficient. Tax planning may involve the formation and interposition of a Canadian holding company to acquire the Canadian target. The U.S. purchaser would fund the holding company with debt and/or equity equal to the purchase price of the Canadian target. Assuming (1) that the Canadian holding company was capitalized with $1,000,000 of equity and (2) that
16 ITA,
subsection 84(3). part XIII, subsection 212(2). 18 Paid-up capital is generally determined by the amount of the consideration received by the issuer for shares issued out of treasury. 19 ITA, subsection 212.1(1). 17 ITA,
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the holding company acquired the shares of the target, then the holding company could repatriate to the U.S. nonresident parent up to $1,000,000 of paid-up capital free of Canadian withholding tax. Again, without such planning, the American purchaser could repatriate only $1000 from its Canadian subsidiary free of withholding tax. The paid-up capital resulting from the use of a holding company would also increase the equity for purposes of the Canadian thin-capitalization rules. This is because, as noted above, if the U.S. parent acquired the shares of the Canadian target directly, the paid-up capital would be only $1000 for purposes of Canada’s thin-capitalization rules. The use of a Canadian holding company for purposes of acquiring a target corporation also allows a U.S. purchaser to deduct interest on loans made in order to finance the acquisition. The interest is deducted against the profits earned by the recently acquired business. The purchaser will borrow funds to acquire the shares of the Canadian company. Following this, the Canadian holding company can be merged with the operating company on a tax-free basis.20 Alternatively, the operating company could be wound up into the holding company, also on a tax-deferred basis.21 Subject to the Canadian thin-capitalization rules, the interest on the borrowed funds would be deductible against the profits of the target business.22 To qualify under the Canadian thin-capitalization rules, for taxation years beginning after 2000, the required debt/equity ratio is 2:1.23 Acquisition Using a Nova Scotia Unlimited Liability Company. In recent years, U.S. purchasers have been using a new vehicle to purchase Canadian businesses. Cross-border tax planning specialists and financial advisors have been paying particular attention to the Nova Scotia unlimited liability company (NSULC).24 This is because of the different manner in which the NSULC is characterized for income tax purposes in Canada and the United States. Under this structure, the U.S. purchaser forms an NSULC. The NSULC, in turn, acquires the target corporation or business operating assets. This target corporation can subsequently be converted into an NSULC.25 Nova Scotia has the only corporation laws in Canada providing for the incorporation of an unlimited liability company. The NSULC has become a very popular business form in recent years. This is because of the ability to characterize this type of business as a pass-through entity for U.S. income tax purposes.26
20 Applying
special “rollover” provisions of the ITA. section 88. 22 Where debt is owing to significant nonresident shareholders, the thin-capitalization rules limiting the deductibility of interest expense would apply to the extent the debt exceeds three times the corporation’s equity. The Canadian company must deduct withholding tax on interest paid to a nonresident lender (which taxes may receive foreign-tax credit treatment in the United States). If the U.S. tax rate is less than the Canadian tax rate on the interest, and the Canadian taxes are fully creditable, then the U.S. nonresident would enjoy an income tax saving. 23 The method of calculating the debt and equity for purposes of this ratio is based on monthly averages. 24 The Nova Scotia Companies Act is the only Canadian statute that allows for incorporation by members having unlimited liability. 25 Through its continuance under Nova Scotia company law or by winding up into an NSULC. 26 U.S. Treasury Regulation Section 301.7701-1 to 301.7701-3. This simplified the task of entity classification for U.S. income tax purposes. Under the check-the-box regulations, entities known as “per se” corporations are classified as corporations. Those that are not on the list of per se corporations are known as “eligible entities.” An eligible entity can elect its classification for U.S. income tax purposes. Such classification will depend on the number of members of the entity. Certain U.S. states continue to rely on the “four factors” test, which may require the alteration of Standard Memorandum and Articles of Association for the NSULC. See T.W. Nelson, Proposed Check-the-Box Regulations and Use of Hybrids in Cross-Border Tax Planning, 9 International Law Practicum 38, 42 (1996). 21 ITA,
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For Canadian income tax purposes, the NSULC is considered a corporation because it is incorporated under the Nova Scotia Companies Act. Accordingly, it is subject to Canadian federal and provincial corporation income tax and does not have the character of a conduit, or pass-through entity. The advantage of this is that the Canadian operations of the U.S. company, which are operated through an NSULC, would pay Canadian corporation income tax rather than both corporation tax and branch tax. Also, as discussed above, if controlled by a nonresident of Canada, the NSULC would not be eligible for the Canadian small business deduction. For U.S. income tax purposes, an NSULC is considered a partnership, provided that it has more than one member. Under the U.S. income tax rules, a partnership is a pass-through entity in which the individual partners are taxed directly, as they would be under the Canadian tax legislation.27 Any Canadian taxes paid by an NSULC would be considered to have been paid by its shareholders for U.S. income tax purposes. In that case, the Canadian taxes would be eligible for the U.S. foreign tax credit. Therefore, for Canadian income tax purposes, the NSULC is taxed as a corporation and does not have the pass-through character of a partnership. Under the Canada-U.S. Income Tax Treaty, an NSULC is a “company” for Canadian purposes of the treaty and is a “resident” of Canada. Hence, unlike a U.S. limited liability company, an NSULC benefits from the Treaty. For U.S. income tax purposes, Canadian operating losses incurred by the NSULC could be applied against the profits of the U.S. parent. That is, the Canadian operating losses are considered to be realized by the American parent for U.S. federal tax purposes.28 The NSULC is governed by a Memorandum of Association and Articles of Association, which are filed with the Nova Scotia registrar of joint-stock companies.29 To form an NSULC, the following documents should be filed with the Nova Scotia registrar of joint-stock companies: 1. Memorandum of Association: This document effectively acts as a contract between the company and its members. 2. Articles of Association: These articles include detailed items such as the procedure for declaring dividends, the structure of the share capital, and the selection of directors. 3. Solicitors Declaration. 4. List of Officers and Directors. There are numerous differences between the Nova Scotia company law and the Canada Business Corporations Act (CBCA).30 It is because of these differences that there are opportunities for using NSULCs in cross-border business and income tax planning. For example, directors of an NSULC are not required to be Canadian residents, whereas the CBCA requires that the majority of the directors reside in Canada.
27 Under
the “check-the-box regulations,” any business entity that is not required to be treated as a corporation is eligible to select its classification for U.S. federal income tax purposes. 28 26 CFR 301.7701-2(b)(8)(ii)(1) and -3(a), (b)(2)(C). 29 These documents are relevant for the default rule prescribed in the regulations under the U.S. Internal Revenue Code (determining whether an entity confers limited liability on its members). The organizational documents of an NSULC are the Memorandum of Association, which details the rules specific to the individual company and also states that the members of the company have unlimited liability. 30 Unlike in the United States, Canada has, in addition to each province’s individual corporations act, its own company law statute— the CBCA. Shareholder appraisal and oppression remedies are available under the CBCA.
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Some examples of how NSULCs can be used in tax planning are outlined below. When a U.S. purchaser uses an NSULC to acquire shares from a Canadian seller, the shares’ “adjusted cost base” (i.e., cost basis) equals the purchase price of the shares. As the paid-up capital of the acquired shares is unchanged, it also precludes repatriation of the purchase price from the Canadian target by the U.S. purchaser without the repatriation being subject to Canadian withholding taxes (see Withholding Taxes above). However, the NSULC can be capitalized with a combination of debt and equity (exceeding the Canadian thin-capitalization rules of 2:1). These funds may be used to acquire the Canadian business. The Canadian target’s original purchase price up to the NSULC paid-up capital may be repatriated free of Canadian withholding taxes.31 Alternatively, an NSULC may be used in an exchangeable-share transaction. In such a case, the U.S. purchaser’s NSULC would subscribe to common shares of the Canadian target. And, the Canadian sellers would exchange their common shares of the target for “retractable”32 and exchangeable preferred shares. These preferred shares would have the same rights and conditions as the U.S. parent company’s shares. Upon a retraction demand by the shareholder, the NSULC would acquire the shares of the U.S. parent and use those shares to repurchase the preferred shares of the Canadian acquiree.33
Other There are, of course, many other aspects of acquisition tax planning that should be considered in a valuation. In such cases, the American valuation analyst may wish to consult with a Canadian valuation analyst and/or tax counsel. For example, the Canadian Income Tax Act and Regulations contain rules for depreciation and amortization. However, these depreciation rates are prescribed by regulation and differ from those permitted under the U.S. Internal Revenue Code. In any share transaction, particularly with respect to capital-intensive businesses or businesses owning valuable intellectual property, an income tax “shield” from depreciation/amortization deductions may be considered for cash flow purposes.
Business Corporations Acts—Shareholder Rights Dissent and Oppression Remedies A U.S. purchaser of either a noncontrolling interest or a controlling interest in a Canadian company should be aware of the rights available to minority shareholders. This is particularly true if the purchaser having control has the intention of subsequently (1) merging the acquired company with another, (2) disposing of the acquiree’s significant assets, and/or (3) issuing shares.
31 While the distribution by a Canadian limited company to a U.S. corporation out of paid-up capital would not be taxable in Canada, it may nonetheless be taxable in the U.S. as a distribution of profits. 32 Retractable shares are special shares (preferred shares) that are redeemable at the option of the holder (and the corporation), much like a promissory demand note. 33 The foregoing summary assumes that the structure will be designed in such a manner as to be acceptable to the U.S. tax authorities. See, for example, The Loewen Group et al v. U.S., ICSID Case No. ARB(AF)/98/3.
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Under the CBCA and most of the provincial corporation-related acts, a number of remedies are available to a noncontrolling shareholder. These remedies depend on the nature of the conduct and/or action of the controlling shareholders. As in the United States, the two major remedies are (1) the dissent (appraisal) remedy and (2) the oppression remedy. These noncontrolling shareholder remedies were enacted in Canada in the federal and provincial company law statutes in the mid1970s.34 A petition to the court by a noncontrolling shareholder to wind up the company is one available option under the oppression remedy. Companies incorporated under the statutes of either Quebec or Prince Edward Island do not provide shareholders the right to dissent or to invoke an oppression remedy. Noncontrolling shareholders of companies incorporated in these two provinces must instead launch a civil action for damages in the event of a dispute with the controlling shareholder. Dissent Remedy. The CBCA35 (and the similar provisions of the relevant provincial business corporation acts) gives a shareholder the right to have his or her shares purchased by the corporation at “fair value.” This right is available when the controlling shareholders make certain major or fundamental changes in the way the corporation is to carry on business. Fundamental changes that give a holder of any class of shares the right to dissent include the following: 1. Where a corporation resolves to amend its articles of incorporation to add, change, or remove any provisions restricting or constraining the issue, transfer, or ownership of shares of that class. 2. Where a corporation resolves to amend its articles of incorporation to add, change, or remove any restriction on the business or businesses that the corporation may carry on. 3. Where a corporation resolves to merge with another corporation; this does not apply to a merger between a holding company and its wholly owned subsidiary, or between two subsidiaries of the same holding company. 4. Where a corporation resolves to continue under the laws of another jurisdiction. 5. Where a corporation resolves to sell, lease, or exchange all or substantially all of its assets. 6. Where a corporation resolves to carry out a going-private transaction or a squeeze-out transaction. A dissenting shareholder is entitled to fair value for his or her shares, determined as of the close of the day before the resolution giving rise to the dissent was adopted. If fair value cannot be agreed on by the parties, first the corporation, then the dissenting shareholder, may apply to a court to establish the fair value of the shares. Oppression Remedy. The CBCA36 (and the similar provisions of the relevant provincial business corporations acts) gives a “complainant” the right to bring a court action against a corporation. To bring an action, the complainant must allege that conduct has occurred that is “oppressive or unfairly prejudicial to or that unfairly disregards the interests of any security holder, creditor, director or officer.” The oppression remedy has been interpreted by the Canadian courts and legal commentators 34 Richard M. Wise, “Determining ‘Fair Value’ under the Appraisal and Oppression Remedies,” Corporate Structure, Finance and
Operations (Vol. 3), L. Sarna, ed. (Toronto: Carswell, 1984), pp. 105–149. 35 Section 190. 36 Section 241.
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as imposing a general standard of “fair” conduct on each corporation and its management. When this standard has been breached, complainants may apply to a court for an order rectifying the oppressive conduct. The business corporations acts set out the remedies available to the court. These remedies include the power to: • • • • • • • • •
Restrain the conduct complained of Appoint a receiver-manager Amend the articles or bylaws of the corporation or to amend a unanimous shareholder agreement Issue or exchange securities Appoint directors in addition to, or in replacement of, existing directors Direct the corporation, or any other person, to purchase the shares of a shareholder Liquidate and dissolve the corporation Set aside a transaction or a contract Order compensation to an aggrieved person
There is no definition as to what is considered conduct that is oppressive, unfairly prejudicial, or unfairly disregards the interests of a complainant. The Canadian courts adjudicate on a case-by-case, fact-specific basis. Potential complainants under the oppression remedy are shareholders (present and past), directors, and officers of a CBCA corporation or its affiliates, the director appointed under the CBCA, and any other person the court decides may properly make an application (including creditors). The first dissent-remedy case to be pleaded was Neonex International Ltd. v. Kolasa,37 before the British Columbia Supreme Court (a trial court). In the decision of that case, Justice Bouck stated: “Because of the unique and different nature of the new legislation, . . . new ground must be ploughed and new principles enunciated.” The Canadian courts have been looking to the U.S. jurisprudence for guidance and assistance in addressing fair value issues in litigation involving shareholder dissent and oppression. For example, in Re Domglas Inc.,38 the Quebec Superior Court noted: The concept of an appraisal remedy in favour of dissenting shareholders is American in origin. It was first granted in the early part of this [20th] century by Maryland and Delaware. Today, the company law of every state of the American Union provides such a remedy, excepting only West Virginia. Thus, it goes without saying that the American jurisprudence on the matter is also relevant and helpful in the determination of the present case [emphasis added]. The Court devoted several pages in its decision to the review of a number of the early U.S. valuation cases relating to the appraisal remedy.39 The judge commented extensively on Columbia University Professor Bonbright’s 1937 two-volume treatise,
37 (1978)
3 BLR 1. Domglas Inc. (1980) 13 BLR 135; 1980 CS 925 (Que. S.C.), aff’d (1982) 138 DLR (3d) 521 (QCA). 39 American General Corp. v. Camp, 190 A. 225 (Md. App. 1937); Roessler v. Security Savings & Loan Co., 72 N.E.2d 259 (Ohio 1947); Phelps v. Wattson-Stillman Co., 293 S.W.2d 429 (Mo. 1956); Warren v. Baltimore Transit Co., 154 A.2d 796 (Md. App. 1959); Woodward v. Quigley, 133 N.W.2d 280 (Iowa 1965); Felder v. Anderson Clayton & Co., 159 A.2d 278 (Del. Ch. 1960); Southdown Inc. v. McGinnis, 510 P.2d 636 (Nev. 1973); In Re Libby, McNeill & Libby, 406 A.2d 54 (Me. 1979); Tri-Continental Corporation v. Battye, 74 A.2d 71 (Del. 1950); First National Bank in Cedar Falls v. Clay, 2 N.W.2d 85 (Iowa 1942); Levin v. Midland-Ross Corp., 194 A.2d 50 (Del. Ch. 1953). 38 Re
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Valuation of Property,40 referred to the Libby case,41 and quoted from Graham, Dodd and Cottle’s celebrated Security Analysis.42 In an early “classic” Canadian case, Re Wall and Redekop Corp.,43 the British Columbia Supreme Court was guided in part by the American General44 decision. Also, the Court of Queen’s Bench of Saskatchewan, in deciding the Montgomery v. Shell Canada45 case, considered the U.S. decision in Endicott Johnson Corp. v. Bade.46 In a more recent case, Maple Leaf Foods Inc. v. Schneider Corporation,47 the Ontario Court, in analyzing the conduct of the Schneider Board of Directors who were alleged by Maple Leaf Foods Inc. to have unfairly disregarded the interests of the minority shareholders, reviewed Delaware case law. The Ontario Court stated that “[a]lthough the . . . decisions of the courts in Delaware . . . are not the law of Ontario, they can, however, offer some guidance.” The U.S. jurisprudence the Ontario court had reviewed was Revlon, Paramount, and Barkan.48 Where a Canadian shareholder alleges oppression, rather than using the oppression remedy route outlined above, he or she may alternatively seek a liquidation and dissolution of the corporation.49
Take-Over Bids and Follow-Up Offers It is important, of course, that a purchaser of a Canadian public company ensures that the relevant securities and corporate laws are complied with. An acquisition of a Canadian publicly traded company is considered a take-over bid if the purchaser acquires more than 20 percent of the target’s shares. This 20 percent of target company shares threshold includes any shares already owned by the purchaser. In certain jurisdictions, if a premium is paid to acquire the target’s shares and the purchaser already holds more than 20 percent of the shares, the purchaser will be forced to make an offer for all of the issued and outstanding shares at the most recent purchase price. This is true whether or not the purchaser intends to acquire 100 percent of the target company shares. The effect of this rule is to ensure that the purchaser pays the same price for both the controlling shares and the noncontrolling shares of the target company. This rule ensures that the purchaser does not acquire the controlling shares at a premium and acquire the noncontrolling shares at a lower price. A take-over bid is defined as “an offer by an offeror to shareholders of a distributing corporation at approximately the same time to acquire all of the shares of a class of issued shares, and includes an offer made by a distributing corporation to
40 James
C. Bonbright, The Valuation of Property (New York: McGraw-Hill, 1937).
41 In Re Libby, McNeill & Libby, 406 A.2d 54: V. Brudney and M.A. Chirelstein, “Fair Value in Corporate Mergers and Takeovers,”
88 Harvard L.R., 297 (1974). 42 Benjamin Graham, David L. Dodd, and Sidney Cottle, Security Analysis—Principles and Technique (New York: McGraw-Hill, 1962). 43 [1975] 1 WWR 621 (3d) 733 (BCSC), 50 DLR (3d) 733. 44 Supra, footnote 39. 45 [1980] 5 WWR 543 (Sask. Q.B.). 46 376 N.Y.S.2d 103 (N.Y. App. 1975). 47 (1998), 42 OR (3d) 177 (CA). 48 Revlon v. McAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986); Paramount Communications v. QVC Network Inc., 637 A.2d 34 (Del. 1934); Barkan v. Amsted Industries Inc., 567 A.2d 1279 (Del. 1989). 49 CBCA, subsection 214(1).
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repurchase all of the shares of a class of its shares.”50 In the event of a take-over bid, shareholders have a dissent remedy available to them. The dissenting shareholders may demand payment of the fair value of their shares,51 as in the case of a fundamental corporate change (including going private).
Canadian Publicly Traded Securities Unlike the United States, Canada does not have a national securities regulator. Rather, each province has jurisdiction over its securities law. The Ontario Securities Commission (OSC) is the regulatory body that usually takes the lead, and the other provinces generally follow. The Toronto Stock Exchange is the largest and most prominent stock exchange in Canada. The Securities Commissions of the Provinces of Quebec and British Columbia also have prescribed rules and have formulated policies regarding valuations for regulatory purposes. No formal policies or rules exist in the United States for securities regulatory purposes in the same “codified” and comprehensive manner as in Canada. The following discussion provides an informal checklist for analysts preparing a “formal valuation” of publicly traded securities in a regulatory context. Such regulatory contexts may include (1) a take-over bid by an insider, (2) a going-private transaction, or (3) a related-party transaction.
Formal Valuations—Ontario Securities Commission In May 2002, the OSC promulgated Rule 61-501 (Rule) and Companion Policy 61501CP (Companion Policy).52 These documents contain specific requirements and recommendations concerning formal valuations in situations involving insider bids, issuer bids, going-private transactions, and related-party transactions. The Regulation to the Ontario Securities Act53 defines “formal valuation” as: A valuation prepared by a qualified and independent valuer based upon techniques that are appropriate in the circumstances, after considering goingconcern or liquidation assumptions, or both, together with other relevant assumptions, that arrives at an opinion as to a value or range of values for the participating securities. No downward adjustments may be made to reflect the fact that the participating securities do not form part of a controlling interest. More specifically, Rule 61-501, entitled “Insider Bids, Issuer Bids, Going Private Transactions and Related Party Transactions,” relates to the following types of transactions:
50 CBCA,
subsection 206(1). subparagraph 206(3)(c)(ii). 52 The Companion Policy sets out the OSC views on certain issues relating to the subject matter of the Rule. 53 Subsection 163(1) of Regulation 910. 51 CBCA,
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Transaction Type Insider bids Issuer bids Going-private transactions Related-party transactions
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Transaction Description Take-over bids by an insider Offers by an issuer to acquire its own securities Transactions involving the termination of a security holder’s interest Transactions between an issuer and persons related to it
The Rule relates to formal valuations and prior valuations. The Rule and Part 5 of the Companion Policy address the following valuation-related subjects: 1. 2. 3. 4. 5. 6. 7. 8. 9.
Independence Disclosure regarding the valuation analyst Subject matter of formal valuation Preparation of formal valuation Summary of formal valuation Filing of formal valuation Valuation analyst’s consent Disclosure of prior valuation Filing of prior valuation
Independence and Qualifications of Valuation Analyst. The Rule requires that the valuation analyst be “independent” and have “appropriate qualifications.” While the analyst’s credentials and expertise should be considered in determining qualifications, independence is a question of fact and depends on the circumstances surrounding a given transaction. The independent auditor (or any of its affiliates) of the issuer or interested party is viewed as lacking, or being perceived to lack, independence. This is the case unless it is publicly disclosed that the auditor will cease to be the independent auditor upon completion of the transaction. Conflicts of Interest and Lack of Independence. The following situations would give rise to a lack of independence on the part of the valuation analyst: • • • •
The analyst is an insider, associate, or affiliate of the interested party. The analyst or any of its affiliates is an advisor to the interested party in respect of the transaction. The analyst has a material financial interest in the completion of the transaction. The compensation of the analyst or any of its affiliates depends in whole or in part on any arrangement or understanding that gives the analyst or any of its affiliates a financial incentive in respect of the conclusions reached in the valuation or the outcome of the transaction.
The Companion Policy states that factors relevant in determining the independence of the valuation analyst include whether the analyst has a material financial interest in future business involving the issuer or an affiliated entity thereof. Another factor is whether, during the 24 months before being first contacted for the purpose of the formal valuation or opinion, the analyst had (1) a material involvement in any valuation, appraisal, or review of the financial condition of the issuer or affiliated entity, (2) a material financial interest in a transaction involving the issuer, or (3) acted as lead or colead underwriter of a distribution of securities by the issuer (even if such engagement was carried out at the direction or request of an interested party other than the issuer in the case of an issuer bid). Where the financial services include (1) being a lead or colead lender or manager of the lending
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syndicate for the transaction in respect of which the formal valuation is being obtained or (2) being a lender of a material amount of funds where the issuer or interested party is in financial difficulty and the transaction would materially enhance the lender’s position, the analyst will not be considered by the OSC to be independent. A valuation analyst would not lack independence solely by virtue of being a member (but not manager or comanager) of a soliciting dealer group formed in respect of the transaction, where the analyst, in the capacity as a soliciting dealer (1) does not perform services beyond the customary soliciting dealer’s function and (2) does not receive more than the per-security or per-security-holder fees payable to other members of the soliciting dealer group. The disclosure document should state that it was determined that the valuation analyst is qualified and independent and should disclose the basis of the determination. Disclosure is required of (1) any past, present, or anticipated relationship between the analyst and the interested party or the issuer, which may be relevant to a perceived lack of independence of the analyst, (2) the compensation paid or payable to the analyst, and (3) any other factors relevant to a perceived lack of independence of the analyst. The reason that the compensation and other factors were determined to not result in a loss of independence should also be stated. The Rule also states: 6.1(4) A valuator or a person or company . . . that is paid by one or more interested parties to a transaction or is paid jointly by the issuer and one or more interested parties to a transaction to prepare a formal valuation for a transaction or to provide the opinion . . . for a transaction is not, by virtue of that fact alone, not independent. 6.1(5) . . . a valuator or person or company . . . that is retained by an issuer to provide a formal valuation for an issuer bid or to provide the opinion . . . for an issuer bid is not, by virtue of that fact alone, considered to be an adviser to the interested party in respect of the transaction. Valuation Procedures. The Rule requires a valuation to be performed in a diligent and professional manner. And, the Rule recognizes that the appropriate valuation technique(s) will vary depending on the nature of the subject business, asset, liability, or security. Transaction Type Insider bid/Issuer bid Going-private transaction Related-party transaction
Nature of Securities to Be Valued Securities of the issuer that are the subject of the offer Any securities in which the interest of the holders will be terminated The subject matter of the transaction
In each of the foregoing cases, any noncash consideration being offered, or forming part of the transaction, should be valued. However, a formal valuation of noncash consideration would not be required under Section 6.3 of the Rule, provided that: 1. The noncash consideration consists of securities of a class of an issuer for which a liquid market exists. 2. Securities offered as noncash consideration constitute 10 percent or less of the aggregate number of securities of the class issued and outstanding immediately before distribution and are freely tradable.
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3. The analyst is of the opinion that a valuation of the noncash consideration is not required. 4. The issuer or offeror states in the disclosure document that it has no knowledge of any material nonpublic information concerning the issuer of the securities or said securities that has not been generally disclosed. Valuation Data. The effective valuation date should not be more than 120 days before the date that a disclosure document for the transaction is either filed or sent to security holders. And, the disclosure document should contain appropriate adjustments for material intervening events. A person or company required to have a valuation prepared should, at the request of the analyst, promptly furnish the analyst with access (1) to its management and advisors and (2) to all information in its possession relevant to the valuation. This information should include all financial information it has furnished to its financiers or potential financiers of the proposed transaction. The valuation analyst is expected to use that access to perform a comprehensive review and analysis of information upon which the valuation is based. The analyst should form his or her own independent view (1) of the reasonableness of this information (including any forecasts or projections or other measurements of the expected future performance of the enterprise) and (2) of the assumptions on which it is based. In addition, the analyst should adjust the information provided based on his or her assessment of its reasonableness. Lack of Control and Lack of Marketability Discounts. When estimating the fair market value of securities, no downward adjustment should be made for (1) lack of marketability, (2) posttransaction synergies, or (3) lack of control. Disclosure Requirements. Sufficient disclosure should be provided to allow the beneficial owners of the securities to understand the principal judgments and principal reasoning of the analyst. This disclosure should allow the beneficial owners of the securities to form a reasoned judgment of the valuation opinion. The Companion Policy stipulates that any limitation on the scope of review— and the implications of such limitation on an analyst’s conclusion—should be disclosed in the scope of review section of the report. Scope limitations should not be imposed by the issuer, an interested party, or the analyst. Rather, they should be limited to those beyond their control, arising solely as a result of unusual circumstances. A statement signed by the analyst should be included in the disclosure document referring to the formal valuation, including the following: 1. 2. 3. 4. 5.
The date of the valuation report. The name or the person or company for whom the valuation was prepared. A description of the transaction for which the valuation was prepared. An explicit consent to the filing of the formal valuation with the OSC. The inclusion of the valuation (or a summary thereof) in the disclosure document.
Valuation Summary. As noted above, the offering bid circular, proxy material or material change report should include a “Valuation Summary” (if a formal valuation report is not included therein). The purpose of the Valuation Summary is to provide security holders with sufficient information to understand the principal judgments and the underlying reasoning of the analyst. This information should allow the security holders to form a reasoned judgment with respect to the valuation opinion or conclusion.
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The disclosure requirements of the Valuation Summary also include, among others: 1. The valuation date. 2. Any distinctive perceived benefits/synergies that might accrue to an interested party as a consequence of the transaction, including the following: a. the earlier use of available income tax losses b. lower income taxes c. reduced costs d. increased revenues 3. Explanations of material differences between the formal valuation and a prior valuation report (or, if not practicable, the reasons why not). Prior Valuations. A “prior valuation” is a valuation or appraisal of an issuer, its securities or material assets (whether or not prepared by an independent valuation analyst) that, if disclosed, would reasonably be expected to affect the decision of the beneficial owner (1) to vote for or against a transaction or (2) to retain or dispose of affected securities or offeree securities. If there are no prior valuations, the existence of which is known after reasonable inquiry, the person preparing the document (in which the person would be required to disclose the prior valuation, if any) should include a statement to that effect in the document. Despite any provisions to the contrary in the Rule, the disclosure of a prior valuation is not required in a document if: 1. The contents of the prior valuation are not known to the person required under this Rule to disclose the prior valuation. 2. The prior valuation is not reasonably obtainable by the person referred to in (1) above, irrespective of any obligations of confidentiality. 3. The document contains statements in respect of the prior valuation substantially to the effect of (1) and (2) above. An issuer or offeror required to disclose a prior valuation should file a copy of the prior valuation concurrently with the filing of the document to which the prior valuation relates.
Environmental Laws In Canada, the protection of the environment is a responsibility shared among federal, provincial, and—to a certain degree—municipal levels of government. The provinces have the greatest jurisdiction with respect to such matters. And, the enforcement of applicable laws varies substantially from province to province. Under provincial laws, there is generally a prohibition against the discharge of pollutants into the environment. The definition of what constitutes a “pollutant” and the “environment” varies from province to province. Generally, the standards of environmental compliance are becoming increasingly stringent. And, the consequences of noncompliance are becoming more serious. A U.S. purchaser of a Canadian business would need to ensure that the target is in compliance with environmental laws in the province(s) in which it does business, as well as applicable federal environmental laws. The most important environmental legislation is contained in the Canadian Environment Protection Act (CEPA). The CEPA regulates the import, export, manufacturing, and use in Canada
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of certain proscribed substances and prescribes certain obligations in the event of the unlawful discharge into the environment of defined toxic substances. Penal sanctions for the violation of CEPA may be severe, with directors of a corporation being held personally liable if they assented to or acquiesced in the commission of an offence. Other important federal environmental legislation includes the following: 1. Canadian Environmental Assessment Act (CEAA)—The CEAA may apply to projects involving federal government financing, federal lands, or where certain specified federal approvals are required in order for the project to proceed. If the CEAA applies, an environmental assessment of a project is required. 2. Fisheries Act. 3. Transportation of Dangerous Goods Act, 1992. Costs to comply with environmental regulations can vary from minimal outlays to conform to administrative requirements (e.g., record-keeping, training, and improved reporting) to substantial capital expenditures. Companies may be required to incur costs to clean up contaminated real property and may face civil and criminal fines and penalties for statutory or regulatory noncompliance. And, companies may face punitive damages for grossly negligent conduct. Two methods can be used by a purchaser to adjust the purchase price to reflect a known or potential environmental liability. First, the discount rate applied to expected cash flow can be increased to reflect the increased risk that the environmental liability will negatively affect the future cash flow. Second, the purchaser can reduce the purchase price by the estimated present value of the future environmental costs. In attempting to quantify the future environmental costs, the purchaser should consider: 1. The quantum and timing of the anticipated future after-tax environmental costs (net of related benefits). 2. The probability of the environmental liability materializing and the cost thereof, when the liability is contingent on a future event (such as the enactment of impending environmental legislation). In estimating these costs, it may be appropriate to retain an independent expert. Furthermore, it may be appropriate to consider best-case, worst-case, and mostlikely scenarios.
Intellectual Property Where a U.S. purchaser acquires a Canadian business that has valuable intellectual property, the following factors should be considered: (1) the respective Canadian laws that protect the owner thereof, (2) the trend of the relevant Canadian case law where there has been infringement, and (3) the income tax laws permitting the Canadian target company to amortize the intangible asset(s). For example, in the United States, patent rights are granted to the “first to invent.” In Canada, there is a simpler “first to file” system. Under this system, inventions are patentable provided that the invention has not been publicly disclosed by the inventor anywhere in the world more than 1 year prior to the filing of the application in Canada. Also, whereas methods of medical treatment are patentable in the United States, they are not patentable in Canada (except for pharmaceuticals).
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When intellectual property is developed in-house, the Canadian income tax laws provide for incentive for research and development carried on in Canada. Such incentives include a deduction of both operating expenses and capital expenditures for scientific research and experimental development. An additional tax incentive is an investment tax credit based on qualified expenditures. However, as noted earlier in this chapter, the valuation analyst should verify whether such income tax incentives would be available if the corporation were not Canadian-controlled.
Conclusion This discussion is intended to serve as a checklist for a valuation analyst pricing/valuing a Canadian business that is the target of a U.S. purchaser. A number of the federal and provincial laws can affect both the investment risk and anticipated benefit stream of the target company. As value is in the eye of the buyer, the valuation analyst should objectively assess all of the subjective factors that an informed, prudent, and uncompelled U.S. purchaser would consider.
Chapter 10 Sports Team Valuation and Sports Venue Feasibility Roger J. Grabowski, Jack Huber, and Robert Canton
Introduction The State of the Major Professional Sports Leagues Economics of the Four Major Sports Leagues National Broadcasting Revenue Local Broadcasting Revenue Ticket Revenue Stadium Leases Naming Rights Sponsorships Collective Bargaining Agreement Buyers of Professional Sports Teams Sports Team Values National Football League Major League Baseball National Basketball Association National Hockey League Income Tax Consequences of Professional Sports Team Acquisitions Acquired Assets Player Contracts Stadium Lease/Premium Seat Agreements Season Ticket Holders Broadcasting Agreements Sponsorship Agreements Nonplayer Contracts and Noncontractual Employees Draft Picks Other Intangible Assets Venue Feasibility Analysis The Study Process for the Franchise Owner Considering a New Market Income from Operations
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Venue Financing Alternatives Economic Impact on the State and/or Local Community Conclusion
Introduction At 5:02 PM on February 27, 2003, John Henry, an investment guru, finally closed the purchase of the fabled Boston Red Sox baseball club for a reported $700 million. The sale followed nearly 2 years of deliberations with the Yawkey Trust, the decades-long owner of the team. Various potential bidders emerged throughout the 2-year negotiation process. Those negotiations pushed the value of the team to a level never before seen in Major League Baseball (MLB). The $700 million purchase price seemed unbelievable to many. In reality, however, John Henry was not even the highest bidder. That distinction went to the team of John Harrington and Charles Dolan (who reportedly made a $750 million purchase offer) and to Miles Prentice (who reportedly made a $755 million purchase offer). However, those higher offers were received too late in the bidding process and were considered by the seller to be inadequately supported. Prior to the Boston Red Sox transaction, the largest acquisition in MLB had been for the Cleveland Indians, purchased by Larry Dolan for a reported $323 million in the spring of 2000. To make the Boston Red Sox transaction even more confounding, John Henry had just sold his previous baseball team, the Florida Marlins, to Jeffrey Loria for a reported $158 million earlier in the month. That sales price was less than 25 percent of the price he paid for the Red Sox. Why did John Henry, known for his shrewd investment strategies, buy a MLB team for nearly $550 million more than the one he sold less than a month earlier, and what were the financial ramifications of buying and selling MLB teams within the same month? Clearly, the sports industry has become big business in the last 20 years. Between television rights fees for the NCAA Men’s Basketball Tournament ($6 billion over 11 years, signed in 1999) and acquisition prices paid for National Football League (NFL) teams (e.g., $700 million for the newly created Houston Texans), the numbers have become staggering. Ironically, while some owners pay record prices to acquire professional sports franchises, other owners cry “poor” when it comes to their inability to generate annual operating profits. First, this chapter will focus on the financial aspects of major league sports. Second, this chapter will consider the issue of how a sports franchise creates value for its owners. And third, this chapter will discuss the specific valuation issues that come into play when valuing a sports team and analyzing a sports event venue.
The State of the Major Professional Sports Leagues Professional sports leagues have become big business in the United States. The four major sports leagues command billions of dollars in television contracts and attract over 100 million in annual attendance. The proliferation of cable channels and their need for programming has led to national television contracts for new leagues such
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as (1) the Women’s National Basketball Association, (2) Major League Soccer, and (3) the Arena Football League. In today’s world, major professional sports cannot succeed without the significant revenue generated by television contracts. It follows, then, that ratings are paramount to the sustainability of sports league revenue. Professional sports leagues and media conglomerates have become partners in everything from the scheduling of games to the halftime entertainment at the Super Bowl. It would seem that, with such enormous national exposure and large television contacts, sports leagues would be the envy of the business world. However, the health of each sports league can best be diagnosed by examining the relationship between the leagues and their respective player unions. The NFL suffered a work stoppage in 1982. Since then, the NFL has created a partnership with its player union unrivalled in professional sports. The “hard” salary cap of the NFL has helped assure the basic profitability of all teams. There seems to be little contention between the players’ union and the league. And, players’ union negotiations do not take center stage like they do in other leagues. From a business standpoint, the NFL is the epitome of a success story among all professional sports leagues. MLB narrowly escaped a lockout in 2002. However, there have been work stoppages at every players’ union renegotiation from 1972 to 1995 (including the years 1972, 1973, 1976, 1980, 1981, 1985, 1990, and 1995).1 While many claim the 2002 collective bargaining agreement (CBA) represents a new era in the economics of baseball, the disparity in team payrolls has reached a new high. The New York Yankees and Tampa Bay Devil Rays entered the 2003 season with payrolls approximating $150 million and $20 million, respectively, the largest gap in baseball history. It appears that MLB teams with the largest revenue bases will not be deterred by the league’s new luxury tax. The National Basketball Association (NBA) suffered a work stoppage in 1998. That work stoppage caused many team owners to believe it was necessary to put the league on a stronger financial footing. The current collective bargaining agreement has certainly brought cost containment to the NBA. Its most recent television contract moved NBA games from broadcast networks to cable outlets. Revenues from this television contract increased over the revenues from the previous contract despite declining viewer ratings. However, many analysts believe that using a distribution channel other than free TV could have a detrimental long-term effect on the league. Still, early indications have shown ratings increases, a very promising start to the new contract.2 The National Hockey League (NHL) appears headed for financial disaster. The Buffalo Sabres filed for bankruptcy protection. And, the Sabres were reportedly purchased for only $92 million, which included an arena and a professional lacrosse team. The Ottawa Senators, despite the best record in hockey in the 2002–2003 season, were unable to meet payroll during that season. Other NHL teams face similar financial hardships. Interestingly, only three of the top 15 payroll franchises in the NHL made the second round of the playoffs in 2003. However, many analysts consider this an aberration. These same analysts forecast a work stoppage in the future for the NHL.
1 David M. Carter and Darren Rovell, On the Ball: What You Can Learn about Business from America’s Sports Leaders (London: Financial Times Prentice Hall, 2003), p. 190. 2 Sports Business Daily, a publication of Street & Smith’s Sports Group, April 30, 2003, p. 7.
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Exhibit 10.1
State of the Major Sports Leagues ($ in 000s, Except Ticket Prices) NFL (’01–’02)
MLB (’02)
NBA (’01–’02)
NHL (’01–’02)
$4,318,500 $139,300 $2,112,100 $68,100 49% $1,100 $209.0
$3,355,200 $111,800 $2,023,400 $67,400 60% $2,400 $200.0
$2,494,300 $86,000 $1,408,800 $48,600 56% $3,400 $332.8
$2,031,800 $67,700 $1,261,800 $42,100 62% $1,300 $300.0
$2,066,700 $1,537,000 $(529,500)
$433,000 $401,900 $(31,100)
$702,000 $561,800 $(140,200)
$120,000 $109,200 $(10,800)
$269.2 $316.4 $2,109.1
$32.6 $12–13 $299.2
$56.3 $98.7 $404.2
$19.6 $40.9 $61.1
11.5 4.2 14.7 40.4
2.6 11.0 7.0 15.5
3.0 8.2 5.6 10.2
1.1 2.7 2.3 3.6
16,200 65.1 $53.64 248 $3,494.20 $867,000
65,200 26.8 $18.20 2,430 $490.60 $1,192,000
20,200 17.0 $50.10 1,189 $850.40 $1,011,000
20,600 16.8 $49.86 1,230 $835.50 $1,028,000
Team Revenue and Payroll League-wide revenue Average revenue per team League-wide payroll Average team payroll Payroll to revenue ratio Average salary per player League minimum salary TV Rights Fees/Ad Stats National broadcasting rights fees Network advertising revenue Gross profit/(loss) National cost per 30-second ad Regular season Playoffs Championships National Broadcast TV Ratings Regular season All-star game Playoffs Championships Stadium/Arena Statistics Regular season attendance total Average attendance per game General admin. ticket price per game Games/season Average gate revenue per game Gate revenue per season
SOURCE: The Business of Baseball, Kagan World Media, p. 34. Printed with permission.
This is due to the inability of the players’ union and league to work together on a common plan. The league and its commissioner, Gary Bettman, realize that the NHL cannot continue without some sort of financial restructuring. Exhibit 10.1 presents a summary of the financial state of the four major sports leagues as of the 2001–2002 season.
Economics of the Four Major Sports Leagues Each major sports league has its own unique economics. However, in each league, the ability of teams to generate a profit is determined by seven major factors: 1. National broadcasting revenue 2. Local broadcasting revenue
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3. 4. 5. 6. 7.
257
Ticket revenue Stadium leases Naming rights Sponsorship agreements The CBA with its respective players Each of these seven common factors will be discussed below.
National Broadcasting Revenue Each major sports league has a national broadcasting agreement in which revenues are shared among the leagues’ teams. The most significant agreements are between the NFL and (1) Disney Corporation (ABC and ESPN), (2) Viacom, Inc. (CBS), and (3) News Corp. (Fox). The agreement will bring $18 billion to the NFL in the period from 1998 to 2006. MLB has network agreements with FOX and ESPN. Total revenue from these contracts is expected to increase from $433 million in 2002 to $584 million in 2003 and to $638 million in 2005. The ESPN contract expires after 2005, and the FOX contract expires after 2006. The NBA entered into agreements with ABC, ESPN, and TNT for a combined $4.6 billion over 6 years—at a time of declining overall television ratings. Conversely, the NHL has the smallest national broadcasting agreement. That broadcasting agreement provides for the broadcast of only (1) selected playoff games, (2) the all-star game, and (3) selected games of the week. The NFL, by generating over $75 million annually in revenue per team (versus less than $6 million annually per NHL team), provides each team similar base financial resources to compete each year. Consequently, the NFL has unrivalled team parity. Three recent Super Bowl winners (i.e., New England, Baltimore, and St. Louis) turned losing teams into championship teams in a single year.
Local Broadcasting Revenue Local broadcasting agreements represent a larger revenue source for many major league teams than the national television agreement. And, local broadcasting revenue is not shared among teams in any of the four major sports leagues. MLB teams are most dependent on local broadcasting agreements. For years, MLB’s Atlanta Braves and Chicago Cubs have been broadcast nationally on TBS and WGN, respectively. Since those stations were owned by the same entity that owned the team, the owners of the Braves and Cubs reaped significant broadcasting revenue not available to other teams. In recent years, many other MLB teams have recognized the importance of maximizing local broadcast revenue. In 2002, the MLB Yankees and certain outside investors created the YES network. The YES network televises all Yankee games in the New York metropolitan area. The network is expected to generate marginal annual revenues of approximately $70 million for the Yankees. Clearly, the ability to generate local broadcasting revenue is directly tied to the size of each team’s immediate market. This has created an atmosphere of “haves” versus “have-nots” for the major sports leagues.
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Ticket Revenue Ticket revenue remains a significant revenue source for all four major sports leagues. However, each league treats ticket revenues differently. The NFL shares all gate receipts between the home team and the visiting team. After recognition of game-day costs by the home team, ticket revenue is effectively split 2/3 to the home team and 1/3 to the visiting team. This NFL sharing approach allows teams in weak markets to enjoy the upside of visiting a team with a strong attendance history. The NHL and NBA allow the home team to keep 100 percent of all gate receipts. And, MLB allows the home team to keep an overwhelming majority of gate receipts. Obviously, these policies reward those teams with the greatest fan bases. And, these policies have put the value of teams such as the Yankees, Red Sox, Lakers, and Red Wings above most of the others.
Stadium Leases Many professional sports franchises lease their stadiums from municipalities or publicly financed stadium authorities. There are exceptions in each league, such as (1) the NFL Miami Dolphins, Washington Redskins, and New England Patriots; (2) the MLB Chicago Cubs, Boston Red Sox, Los Angeles Dodgers, San Francisco Giants, and Atlanta Braves; (3) the NBA Chicago Bulls and Dallas Mavericks; and (4) the NHL Chicago Black Hawks. With the advent of club seats, luxury suites, and permanent seat licenses in the 1980s and 1990s, many teams began reaping significant revenues from their stadiums. Teams in stadiums without such luxuries began negotiating with cities for the construction of stadiums with comparable revenue-generating capabilities. The move of the NFL Cleveland Browns to Baltimore and the NFL Los Angeles Rams to St. Louis are two prime examples of stadium lease offers that were too good for their owners to ignore. Both cities built brand-new facilities for the teams with little or no initial or recurring cost to the team owners. As a result, the teams benefited from revenues generated from numerous high-priced club seats and expensive luxury suites, which were bought mostly by local businesses. The new leases allowed the teams to enjoy revenue from events in those stadiums other than football games (e.g., concert revenue). Those leases immediately put the Browns and Rams into the top five most valuable NFL franchises. On the heels of these attractive stadium leases, other cities were motivated to provide similar revenue sources to their professional sports teams in order to keep the teams from moving. This trend resulted in dozens of new stadiums—from Tampa Bay to Seattle—built at little cost to the team owners. Of the 120 teams in the four major sports leagues, 65 teams (or 54 percent), are playing in (or are scheduled to move into) stadiums built since 1995.
Naming Rights Naming rights have become very lucrative for major league sports teams in the past 10 years. In November 1999, the Washington Redskins (which owns its stadium) entered into a naming rights contract with Federal Express. That contract pays the team an average of $7.6 million annually through 2025.
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The Baltimore Ravens have a 15-year, $5 million per year naming rights deal with M&T Bank. The Ravens, like many other franchises, were able to rebound from losing their previous naming rights sponsor to bankruptcy in order to sign a new naming rights agreement. The new agreement generates even greater revenue to the team. Many communities have offered naming rights revenue to teams in order to lure them to—or to keep them in—their city. As an example, the city of Oakland offered all naming rights revenue to the old Oakland Coliseum (now Network Associates Coliseum) to the NFL Raiders as part of the Raiders move to Oakland from Los Angeles. However, some other communities have reserved naming rights revenue for the benefit of the municipality. An example of this is the Chicago stadium authority and U.S. Cellular Field, formerly Comiskey Park. That stadium authority retained the naming rights as a source of revenues to build, maintain, and/or upgrade the facility. Naming rights generally exceed $1 to 2 million per year. And, they have become a major element of any stadium lease between a sports team and a city. Exhibit 10.2 presents a summary of naming rights contracts in major league sports.
Sponsorships All of the major sports leagues have marketing partnerships that are responsible for selling officially sponsored league merchandise. These partnerships are responsible for selling jerseys, hats, and (in many cases) advertising on the league’s Internet home page. These merchandising royalties are usually split evenly by all teams in the league regardless of the amount of merchandise attributable to each team. Other sponsorship agreements are the responsibility of the individual teams. Such agreements often include advertising on the stadium or in game programs, logo usage, and other partnership arrangements. This has become a growing revenue area for some teams. For example, the Dallas Cowboys recently entered into an exclusive sponsorship agreement with Pepsi.
Exhibit 10.2
Major League Sports Largest Naming Rights Contracts ($ in millions)
Sports Stadium
Naming Rights Sponsor
Reliant Stadium Phillips Arena FedEx Field Lincoln Financial Field American Airlines Arena Minute Maid Park Staples Center
Reliant Energy Royal Phillips Elec Federal Express Lincoln Financial Group American Airlines Coca-Cola Staples
M&T Bank Stadium
M&T Bank
Sports Team Houston Texans Atlanta Hawks/Thrashers Washington Redskins Philadelphia Eagles Dallas Mavericks/Stars Houston Astros Los Angeles Lakers/Kings/ Clippers/Sharks Baltimore Ravens
Average Revenue per Year
Contract Expires
$10.00 $9.30 $7.60 $6.70 $6.50 $6.00 $5.80
2032 2019 2025 2022 2031 2030 2019
$5.00
2018
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Collective Bargaining Agreement The single most significant expense category for a professional sports franchise is player costs. Each league has a CBA with their respective players’ association stipulating the terms of player contracts. The NFL has imposed a “hard” salary cap that limits each team’s payroll to a specific percentage of league revenue (as defined by the agreement). For salary cap accounting purposes, signing bonuses are prorated over the duration of a player’s contract. However, the signing bonuses are immediately recognized for salary cap purposes if a player is cut. Due to the rigid nature of the salary cap, teams have certainty with respect to the salary expense of their players. However, the downside of the NFL CBA is that teams are often unable to resign veteran stars when their contracts expire due to salary cap limitations. This has forced players such as Emmitt Smith, Jerry Rice, and Joe Montana to leave the teams with whom they originally established their reputations in order to get a competitive compensation package. MLB avoided a work stoppage in August 2002 with the signing of its collective bargaining agreement running through 2006. The agreement imposes a luxury tax for team payrolls over a certain threshold (i.e., 17.5 percent tax on payroll above $117 million in 2003). Many analysts thought that such an agreement would eliminate the large disparity among payrolls in the league. However, the New York Yankees (payroll exceeding $150 million during the 2003 season) immediately became an exception. Without delay, teams surpassed the luxury tax threshold (e.g., the New York Yankees and the New York Mets in 2003) making it apparent that player costs are still a significant competitive disadvantage for most MLB teams. The NBA had a work stoppage in 1998, which led to a collective bargaining agreement many analysts believe was crucial for the financial stability of the league. The agreement stipulates minimum and maximum salaries for players, based on years of experience. While it does not impose a hard salary cap, the agreement does provide for a luxury tax if the league exceeds certain payroll thresholds. Luxury tax rebates are then given to teams that are under the salary cap at the end of each season from those teams that exceed the luxury tax threshold. The NHL currently has the least controls surrounding its player costs. As a result, the discrepancy between high payroll teams and low payroll teams is significant. The NHL also faces two distinct disadvantages over other leagues: (1) the league is most dependent on ticket sales for overall revenue and (2) there exists a significant currency gap between the U.S. and Canada. Many analysts consider a significant work stoppage to be the only vehicle to instill financial stability to the NHL.
Buyers of Professional Sports Teams Professional sports teams are owned by a wide array of organizations and individuals. Most leagues allow individuals, partnerships, or corporations to own their teams. A large majority of professional sports teams are owned by partnerships. These partnerships are often characterized by a general partner well known to the public (e.g., George Steinbrenner or Al Davis) and many limited partners who stay behind the scenes. While most teams are owned by partnerships with several owners, all leagues require that any ownership group include one principal owner who takes “center stage” in the eye
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of the public. This allows the team to have a public voice in the local community, and it allows the league to hold one person responsible for the activity of the team. In the past 20 years, several public companies, mostly within the media industry, have acquired professional sports teams.3 Many analysts in the media industry believed the inclusion of professional sports with media conglomerates would create synergies that would benefit both businesses. However, the trend may be reversing as Disney has recently sold the MLB Anaheim Angels, and AOL Time Warner has sold the NBA Atlanta Hawks and the NHL Atlanta Thrashers. Time Warner has also announced its intention to sell its MLB Atlanta Braves. Most recently News Corp. has agreed to sell its interest in the MLB Los Angeles Dodgers. Still other media companies have found valuable long-term synergies in combining their media interests with their ownership of professional sports teams. For example, the Tribune Company owns the MLB Chicago Cubs, Cablevision Systems owns the NBA Knicks and the NHL Rangers, and Comcast owns the NBA 76ers and the NHL Flyers. Due to cross-ownership of related businesses such as sports teams and media companies, it is often difficult to determine the true financial picture of the sports franchise. Many analysts argue that the accounting profits reported by the major sports leagues underestimate true economic profits enjoyed by the corporate team owners due to the ability of the corporate team owner to control intercompany transfer pricing. Ironically, many of these public companies have found themselves uncomfortable with the significant uncertainty in the professional sports industry. Unlike most industries, success on the sports field is hard to predict. Increasing earnings by winning games usually requires an investment in top-flight players. However, even large payrolls do not guarantee winning seasons. And, winning seasons do not always translate into increasing earnings. Professional sports teams often generate negative cash flow on an annual basis. Professional sports teams are entertainment businesses. However, some team purchasers failed to realize that many professional sports teams are not strictly operated as the typical financial organization that is motivated to increase annual earnings. Rather, there is strong pressure by the owners and the communities to produce winners. Often, these pressures conflict with the objective of increasing annual earnings. Many sports teams are owned by entrepreneurs who have already made their fortunes. Along with being business ventures, professional sports teams are viewed as rare commodities. The sports teams allow their owners to compete in a very public forum with entities that are beloved by their local communities. In many cases, professional sports team ownership is as much of a hobby as it is a business for the extraordinarily wealthy team owners.
Sports Team Values Professional sports team owners have two objectives: (1) to win games and (2) to make a profit (or at least to break even on a cash flow basis). These goals often conflict with one another on an annual basis. As a result, sports teams do not lend themselves to being valued like typical businesses. In order to meet the first above-stated 3 The NFL has a strict prohibition against corporations or public entities owning a team. With the exception of the Green Bay Packers (owned by the City of Green Bay), which grandfathered from existing rules, only partnerships and individuals are allowed to own NFL teams.
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objective, some owners are willing to suffer annual losses while they own the team. The team owners believe their return on investment (ROI) will be realized by the capital gain on the increased value of the franchise over time. Other team owners seemingly care less about winning games and concentrate on turning an annual positive cash flow. Unfortunately for this latter set of owners, their franchise values usually lag industry averages. This is because buyers are generally more willing to pay high prices for the cachet of a team with a tradition of winning. Valuation analysts typically use three general approaches in valuing businesses: (1) the income approach, (2) the market approach, and (3) the asset-based approach. The income approach involves a projection of annual cash flow expected to be earned by the business plus an expected residual value at the end of an assumed investmentholding period. The projection of the future cash flows and residual value are discounted to present value using a rate of return that incorporates the risk and timing of this projected cash flows. The market approach involves the comparison of the subject business to transaction prices paid for similar businesses or to market values of similar publicly traded businesses. The asset-based approach estimates the value of a business based on the cost that would be incurred to reassemble the business tangible and intangible assets and to reestablish the business. Since there is a limited pool of available professional sports franchises, the asset-based approach is not as commonly used to estimate the value of a professional sports franchise business. Many professional sports team buyers look at their ownership as part business and part hobby. Unlike other businesses, annual cash flows during the investmentholding period of a sports team are often near zero or negative. Consequently, nearly the entire return on an investment in a professional sports team results from the expected increased sales price (residual value). The traditional application of an income approach does not always explain the prices paid for professional sports teams due to nominal cash flows produced during the investment-holding period and the inability to capture the “premium” buyers will pay for the cachet of owning a very rare commodity. The market approach is a typical valuation approach to value professional sports teams. Potential buyers generally consider (1) the prices paid for other teams and (2) the comparative strengths and weaknesses of the “comparable” teams. In comparing prices between teams, the analyst should consider the differences in the value drivers among those teams. The value drivers, which are usually specific to an individual team, include the following: • • • • • • • • • •
Form of ownership (e.g., asset purchase versus stock purchase)4 Population of the team’s fan base Demographics of the team’s fan base Passion of the team’s fan base The team’s stadium/arena (e.g., leased or owned) Revenue streams related to the stadium/arena (including suites, boxes, naming rights, etc.) Local advertising opportunities Local sponsorship opportunities Local radio and television contract opportunities History and tradition of the franchise
4 A buyer of a franchise in a transaction treated as an asset purchase will realize significant income tax advantages compared to a transaction involving a stock purchase with carry-over basis and no “step-up” in the tax basis of the acquired assets.
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Livability of metropolitan area for potential free agent players Exchange rate risk (for Canadian teams) Any specific team dynamic
The beginning point for valuing a professional sports team is typically a multiple of revenue derived from recent comparable franchise sale transactions. Revenue pricing multiples are then adjusted upward or downward based on the difference in the value driver factors listed above. However, in the end, the eagerness of the individual buyer for their desired team and the size of the pool of potential bidders will determine the actual purchase price.
National Football League Unlike the other sports leagues, team values in the NFL have continued to increase. With a very beneficial stadium lease in hand, Bob McNair spent $700 million for the future Houston Texans in 1999. The stadium was built at no cost to the team. And, the stadium-related contracts provide the new Houston team with significant revenue. Daniel Snyder’s record-setting price for the Washington Redskins needs to be evaluated with consideration to (1) the inclusion of the stadium (the largest in the NFL), FedEx Field, with the transaction and (2) the subsequent $200 million naming rights contract with Federal Express. Snyder has created significant new revenue streams since taking the helm of the team (such as charging visitors to attend team practices). The Redskins became the number one revenue-generating team in the NFL due, in good part, to the fact that the team owns and controls its own stadium. It is important for the analyst to understand all of the relevant acquisition provisions when analyzing a sports franchise acquisition. For example, Steve Bisciotti purchased only 49 percent of the Ravens in 2000. However, he also purchased an option to acquire the remaining 51 percent ownership interest. Thus, the 2000 purchase cannot be considered a true noncontrolling ownership interest transaction due to the inclusion of a valuable embedded call option. Exhibit 10.3 presents recent transactions involving NFL franchises.
Exhibit 10.3
Recent NFL Team Sale Transactions ($ in millions) NFL Team
Year
Principal Buyer
Atlanta Falcons New York Jets Baltimore Ravens Washington Redskins Houston Texans
2002 2000 2000 1999 1999
Arthur Blank* Woody Johnson Steve Bisciotti* Daniel Snyder † Bob McNair
Ownership Interest Bought (%) 73.0 100.0 49.0 94.0 100.0
Implied Team Value $619.3 $635.0 $561.2 $800.0 $700.0
* Holds an option to acquire the remaining ownership interest. † Includes the acquisition of FedEx Field. SOURCE: The Business of Football 2002; Pro Team Economics 1991–2001, Kagan World Media, p. 41, and Media Mergers & Acquisitions, 2003, Kagan World Media, p. 343.
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Major League Baseball In February 2003, the sports world learned that John Henry bought the storied Boston Red Sox baseball club for a reported $700 million. However, many major publications neglected to provide the significant details of the transactions and led the public to believe that the transaction implied a $700 million value for the Red Sox franchise. In reality, John Henry bought a number of assets including (1) Fenway Park, (2) 80 percent of New England Sports Network (i.e., a sports cable channel located in Boston), and (3) the Boston Red Sox for an aggregate purchase price of $700 million. We will never know how much Mr. Henry would have spent for just the Boston Red Sox without the benefit of a media partner. However, many analysts believe that New England Sport Network was just as important to the transaction as the Boston Red Sox franchise. In order to unravel a sports team acquisition transaction, a valuation analyst should understand the income tax treatment underlying the transaction. Since John Henry had recently sold the Florida Marlins for a reported $158 million and since his income tax basis in that team had been amortized well below that value, he was facing a possible taxable gain on the sale. By structuring the purchase of the Red Sox as a “like kind exchange” for federal income tax purposes, Henry may have been able to defer the tax on the sale of the Marlins. That income tax savings was estimated by analysts to be $20 to $30 million. After all proper adjustments are made to the Red Sox transaction, John Henry and his group of investors (which included The New York Times Company and television executive Tom Werner) paid significantly less than $700 million for the Red Sox franchise on an after-tax basis. For a valuation analyst to use this transaction when estimating the value of other sports franchises, the values of all of the components in the transaction bundle of assets should be considered. Only after a proper allocation of the purchase price is made to all of the acquired assets can a valuation pricing multiple be extracted solely for the sports team. Exhibit 10.4 presents recent transactions involving MLB teams. Valuation analysts should take note of any sports franchise transaction involving noncontrolling ownership interests. For example, Carl Lindner reportedly Exhibit 10.4
Recent MLB Team Sale Transactions ($ in millions) MLB Team
Year
Principal Buyer
Ownership Interest Bought (%)
Implied Team Value
Anaheim Angels* Boston Red Sox Florida Marlins Cleveland Indians Cincinnati Reds Los Angeles Dodgers
2003 2002 2002 1999 1999 1998
Arturo Moreno John Henry† Jeff Loria Larry Dolan Carl Lindner Fox Group‡
100.0 100.0 100.0 100.0 37.0 100.0
$182.0 $700.0 $158.5 $323.0 $183.1 $311.0
* Pending offer—sale price is estimated. † Includes Fenway Park Stadium and 80% of New England Sports Network. NESN is estimated to be worth $183.6. ‡ Includes Dodger Stadium. SOURCE: The Business of Football 2002; Pro Team Economics 1991–2001, Kagan World Media, p. 41, and Media Mergers & Acquisitions, 2003, Kagan World Media, p. 343.
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purchased 37 percent of the Cincinnati Reds from Marge Schott for $67.0 million. This implies an enterprise value for the MLB team of approximately $183 million. However, while Marge Schott did not own a majority of the Reds she was the general partner and did have control of the club. Mr. Linder’s purchase of Ms. Schott’s interest provided him with sufficient shares in the club to elevate him from a minority holder to the general partner of the Reds. Such details are very important, because some minority interest transactions can confer controlling status to the acquirer. In 2002, the U.S. Bankruptcy Court approved the sale of a 24 percent stake in the Colorado Rockies for $35 million. On a pro rata basis, this would imply a team value of $145 million. Nevertheless, most analysts value the Rockies franchise at $350 million or more. Using these data, the noncontrolling ownership interest sale represented a discount of over 40 percent as compared to the pro rata control value of the team. Such lack of control valuation discounts should not be ignored when valuing noncontrolling ownership interests. The sale of the Anaheim Angels, however, bucks the trend for MLB transactions. The Disney Corporation, the former owners of the Angels, entered into an agreement to sell the team to Phoenix businessman Arturo Morena for only $182 million. This is significantly less than the original rumored asking price for the Angels of $200 million to $250 million. Disney purchased the Angels in 1998 for an estimated $140 million. After investing $90 million to renovate Edison Field and incurring tens of millions in loses from 1998 through 2002, the Angels acquisition resulted in a net loss for Disney. This sale marks, perhaps, the first time in recent memory that a MLB franchise owner lost money on the investment in a team. Such an occurrence does not bode well for other teams on the trading block.
National Basketball Association The NBA has seen a significant number of franchise sale transactions. All have involved small or middle-market teams. And, most of the teams sold for $150 to $200 million. For example, Mark Cuban’s acquisition of the Dallas franchise is estimated at $200 to $210 million after recognition of his acquisition of a 50 percent ownership interest in the Maverick’s arena. Wyc Grousbeck’s acquisition of the Boston Celtics broke out of that purchase price range. Unlike previous transactions including new arenas and stadium revenue, the Celtics play in an arena from which they will receive little or no revenue until 2006. Many analysts were surprised by such a high price for a team with such a poor stadium lease. However, Mr. Grousbeck and his cadre of investment partners see potential in a sleeping giant whose tradition includes a record 16 NBA championships. Paul Gaston, who acquired the team in 1983 for $18 million, earned a respectable 16 percent annual return on his original investment (excluding annual cash flow considerations). Exhibit 10.5 presents recent transactions involving NBA teams.
National Hockey League No professional sports league has undergone more ownership changes than the NHL. The league is plagued with the poorest national television contract, severe exchange rate risk for its Canadian teams, and a CBA that is expected to be the impetus for a significant work stoppage after the 2004 season. The most recent franchise acquisition highlights many of the league’s problems.
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Exhibit 10.5
Recent NBA Team Sale Transactions ($ in millions) NBA Team
Year
Principal Buyer
Ownership Interest Bought (%)
Implied Team Value
Boston Celtics Seattle Supersonics Dallas Mavericks Denver Nuggets Vancouver Grizzlies
2002 2001 2000 2000 2000
Wyc Grousbeck Howard Schultz Mark Cuban* Stan Kroenke† Michael Heisley, Sr.‡
100.0 100.0 100.0 94.0 100.0
$360.0 $200.0 $280.0 $182.7 $160.0
* Acquisition included 50% ownership of American Airlines arena. Kroenke acquired the Avalanche, the Nuggets, and the Pepsi Center for $450 million. ‡ Moved the team to Memphis shortly after the acquisition. SOURCE: The Business of Football 2002; Pro Team Economics 1991–2001, Kagan World Media, p. 41, and Media Mergers & Acquisitions, 2003, Kagan World Media, p. 343. †
The Buffalo Sabres franchise was purchased out of bankruptcy by B. Thomas Galisano. Included in the transaction were (1) the Sabres arena and (2) a franchise in the National Lacrosse League, the Bandits. The price for the franchise (excluding the arena and Bandits) represents the lowest purchase price seen in the NHL for a decade. With the Ottawa Senators in financial difficulty, the league is becoming desperate to make meaningful financial changes in the upcoming labor negotiations. Exhibit 10.6 presents recent transactions involving NHL teams.
Exhibit 10.6
Recent NHL Team Sale Transactions ($ in millions) NHL Team
Year
Principal Buyer
Buffalo Sabres San Jose Sharks Florida Panthers Phoenix Coyotes Montreal Canadians New York Islanders New Jersey Devils Buffalo Sabres Colorado Avalanche
2003 2002 2001 2001 2001 2000 2000 2000 2000
B. Thomas Golisano* San Jose Sports & Entertainment Alan P. Cohen Steve Ellman George Gillette Charles Wang Puck Holdings John Rigas Stan Kroenke†
Ownership Interest Bought (%)
Implied Team Value
100.0
$92.0 $165.0 $140.0 $91.0 $224.8 $187.5 $175.0 $144.8 $128.0
100.0 100.0 80.1 100.0 100.0 66.0 94.0
* Acquisition includes (1) an arena and (2) the Buffalo Bandits of the National Lacrosse League. † Kroenke acquired the Avalanche, the Nuggets, and the Pepsi Center for $450 million. SOURCE: The Business of Football 2002; Pro Team Economics 1991–2001, Kagan World Media, p. 42, and Media Mergers & Acquisitions, 2003, Kagan World Media, p. 343.
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Income Tax Consequences of Professional Sports Team Acquisitions An important aspect to be considered in any acquisition of a professional sports team is the income tax consequences. Acquisitions of professional sports teams are subject to a unique tax treatment under the Internal Revenue Code. The buyer of a team that is acquired in an asset acquisition can deduct a significant amount of the purchase price from taxable income in the years following the acquisition. Since realization of this taxation benefit requires significant taxable income with which to offset these deductions, it is little wonder that wealthy individuals with significant taxable income acquire sports teams. In a very broad sense, every business acquisition can be characterized as one of two types: (1) an asset purchase or (2) a stock purchase. An asset purchase means that the buyer is acquiring the individual assets of the target entity. The result is that the buyer is able to (1) allocate the purchase price to the assets acquired based on their fair market values and (2) realize future depreciation and amortization deductions for assets that are depreciable/amortizable under the Internal Revenue Code. Asset purchases can be realized through (1) direct purchase of assets, (2) the purchase of partnership interests (with a Section 754 election to allocate the purchase price paid to the acquired assets), or (3) the purchase of limited liability company (LLC) interests (since an LLC is treated as a partnership under the Internal Revenue Code). A stock purchase means the buyer is purchasing the capital stock of the target entity. Thus, the buyer obtains ownership of the business’ assets through a corporation. The result is that the buyer only realizes future depreciation and amortization deductions for the corporation’s assets based on the assets’ carry-over tax basis on the corporation’s books. The Tax Reform Act of 1993 excluded professional sports team acquisitions from Section 197 intangible asset amortization treatment. Section 197 allows for intangible assets acquired in an asset purchase to be amortized over a 15-year period for federal income tax purposes. Since professional sports teams are excluded from this Section 197 treatment, the team may amortize the acquired intangible assets over the assets’ estimated remaining useful lives (RUL). In addition, the Tax Reform Act of 1993 excluded the sports franchise agreement intangible asset itself as an amortizable intangible asset. Therefore, acquirers of professional sports teams, and their tax advisors, are keenly interested in (1) the values allocated to acquired amortizable intangible assets and (2) the values allocated to the nonamortizable sports franchise agreement intangible asset. For a major league sports team, some industry analysts define franchise value as the purchase price residual value after recognizing the fair market value of all acquired tangible assets and identifiable intangible assets. For example, assume a team is acquired for $500 million and holds net working capital valued at $25 million, tangible assets (real estate, equipment, fixtures and furniture) valued at $25 million, and identifiable intangible assets (including player contracts) valued at $400 million. Under the above-mentioned residual value definition, the acquired franchise value would equal $50 million (i.e., $500 million less $25 million less $25 million less $400 million).
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Exhibit 10.7
Typical Major League Sports Franchise Purchase Price Allocation Typical Acquired Tangible Assets Real Estate Stadium (if owned) Practice facility (if owned) Corporate offices (if owned) Tangible Personal Property Equipment Furniture and fixtures Computers, etc.
Typical Acquired Intangible Assets Player contracts Stadium lease/premium seat agreements Season ticket holders National broadcasting agreements Local broadcasting agreements Sponsorship agreements Nonplayer contracts (coaches, scouts, etc.) Draft picks Other intangible assets
Since team values have increased dramatically over the past 10 years, the Internal Revenue Service has become much more active in auditing professional sports team purchase price allocations. Valuation analysts should be aware that their analyses may be subject to contrarian review. Accordingly, analysts should be prepared to defend their sports team purchase price allocations under IRS examination. Some tax advisors to the sports industry have negotiated with IRS representatives regarding the development of guidelines for the valuation of purchased intangible assets. Since valuation analysts have not adopted a uniform methodology for the valuation of player contract intangible assets, tax advisors, valuation analysts, and IRS agents spend considerable time analyzing each sports franchise team acquisition. In order to bring some uniformity to the process, the IRS is expected to issue guidelines regarding the amount of allowable amortization with respect to sports franchise intangible assets. For example, the IRS may accept purchase price allocations in which the values of the sports franchise agreement intangible asset do not exceed a certain (but, as yet, unspecified) guideline percentage of the total purchase price.5
Acquired Assets The typical acquisition of a professional sports team will include the categories of tangible and intangible assets listed in Exhibit 10.7. The valuation of sports franchise tangible assets is similar to the valuation of any tangible assets acquired in connection with a business. Therefore, the following discussion will focus on the valuation and RUL methodologies related to acquired sports franchise intangible assets. In preparing a purchase price allocation valuation for federal income tax purposes, the appropriate premise of value is value as part of a going-concern business. In addition, valuation analysts should consider that there is no active secondary market for sports franchise intangible assets.
5 For purposes of calculating total intangible value, the value of tangible assets is subtracted from the purchase price. Since the IRS has historically treated national television agreements as a part of franchise value, amortization deductions related to these contracts may not be recognized by the IRS.
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Player Contracts Player contracts are typically the most significant intangible asset of an acquired professional sports franchise. Since the values of player contracts are amortizable over the contracts’ RUL, this intangible asset is important to the sports franchise tax advisor. The IRS is particularly interested in the values allocated to acquired sports team player contracts. In this regard, Section 1056(d) stipulates the following: It shall be presumed that not more than 50 percent of the consideration is allocable to contracts for the services of athletes unless it is established to the satisfaction of the Service that a specified amount in excess of 50 percent is properly allocable to such contract. Some tax advisors have interpreted this statutory provision to mean that 50 percent of the purchase price is the appropriate value for sports team player contracts. Of course, this is not always the case. The IRS need not presume that the value of acquired sports team player contracts is 50 percent of the total purchase price. Rather, the IRS examination agents may become skeptical if the value allocated to the acquired player contracts exceeds 50 percent of the total purchase price. Valuation analysts typically value sports team player contracts using either the cost approach or the market approach. The cost approach may be used to estimate the value of each player contract based on the economic cost of developing and training the player. In estimating the value of a player’s contract, special consideration should be made of the player’s position, experience in the sport, and skill. The cost of developing a player often includes an analysis of costs incurred to support minor league affiliates in the development of major league talent. Individual contract value adjustments may be appropriate for players that are compensated at above- or below-market salary rates. The valuation analyst may consult a sports industry expert in player talent as part of the valuation process. Other relevant data include the CBA and other player contracts. The cost approach is often cited by tax advisors as the player contract valuation approach that is (1) favored by the IRS or (2) most supportable during an IRS examination. As with all valuation adjustments, adjustments to the player contracts should be documented with empirical data based on comparable player contracts. On occasion, a player may bring a specific value to a team. For example, Michael Jordan’s ability to produce consistently sold-out stadiums for his teams made him an extremely valuable asset to the franchise owning his contract. Any valuation of the Michael Jordan player contract should have included consideration of his ability to produce revenue for his team. Some valuation analysts rely solely on the market approach in the valuation of player contracts. In these instances, an independent sports industry expert values the player contracts based on his/her opinion of the player’s skill and experience in comparison to recent market contracts. Most leagues restrict the free market sale of player contracts. This restriction makes market value estimates based on arm’slength sales of player contracts difficult to justify. Sports teams that have relied exclusively on independent sport industry expert valuations of player contracts (without regard to a rigorous cost approach analysis) routinely have been challenged by the IRS. The valuation analyst will need to estimate the RUL for each player contract. Player contract RUL factors include (1) the player’s current contact terms, (2) the
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player’s age, (3) the estimated remaining career of the player, (4) the likelihood of player resignation, and (5) any special league rules (e.g., the Larry Bird clause in the NBA CBA or the franchise player tag in the NFL CBA).
Stadium Lease/Premium Seat Agreements In the past 20 years, stadiums have been a source of increasing revenue for professional sports teams. Many municipalities have absorbed the costs (to be recovered via local hospitality taxes, for example) to build stadiums and arenas and then have allowed the resident team to receive most (if not all) of the stadium revenue. The importance to the team of the stadium lease depends on the amount of shared revenue in the particular league. In the NFL, for example, the stadium lease is the largest source of nonshared revenue. Therefore, differences in stadium lease terms can often explain much of the difference in NFL team franchise values. In instances where the team owns the stadium (e.g., the Washington Redskins), valuation analysts do not need to consider the value of the stadium lease but, rather, the market value of the owned stadium. In the past 10 years, the number of premium seat agreements has increased throughout all major professional leagues. The most significant economic impact has come from the creation of personal seat licenses (PSLs) in which fans pay for the “right” to buy season tickets. This right can be very valuable because many teams allow the PSL owner to sell the PSL or to bequeath it upon death. Since PSLs are required by some teams to purchase season tickets, they can be very valuable to the teams with long season ticket waiting lists. Other premium seat agreements include luxury box and club seat agreements. Each franchise has different arrangements with its stadium with respect to the sharing of club premium revenue. And, a valuation analyst should become familiar with the specifics of each type of premium seat agreement. Stadium leases and related premium seat agreements are typically valued using the income approach. A typical lease analysis includes a comparison of the subject lease with other comparable leases. Any above-market or below-market terms related to the subject lease are valued over the term of the lease. In practice, such lease comparisons are difficult to make in the professional sports industry. The terms of professional sports leases are usually not publicly disclosed. Furthermore, the variation of terms in stadium leases can be significant and difficult to quantify. A common complication is that some teams are the sole user of their stadium and other teams share the stadium with other professional teams. And, recent leases have included provisions that allow some teams to realize revenue from nonsporting events in the stadium, such as concerts. A practical valuation methodology for stadium leases and premium seat agreements is the income approach. However, in the income approach analysis, when considering the total economic benefit of the stadium/premium seat agreement, all revenues (and costs) related to personal seat licenses, luxury box premiums, club seat premiums, stadium advertising, naming rights, and so forth may need to be analyzed. The present value of the net economic benefits over the term of the lease is then calculated to estimate the overall value of the stadium lease. The RUL of a stadium lease is typically the remaining term of the lease agreement. If special renewal option provisions exist, these should be considered in estimating the overall lease term.
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Season Ticket Holders As an intangible asset, season ticket holders are typically valued using the income approach. Accordingly, the economic value of the season ticket holder base is the present value of the cash flow expected to be earned from the season ticket holders over their RULs. This analysis should consider: (1) expected ticket price increases, (2) expected season ticket holder attrition rates, and (3) the cost of providing the sporting entertainment to the season ticket holder. The present value of the net economic benefits over the RUL of the current season ticket holders (including expected season ticket renewals) provides an estimate of the value of the ticket holder base. A rigorous analysis of the historic attrition patterns of season ticket holders should be performed in order to estimate the expected RUL of the season ticket holders.
Broadcasting Agreements All of the major professional sports leagues have national television agreements. These national television agreements are negotiated by the league. And, these national broadcast revenues are typically allocated to each of the league’s teams on an equal basis. The IRS has generally taken the position that national television agreements are part of the professional sports team franchise value. The IRS’s premise for this position is that national broadcast agreements are negotiated by the league and not by the individual teams. And, the IRS notes that the national broadcast agreement rights come automatically to the team as part of the team’s league franchise. This issue is a subject of ongoing controversy between the IRS and the team owners and their financial and taxation advisors. Local broadcasting agreements typically include television and radio agreements that are directly entered into by the individual team. Local broadcasting revenue is not shared in major league sports. Local broadcasting revenue is a primary income source for MLB and NHL teams. National and local broadcasting agreements are often valued using the income approach. The analysis involves calculating the present value of the economic benefits to the sports team over the RUL of the broadcast agreements. If the analyst only considers the remaining term of the contracts in place, then the value of expected broadcast agreement renewals is not encompassed in this analysis. Using that procedure, the value of the expected broadcast contract renewals would be captured in either the team goodwill value or in the franchise value.
Sponsorship Agreements Sponsorship agreements typically include agreements in which a local company partners with the sports team. Under the terms of the sponsorship agreement, the sponsor company pays a fee or a royalty in return for the use of the team name, logo, or relationship. The value of sponsorship agreements is often estimated using the income approach. The present value of the economic income associated with these agreements may be estimated over the remaining contract term of the existing agreements. The economic income associated with the sponsorship agreements should consider the cost of goods or services provided by the team. For example, many
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sponsorship agreements include provisions whereby the team exchanges complimentary tickets, suites, or ad space in return for the sponsorship income.
Nonplayer Contracts and Noncontractual Employees Typically, major league franchise coaches, scouts, and general managers are employed under employment contract provisions. Noncontractual franchise staff members include back office personnel such as marketing, accounting, and finance employees. Contractual and noncontractual employees are often valued using the cost approach. The cost to replace each individual employee is estimated based on the time and out-of-pocket costs to (1) recruit, (2) screen, (3) interview, (4) hire, and (5) train employees of comparable experience and expertise as the subject assembled workforce. Often, the cost of training will include the salary and employee benefits incurred after hiring the employees that are necessary in order to train the hypothetical replacement employees to the experience level of the actual team workforce. Coaches, scouts, and general managers are typically more valuable than noncontract team employees. This is because of the limited pool of qualified candidates for these specialized positions. The analyst should consider the current employment market conditions in the valuation of the nonplayer contracts. And, the analyst should also consider any above- or below-market compensation levels in the subject employment contracts. The significant value of coaches’ contracts was highlighted in the NFL after the 2001 season. Jon Gruden, the head coach of the NFL Oakland Raiders was traded to the NFL Tampa Bay Buccaneers. Coach Gruden was traded to the Buccaneers for two first round draft picks, two second round draft picks, and $8 million in cash. The Buccaneers then agreed to pay Coach Gruden an annual salary of $3.5 million for a 5-year employment contract. The value of the draft picks traded by the Buccaneers in order to obtain Gruden’s contract is considered in the range of several million dollars. Ultimately, this trade for coach Gruden’s contract proved a wise move for the Buccaneers because the Tampa Bay Buccaneers beat the Grudenless Oakland Raiders in the Super Bowl following the 2002 season.
Draft Picks All professional sports teams are allocated draft picks by their respective sports leagues. However, certain sports teams may find themselves with an overabundance of draft picks. This may be due to previous trades or waiver signings. Some sports teams may have access to high draft picks. And, some sports teams have the ability to select players of significant potential. The condition of an individual team’s draft pick allocation should be considered in light of the league’s “average” teams. Certain draft picks may have significant value to an individual team. Valuation analysts sometimes consult with independent sports industry experts in the objective assessment of the importance of individual draft picks to an individual team. A recent example of a draft pick with significant value is the number one pick in the 2003 NBA draft, LeBron James. The inclusion of LeBron James on any team, especially the Cleveland Cavaliers (i.e., his hometown team), has a significant economic impact on the team ticket revenue, sponsorships, and other agreements. Such unique draft pick circumstances should be individually considered by the valuation analyst.
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Other Intangible Assets A valuation analyst should consider any other intangible assets that are purchased as part of a professional sports franchise acquisition. Such intangible assets may be associated with (1) future expansion fees (e.g., the $700 million expansion fee paid by the NFL Houston Texans was split by the other 31 NFL teams) and (2) relocation fees (e.g., the NBA Hornets paid fees to all other NBA teams for its move from Charlotte). Some sports teams have significant value in a minor league association (e.g., MBL and NHL teams) and also have large video libraries (e.g., NFL teams) that are used extensively by team personnel. An individual team’s unique characteristics should be considered by the analyst in the process of identifying all discrete intangible assets.
Venue Feasibility Analysis The term feasible refers to: “(1) capable of being done or carried out (e.g., a feasible plan); (2) capable of being used or dealt with successfully: suitable; (3) reasonable, likely.”6 Therefore, when used to describe a proposed sports venue, this definition would suggest that it is feasible for most mid- to large-sized communities to build a new 20,000-seat arena with 75 luxury suites (in other words, they are capable of building such a venue). This definition of feasibility, however, does not address the important issues related to the costs and benefits of sports venues. While it may be feasible for a city to build a new sports venue, it may be years (if ever) before that venue is home to a professional sports franchise. If a city builds a venue and is successful in attracting a franchise, what is the cost to the community? In addition, what economic concessions must be given to the franchise owner as an inducement to locate the team in the city’s venue? Conversely, from the team owner’s perspective, it may be feasible for the owner to develop a new venue with his or her own money. However, why would a team owner be interested in making such an investment, particularly when there are cities lined up and more than willing to form a “public-private partnership” with a professional sports team? Rather than simply evaluating facility feasibility, a more useful sports venue analysis (1) considers the audience for the study and (2) addresses the multitude of factors involved in the strategic planning process. It is likely that several sports industry consultants will claim credit for preparing the feasibility study of a particular sports venue. In fact, multiple feasibility studies are often prepared for the parties involved in the sports venue development decision. Some of the interested parties involved in assessing new sports venue feasibility include the following: •
6 Merriam-Webster’s
The Public Sector. When elected officials and other representatives of cities, counties, or states are involved in the decision to develop a new sports venue, they often focus on improving the quality of life for their constituents. Unlike a commercial developer’s evaluation of the feasibility of an office complex or apartment building, the public sector does not typically measure feasibility based on cash flow.
Collegiate Dictionary, 10th ed. Springfield, MA: Merriam-Webster, 1994.
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•
•
Rather, the anticipated benefits to offset the significant public investment in a new sports venue may be considered from the perspectives of (1) improving a neighborhood (e.g., Camden Yards in Baltimore, Lower Downtown Denver), (2) generating broader-based economic impacts (e.g., increased sales, jobs, taxes), or (3) simply becoming, or maintaining status as, a “major league city.” The Franchise Owner. While more often a direct function of cash flow (whether (1) to improve profitability for the owner or (2) to improve the team’s competitiveness by providing additional resources to invest in players), feasibility from the perspective of the franchise owner often involves several factors. Some franchise owners have exhibited a genuine desire to share in the public sector’s desire for improving the community. However, franchise owners have to balance this motivation against issues such as (1) competing locations (e.g., cities offering better/newer venues and/or leases), (2) costs of improving existing venues versus starting over with new construction, and (3) alternate markets that may or may not yield higher levels of ticket sales, corporate sponsorships, and media/broadcast rights. In most cases, the strategic planning process involves a complex negotiating process. This process involves the public sector regarding (1) public versus private investment in up-front development costs and (2) public versus private sharing of operating revenues and expenses (e.g., leases and lease guarantees). The Project Lender. Less high profile, yet often just as important, is the sports venue feasibility study conducted on behalf of the lending institution. Here, feasibility is simply measured as the ability of the sports venue direct or indirect cash flow to adequately repay the costs of financing of the venue development. For example, a portion of development costs may be financed by a simple bank loan taken out by the venue owner. In such cases, the funding source may be identified as a venue’s contractually obligated income such as (1) naming rights, (2) luxury suite contracts, or (3) guaranteed food and beverage concessionaire payments. In other cases, a portion of development costs may be financed by the public sector. This public-sector financing is often in the form of a revenue bond, which is backed by expected tax proceeds.
The Study Process for the Franchise Owner Considering a New Market As described above, there are multiple parties involved in the sports venue development and feasibility process. And, that sports venue development can involve (1) new or replacement venues and (2) new or replacement markets. The remainder of this discussion will focus on the strategic planning process from the perspective of an existing or prospective franchise owner considering a new market. Venue feasibility cannot be considered in a “vacuum.” Rather, the cash flow generated by a stadium, ballpark, or arena is only relevant when evaluated along with the other revenues and expenses associated with the sports team operation. A new venue can have a measurable impact on franchise attendance and, thus, on value. For example, as illustrated in Exhibit 10.8, MLB teams with recently constructed ballparks experienced significant increases in attendance compared to the year prior to occupying the new facility.
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Exhibit 10.8
Annual Attendance Change in New MLB Stadiums Since 1990
Team
Year
Stadium
Percent Change in Attendance from Previous Year (%)
San Francisco Giants Chicago White Sox Milwaukee Brewers Baltimore Orioles Pittsburgh Pirates Detroit Tigers Atlanta Braves Houston Astros Texas Rangers* Seattle Mariners† Colorado Rockies‡
2000 1991 2001 1992 2001 2000 1997 2000 1994 2000 1995
Pacific Bell Park U.S. Cellular Field Miller Park Oriole Park at Camden Yards PNC Park Comerica Park Turner Field Minute Maid Park The Ballpark in Arlington SAFECO Field Coors Field
60.0 47.0 44.0 40.0 39.0 25.0 16.0 13.0 12.0 8.0 0.3
* Texas lost 18 home games due to the 1994 players’ strike. † Seattle began play in its new stadium in July 1999. ‡ Colorado lost nine home games due to the strike-shortened schedule in 1995 and played their first two seasons in the significantly larger Mile High Stadium. SOURCE: Major League Baseball.
There are several key analyses involved in evaluating the economics of a new venue to host a new professional sports franchise. And, there are several key analyses involved in understanding the economics of investing in professional sports. These analyses include the following: • • • • • •
What is the anticipated price to be paid for the team? Are there additional costs associated with franchise relocation? What are the sources of funding for a new sports venue? What is the expected private-sector investment in the new sports venue? What is the cash flow potential of the franchise (e.g., venue, broadcast, other)? What is the potential for future appreciation in franchise value?
One goal of this analysis is to illustrate, as dictated by these and other factors, the extent of the franchise owners’ investment. The analysis should consider how much should be paid for the franchise—balanced against how much should be invested in sports venue–related costs. The following is a brief discussion of the factors that should be considered as part of such an analysis. •
•
•
League Trends. Evaluation of league structure and competition, attendance characteristics, local versus national revenues, revenue sharing, CBA, national broadcast revenues, and other characteristics. Franchise Purchase Price Estimate. Evaluation of trends in sales, expansion fees, and other current issues: the purpose of this evaluation is to estimate the potential price that should be paid to acquire an existing franchise or expansion team. Franchise Characteristics. Analysis of operating revenue and expenses associated with the franchise. Such an analysis should consider (1) local television, cable, and radio broadcast revenue, (2) team store and other merchandise,
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•
(3) team licensing and sponsorships, (4) league income, (5) training (e.g., preseason, Spring training), and (6) other revenue. Sources of franchise operating expenses should be evaluated, including (1) team (i.e., players and coaches) salaries and expenses, (2) scouting and player development, (3) net cost of revenue sharing, (4) marketing, (5) venue operations (net of amounts that may be paid by the local municipality), (6) general and administrative, and (7) other costs. Venue Characteristics. A detailed venue analysis involves an assessment of demand and revenue potential including (1) physical characteristics (total capacity, number of suites and club seats, private clubs, restaurants, etc.); (2) attendance (i.e., initial honeymoon period versus stabilized year); (3) ticket prices; (4) suite and club seat premiums; (5) permanent seat licenses/seat charters; (6) food and beverage concessions and catering (including franchise versus concessionaire splits); (7) merchandise; (8) advertising; (9) sponsorships (including potential for up-front versus capitalized naming rights); (10) parking; (11) special events; and (12) other ballpark revenues. Stadium operations including rent and related operating expenses (fixed versus day-of-event) should also be evaluated. Potential venue lease terms between the franchise owner and the municipality/authority that is the venue’s landlord should also be considered.
Income from Operations Based on the results of both franchise and venue analyses, the analyst may prepare a financial model that presents a 5- to 15-year projection of operating revenue and expenses. This model should allow for various sensitivity analyses. The sensitivity analyses may relate to potential impacts of critical factors such as (1) site location, (2) lease terms, (3) player salaries and “spikes” related to free-agent signings, (4) the value of naming rights, (5) work stoppages/player strikes, and (6) potential future issues related to collective bargaining agreements, luxury tax, revenue sharing, and so on. As described previously, this analysis is helpful both to the franchise owner in evaluating a potential investment in a sports franchise and a sports venue and to lenders considering the potential for income to fund project debt service.
Venue Financing Alternatives Analysts should understand the range of financing alternatives and funding sources associated with the improvement to an existing sports venue or the development of a new facility. Primary costs including (1) construction, (2) infrastructure and site development costs, (3) site acquisition/value, (4) parking, and (5) other costs. These primary costs often range from $250 to $500 million. The potential range of funding sources available to cover these costs, as well as potential public- and private-sector financing instruments that may be available, should also be considered. A list of funding sources based on sports venues developed over the past several years is presented in Exhibit 10.9. This list is divided into “public” funding sources versus “private” funding sources. An example of public versus private funding of MLB ballpark development costs for recently developed stadiums is presented in Exhibit 10.10. With few
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Exhibit 10.9
Sports Venue Development, Public versus Private Funding Sources Public Participation Funding Sources • • • • • • • • • • • • •
Land contribution Tax increment financing (including incremental ad valorem, sales, restaurant, admissions, and other taxes) Revenue bonds supported by hotel tax Revenue bonds supported by rental car tax increase Revenue bonds supported by sales tax increase Revenue bonds supported by restaurant tax increase General obligation bonds supported by hotel, rental car, sales, or restaurant tax increases Lottery proceeds Parking tax Amusement tax Revenue bonds backed by “sin taxes” (e.g., taxes on cigarettes, liquor, beer/wine, etc.) Federal grants Joint development revenues
Private Participation Funding Sources • • • • • • • • •
Public financing funded by franchise guaranteed rental payments Naming rights Personal seat licenses (PSLs)/charter seat licenses Founders suites Food and beverage concessionaire build-out Private suite and club seat deposits Beverage company “pouring rights” Ticket surcharge Financing backed by the ballpark contractually obligated income (C.O.I)
exceptions (e.g., the San Francisco Giants’ Pacific Bell Park and the Atlanta Braves’ Turner Field, which were developed with private funds), ballpark development costs are shared between the public sector (i.e., the local city/county) and the private sector (i.e., the MLB franchise). As evidenced in Exhibit 10.10, the majority of development costs are typically borne by the public sector. Exhibit 10.10
MLB Ballpark Development Costs, Source of Funding MLB Ballpark Ballpark in Arlington Bank One Ballpark/Phoenix Comerica Park US Cellular Field/Chicago Coors Field/Denver Great American Ballpark/Cincinnati Jacobs Field/Cleveland Minute Maid Park/Houston Oriole Park Camden Yards/Baltimore Pacific Bell Park/San Francisco Philadelphia Phillies Ballpark PNC Park/Pittsburgh SAFECO Field/Seattle San Diego Padres Ballpark Turner Field/Atlanta
Private Sources (%)
Public Sources (%)
30 33 68 0 25 9 27 18 10 95 50 18 25 33 100
70 67 32 100 75 91 73 82 90 5 50 82 75 67 0
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Exhibit 10.11
Typical Range of Sources of Private Funding Source of Private Funding
Low
High
PSLs Ticket surcharge Naming rights Team rent C.O.I. Concessionaire
$10,000,000 15,000,000 25,000,000 25,000,000 10,000,000 10,000,000
$20,000,000 20,000,000 30,000,000 30,000,000 20,000,000 15,000,000
TOTAL
$95,000,000
$135,000,000
Excluding the unique “outliers” (e.g., (1) Pacific Bell Park and (2) Turner Field, which was funded primarily through the Olympics), the average and median private investments in stadium development costs are 27 and 25 percent, respectively. To illustrate the potential private-sector funding for a new sports venue, the analyst should consider that construction of a new ballpark may cost upward of $400 million. Thus, based on the previous illustration, the public sector may fund as much as 75 percent or $300 million. And, the private sector (i.e., the franchise owner) would be responsible for at least $100 million. Exhibit 10.11 provides an illustrative range of the typical sources of private funding.
Economic Impact on the State and/or Local Community To the extent necessary to support the public-sector investment required in a new sports venue, it is important to consider the potential economic and development impact of both the team franchise and the sports venue. These analyses can assess both the quantifiable impact on the community (e.g., sales, jobs, taxes) and the development impact on the area surrounding the proposed sports venue. Earlier in the chapter, we described a range of preliminary assessments that are involved in sports venue “feasibility analysis.” The analyst should conduct primary research, demand analysis, surveys of local corporations and residents, and other detailed planning and analysis during more in-depth sports venue feasibility analysis.
Conclusion Professional sports franchises are unlike other businesses in many ways. The need to compete both athletically and financially creates dual objectives for the franchise owner. Often, these dual objectives are at odds with each other. When team owners consider the cachet of owning their hometown team or a World Series or Super Bowl winner, the prices they pay for sports franchises often bear little relationship with economic reality. Valuation analysts who serve the sports industry should keep current with the industry news that affects team values. In this way, analysts can include consideration of the most recent industry trends in their sports franchise and sports venue valuation analyses.
Chapter 11 Health Care Entity Valuation Charles A. Wilhoite
Introduction Health Care Entity Valuation Methodology Valuation Approaches Asset-Based Approach Income Approach Market Approach Significant Valuation Issues Managing Expectations Identifying and Rationalizing Value Trade-Offs Issues of Management/Operational Control Complying with Regulatory Constraints Impact of Market Activity on Current Practice Values Shift toward Gainsharing Summary and Conclusion
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Introduction A total of 3,524 health care services entities were acquired between 1997 and 2001.1 In order of relative significance, the largest number of acquisitive transactions— roughly two-thirds of the reported total—was represented by participants in the following health care segments: 1. 2. 3. 4.
Physician groups Hospitals Long-term care Home care
Over the past decade, some form of managed care [e.g., health maintenance organizations (HMOs) or preferred provider organizations (PPOs)] has become the dominant vehicle of health care delivery in most major markets. As a result, the emphasis on health care delivery has shifted and will continue to shift. In order to be successful in today’s health care industry environment, health care providers of all types are required to administer fewer, more effective services to an increasing population of patients. This is not to suggest that health care providers are withholding needed services from their patients. In fact, the opposite is true. Reputable health care providers continue to strive to provide services in a manner that prevents patients from becoming sicker and prevents their existing ailments from becoming chronic. Health care providers are motivated to provide needed services in order to minimize the level and severity of future treatments required by patients. In a traditional fee-for-service delivery system, most health care providers are compensated for each unit of care or procedure administered. However, in the managed care environment, the economic mechanisms and reimbursement fee schedules imposed upon most health care providers motivate the providers more to control and prevent illnesses rather than to treat illnesses. Therefore, in conforming to the practice requirements imposed by managed care, health care providers have adopted a fundamental change in practice habits in order to maintain the long-term health of their patients. This change, of course, explains the formation of the HMOs and PPOs that have come to dominate the coordination and delivery of health care services in our country. In an effort to ensure some level of success in the changing health care market, insurance companies and health care providers emphasize the formation of integrated delivery systems (IDSs). The goal of an IDS is to create a health care delivery system capable of administering services ranging from the most critical and complex (e.g., inpatient, cardiovascular surgery) to the least invasive (e.g., outpatient visits for minor ailments such as sore throats). In essence, the development of an IDS represents an attempt to gain greater control over a patient’s passage through the health care delivery system. The objective of the IDS is to control the cost of that patient to the related delivery system. Hospital systems have to contend with health insurance reimbursement pressures expected to result from the proliferation of managed care. Therefore, hospital
1 According
to The Health Care M&A Report, published by Irving Levin Associates, Inc.
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systems throughout the country—both for-profit and tax-exempt—have embraced the strategy of integration through physician practice acquisition. Both for-profit and tax-exempt hospitals are limited in their practice acquisition efforts by the economic feasibility of the contemplated acquisitions. However, when making acquisitions, tax-exempt entities must also comply with several significant federal and state regulatory requirements. Otherwise, the tax-exempt entities expose themselves to severe penalties and fines, including the potential loss of their tax-exempt status. The valuation approaches and methods discussed in subsequent sections of this chapter are relevant for the valuation of most health care entities. For simplicity purposes, however, the examples presented in this chapter focus on valuation issues relating to the acquisition of physician practices by tax-exempt hospital systems. Although the focus of this chapter emphasizes valuation issues in the circumstance of a contemplated practice acquisition by a tax-exempt hospital system, many of the issues discussed are generally relevant in any practice valuation. Specifically, this chapter addresses: 1. Physician practice valuation methodology (i.e., methodology that is equally relevant for the valuation of most health care entities) 2. Key valuation issues when performing a physician practice valuation 3. The impact of market activity on current practice values The actions and the financial performances of several significant publicly traded health care organizations over the past 5 years have generally exerted downward pressure on the value of physician practices and other health care entities. In fact, several health care industry participants currently claim that the value of a physician practice is represented entirely by the hard (i.e., tangible) assets only. This implies that no intangible asset value exists in a typical physician practice. Market forces and industry conditions clearly should be considered during the valuation of a health care entity. However, the naïve acceptance of a generalization that disregards the physician practice’s intangible assets clearly ignores relative profitability, local and regional market conditions, market position, reputation, and structural and operating characteristics that differentiate health care entities across the country. Therefore, qualified and experienced financial and legal professionals should analyze the facts and circumstances in each contemplated transaction in order to advance the participants’ efforts toward the successful development of an integrated delivery system. The recognition and dissemination of a clear understanding of relevant health care entity valuation methodology is an important step in the process.
Health Care Entity Valuation Methodology Valuation Approaches Generally, health care entity valuation methods can be categorized into one of three general valuation approaches: (1) the asset-based approach, (2) the income approach, and (3) the market approach. Each valuation approach, as well as relevant methods within each approach, is discussed in the following sections.
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Asset-Based Approach The asset-based approach is based upon the economic principle of substitution. The underlying premise is that an investor will pay no more for an asset (i.e., a business or business interest) than the cost to obtain—either through purchase or construction—an asset of equal utility. Although utility can be measured in many ways, the utility measure generally considered most relevant with regard to the purchase of a health care entity, or a fractional interest in a health care entity, is the economic returns that the investor expects the investment to generate. When valuing a practice or fractional interest in a health care entity by applying the asset-based approach, the valuation analyst should approach the assignment by viewing the entity as a revenue-producing assemblage of assets—both tangible and, potentially, intangible. Accordingly, the initial step in an asset-based valuation analysis is to identify each tangible and intangible asset encompassed in the subject health care entity. After being discretely identified, each tangible and intangible asset is separately valued based on the most relevant method (given the available data). The summation of the estimated values of each tangible and intangible asset represents the overall asset value of the subject health care entity. In a typical asset-based valuation analysis, the assets are valued on a fee simple ownership interest basis. That is, the valuation analyst assumes that, if acquired, the assets of the business will be transferred without any associated long-term liabilities. Typical Health Care Entity Assets. All health care entities maintain some level of practice assets that typically can be classified into one of three general categories: (1) financial assets, (2) tangible real estate and personal property, and (3) intangible assets. Financial assets typically include cash, accounts receivable, prepaid expenses, and inventory and supplies (including office and medical materials and supplies). The tangible real estate and personal property will typically include office furniture and fixtures, medical equipment, medical buildings and land, and leasehold improvements. The potential for the existence of intangible assets in a health care entity, particularly larger practices, is significant. Generally, the intangible assets of a health care entity can be categorized as follows: 1. Technology-related (e.g., proprietary technology, technical know-how, systems and procedures, technical manuals and documentation) 2. Patient-related (e.g., patient relationships, referral relationships) 3. Contract-related (e.g., certificates of need, licenses, affiliation agreements, noncompetition agreements with practice partners) 4. Data processing–related (e.g., computer software, automated databases) 5. Human capital–related (e.g., a trained and assembled workforce, employment/ noncompetition agreements) 6. Marketing-related (e.g., practice trademarks and trade names) 7. Location-related (e.g., leasehold interests) 8. Goodwill-related (e.g., going-concern value) Numerous intangible assets within each identified category may exist within a particular health care entity. However, the most significant intangible assets of a health care entity are generally (1) patient and referral relationships, (2) a trained
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and assembled workforce, and (3) going-concern value. The valuation of the identified intangible assets of a health care entity most often is based on the income approach. And, the most commonly used method within the income approach is the discounted cash flow (DCF) method, which is discussed below. The cost approach is sometimes used. However, health care entities rarely maintain detailed and readily available cost analysis data regarding internally developed intangible assets. The market approach is rarely used. This is because generally it is very difficult to locate marketbased empirical data regarding transactions related to the discrete intangible assets of health care entities. The following section describes several acceptable methods for the valuation of tangible assets maintained at health care entities. Valuing Tangible Assets Cost Approach Methods. The theoretical underpinnings of the various cost approach methods relate to the following basic economic principles: • • •
Substitution—affirms that no prudent buyer would pay more for a property than the total cost to “construct” one of equal desirability and utility. Supply and demand—shifts in supply and demand cause costs to increase and decrease and cause changes in the need for supply of different types of properties. Externalities—gains or losses from external factors may accrue to industrial and commercial properties. External conditions may cause a newly “constructed” property to be worth more or worth less than its cost.
Types of Cost. Within the cost approach, there are several groups of related analytical methods. Each of these groups uses a similar definition of the “type” of cost that is relevant to the analysis. The most common types, or definitions, of cost include the following: • •
Reproduction cost Replacement cost
There are subtle, but important, differences in the definitions of these “types” of cost. Reproduction cost is the total cost, at current prices, to construct an exact duplicate or replica of the subject health care property. This duplicate would be created using the same materials, standards, design, layout, and quality of workmanship used to create the original property. The replacement cost of a health care property is the total cost to construct, at current prices, a property having equal utility to the subject property. However, the replacement property would be created with modern methods and constructed according to current standards, state-of-the-art design and layout, and the highest available quality of workmanship. Accordingly, the replacement property may have greater functionality or utility than the subject health care property. Functionality is an engineering concept that means the ability of the subject health care property to perform the task for which it was designed. Utility is an economic concept that means the ability of the subject health care property to provide an equivalent amount of satisfaction. While the replacement property may perform the same task as the subject property, the replacement property is often better (in some way) than the subject. In that case, the replacement property may yield more satisfaction than the subject property.
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If this is the case, analysts should be careful to adjust for this factor in the obsolescence estimation of the replacement cost analysis. Depreciation and Obsolescence. Replacement cost new typically establishes the maximum amount that a prudent investor would pay for a fungible property. To the extent that a health care property is less useful than an ideal replacement for itself, the value of the subject property must be adjusted accordingly. The replacement cost new is adjusted for losses in economic value due to: • • • •
Physical deterioration Functional obsolescence Technological obsolescence (often considered a specific form of functional obsolescence) External obsolescence
There are several other definitions of cost that are encompassed by the assetbased approach. Some analysts consider a measure of cost avoidance as an appropriate method within the cost approach. This method quantifies either historical or prospective costs that are avoided (i.e., not incurred) by the property owner due to the ownership of the subject health care property. Some analysts consider trended historical costs as an indication of value. In this method, actual historical property development costs are identified, quantified, and then “trended” to the valuation date by an appropriate inflation-based index factor. All asset-based valuation methods typically include a comprehensive and all-inclusive definition of “cost.” It is important to recognize that the cost of a property typically includes not only hard costs (e.g., materials and labor) and soft costs (e.g., engineering and design labor and overhead), but also the property developer’s profit (on both the hard and soft cost investment) and an entrepreneurial incentive to economically motivate the property development process. And, the cost of a property should be reduced by all relevant forms of obsolescence—including external obsolescence. So, while the cost approach is a distinct and different set of valuation analyses than the income approach, there are necessary economic analyses involved in the asset-based approach. These economic analyses (which may involve some analysis of income) provide indications both of the appropriate levels of entrepreneurial incentive (if any) and of external obsolescence (if any).
Income Approach The income approach is based upon the premise that the value of a health care entity equals the present value of all estimated future economic income to be derived by the owners of the entity. Ownership interests represent both equity investments (i.e., various classes of shareholders) and debt investments (e.g., bondholders or other interest-charging lenders). Discounted Cash Flow Method. A common income approach method is the DCF method. This method requires the following analyses: revenue analysis, expense analysis, investment analysis, capital structure analysis, and residual value analysis. Each of these analyses will be discussed briefly. Revenue Analysis. Revenue analysis involves a projection of prospective revenues from the provision of health care and related services by the entity.
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This analysis generally includes consideration of the following microeconomic factors: patients seen/procedures administered, average patient/procedure charge, market dynamics, competitive pressures, fee flexibility, regulatory changes, demographic analysis, and technological changes. Expense Analysis. The expense analysis requires consideration of the following aspects: patient and third-party payer allowances, fixed versus variable costs, patient-related versus period costs, cash versus noncash costs, direct versus indirect costs, cost absorption principles, cost/efficiency relationships, and cost/volume/profit relationships. Investment Analysis. The investment analysis requires consideration of the following aspects: required minimum cash balances, days revenues outstanding in accounts receivable/payable, facilities utilization and related constraints, and capital expenditure budgets. Capital Structure Analysis. The capital structure analysis requires consideration of the following aspects: current capital structure, optimal capital structure, cost of various capital components, weighted average cost of capital (WACC), systematic and nonsystematic risk factors, and marginal cost of capital. Residual Value Analysis. The residual value analysis results in an estimation of the value of the prospective cash flow generated by the subject practice at the conclusion of a discrete projection period. This residual value can be estimated by various methods—for example, price/earnings multiple, annuity in perpetuity method, or the Gordon growth model. Based on the results of the above-mentioned analyses, a projection of net (typically after-tax) cash flow from health care operations is made for a reasonable discrete projection period. The cash flow projection is discounted at an appropriate (typically after-tax) present value discount rate resulting in an indication of the present value of each year’s cash flow. The residual value of the subject practice is estimated at the end of the discrete projection period. This residual value is also discounted to its present value. The present value of the discrete period net cash flow projection is added to the present value of the residual value. This summation represents the value of the subject health care entity, based on the DCF method. Internal Revenue Service Position. Net cash flow is defined by the Internal Revenue Service (IRS) as cash flow developed on an after-tax basis.2 The appropriate level of net cash flow is calculated after the subject health care entity has funded all investments required to sustain profitable earnings growth. In other words, net cash flow is calculated after cash disbursements for capital expenditures (e.g., new medical equipment and facilities) and after investments in net working capital (e.g., net investment in accounts receivable and inventory in excess of interim funding provided by accounts payable and other accrued liabilities).
2 Based
on data presented in The Health Care M&A Report, published by Irving Levin Associates, Inc.
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The principal components of the net cash flow model for the valuation of health care entities are expressed as follows: Less: Equals: Less: Equals: Less: Equals: Plus: Plus: Less: Less: Plus: Equals:
Gross patient service and medical revenues Third-party payer and other contractual allowances Net patient service and medical revenues Total operating expenses (including reasonable provider compensation) Profit before tax Income taxes After-tax profit Tax-affected interest expense Depreciation expense Capital expenditures Annual increases in (noncash) current assets Annual increases in non-interest-bearing current liabilities Annual net cash flow
The basic format of our net cash flow projection model, then, is a combination of several traditional income statement accounts, adjusted for changes in several balance sheet accounts that affect net cash flow. The above model is an after-tax net cash flow model. That is, there is no provision in the model for either periodic debt service payments or for periodic interest expense. Therefore, the conclusion of this particular cash flow model (i.e., the present value of the net cash flow projection) represents the total business enterprise value of the health care entity. The subject entity’s enterprise value (i.e., total invested capital) is the sum of the entity’s long-term interest-bearing debt—both current and long term—plus preferred stock plus common stock. In order to estimate the fair market value of the entity’s equity, all interest-bearing debt that is expected to be paid should be deducted from the indicated value of the subject health care entity’s capital structure. Discounted Cash Flow Analysis Example. Exhibit 11.1 presents a simplified example of a DCF analysis with regard to a large, multispecialty physician practice (Medical Clinic, Inc., or Medical). Typically, in health care entity valuations, the DCF analysis is based on a 5-year discrete projection period. Projected Practice Performance. The projected performance of the subject practice is based on empirical research regarding: (1) the historical financial and operating performance of the subject practice, including historical compensation practices and planned compensation practices; (2) the historical performance of the physician services segment of the health care industry—both nationally and regionally; (3) the projected performance of the physician services segment of the health care entity—both nationally and regionally; (4) the projected performance of service providers for the subject practice and anticipated utilization rates; (5) the historical and expected reimbursement rates of major payer classes; and (6) the analysis of historical and projected demographic statistics for the practice market area. Present Value Discount Rate. Because the analyst is discounting net cash flows projected on an after-tax basis, the appropriate discount rate should represent a combination of risk applicable to both (1) equity investors and (2) debt investors. This rate is typically referred to as the WACC. To arrive at the WACC, the analyst should estimate (1) the relevant required rate of return on equity, (2) the relevant required rate of return on debt, and (3) the
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62.50 25.0% 46.88 50.0% 23.44 35.0% 7.03 40.0% 4.22 0.50 4.72 0.60 −0.70 −0.15 4.47 0.50 0.9325 4.17 44.77 15% 3%
Gross patient service and medical revenue Less: Third-party and contractual allocation (% of gross) Net patient service and medical revenues Less: Operating expense (% of net revenues—excluding physicians) Operating profit before physician compensation Less: Physician compensation (% of net revenues) Equals: Pretax income Less: Taxes Equals: After-tax net income Plus: Tax-affected interest expense Equals: After-tax net income Plus: Depreciation Less: Capital expenditures Less: Annual working capital requiremnets Equals: Net cash flow Present value period Present value factor Present value net cash flow
Business enterprise value
Present value discount rate (WACC)* Expected long-term growth rate†
68.75 25.0% 51.56 50.0% 25.78 35.0% 7.73 40.0% 4.64 0.50 5.14 0.60 −0.70 −0.15 4.89 1.50 0.8109 3.97
Year 2 75.00 25.0% 56.25 50.0% 28.13 35.0% 8.44 40.0% 5.06 0.50 5.56 0.60 −0.70 −0.15 5.31 2.50 0.7051 3.75
Year 3 81.25 25.0% 60.94 50.0% 30.47 35.0% 9.14 40.0% 5.48 0.50 5.98 0.60 −0.70 −0.15 5.73 3.50 0.6131 3.52
Year 4
†
* Based on (1) estimated equity rate of return of 19% and (2) estimated after-tax cost of debt rate of 5%, weighted 70% equity and 30% debt. Based on analyses of historical growth rates and current industry research.
Year 1
Multispecialty Discounted Cash Flow Analysis, Medical Clinic, Inc.
Projected ($ MM)
Exhibit 11.1
83.75 25.0% 62.81 50.0% 31.41 35.0% 9.42 40.0% 5.65 0.50 6.15 0.60 −0.70 −0.15 5.90 4.50 0.5332 3.15
Year 5
49.19 4.50 0.5332 26.23
Terminal Value
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relevant proportions of debt and equity comprising the relevant capital structure of the subject practice. Return on Equity. The required rate of return on equity is typically developed from empirical market evidence and recognition of the subject practice’s investment risk. Developing a required rate of return on equity begins with estimating a risk-free rate of return that incorporates investors’ expectations for the real rate of interest on money and the impact of inflation or loss of purchasing power over time. Because we are interested in concluding a required rate of return for an equity investment, equity risk premiums over the risk-free rate of return must also be researched. The relevant required rate of return on equity is often developed based on the capital asset pricing model (CAPM). Using the CAPM, the return on equity is estimated by adding to the risk-free rate an equity risk premium established by comparison of risk characteristics of the subject practice with guideline publicly traded entities. With regard to physician practices, guideline publicly traded company information generally is limited to large publicly traded companies that manage physician practices. Beta, which represents the relative level of risk for an entity in comparison with general market risk for the publicly traded companies, is used to estimate the appropriate market-related risk factor for the subject practice. The appropriate beta factor is then applied to the estimated equity risk premium in order to estimate the relevant equity risk premium for the subject physician practice. Because no physician practices (in their pure operating form) are publicly traded, analysts are generally required to make subjective determinations regarding any additional, or reduced, equity premiums warranted for the subject practice, based on factors and characteristics specific to the subject practice. Based on the limited nature of direct comparable information that can be relied upon to estimate the required rate of return on equity for closely held physician practices, analysts often use the build-up model as a substitute for the CAPM. In this model, the analyst starts with a risk-free rate and adds relevant equity risk premiums to estimate the appropriate required rate of return on an equity investment in the subject practice. A common source of the equity risk premium components is Ibbotson Associates Stocks, Bonds, Bills and Inflation. Exhibit 11.2 presents a simple application of the estimation of a required rate of return on equity based on a build-up model. As indicated, the summation of the risk-free rate of return and the estimated equity risk premiums represents the estimated required rate of return on equity. Return on Debt. The required return on debt for the subject physician practice is typically represented by the practice’s marginal cost of borrowing. Because the DCF method is performed on an after-tax basis, the relevant borrowing rate is reflected after the impact of effective taxes, or as follows: borrowing rate × (1 – effective income tax rate) Cost of Capital Weightings. The overall required rate of return, or WACC, for the subject practice can now be estimated from each cost of capital component and the relevant weighting applied based on the capital structure mix. The relevant capital structure is typically estimated based upon a review of the subject practice’s historical capital structure and an analysis of the capital structures of the guideline publicly traded health care companies considered to estimate the equity risk premium.
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Exhibit 11.2
Estimated Required Return on Equity Cost of Equity Component
Rate (%)
Risk-free rate (i.e., 20-year Treasury bond) Long-horizon equity risk primium Small stock equity risk premium Company-specific equity risk primium
5.6* 7.4† 4.7‡ 1.0§
Estimated required rate of return on equity, rounded
19.0
* Represents the yield on a 20-year U.S. government bond, as quoted in the Wall Street Journal and effective June 2002. † Represents the large company stock total returns minus long-term goverment bond income returns, as presented in Ibbotson Associates Stocks, Bonds, Bills and Inflation, 2002 Yearbook. ‡ Represents the small company stock total returns minus the large company stock total returns, as presented in Ibbotson Associates Stocks, Bonds, Bills and Inflation, 2002 Yearbook. § Estimated based on consideration of practice-specific factors, including size, physician mix, payer mix, duration of the practice, and market position.
Weighted Average Cost of Capital. Assume that a reasonable weighting of debt and equity components as of the valuation date is 30 and 70 percent, respectively. Further, let’s assume that the estimated after-tax required rate of return on equity and debt are 19 and 5 percent, respectively. Applying this capital structure weighting to the subject practice’s cost of debt and equity capital produces the WACC, as presented in Exhibit 11.3. Indicated Value—Discounted Cash Flow Method. As presented in Exhibit 11.1, the business enterprise value of the subject physician practice as of the valuation date, based on the DCF method, is approximately $45 million. This value is based on an estimated long-term earnings growth rate of 3 percent and an after-tax, WACC discount rate of 15 percent. The estimated physician practice business enterprise value represents the value of all invested capital—preferred stock, common stock, and interest-bearing debt. In transactions involving larger practices, a detailed analysis of working capital as of the transaction date will be performed. This analysis is performed in order to determine if any deficiency (or excess) in working capital exists relative to that required for the normal continuing operations of the practice. The estimated value of the invested capital of the practice is typically adjusted by any deficiency or excess in working Exhibit 11.3
Weighted Average Cost of Capital Required Rate of Return on Capital Components Debt capital @ 5% Equity capital @ 19% Total required rate of return on capital Present value discount rate (rounded)
Percent of Total Capital Structure × ×
0.30 0.70
Weighted Cost of Capital (%) = =
1.50 13.30 14.80 15
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capital noted. With regard to the example presented, let’s assume that existing working capital is at an appropriate level, and no adjustments to the estimated value are required. In order to arrive at the market value of equity capital, we then deduct all long-term interest-bearing debt outstanding at the valuation date. Long-term interest-bearing debt at that date totaled $15 million. Subtracting the market value of the subject practice’s interest-bearing debt from the above-determined business enterprise value of the entity results in the following value of equity: Total business enterprise value (rounded) $45 million Less: Market value of interest-bearing debt capital (rounded) $15 million Equals: Publicly traded equivalent value of equity (rounded) $30 million
Market Approach Overview. The third approach to estimate the value of a health care entity is the market approach. The market approach is based on the premise that the value of a physician practice is equal to the price investors are willing to pay for similar assets with comparative economic earnings capacity. Two methods are typically used in applying the market approach: (1) the guideline publicly traded company method and (2) the guideline merged and acquired company method. The guideline publicly traded company method relies on data from publicly traded health care companies for guidance in the valuation of closely held physician practices. The guideline merged and acquired company method relies on data from completed transactions involving public or private health care companies for guidance in the valuation of the subject physician practice. Guideline Publicly Traded Company Method. The first step in the guideline publicly traded company method is to search for similar publicly traded companies by identifying the most appropriate Standard Industrial Classification (SIC) code. Sources typically reviewed for information on publicly traded companies include databases such as Standard & Poor’s Corporations and Disclosure’s Compact D/SEC. These products have information for approximately 9,000 and 12,000 public companies, respectively. The next step is to narrow the list of publicly traded companies to arrive at a list of selected guideline companies. The steps to narrow the list of companies typically include reviewing business descriptions, financial data, and pricing information for each of the health care companies. After a list of the selected guideline publicly traded companies is compiled, 5 years of historical financial statement data (and projected data, if available) are typically used to calculate various pricing multiples. The pricing multiples are applied, after any necessary adjustments, to the subject company’s financial fundamentals. The pricing multiples calculated for the guideline publicly traded health care companies typically include, among others: 1. Direct equity pricing multiples a. Price per share/earnings per share b. Price per share/cash flow per share c. Price per share/book value per share d. Price per share/revenue per share
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2. Invested capital pricing multiples a. Market value of invested capital (MVIC)/earnings before interest and taxes (EBIT) b. MVIC/earnings before interest, taxes, depreciation, and amortization (EBITDA) c. MVIC/debt-free cash flow (DFCF) d. MVIC/debt-free net income (DFNI) e. MVIC/revenues f. MVIC/tangible book value per share (TBV) g. MVIC/physicians Depending on the circumstances of the valuation, each of the listed pricing multiples may be calculated based on average, weighted average, last 12 months, or projected financial data. Invested capital pricing multiples are often useful when comparing the subject practice to guideline companies that have substantially different capital structures. Applying invested capital pricing multiples to the financial fundamentals of the subject practice results in the subject practice market value of invested capital. To estimate the value of the equity only, the market value of the subject practice interestbearing debt should be subtracted from the MVIC. The next step in the guideline publicly traded company method is to select the appropriate pricing multiples for the subject practice. Adjustments to the guideline pricing multiples are generally required to reflect differences in the risk and expected return between the subject practice and the publicly traded companies. Such risk and expected return differences include size of the subject practice (based on assets, revenues, number of physicians, patient base, patient mix, and payer mix); geographic coverage; differences in demographics of areas served; depth of practice management; expected profitability; expected growth; and variability of historical earnings and cash flow. After estimating the appropriate pricing multiples, the analyst applies the selected multiples to the subject practice financial fundamentals. The subject practice historical earnings data may need to be adjusted to eliminate the effects of any nonrecurring or extraordinary items. The indicated values from the various pricing multiples are then reconciled into a single value or into a range of values estimated by the guideline publicly traded company method. As previously discussed, guideline publicly traded company information with regard to physician practices is generally limited to public companies that manage large and multispecialty physician practices. As a result, the guideline merged and acquired company method may be more relevant than the guideline publicly traded company method with regard to the valuation of small physician practices. Guideline Merged and Acquired Company Method. In the guideline merged and acquired company method, the value of a physician practice is estimated by analyzing completed sale transactions involving similar physician practices. To search for mergers and acquisitions, the analyst focuses on the appropriate SIC codes, as discussed in the guideline publicly traded company method. Commonly used sources for mergers and acquisitions data include, among others, Mergerstat Review and SDC Platinum (Thomson Financial). In addition, there are also publications that summarize completed sale transactions for specific categories of health care organizations (e.g., hospitals, HMOs, and physician practices). An example of such a publication is the Irving Levin Associates, Inc., The Health Care M&A Report.
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Additionally, with regard to physician practices, The Goodwill Registry publishes data for the estimated price paid for physician practice intangible assets (presented as a percentage of practice gross revenue). These data, published annually, are sorted by year of sale transaction and physician specialty. When using the guideline merged and acquired company method, the terms of each sale transaction should be carefully reviewed. This transaction review should include (1) the actual transaction price paid and (2) whether the transaction involved the sale of equity or assets. If the transaction involved the sale of assets, it is important to determine the exact assets purchased and any liabilities assumed. After selecting a group of guideline transactions and determining each transaction’s purchase price, the analyst will calculate various transaction-derived economic earnings pricing multiples. As in the guideline publicly traded company method, after estimating the appropriate pricing multiples, the analyst applies the selected pricing multiples to the subject practice’s normalized financial fundamentals. A simplified example of the guideline merged and acquired company method is presented in Exhibit 11.4. This example presents pricing multiples resulting from the analysis of 11 acquired multispecialty practices for the valuation of Medical Clinic, Inc. Medical operates as a 100-physician multispecialty practice with five sites in a major metropolitan area. Based on the information provided by the analysis of the merged and acquired physician practices, the analyst should consider the following factors, among others, for the purpose of selecting the appropriate pricing multiple: • • • •
The dates of the guideline transactions relative to the valuation date of Medical. Market conditions at the date of the guideline transactions relative to market conditions existing at Medical on or around the valuation date. Size of Medical (based on assets, revenues, and number of physicians) relative to the size of the guideline companies. Physician mix (i.e., primary care vs. specialty care) of Medical relative to the physician mix of the guideline companies.
Exhibit 11.4
Multispecialty Guideline Merged and Acquired Company Analysis, Medical Clinic, Inc. Acquired Practice Riverside Medical Clinic Lexington Clinic Arnett Clinic Diagnostic Clinic Glen Ellyn Clinic Cardinal Healthcare, PA Summit Medical Group Lewis-Gale Clinic, Inc. Clinical Associates Meridian Medical Group Berkshire Physicians
Location
No. of Physicians
Practice Revenue ($)
Price/Physician Multiple
Price/Revenue Multiple
Riverside, CA Lexington, KY Lafayette, IN Largo, FL Glen Ellyn, IL Raleigh-Durham, NC Summit, NJ Roanoke, VA Baltimore, MD Marietta, GA Pittsfield, MA
90 125 109 93 89 75 75 106 71 67 93
50,000,000 51,000,000 87,438,000 49,000,000 60,000,000 34,170,500 47,000,000 68,200,000 35,870,000 63,950,000 43,683,000
355,556 512,000 660,528 395,699 707,865 573,333 736,087 410,377 245,070 419,597 317,204
0.64 1.25 0.82 0.75 1.05 1.26 1.17 0.64 0.49 0.44 0.68
SOURCE: Integrated Delivery Systems and Joint Venture Dissolutions Update (Washington: Internal Revenue Service, October 1994).
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• •
• • • •
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Payer mix (i.e., fee-for-service, HMO, PPO, Medicare, Medicaid) of Medical relative to the payer mix of the guideline companies. Profitability—measured by consideration of total physician compensation, physician employee benefits, and practice profits—of Medical relative to the guideline companies. Historical growth—in assets, revenues, physician compensation and profits— of Medical relative to the guideline companies. Diversity of practice (i.e., level of ancillary services) of Medical relative to the diversity of the guideline companies. Location of Medical (i.e., rural, urban, suburban) relative to the location of the guideline companies. Market position of Medical relative to the market position of the guideline companies.
While all of the above information may not be available for the acquired practice transactions, an analysis of all available information is an important step in the selection of relevant and supportable market-derived pricing multiples.
Significant Valuation Issues A thorough understanding of relevant physician practice valuation methodology will enable the analyst to incorporate the impact of several significant considerations specific to physician practice valuations. Several of the most significant of these considerations are listed below: • • • •
Managing expectations Identifying and rationalizing value trade-offs Issues of management/operational control Complying with regulatory constraints
Managing Expectations During the past 5 years, physician practice acquisitions have occurred at prices implying practice multiples ranging from a low of 9 percent of revenues, or $637 per physician to a high of 300 percent of revenues, or $11.0 million per physician. Clearly, such a wide range of valuation pricing multiples implies an equally wide set of facts and circumstances with regard to the underlying transactions. As a result of the wide and varying range of physician practice multiples disclosed in publicly available documents, a critical service provided by physician practice valuation analysts in a transaction situation is managing the expectations of the client—whether working for the physician seller or the hospital acquirer. Typically, both the physician(s) and the hospital system involved will have read stories or heard anecdotes regarding “similar” physician practice transactions and the implied transaction pricing multiples. The success of most transactions should be determined not only by the signing of the closing documents, but also by the perceived high probability of long-term financial success of the IDS formed by the transaction. Therefore, success is dependent on an economically sound transaction price.
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As a seller, the physician typically will lean—with the support of facts and financial advice—toward market-based practice pricing multiples at the higher end of the market-based range. Conversely, the hospital acquirer will have a well-reasoned justification for pricing multiples at the lower end of the range. The most reliable means through which the analyst can affect client purchase price expectations is by performing a comprehensive valuation analysis. Prior to releasing any preliminary value, the analyst should be in a position (and make it a point) to discuss similarities and differences among the subject practice and any guideline merged and acquired practices. Similarly, the analyst should discuss the sensitive variables that are projected in the DCF analysis. The sensitive variables include projected revenue growth and realization rates, operating cost and operating margin expectations, compensation plans, capital expenditure and working capital requirements, capital structure, and the present value discount rate. The sensitive variables are estimable only after the analyst has (1) developed a thorough understanding of the subject practice historical performance (through the review of relevant financial and operating statistics); (2) performed necessary industry research (both on a national level and a regional level); and (3) conducted due diligence interviews with relevant financial and operations personnel of the subject practice. Developing and testing key variables with the client prior to providing value conclusions will provide a more reasonable range of preliminary value conclusions. Due to overzealous client service commitment or compensation arrangements, many consultants adopt the position of striving to attain the highest or lowest value possible (depending on whether their client is the seller or the buyer). As a result, many potential transactions are terminated as a result of initial offers that offend the recipient based on the fact that they are perceived as being either too high or too low. Even in those circumstances in which transactions proceed after extremely high or low initial offers, clients with expectations that are not reasonable are often less than satisfied with the end result. This dissatisfaction is based on the client perception that the price has been inexplicably adjusted by a material amount.
Identifying and Rationalizing Value Trade-Offs Most closely held physician practices are operated for the financial benefit of the owner physicians. In other words, the practice of medicine by the owner physicians generally is based on two primary motivations: (1) satisfying the internal desire to provide the necessary and valuable service of quality health care delivery and (2) satisfying personal financial objectives by generating economic returns commensurate with the value of the services provided. In responding to this second motivational factor, most physicians in closely held practices realize little benefit from reporting significant practice taxable income at the end of a given fiscal operating period. Rather, the maximum economic benefit realized by most practicing physicians in closely held practices results from the withdrawal of substantially all practice earnings in the forms of compensation and related economic benefits. Accordingly, large physician practices may report virtually no bottom-line profits in the operating periods immediately preceding the contemplated transaction as a result of the owner physicians’ historical practice of withdrawing all practice earnings. These practices would not appear to represent an investment with the capacity to deliver significant future returns to a third-party acquirer. Herein lies one of
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the more significant trade-offs that should be addressed in the acquisition of a large physician practice by a hospital system. This trade-off is the potential sacrifice by the selling physicians of future compensation for current purchase price. Physician compensation and economic benefits at most closely held physician practices typically range from 30 to 50 percent of gross practice revenue.3 Absent the ability of the physician practice to significantly reduce operating costs in future periods, physician compensation and benefits represent the most significant expense categories available for reduction in order for the buyer to realize higher future profits. Through a structured physician compensation plan—generally relating physician compensation and benefits directly to physician production—the expected profitability of a targeted acquisition can be projected. A structured physician compensation plan is usually required. A structured physician compensation plan is particularly important in circumstances in which the targeted practice has reported minimal earnings in the periods preceding the contemplated transaction. Clearly, any contemplated transaction requires consideration of the impact that a potential future decrease in average physician compensation may exert on both the subject practice operating performance and its physician retention rate. The selling physicians will undoubtedly reflect on past compensation levels, comparing them with projected future compensation levels. The trade-off to be recognized—and presented—relates to the fact that a dollar of reduced physician compensation in the future generally translates into more than a dollar of increased transaction value today. For example, if the selling physicians of a practice generating $50 million in revenue agreed to an average reduction in total compensation of 3 percent of revenue, the resulting increase in pretax profits would be $1.5 million, and $900,000 on an after-tax basis (assuming a 40 percent effective income tax rate). Assuming a transaction pricing multiple of 12 times after-tax earnings, the increase in practice equity value attributable to the pay cut would be $10.8 million (i.e., 12 × $900,000 = $10,800,000). While the expected remaining practice life of each physician would play a significant role in whether such a trade-off represents an economic benefit, such a trade-off should be analyzed in each practice transaction involving a tax-exempt hospital system. This is particularly true in those circumstances where the subject practice historically has reported minimal profits. Existing private benefit and private inurement provisions restrict a tax-exempt hospital from paying more than fair market value for physician practices. Similarly, government regulations prevent taxexempt entities from transferring assets at less than fair market value. Acquirers risk violating these provisions and regulations in circumstances where (1) the historical earnings of the subject practice are minimal, (2) the transaction does not contemplate the adjustment of physician compensation and benefits in future operating periods to levels that would increase the probability of higher future practice earnings, or (3) the acquiring hospital system pays a price in excess of the fair market value of the target practice’s net tangible assets. The proliferation of managed care, with its attendant precertification and case management requirements, has forced many physicians into the unfamiliar and unappealing bureaucratic and administrative aspects of practice management. The prospect of selling their practices thus provides physicians with an escape from many unpleasant administrative practice burdens. 3 See,
generally, Physician Compensation and Production Survey: 2001 Report Based on 2000 Data (Englewood, CO: Medical Group Management Association, 2001), pp. 66–67.
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The potential positive aspects associated with this escape present valuation analysts with the opportunity to carefully address the sensitive topic of the trade-off between potentially lower future physician compensation and higher current practice value. Further, the sale of “ownership” status of their practices with continued “employee” status—at some level of guaranteed compensation—has provided a financial security previously unknown to many self-employed physicians.
Issues of Management/Operational Control While not typically an immediate concern of valuation analysts, the topic of posttransaction day-to-day operating control and decision-making authority often becomes a material negotiating point in potential physician practice acquisitions. This is particularly true with regard to the acquisition of larger practices. The compensation to the physician for providing representation on tax-exempt IDS governing boards is frequently examined by the IRS. In the 1997 exempt organizations continuing education text, Community Board and Conflicts of Interest Policy, released by the IRS in September 1996, the IRS increased the limitation on potential physician representation on the board of a taxexempt IDS from 20 to 49 percent. This move was generally recognized within the industry as validation by the IRS that many experienced physicians have knowledge and expertise. That knowledge and expertise could reasonably be relied upon to advance the charitable mission of many tax-exempt organizations. As discussed in many of the leading health care industry periodicals and newsletters, one of the primary concerns facing physicians contemplating the sale of their practices is the post-transaction, day-to-day operation and management of their practices. In sum, physicians generally are concerned with the amount of operating— primarily decision making—control that the acquiring hospital will assume after the acquisition. In most cases, the selling physician has devoted many years developing the practice. Often, the selling physician will continue to view the practice as a personal asset rather than as a financial investment. Conversely, acquiring hospitals will view each acquisition candidate as a financial investment from which a reasonable return should be generated in order to justify the cost of the acquisition. One could argue that this circumstance is not unique to physician practice acquisitions. In fact, any owner/operator contemplating the sale of his or her business but expecting to continue as an employee subsequent to the transaction faces some level of internal conflict. This conflict relates to the loss of control over the posttransaction operations of the business. Transaction intermediaries generally agree that a component of every negotiated sales price generally represents value attributable to the elements of operating control given up by the owner/operator in the transaction. This generally applies to physician practice acquisitions as well. However, as readily admitted by most physicians and many hospitals, hospitals generally are not recognized as the most effective managers of physician practices. Nor do hospitals have the desire to provide the day-to-day management of physician practices. The IRS provisions regarding physician representation on governing boards provide negotiating room for physicians concerned about post-transaction involvement in practice decision making. The IRS attempts to ensure that governing boards take advantage of the provisions, increase their physician governing board
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membership, and take the necessary steps to prevent private inurement problems. Accordingly, the IRS requires tax-exempt health care organizations to adopt a conflict-ofinterest policy that includes: • • • • •
Disclosure to the rest of the board of a member’s financial interest in business activities. Standards and procedures for deciding what constitutes a conflict of interest, including provisions for a disinterested person to investigate allegations. Procedures for dealing with a conflict of interest when one is identified. Procedures, incorporated into the organization’s bylaws, for recording conflicts of interest and their disposition. An internal audit procedure—independent of the organization’s normal business activities—periodically reviewing compensation, contracts, and business deals by board members who do not receive compensation from the organization.
Additionally, Internal Revenue Code Section 4958 (enacted by the Taxpayer Bill of Rights 2, July 30, 1996) strengthens the enforcement powers of the IRS. Section 4958 provides targeted sanctions against responsible individuals when private inurement occurs. (Inurement is discussed in the following section.) These sanctions represent an alternative to the revocation of an organization’s tax-exempt status in cases where violations of inurement provisions are identified. Under Section 4958(a)(1), a first-tier tax would be imposed on each excessbenefit transaction. The tax would be equal to 25 percent of the excess benefit. And, the tax would be personally paid by the individual who received the excess benefit. Whenever the excess-benefit tax is imposed on an individual, an additional 10 percent tax may be imposed on any “organizational manager” in the transaction who knew of the excess benefit. The conflict-of-interest policy previously discussed, and the alternative sanctions, provide preventative as well as punitive measures with regard to private inurement violations. Through these measures, physicians are afforded the opportunity to have a greater voice in the IDSs with which they affiliate. Further, these measures provide the IRS a means of permitting physicians to contribute more toward the effective delivery of health care services through an IDS. And, these measures provide an alternative to the revocation of tax-exempt status when violations are identified. Revocation of tax-exempt status is generally recognized as having the potential impact of limiting necessary health care services to patients, and such a limitation is contrary to the tax-exempt requirement of promoting the public good.
Complying with Regulatory Constraints Practice valuation for the purpose of facilitating acquisition by a tax-exempt hospital requires the analyst to understand and consider the impact of several statutory requirements. These statutory requirements can affect the price a tax-exempt hospital can pay to acquire a practice. On the other hand, taxpaying entities—limited only by available capital and their respective boards of directors—may be free to pursue transactions at prices well above those available to a tax-exempt hospital. Based on this fact, valuation analysts should recognize the need to educate transaction participants regarding the limitations placed upon the negotiation process when tax-exempt hospital systems are involved. This generally requires some level of discussion clarifying the difference in transaction price that may
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exist between (1) an offer from a taxpaying entity and (2) an offer from a taxexempt hospital system. Valuation analysts should be familiar with regulatory constraints regarding practice acquisitions by tax-exempt hospital systems. Such constraints include the following: •
•
•
Private inurement and private benefit restrictions of Internal Revenue Code Section 501(c)(3) and Treasury Regulation Section 1.501(c)(3)-1(c)(2). These restrictions forbid any portion of the net earnings of a not-for-profit entity to inure to the benefit of any private individual, with violations representing potential grounds for revocation of a tax-exempt tax status. Medicaid/Medicare Fraud and Abuse Statutes (the Stark Legislation), 42 U.S.C.1320a-7(b)b. These statutes prohibit the payment of remuneration in exchange for the referral of Medicare and/or Medicaid business. Not-for-profit corporation acts of many states. Based on these acts, the attorney general of a state is authorized to regulate transactions involving not-for-profits, including payments made by not-for-profit entities and the distribution of proceeds from transactions involving not-for-profit entities.
The end result of these, and related, regulatory constraints with regard to practice acquisitions by tax-exempt entities is that all transactions should occur at a price representing (1) no more than the fair market value of the assets acquired or (2) no less than fair market value when tax-exempt entities are selling assets. Violations of these regulatory constraints can result in costly fines and penalties. The most severe of the penalties is the revocation of the tax-exempt status of the related hospital. Clearly, the practice sellers are motivated to realize the highest possible sale price. The analyst retained by the selling practice owners may initially be perceived as “working for the buyer” when informing practice management that regulatory constraints may limit the ultimate sales price. However, (1) a thorough understanding of the affect on value attributable to the limitations imposed on practices by regulatory constraints when tax-exempt acquirers are involved and (2) the knowledgeable dissemination of that information will benefit all parties to the transaction. This is to avoid operating disruptions relating to costly litigation—possibly resulting in significant fines, the unwinding of the transaction, and the loss of the hospital’s tax-exempt status.
Impact of Market Activity on Current Practice Values Analysts operate pursuant to both express and implied responsibilities in performing practice valuations. Client demands, IRS and other regulatory rulings, and professional standards each require the valuation analyst to consider specific industry conditions existing at the valuation date. And, the analyst should assess the impact that such conditions exert on the subject practice value. In total, 453 transactions (in the health care service sector) were reported in The Health Care M&A Report (the Report) in calendar year 2001.4 This represents (1) a 4.2 percent decline in acquisitive transactions relative to the 473 total transactions 4 The
Health Care M&A Report, 2001 (New Canaan, CT: Irving Levin Associates, Inc., 2001)
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reported in 2000 and (2) a 25.2 percent decline in acquisitive transactions relative to the 606 total transactions reported in 1999. In calendar 2001, 39 physician medical group transactions were reported in the Report, compared with 71 transactions and 135 transactions in 2000 and 1999, respectively. The decline in the number of physician-related transactions between 1999 and 2001 was almost 50 percent per year. The general decline in transaction activity in the health care services market suggests a decrease in investor demand for, and/or desirability of, various segments of the health care services industry. While such a period-to-period decrease may be attributable to an unusually high level of activity in the prior period, analysts’ due diligence procedures should enable them to analyze whether a decline in the number of transactions would have a detrimental impact on the current value of the subject entity. The state of the physician practice management (PPM) sector (e.g., financial losses and abandonment of practice accumulation strategies) has had a depressing effect on market-based physician acquisition pricing multiples. This trend emphasizes the need to perform a well-reasoned, well-supported income approach analysis of acquisition targets. However, to simply conclude that practice values are affected in a detrimental manner by a lower volume of transactions ignores practicespecific characteristics, operating histories, and market positions. Further, to value all physician practices at “book value” ignores the often significant intangible asset values that exist at many larger practices. Attributing no value to (1) existing longterm patient and payer relationships; (2) a skillful and experienced trained and assembled workforce; (3) efficiency-promoting policies and procedures manuals; and (4) the organized assemblage and coordination of both tangible and intangible assets ignores the economic utility associated with these assets. Therefore, the analyst should perform a critical review of the facts and circumstances specific to each practice acquisition candidate. Dominant practices that are strategically located and strategically positioned in their respective market areas may provide an attractive investment opportunity for a hospital system that is building an integrated delivery system.
Shift toward Gainsharing The development of integrated delivery systems through acquisition has become a less favored strategy because the anticipated efficiencies and profits of acquisitions have not been consistently demonstrated. Accordingly, gainsharing has become a viable alternative strategy for some health systems. Gainsharing arrangements represent contractual agreements between hospitals and clinical specialties (i.e., medical specialties represented by physicians). Under these agreements, reductions in operating costs over a specified period are shared by the health system and the participating physicians. The July 1999 special advisory bulletin issued by the Department of Health and Human Services Office of the Inspector General (OIG) previously concluded that the Federal Health Care Program Civil Monetary Penalties Law (the CMP Law) uniformly prohibited gainsharing arrangements. The CMP Law prohibits a hospital from knowingly making a direct or indirect payment to a physician “as an inducement to reduce or limit services provided” to any Medicare or Medicaid fee-for-service
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beneficiary who is under the direct care of the physician. It also prohibits a physician from knowingly accepting such payment. However, in an apparent reversal of its prior stance, the OIG issued a January 2001 advisory opinion.5 That advisory opinion concluded that gainsharing arrangements (1) are appropriate for review via the advisory opinion process and (2) can be structured with sufficient safeguards to survive scrutiny under the CMP Law. The following safeguards are identified: 1. Transparency—cost-saving initiatives should be clearly and separately identified. 2. Documentation—credible medical evidence should indicate that cost-saving initiatives will not adversely affect patient care. 3. Ongoing review of medical outcomes—the hospital should monitor clinical outcomes regularly to confirm that cost-saving initiatives do not adversely affect clinical care and are not implemented where clinically inappropriate. 4. Ceiling on recognizable cost reductions—the hospital should use objective, historical, clinical measures to establish a distinct baseline beyond which no cost savings would be allowed to accrue. 5. Patient steering—the health status and associated payer of patients referred by those participating in the gainsharing arrangement should be monitored and benchmarked against historical measures. 6. Overutilization—payments should be based on cost reductions on all patients to whom a designated procedure, item, or service is furnished, regardless of a patient’s insurance coverage. 7. Valuation of cost savings—cost savings should be determined separately for each best practice and should be valued at the actual out-of-pocket expense avoided by the hospital. 8. Fair market value—upon calculating the gainsharing payments owed, the hospital should obtain an independent assessment as to whether the payments constitute fair market value and make an appropriate reduction if fair market value is exceeded. 9. Distribution of payments—payments should be distributed in equal pro rata amounts to all participating physicians and not directly correlated to the cost reductions attributable to the individual physician receiving payment. The hospital should distribute no greater than 50 percent of the documented savings. 10. Documentation—the best practices and resulting cost savings under the gainsharing arrangement should be documented thoroughly and made available to the government upon request. 11. Disclosure—prior to a patient’s admission, the hospital and participating physicians should provide written disclosure of their involvement in the gainsharing arrangement to any patient whose care might be affected, granting the patient the opportunity to review the cost-saving recommendations, prior to admission or outpatient procedure, upon request. 12. Term—Pending further guidance from the OIG, gainsharing arrangements should be limited to a term of approximately 1 year, with any renewal to include a rebasing of operating costs.6
5 OIG Advisory 6 Max
2002.
Opinion 01-1, January 11, 2001. Reynolds, “Gainsharing: A Cost-Reduction Strategy That May Be Back,” Healthcare Financial Management, January 1,
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In addition to the safeguards identified above, gainsharing arrangements must comply with antikickback statutes, Stark legislation, and federal income tax laws regarding restrictions on excess-benefit transactions, private benefit, and private inurement. At the same time, health care entities have become reluctant to consummate capital-intensive transactions. Accordingly, joint venture, management, and compensation arrangements are becoming more attractive options for establishing relationships that provide the anticipated benefits of integrated delivery systems. With regard to these types of options, regulatory issues and standard economic considerations should still be considered. These considerations require financial, economic, and valuation analyses and methods that will provide sound bases for the fair market value of (1) assets and/or services lines contributed to a joint venture arrangement; (2) the rate, or “fee,” established with regard to contracted services; and (3) provider services.
Summary and Conclusion Valuation of health care entities, in light of the ever-changing health care environment, present significant challenges. This is particularly true in those circumstances where the potential acquirer is a tax-exempt entity. This chapter discussed the valuation approaches typically used for estimating the fair market value of health-care entities, with examples that focused on the valuation of physician practices. This chapter also identified several key issues that should be addressed during the practice valuation process. These issues should facilitate a successful practice ownership transaction. The successful development of an integrated delivery health care system is dependent, to a large extent, on acquiring the entities that are being combined to form the network at fair market value. Overestimating the value of the entities, and subsequently overpaying to acquire the entities, can lead to the insolvency of the entire network. Further, acquiring health care entities at prices in excess of their supportable fair market values can lead to serious fines and sanctions. These fines and sanctions are imposed by the IRS and the OIG as a result of the violation of private benefit and inurement provisions of (1) Section 501(c)(3), (2) the Medicare and Medicaid Fraud and Abuse Statutes, and (3) the Stark legislation. Given these facts, the application of relevant valuation methodology by experienced analysts is a vital step in the development of an integrated health care delivery system. Many integrated health care delivery systems formed in the past several years have sold the practices they had recently acquired. These practice sales were usually the result of accumulating losses and unfavorable operating results. Taxexempt entities engaging in such activities are legally obligated to transfer the assets back to the physicians at prices no less than fair market value. These tax-exempt entities are subject to the same potential fines and penalties under the private benefit and inurement provisions of Section 501(c)(3). Further, attempts at costsavings and operational efficiency improvements by health systems through gainsharing arrangements, joint ventures, and management and compensation arrangements require adherence to numerous safeguards. These safeguards include fair market value tests based on independent analyses by qualified professionals.
Part III
Advanced Business Valuation Issues
Chapter 12 Three Peas in the Business Valuation Pod: The Resource-Based View of the Firm, Value Creation, and Strategy Warren D. Miller
Introduction Michael Porter Edith Penrose People The Resource-Based View of the Firm, Value Creation, and Strategy External Sources of Investment-Specific Risk Macroenvironmental Analysis Industry Dynamics Competitive Analysis Internal Sources of Investment-Specific Risk Ratio Analysis Tool #1: The Resource-Based View of the Firm Tool #2: The Value Chain Tool #3: The VRIO Framework Tool #4: Generic Competitive Strategy Tool #5: The Star Framework Summary and Conclusion Afterword: Competitive Analysis
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Introduction Valuation analysts can improve the product they deliver to their clients if they are more familiar with three important aspects of the business they are valuing: (1) its resources, (2) its value chain, and (3) its strategic fit. In order to estimate the value of a business correctly, an analyst first must understand how it operates. Only then can the analyst pursue the notion of value, discuss how the firm does (or doesn’t) create it, and assess the durability of its value-creating mechanism(s). The business valuation literature has been regrettably silent on the issue of value creation, except in mathematical measurements such as economic value-added (EVA) and its kissing cousin, market valued-added (MVA). This lapse in the literature is for the understandable, if not commendable, reason that the business valuation literature generally ignores the tools of strategic management. First called “business policy,” it began in 1912 with case studies at the Harvard Business School. Strategic management is now a rigorous academic discipline. This discipline studies firms, their competitive environments, and their top managers in an effort to answer one research question: Why do some firms perform better than others? The central questions in a valuation are similar: What is the value of this firm and why? In order to answer those questions from either discipline, analysts should understand the business and how (or if) it creates value. Until Chandler’s work1 in the early 1960s, the strategy field lacked tested theory. Consultant-professors and retired corporate officers purported to “teach” students about the role of the general manager. These individuals prepared case studies based on real-world companies and situations and told “war stories.” Their contributions were pretty weak by today’s standards, but they affirmed one of George Stigler’s favorite sayings: “The plural of anecdote is data.”2
Michael Porter Then came the rise of Porter in the 1980s. As an industrial organization economist, he made the industry the unit of analysis in his Five-Forces Framework.3 As the framework’s use became widespread, strategy became a matter of “positioning” within an industry. In other words, industry matters. But the performance of the firm matters more.4 We saw that in the battered airline industry. Big airline carriers slashed capacity and payrolls. U.S. Airways and 1 Alfred
D. Chandler Jr., Strategy and Structure: Chapters in the History of the American Industrial Enterprise (Cambridge, MA: MIT Press, 1962). This was the first empirical research in the field. It won the Thomas Newcomen Prize in Business History in 1964. 2 The late Nobel laureate in economics from the University of Chicago. 3 Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York: The Free Press, 1985). 4 Richard P. Rumelt, “How Much Does Industry Matter?” Strategic Management Journal, March 1991, pp. 167–185. Rumelt expanded the FTC dataset Schmalensee used in his 1985 article, “Do Markets Differ Much?” American Economic Review, Vol. 75, No. 3, pp. 341–351, which found that firm-specific effects on profitability were negligible. Using different methods on two datasets, Rumelt found that 37–44 percent of the variation in firms’ rates of return was attributable to firm-specific effects, while only 8–9 percent came from industry effects. A later article by Anita M. McGahan and Michael E. Porter, “How Much Does Industry Matter, Really?” Strategic Management Journal, Special Summer Issue 1997, pp. 15–30, using different data found larger industry effects, but firmspecific effects accounted for even more of the variation in profitability. Writing in 2001, Edward H. Bowman and Constance E. Helfat, “Does Corporate Strategy Matter?” Strategic Management Journal, January 2001, pp. 1–23, noted how the measurement of a corporate effect (i.e., parent-subsidiary) on profitability changes when single-unit businesses are included or excluded from datasets. But, the firm still matters more, no matter how the data are sliced and diced.
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United Airlines filed for Chapter 11 bankruptcy protection. As of this writing, Delta Airlines and American Airlines continue to suffer financially. Newcomer JetBlue has a market capitalization that exceeds that of the four biggest air carriers combined. And, Southwest Airlines continues to operate as it has for over 30 years: buying more planes, hiring more people, adding more routes, and making more money. We also saw it in the personal computer industry. Hewlett-Packard and Compaq merged—and the merged entity lost market share. Gateway fired its CEO and reinstalled its founder. But Dell rolled on, increasing market share, increasing its revenues, and increasing its profits.
Edith Penrose Starting in the 1990s, and continuing into this new century, the “positioning school” perspective gave way to a theory that was at once both nuanced and firm-based. This new view was first articulated 30-plus years before in a 1959 book authored by economist Edith Penrose, The Theory of the Growth of the Firm.5 Penrose challenged a central assumption of “traditional” microeconomics—the homogeneity of firms in an industry. Homogeneity implies that firms’ products and cost structures are alike and, therefore, that all competition is price-based. Penrose didn’t see the world that way. Basing her research on her consulting work, she argued that firms were heterogeneous collections of resources with administrative frameworks that oversee, link, and coordinate individuals and groups. She asserted that the role of management was to bundle and exploit those resources in ways that satisfied customers and produced superior returns to shareholders. She also noted that the ability of a firm to grow was directly related to its resources, which included the ability of its top management group to execute. It is not much of a leap from there to the notion that resource bundles can and do vary significantly among firms within an industry. Penrose studied the people and the teams that made up businesses and concluded that their knowledge, skills, and ways of working together were resources. Thus, she redefined the idea of a “resource” to mean a much broader and deeper notion than the traditional and impersonal factors of production: land, labor, and capital. In her view, people were primary.
People Securities analysts are in the people-judging business. The best strategy, the finest products, and the most well-conceived marketing plans do not increase value unless management executes them in a way that produces returns in excess of the cost of capital. Yet valuation reports, research, presentations, and literature are essentially silent on the topic of judging people. If “Why do some firms perform better than others?” is the overriding question in strategic management, then surely “What is the value of this company and why?” are the questions facing professionals who analyze private equity. People are the heart of the matter. Analysts should be able to explain why a company’s value is what the analyst says it is. That requires cleareyed judgments about specific individuals.
5 Still
available from Amazon.com in a 3d edition that came out just before she died in 1996.
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The Resource-Based View of the Firm, Value Creation, and Strategy That “why” brings us to the three peas in the business valuation pod: (1) the “resourcebased view of the firm” (which has, over the last 15 years, supplanted the positioning school of strategic management); (2) value creation; and (3) strategy. The resource-based view (RBV)6 of the firm offers a way to think about (1) why and how the subject firm is different and (2) whether, that is, as Martha Stewart would say, “a good thing.” It forces us to deal with the uniqueness of the firm and its resources. We can then deploy such tools as the value chain,7 the VRIO framework,8 and generic competitive strategies9 to both identify possible value-creating resources and assess their durability (if any). Finally, the star framework of organizational design10 helps us assess the magnitude of the subject-company-specific risks. From there, it is a relatively easy step to either the company-specific risk premium or the fundamental adjustment, depending on the valuation approach being used. Using these tools, analysts can deliver to their clients, to the courts, to regulatory agencies, and to others, the depth of understanding and insight that support the answer to the questions: “How much is this company worth—and why?” The analyst’s credibility depends on these answers, as may the stature and prospects of the valuation profession, given the corporate and capital market scandals of 2002–2003. This section begins with a brief overview of external sources of investment-specific risk and follows with a discussion of company-level resources and capabilities. The discussion borrows concepts and tools contributed by strategy scholars and explains their application to corporate valuation. The result is a framework for a richer, deeper, more credible understanding of why a company is worth what we say it is. Though our focus is investment-specific risk, the insights we derive from the framework enhance our understanding of how the business works. That understanding improves our ability to judge projections of cash flow and to quantify a fundamental adjustment.
External Sources of Investment-Specific Risk Exhibit 12.1 presents a model from organizational theory and industrial organization.11
6 Nicolai J. Foss and Paul L. Robertson, eds., Resources, Technology and Strategy: Explorations in the Resource-Based Perspective
(New York: Routledge, 2000); and Cynthia A. Montgomery, ed., Resource-Based and Evolutionary Theories of the Firm: Towards a Synthesis (Boston: Kluwer Academic Publishers, 1995). 7 Porter, Competitive Advantage: Creating and Sustaining Superior Performance. 8 Jay B. Barney, Gaining and Sustaining Competitive Advantage, 2d ed. (Upper Saddle River, NJ: Prentice-Hall, 2002). 9 Michael E. Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: The Free Press, 1980), Chap. 2. 10 Jay R. Galbraith, Designing Organizations: An Executive Guide to Strategy, Structure, and Process (Revised) (San Francisco: Jossey-Bass, 2002). 11 For in-depth discussion of macroenvironmental analysis and industry dynamics, readers may refer to an eight-part series prepared by the chapter author and entitled “The Analysis and Interpretation of Investment-Specific Risk” for Business Valuation Review. The first installment appeared in the June 2003 issue.
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Exhibit 12.1
Organizational Theory and Industrial Organization Economic
log no ch
l
Te
ca
Bargaining Power of Suppliers
liti
Industry
Threat of New Entrants
Po
ica
l
Macroenvironment
Rivalry
Bargaining Power of Customers al on ati
cu ltu ral
ern
cio
Int
So
Company Threat of Substitute Products or Services
Demographic
SOURCE: Adapted from Macroenvironmental Analysis for Strategic Management by Liam Fahey and V.K. Narayanan (St. Paul: West Publishing Company, 1986), p. 29; Strategic Management: Competitiveness and Globalization, 3d ed., by Michael A. Hitt, R. Duane Ireland, Robert E. Hoskisson (Cincinnati: South-Western Publishing Company, 1999), pp. 55–60; and Michael E. Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: The Free Press, 1980).
Macroenvironmental Analysis The outermost component, the macroenvironment, encompasses six forces over which few individual firms exert much influence. That is because the forces are either so large, or so remote, or both, that a single company does not have the wherewithal to have an impact. The diagram in Exhibit 12.2 presents a closer look at the six dimensions of the macroenvironment. In most valuation contexts, the economic dimension is the most important. Its most salient aspects include interest rates, inflation, unemployment, GDP, fiscal policy, and tax policy. The technological aspect is hard to research because innovation is seldom announced in advance. Sociocultural influences include such “soft” variables as lifestyles and values. Demographic forces are as important to so-called business-to-business (B2B) firms as they are to business-to-consumer (B2C) companies. Industrial demography includes such measures as number of firms, growth rates, mortality rates, birth rates, size, and so on. As we all know, international forces and events have increasing and measurable impact on the performance of domestic firms. Finally, political factors, including legislative, judicial, and regulatory influences, are an unavoidable fact of business life.
Industry Dynamics One level closer to the company is its industry, as presented in Exhibit 12.3. Drawing from industrial organization and the work of nineteenth-century economist Alfred Marshall, Porter’s Five-Forces Framework aims to provide a context
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Exhibit 12.2
The Six Dimensions of the Macroenvironment
al litic e Po lativ gis l Le Lega ory lat gu Re
Te ch no log To ug ica l Re hes se t to arc h
Economic Interest Rates Inflation Unemployment
Macroenvironment
Rip p to le E Int the U ffect s ern ati .S. on al
s ry) lue da Va on c /Se yles ore st e ral Lif ltu cu cio
(C So
Consumer Industrial/B2B Demographic
SOURCE: Adapted from Macroenvironmental Analysis for Strategic Management by Liam Fahey and V.K. Narayanan (St. Paul: West Publishing Company, 1986); Strategic Management: Competitiveness and Globalization, 3d ed., by Michael A. Hitt, R. Duane Ireland, Robert E. Hoskisson (Cincinnati: South-Western Publishing Company, 1999).
through which to analyze an industry’s infrastructure. As noted previously, corporate strategists in the 1980s used this framework to select industries in which to compete. They then strove to position their firms within those industries. The threat of new entrants is about barriers to entry. Depending on one’s viewpoint, there may be as few as three or as many as eight. At a minimum, there is Exhibit 12.3
Porter’s Five-Forces Framework Barriers to Entry Threat of New Entrants Suppliers Bargaining Power of Suppliers
Rivalry Rivalry Among Existing Firms
Industry Buyers Bargaining Power of Customers
Threat of Substitute Products or Services Substitutes
SOURCE: Michael E. Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: The Free Press, 1980).
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differentiation, economies of scale, and switching costs; other possibilities are capital requirements, access to distribution channels, cost disadvantages independent of scale, government policy, and retaliation by incumbents. The following admonition from Revenue Ruling 59-60 is noteworthy: “Prospective competition which has not been a factor in prior years should be given careful attention.”12 In general, the higher and more numerous the barriers, the harder entry becomes. One might infer that industry profitability increases with the difficulty of entry, but that is not always the case. Four other forces have a say, too. For instance, even with high barriers to entry, intense rivalry can wipe out profitability. That is what happens in oligopolies where a competitor, usually in danger of failing, decides to cut price. It is the same in high fixed-cost industries when demand softens. It occurs in industries where the product or service (e.g., hotel rooms) is perishable. The result is often an industrywide bloodletting in high-barrier arenas. A similar phenomenon occurs in high-growth environments when growth begins to wane. These are often industries with untested managers who have no experience in anything other than situations in which demand far outstrips supply. When growth starts to level off, the bottom line often nosedives. Consider, too, the complementary effects of the bargaining power of suppliers and of buyers. On the supplier side, this effect manifests itself in the power to raise prices, reduce quality, or both. In personal computer assembly, the Microsoft monopoly on the Windows operating system has commoditized PCs. In effect, Microsoft has appropriated much of PC-industry profitability for itself. Buyers can also siphon off industry profits. That sometimes happens (1) when there are fewer industry buyers than there are industry producers, (2) when there are no switching costs, (3) or when the industry output is buyer-group specific and cannot be sold elsewhere. It can also occur when the industry’s product or service is a major cost component for buyers; this condition gives them incentives to find ways to reduce that cost. The last of the five forces is substitutes—other products or services (not competing ones) that use a different technology to satisfy the same needs of the same customers. An example is: Morton’s is a competitor, not a substitute, for Ruth’s Chris or the Palm chain of upscale steakhouses. However, broiling quality beef on a grill at home is a substitute. If they exist, substitutes tend to create price ceilings for industry incumbents. For example, most CPAs can attest to the havoc that TurboTax can create for taxreturn preparers. Substitutes can also replace entire industries, as has happened to slide rules (by handheld calculators). Long-distance and local telephone service providers have certainly felt the heat of cellular technology.
Competitive Analysis This discussion of external risk would be remiss if it omitted the importance of competitive analysis (not to be confused with competitive intelligence). Few valuation analysts seem to focus much on competitors: who they are, where they are, how big they are, what they believe, how they compete, what their strengths and weaknesses are, who their key people are, and so on. It is as if the subject entity exists in a vacuum.13
12 Section 13 The
4.02(b). afterword of this chapter has a short discussion of selected books on competitive analysis.
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Competitive analysis has its roots in military strategy. Its landmark work is Clausewitz’s On War. Over 170 years ago, Clausewitz made the following connection between war and business: Rather than comparing [war] to art we could more accurately compare it to commerce, which is also a conflict of human interests and activities; and it is still closer to politics, which in turn may be considered as a kind of commerce on a larger scale.14
Internal Sources of Investment-Specific Risk It is at the company level of analysis that investment-specific risk can most affect performance. That is because proximity to the firm is the primary driver of risk. Yet at the company level, the valuation profession has no framework and little data. But, analysts have “checklists.” These checklists, however, lead to few insights about investment-specific risk. Fortunately, the strategy literature offers tools that analysts can use to enhance our understanding of how the business works, what its strengths and weaknesses are, whether it has a(ny) value-creating mechanism(s), and if so, what the durability of the mechanism(s) is(are). Without the insights such tools offer, it is difficult to gain an in-depth understanding of the subject business. Except by happenstance, it may be even more difficult to estimate value correctly. And the smaller the business, the greater its risk. Without strategy tools, it is unlikely that the valuation analyst truly understands the risks at the company level.
Ratio Analysis Before we explore the strategist’s toolkit of knowledge and insights, let’s review the fundamentals of ratio analysis. First, there is nothing that so obviously identifies an inexperienced analyst as his/her preparing several dozen (mostly irrelevant) ratios, discussing each in its own paragraph of repetitive verbiage, restating the obvious (two is bigger than one) every time, and drawing not a single meaningful conclusion from the exercise. In essence, the analyst is saying, “Look, I’m going to dazzle you with a bunch of numbers. I’ll leave it to you to figure out that I really don’t have a clue about what any of this means.” In litigation support engagements, demolishing this type of analysis is simple. Many analysts believe that ratio analysis is synonymous with risk assessment. It is not. Ratio analysis is a necessary, but not sufficient, condition for assessing company-specific risk. Ratio analysis tells analysts what has happened. But, a valuation should explain why it happened. Ratio analysis can help highlight many of the firm’s strengths and weaknesses. However, it will not identify all of them. The strategy tools described below can enhance the analyst’s SWOT analysis: identifying a company’s strengths and weaknesses, assessing an industry’s opportunities and threats, and explaining why these SWOTs are what they are. 14 Carl Von Clausewitz, On War, eds. F.N. Maude and Anatol Rapoport, Book 2, Chapter 3 (London: Pelican Classics, 1968, originally published in German as Vom Kriege in 1832).
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Exhibit 12.4
Examples of Financial Capital Resources
Indicators
Borrowing capacity
Debt ratio vs. industry average Debt/equity ratio vs. industry average Net cash flow to invested capital
Liquidity
Quick ratio Current ratio DSO vs. industry average Inventory turnover vs. industry average Credit rating Gross cash flow ÷ net cash flow to equity
Ability to raise equity capital
ROE vs. industry average Net profit margin vs. industry average
Sustainable growth rate
ROE × (1 – dividend payout ratio)
Tool #1: The Resource-Based View of the Firm As noted in the introduction to this chapter, the RBV represents a distinct break from the homogeneous model that traditional microeconomics has used for a century. The RBV emphasizes the importance of resources and how they are bundled. It is those combinations that produce the heterogeneity of firms in the same industry. It is this heterogeneity that analysts should understand in order to assess wealthcreating mechanisms and their staying power. But how does an analyst recognize resources in the first place? Barney15 and others separate them into four groups of “capital.” Financial capital includes funds from investors and lenders. Exhibit 12.4 presents some examples. Physical capital includes all physical resources that a firm owns or leases. Exhibit 12.5 lists some examples. The third group is human capital. Examples include the knowledge, education, experience, training, insights, intelligence, management skills, trust, and leadership abilities of the individual officers and employees of a company. Some additional examples of human capital resources are presented in Exhibit 12.6. Human capital contrasts with organizational capital, which means group, not individual, resources. Examples of organizational capital include culture, systems, informal relationships, and the efficacy of organizational structure. Exhibit 12.7 offers additional aspects. Considering resources in terms of these four types of capital augments a strategic analysis. But the real value of a resource occurs when it becomes part of a capability—that is, the capacity to perform an activity better than the firm’s competitors. According to Hamel and Prahalad,16 the key is for companies to leverage their resources into capabilities. How and why do some companies accomplish that,
15 Barney, 16 Gary
Gaining and Sustaining Competitive Advantage, p. 156. Hamel and C.K. Prahalad, Competing for the Future (Boston: Harvard Business School Press, 1994).
Exhibit 12.5
Examples of Physical Capital Resources
Indicators
Productive capacity
Annual revenues ÷ FTE employees Annual revenues ÷ production sq. ft. “Line” sq. ft. ÷ total sq. ft.
Investment service
Capital expenditures vs. depreciation expense Accumulated depreciation ÷ gross fixed assets
Dedication to maintenance
Maintenance expense/revenues vs. industry average
Flexibility of fixed assets
Market value of equipment ÷ book value
Technological commitment
Average RAM ÷ number of computers Average age of software applications Number of computers ÷ FTE employees
Access to suppliers
Weighted average distance of goods received
Exhibit 12.6
Examples of Human Capital Resources
Indicators
Education
# years of education ÷ FTE employees
Training
# training hours per year ÷ FTE employees
Knowledge
Educational reimbursement ÷ FTE employees
Employee commitment
% of absentee days vs. industry average Sick leave taken ÷ sick leave available
Leadership ability
Weighted average manager rating by FTEs
Trust
Annual number of workplace thefts Number of complaints to HR/ombudsman
Experience
# years with company ÷ FTE employees
Exhibit 12.7
Examples of Organizational Capital Resources
Indicators
Loyalty
Employee turnover vs. industry average
Teamwork
$ cost of rework ÷ FTE employees # years with company ÷ number of managers Performance of company sports teams
Reputation
Overall customer satisfaction % of revenue from repeat customers Average length of customer presence
Product innovation
Number of patents Revenues from patents and copyrights R&D $ ÷ revenues vs. industry average
Process innovation
% of employees making suggestions
Speed
Number of organizational levels
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while others do not? No one knows. However, we do know that organizational routines play a major role.17 Grant elaborates: Routines are to the organization what skills are to the individual. Just as the individual’s skills are carried out semi-automatically, without conscious coordination, so organizational routines are based on firm-level tacit knowledge that can be observed in the operation of the routine, but cannot be fully articulated by any member of the team, not even the manager. Just as individual skills become rusty when not exercised, so it is difficult for organizations to retain coordinated responses to contingencies that arise only rarely. Hence, there may be a trade-off between efficiency and flexibility. A limited repertoire of routines can be produced highly efficiently with near-perfect coordination— all in the absence of significant intervention by top management. The same organization may find it extremely difficult to respond to novel situations.18 An analyst can identify some of the replicable routines in the organization by getting a copy of the forms (electronic and paper) the company uses. The analyst can then understand what the purpose of each form is, how it moves, who is involved in its preparation and why, and what its retention period is. The analyst should pursue the question of exceptions: (1) how they are handled and (2) how they are tracked over time. The goal here is to identify the variability in everyday tasks. The greater the variability, the greater the depressing effect on profits. Variation increases risk. The key contribution of routines to superior performance is minimizing variation, especially in low value-added tasks. These tasks should be performed the same way every time. That is one of the legacies of the quality revolution. Yet, it is common for smaller organizations that have grown rapidly to have a smorgasbord of forms and (non)routines that were created with little or no management oversight. Other company capabilities are less tangible, as Grant suggests. For instance, how teams of people who have worked together for years behave intuitively is less amenable to analysis. That is why measures like average years of management experience are important. Such groups resemble a well-coached, well-drilled, injuryfree football team. They instinctively know what to do, and they do it. Competitors trying to imitate such teams are not only playing the game by someone else’s rules, they are also susceptible to “causal ambiguity.” That is, they cannot observe cause and effect, because much of what they see is subconscious and intuitive. In summary, capabilities are clusters of resources, made to work in companyspecific ways to produce superior returns. The capabilities may be teams of people, groups of fixed assets, or combinations of people and assets. It is the job of senior management to spot, design, mold, support, reinforce, and reinvigorate capabilities across the firm. The more capabilities a company has, the lower is its companyspecific risk, because it does not depend on a limited number of capabilities.
Tool #2: The Value Chain Besides seeing resources through a capital “lens,” the analyst should also understand them in the context of how the business works. No firm can optimize performance
17 For an elegant examination of routines and how they contribute to superior performance, see Richard R. Nelson and Sidney G. Winter, An Evolutionary Theory of Economic Change by (Cambridge, MA: Belknap Press, 1982). 18 Robert M. Grant, Contemporary Strategy Analysis: Concepts, Techniques, Applications, 4th ed. (Malden, MA: Blackwell Publishers Inc., 2002), p. 149.
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Exhibit 12.8
Support Activities
The Value Chain Firm Infrastructure Technology Development
in rg Ma
Human Resource Management
Service
Marketing & Sales
Outbound Logistics
Operations
rgi n
Ma
Inbound Logistics
Procurement
Primary Activities
of every activity. However, analysts should understand how management deploys resources and should communicate that understanding in the context of value creation. An essential tool for analyzing value creation is the value chain.19 It comprises nine groups of activities—five “primary” and four “support”—that a typical firm performs. Part of the value chain’s intuitive appeal is that its flow reflects the flow in an organization’s operating cycle. The value chain is illustrated in Exhibit 12.8. Barney’s insights about combining resource-based analysis and the value chain are instructive in this context: What value-chain analysis does is to force analysts to think about firm resources at a very micro level. Although it is possible to characterize a firm’s resources more broadly, it is usually more helpful to think about how each of the activities a firm engages in affects [its] financial, physical, individual, and organizational resources. With this understanding, it is possible to begin to understand potential sources of competitive advantage for a firm in a much more detailed way. Moreover, this approach to identifying a firm’s resources suggests that firms simultaneously gain competitive advantages in some value-chain activities, [maintain] competitive parity in other[s], and [suffer] competitive disadvantages in [still] other[s]. That is, not only should a firm’s resources be understood at a micro level, but the concept of competitive advantage can also be applied at this level. This can lead to a much richer and complex understanding of a firm’s overall competitive position in an industry.20 Primary activities are those associated with designing, making, selling, delivering, and servicing the product—in other words, line activities. Support activities are what used to be called “staff” functions. That is, they support primary activities. Contrary to popular misconception, value can be created anywhere in the value chain, including in support activities!
19 Porter, Competitive Advantage: Creating and Sustaining Superior Performance, p. 37. The circle with the X in it is the “company” in the three-level risk framework on Exhibit 12.1. 20 Barney, Gaining and Sustaining Competitive Advantage, p. 158.
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Note that the value chain diagram in Exhibit 12.8, including margin, is the value of what the firm sold (i.e., its revenues). “Margin” is what is left after the firm pays for the nine groups of activities in its value chain. Note also, the vertical lines from primary activities to three of the four support activities. These lines reflect the fact that procurement, technology development, and human resource management (HRM) can (and usually do) work in concert with each of the primary activities. Firm infrastructure is firm-wide and is not associated with individual primary activities. It is noteworthy that these activities are not nine departments that would show up on a company organization chart. To be sure, perhaps two or three of these functions (e.g., Operations, Service, and, maybe, Marketing and Sales) might. Rather, these are nine groups of activities (or routines) in which a company’s people, processes, and reward systems combine to execute strategy. These activity groups should reflect the operational flow of a business. Finally, note that what separates these groups of activities is technology—the processes, systems, and routines required to get the work done. Traditional accounting measurements of these activities tend to aggregate activities with dissimilar technologies. This is why valuation analysts should get beyond the numbers to understand what makes the subject company tick. Primary Value Chain Activities. Inbound logistics include receiving, storing, material handling, inventory control, and warehousing. Inbound logistics function in a service company, as well. For example, a business valuation firm must generate professional engagements. It must store and track progress on them (usually in a computer), maintain an inventory of them, schedule them, and match people with engagement requirements. Operations activities refer to the transformation of inputs into outputs. Examples include gathering raw materials (data and information in consulting firms) and constructing the product consistent with engagement definitions and client expectations, on the one hand, and with internal realization benchmarks, on the other. Analysts in professional services firms can attest to the difficulty of balancing external and intrafirm pressures. Outbound logistics encompass preparing the product for delivery and then getting it to the buyer. In a consulting firm, this would include proofing and checking calculations and writing logic, and then printing, binding, packaging, and presenting the engagement deliverables to the client. Marketing and sales are a mechanism for connecting the firm with its customers. This includes not only the traditional marketing mix (i.e., advertising and promotion, product design, distribution channel(s), and pricing) but also quoting and closing the sale. As the consolidation wave in the accounting profession attests, soft markets exert pressure on all professionals, but especially on firms with no well-conceived marketing function. CPA firms are particularly susceptible to weak (or nonexistent) marketing. The last primary activity is service after the sale. Traditional service functions include warranty claims, customer service, repair, training the customer, and so on. In a consulting firm, for example, this would include answering client questions about the engagement deliverable(s) and perhaps advising—or even assisting—in the implementation of the deliverables/recommendations. Most important, this activity includes the swift and satisfactory resolution of client complaints. Secondary Value Chain Activities. Perhaps the most important of these four secondary value chain activities is procurement. It is noteworthy that the title of this
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activity is not “purchasing.” If it were, it would be confined to a small group of specially trained people. Procurement is a broader concept. It entails purchasing, of course. However, it also includes recruiting, site selection and preparations, and technology (the routines and procedures for dealing with vendors and qualifying them). For example, it is interesting how casually some business valuation firms will engage a headhunter who (1) knows nothing about securities analysis, (2) knows nothing about how to identify and measure the attributes that make for a good analyst, (3) may know nothing about the firm and its culture, yet (4) is working on a contingency (i.e., if there is no placement, there is no fee payable). This process should, and usually does, produce disastrous and contentious results. Procurement is performed throughout a firm. This is why attempts to measure how much a firm has procured are usually destined to fail, except in companies with extraordinary internal systems. Technology development is equally broad. It includes information technology and systems. More important, this activity means know-how, know-what, and keeping knowledge current. Most important, it deals with upgrading and improving how work gets done. Porter suggests that a good way to think about technology development is to separate it into activities that improve the product/service and those that improve the process.21 Too many firms focus on the former at the expense of the latter. The result is that revenues go up and profits go down. For example, a $10 million consulting firm has a cadre of managers still managing at the $1 million level. Firm management complains about “vicious competition,” “low-ballers,” and “demanding clients,” all the while ignoring the fact that the firm’s processes didn’t change a bit as the company grew. HRM is too often viewed as a mere compliance activity. It can and should be more than that. Like procurement and technology development, HRM is a firmwide phenomenon. This is why any attempt to measure it is likely to understate its real cost. HRM involves not only the obvious compliance tasks, but also training, recruiting, screening, professional development, skills inventories, performance appraisal, and compensation policies. In a consulting firm, the implications of HRM are obvious. Nonetheless, few midrange firms pay much attention to it. The result is that talented nonpartners leave and less-talented ones stay. This is just the opposite of what the partners insist that they want. They will blame ingrate employees with no work ethic and no loyalty, when, in fact, management is the problem! The fourth and last support group of activities is firm infrastructure. This activity includes general management, finance, accounting, contract administration, legal activities, government affairs, and planning. Often the term used to describe infrastructure is “overhead.” Consulting firms are especially susceptible to underestimating the importance of overhead. When a consulting firm takes 10 or 15 days to get an invoice out it should not boast on its Web site that it helps clients whose “operations are bogged down” or that are “looking for the latest technology”! Constructing a Firm’s Value Chain. Each of the nine groups of activities has its own economics and technology. But each of the nine groups has subgroups, too. What those subgroups are for a given firm will depend on its industry and its own persona. Several observations will help the analyst construct the value chain. In general, each operating division should have its own value chain. Within a division, broad categories (e.g., manufacturing) should be subdivided. The extent of disaggregation depends on the scope of the subject company’s activities. Analysts should focus on 21 Porter,
Competitive Advantage: Creating and Sustaining Superior Performance, pp. 41–42.
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separating activities (1) that have high potential for being sources of differentiation from competitors or (2) that are a major or fast-growing cost component. Assigning an activity to a particular value chain category requires an understanding of the business and how it works. But value activities should fall into classifications that reflect their place in how a firm creates value for its customers. In general, classifications should be consistent with the flow of the business. It is important to recognize that companies do several things at once, so some classifications may be arbitrary. Here, as in all valuation tasks, the analyst’s judgment is the key. Ultimately, what is important is that the classifications make sense to the analyst. The subject company’s managers need not agree with the classifications. In this exercise, the analyst is simply organizing his or her thinking for what will become the underlying rationale for the estimate of value to follow. Horizontal Linkages. Horizontal linkages are those within the firm’s value chain. We have already discussed one such linkage: the one between primary activities and support activities. Porter defines linkages as “relationships between the way one value activity is performed and the cost or performance of another (value activity).”22 It is not uncommon to see company accounting departments run ragged by the actions of operating executives who see accounting as separate from (and unrelated to) company operations. Yet, we know there is a linkage: the less attentive to administrative detail that operating executives are, the greater the cost (and the angst) in the accounting department. Thus, the notion of linkages means that activities are not independent but, rather, are interdependent. Linkages that optimize the performance of one activity involve trade-offs between two or more activities. Linkages may also coordinate activities. The latter are more common, but they are more difficult to identify. However, these coordinating activities usually offer notable opportunities for cost reduction, differentiation, or both. Linkages between primary activities are the hardest to spot, but they may have the greatest impact on value creation. For instance, the failure of a consulting firm’s practice development leader to recognize a “high maintenance” client may generate revenue, but reduce profitability. In firms where the emphasis is on the “book of business,” this linkage may create tension—if it is recognized at all. Vertical Linkages. A firm also has linkages between its value chain and those of its suppliers and its customers. Such vertical linkages with suppliers are often, and wrongly, perceived as zero-sum games. However, coordination of certain of the firm’s activities with certain of the suppliers’ activities will produce gains for both. Just-intime systems, for instance, increase cash flows for suppliers and reduce working capital requirements for customers. Late-fall consultations between suppliers of income tax services and their clients should reduce the tax liabilities of the taxpayer while enhancing differentiation and profitability of the tax return preparer. But these linkages, like those between primary activities within the firm, are often difficult to see.
Tool #3: The VRIO Framework Once the analyst identifies the resource-linkage bundles (e.g., capabilities) that create value, he or she should try to assess their “staying power.” Clearly, value creation that is temporary has less impact on the value of the enterprise than value 22 Ibid.,
p. 48.
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creation that is sustainable. How can we assess sustainability? One way is through the VRIO framework.23 VRIO stands for valuable, rare, inimitable, and organized. These factors translate into four questions: of value, of rarity, of inimitability, and of organization. The answers help the analyst (1) gauge the competitive implications of a capability, (2) classify (i.e., below normal, normal, and above normal) its effect on economic performance, and (3) determine whether it is a strength or a weakness. Analysts may need to quantify this qualitative analysis. The ease of doing so varies directly with the rigor of the qualitative reasoning. Let’s briefly consider each of the components of the VRIO framework. Value—Question No. 1: Do the Firm’s Capabilities Allow It to Respond Effectively to External Opportunities and Threats? Recall that opportunities and threats are the “OT” in SWOT analysis. Capabilities that prevent a firm from capitalizing on opportunities or neutralizing threats are weaknesses. Capabilities that help a company capitalize on opportunities or neutralize threats are strengths. So, it is noteworthy that the resource-based view of the 1990s doesn’t really replace Porter’s “positioning school” of the 1980s. Rather, the RBV enhances his theories. Just because a capability is a strength doesn’t mean that it will remain so. Capitalism, as Schumpeter observed, is a system of “creative destruction.”24 Such dynamism means that a firm should constantly develop new capabilities to grapple with uncontrolled changes in its macroenvironment and industry. For example, the federal regulation that shelters an industry today may expose it tomorrow. Or, innovation that has enriched a firm and its owners may become obsolete. Ultimately the value of a capability depends on its ability (1) to either increase revenues or reduce costs (compared to what would have been the case without the capability) and (2) to adapt that capability as both the company and the industry evolve. Rarity—Question No. 2: How Many Competitors Have the Same or a Similar Capability? If a capability is widely held, then it will produce short-run competitive parity, not competitive advantage. A capability may be valuable, but not rare. That does not mitigate its short-run importance, however. A widely held capability may help the subject company just “stay in the game” as it buys time to develop other capabilities that are valuable and rare. How rare must a capability be in order to help the firm move from parity to advantage? As with so many other questions in the business valuation arena, the answer is: it depends. For example, if most firms in an oligopoly have the same capability, none will enjoy competitive advantage. But, several companies may have the same capability in a less-concentrated industry and enjoy a competitive advantage, at least temporarily. Whether the competitive capability is more durable depends on the answer to the next question in the VRIO Framework. Inimitability—Question No. 3: Do Competitors Not Possessing a Particular Capability Face a Major Cost Disadvantage in Obtaining It, Imitating It, or Substituting Against It? In answering this question, cost should be measured not only in hard dollars, but also in the cost of potential disruption to the operating routines and cultures of the competing companies. So long as the threat that not having
23 Barney, Gaining and Sustaining Competitive Advantage, pp. 159–174. Barney used “inimitable,” which seems just the opposite of the criterion that he intended. 24 Joseph Schumpeter, Capitalism, Socialism, and Democracy (New York: Harper & Row, 1942), p. 83.
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the capability poses is not “life threatening” (i.e., it does not cause the firm to earn long-term below-normal profits), the company can survive while it looks for or develops other capabilities. This situation, of course, is not nearly so simple as the previous sentence implies. But if the capability can be replicated, purchased, or substituted against, then the competitive advantage conferred on the capability holders will be only temporary. The above-normal profits of those holders will ultimately be competed away. To the extent that one firm has a capability that is valuable, rare, and inimitable, it has the potential to enjoy a period of sustained competitive advantage (and the superior returns that go with it). Before complacency sets in, however, corporate management should remember that the American economic system is a system of creative destruction. For example, of the 51 largest U.S. firms in 1909, only three—ExxonMobil (#3 in 200, nee Standard Oil), General Electric (#5 in 2003), and Sears Roebuck (#30 in 2003)—still remained there in 2003. That is an attrition rate of more than 94 percent—probably not much less than the percentage of Americans born in 1909 who were still alive in 2002. Six other companies in the top 51 U.S. firms in 1909— Bethlehem Steel (#440), DuPont (#67), Eastman Kodak (#150), International Paper (#64), Navistar (#274 nee International Harvester), and Phelps Dodge (#428)— made the Fortune 500 in 2003.25 Organization—Question No. 4: Is the Firm Organized to Seize the Greatest Possible Advantage Its Capabilities Offer? This is a broad question, the answer to which requires knowledge of the alignment between a company’s strategy, its organizational structure, and its systems. An organization’s strategy and structure should be aligned. Its systems—incentive programs,26 policies and procedures, routines, and so on—should also support and reinforce its capabilities. However, even if the firm isn’t organized to maximize the advantage its capabilities offer, analysts should ask if it can take effective advantage of its capabilities. A company’s normalized historical financial performance offers an answer to this question. If, for example, the firm can meet one or more of the criteria in the VRIO Framework, yet its earnings and cash flows are weak, it is likely that it can realize some advantage. This is true even if the competitive advantage is not as great as it could be. Trend analysis and comparisons with guideline companies and industry composites can indicate its potential. The textbook example of a company with capabilities that were valuable, rare, and expensive to replicate is the Xerox Palo Alto Research Center (PARC). In the 1960s and 1970s, scientists there developed an early version of the Windows operating system, the ubiquitous computer “mouse,” the laser printer, the personal computer, and Ethernet, among other innovations. Yet few Xerox executives had ever heard of PARC, much less embraced any of its products or taken them to market. Even after the word seeped out, the analysis paralysis of the Xerox “corpocracy” suffocated further development. The company’s organizational structure, communications, and reward systems were totally disconnected from the amazing work that its PARC scientists turned out.
25 Albert D. Chandler Jr., Strategy and Structure: Chapters in the History of the American Industrial Enterprise (Cambridge, MA: MIT Press, 1962), p. 5, and www.fortune.com/fortune/fortune500. 26 No valuation professional should be without Steve Kerr’s “On the Folly of Rewarding A, While Hoping for B,” Academy of Management Journal, 1975 (18), pp. 769–783. Kerr is the former chief of the GE Management Training Center in Crotonville, NY. His article is the classic on dysfunctional reward systems.
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Tool #4: Generic Competitive Strategy Strategy, of course, is the word analysts use to describe how a firm is going to compete against its rivals. Essentially, it has three choices. Porter labeled these “generic competitive strategies.” Two are industrywide—cost leadership and differentiation. The third, focus, aims at a segment or strategic group.27 A focus competitor can be either a cost leader or a differentiator. The following comments about cost leaders and differentiators also apply to focusers. It should be intuitive to the casual observer that there can be only one cost leader in an industry—usually the company with the largest market share. This is because share gives it the most units of output over which to spread its fixed costs, thus reducing unit cost. The typical (but not automatic) result is that the cost leader is also the market leader (and offers the lowest price). Cost leaders tend to exhibit certain attributes that reflect their focus on low cost: (1) they believe in standardization because it helps produce economies of scale; (2) they are quasi-addicted to measurement; (3) because variation increases costs, they are relentless in their drive to stamp it out; (4) they centralize authority; (5) their systems generate many reports (more than the typical differentiator); (6) process engineering skills are common; and (7) low-cost distribution is the rule. Innovation is, if not discouraged, certainly not encouraged. Heavy investment in R&D in existing product lines is common. Senior managers often come from operations (e.g., Intel) or accounting (e.g., McDonald’s) backgrounds. And then there is Dell, which turns its inventory in under 5 days and has a “reverse cash conversion cycle” (i.e., its customers pay Dell before Dell has to pay its suppliers). The emphasis among cost leaders is on simplifying product and service designs. Simplicity lowers costs and leads to scale economies in production and purchasing. Cost leaders also tend to have state-of-the-art facilities to enhance scale economies. Maintaining their low-cost position usually requires continuing reinvestment. The rewards are falling costs, increasing margins, and market leadership. For example, one attendee at a 1992 seminar introduced himself to his colleagues by saying he was there because “our CEO, Andy Grove, says we must reduce manufacturing costs by 15 percent.” He paused. “Per month.”28 Now that is an example of cost leadership. For firms that are not cost leaders (which means most companies), the only sensible strategy is differentiation, either industrywide or focus. Differentiation means perceived uniqueness, which implies a wide range of choices. Sources of differentiation are limited only by management’s imagination, its knowledge of its customer base, and its ability to market. Because price-based competition makes the buying decision easy for the customer,differentiation should complicate that buying decision. Successful differentiators usually exhibit certain characteristics. They are innovative, obsessively customer-oriented, and highly decentralized. They usually have product engineering know-how. They do what they have to do to attract the best employees, including pay, workplace frills, and tons of personal freedom. Their costs are higher, so they aim to deliver value that customers are willing to pay for.
27 Porter,
Competitive Strategy: Techniques for Analyzing Industries and Competitors, Chap. 2.
28 Reducing costs by 15 percent per month results in an 85.8 percent cost reduction every year. At the end of 24 months, what orig-
inally cost $1 to make will cost just over $0.24! No wonder PC prices plummet.
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So long as the differentiator’s price is not so disparate as to drive customers to the cost leader, it can be successful. But, the differentiator must measure customer satisfaction often to ensure that the pricing gap is not too big.29 It must also scan the external environment to avoid being wedded to its own success path. Research shows that even small start-ups have significantly better performance if they monitor the macroenvironment and industry.30 Start-ups must adapt their strategy to changing environmental conditions. So, contrary to what many small-business owners seem to think, environmental scanning is not just a big-company activity. Differentiators are usually led by marketers (e.g., Procter & Gamble, Johnson & Johnson), engineers (e.g., 3M, Hewlett-Packard), or scientists (e.g., Merck). Other notable differentiators are Lexus, Ritz-Carlton, Cartier, Nordstrom, Ruth’s Chris, Virgin Atlantic, St. John, Winston (fly rods), Nike, Wharton, and Sony. Differentiators are afforded a measure of protection against rivalry because of customer loyalty. That loyalty weakens buyer bargaining power. Higher prices increase margins and help avoid conflicts with the market leader. Whether the subject company is a cost leader, a differentiator, or a focuser, the analyst should ascertain whether capabilities produce competitive advantage, which supports the appropriate strategy. There is a natural up-the-food-chain progression from resources to capabilities to strategy to competitive advantage.
Tool #5: The Star Framework The last step in the company-specific risk process is checking the alignment of the key features of organizational design. The aforementioned Xerox fiascoes provide a logical lead-in for our tool here, the star framework.31 As presented in Exhibit 12.9, the star framework is a simple five-cell model that the analyst can use to assess the appropriateness of the subject company’s organizational design. The analyst’s key question is whether the five features support and are aligned with one another, or whether they are in conflict. As the framework shows, the five facets of organization design blend to produce behavior. This, in turn, results in performance and in organizational culture. Note, too, that every aspect is connected to every other aspect. That connotes the desirability of interdependence, consistency, and alignment among design features. We could just as easily have “stacked” these five components to reaffirm the importance of alignment. But that would have made the linkages and interdependency among them more difficult to illustrate. A brief discussion of each star framework feature follows. Strategy is the first aspect of design. The other aspects follow and reinforce it. As previously noted, strategy is a choice of generic competitive strategy—that is, cost leadership, differentiation, or focus. Some companies mistakenly confuse strategy with tactics. Tactics are the short-term steps in executing the long-term strategy. Structure means power, degree of specialization, extent of centralization, and how departments will be organized (by function, by product group, by markets, by
29 See Warren D. Miller, “Measuring Customer Satisfaction,” in the business-and-industry supplement of the CPA Letter (October 2000), http://www.aicpa.org/pubs/cpaltr/oct2000/supps/busind4.htm. 30 See Thomas M. Box, “Performance Predictors for Entrepreneurial Manufacturing Firms: An Empirical Study of Psychological, Background and Environmental Scanning Attributes” (Unpublished Dissertation, Oklahoma State University, 1991). 31 Galbraith, Designing Organizations: An Executive Guide to Strategy, Structure, and Process (Revised).
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Exhibit 12.9
The Star Framework Direction Strategy
Skills and mindsets
Power
People
Structure
Rewards
Processes
Motivation
Information
Behavior
Performance
Culture
SOURCE: Jay R. Galbraith, Designing Organizations: An Executive Guide to Strategy, Structure, and Process (Revised) (San Francisco: Jossey-Bass, 2002), p. 10.
geography, or by work processes). In too many organizations, too little attention is paid to anything except departmental boxes. But when organization life is chaotic, shortcomings in structure are usually the primary culprit. For example, one small company ($12 million in annual revenues, one location) has 14 levels on its organization chart. Toyota has five. Processes include routines, procedures, and policies. These all deal with information, the organization’s internal medium of exchange. They are what preserve (or should preserve) a semblance of order and functionality in a company. Less-effective CEOs and other executives are often so outcome-oriented that they have forgotten the importance of processes in shaping and driving outcomes. Rewards encourage or discourage choices and decisions. There’s a cardinal rule in organizational design: If you want to change behavior, you must change the reward system. Rewards drive behavior, which drives both performance and culture.
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Finally, and not least important, is people. Often called HR or HRM, this component is about screening, testing, recruiting, training, and developing. The resulting skills and mindsets should underpin, reinforce, and affirm the strategy of the organization. In many high-growth organizations, two of the five features usually get short shrift: processes and people. The processes are ignored because management is often reactive, just trying to keep its head above water. Instead of revamping processes, managers overhire. That manifests itself when the analyst compares the company’s average revenues per full-time-equivalent employee with the industry average and with public companies. Other symptoms of inattention to processes include missing data, incomplete information, broken communications, and work falling through the cracks (as employees blame one another for not getting it done). This is all because senior managers never had enough time to do it right the first time. At least as important, the need to develop people is usually overlooked. Everyone—but especially the shareholders—suffers because the organization revenues take off, but the skill-sets remain grounded. For example, I know of a company whose revenues increased from $5 million to $50 million in 10 years. However, its bottom line declined in both relative and nominal terms. This was because everyone was still managing at the $5 million level. Even in slow-growing organizations, increasing and enhancing skill-sets and knowledge should be a top priority.
Summary and Conclusion This chapter explained the relevance and use of certain tools in the strategist’s toolkit. These tools help analysts understand how a given business works and gauge its potential risk-return profile, especially at the company level. These tools offer analysts practical and proven ways to: • • • • •
Estimate investment-specific risk and fundamental adjustments by recognizing the potential impact of organization resources, capabilities, and routines. Understand how external and internal linkages can create value. Assess the durability of value-creating capabilities. Understand the normative aspects of a company’s competitive strategy. Gauge the extent to which major facets of an organization reinforce (or undermine) value creation.
This chapter also emphasized these tools’ connections to human behavior and to the ability of an organization to execute. In reality, analysts make judgments about people—numbers simply quantify those judgments. This chapter has borrowed from four other fields: 1. Industrial organization—for external risk assessment. 2. Evolutionary economics—for the resource-based view of the firm, the contribution of routines to our understanding of organizations, and internal risk estimation. 3. Strategic management—for the value chain, the VRIO framework, and competitive strategies. 4. Organizational theory—for the star framework.
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This chapter began with the resource-based view of the firm, a seminal contribution to analysts’ ability to analyze and understand organizations. The discussion of the RBV included resources, four kinds of capital, capabilities, and routines. One of the most important aspects of the RBV is its rejection of the firm as a homogeneous entity. The RBV emphasizes heterogeneity, which is consistent with the importance of diversity in biology and the resulting implications for differences among companies. Porter’s value chain followed. The analyst should integrate his or her grasp of resources and capabilities with the nine groups of activities a typical business performs. The challenge is to identify linkages between a company’s internal activity groups and its external suppliers, customers, and other constituencies. How capabilities are classified within the value chain is not so important as the analyst’s understanding of those capabilities. The VRIO framework was tool no. 3. This framework helps the analyst answer four questions related to value, rarity, inimitability, and organizational alignment. The analyst can then determine whether a certain capability offers a business a competitive advantage and, if it does, whether the advantage is likely to be short or long term. This section also discussed the benefits of competitive parity and how its fleeting presence can help a company buy time. The chapter then discussed strategy. Organizations can compete in three ways: cost leadership, differentiation, and focus. The discussion focused on the characteristics and risks of cost leaders and differentiators, emphasizing that within an industry or strategic group, there can be only one low-cost producer. In order to produce above-average rates of return over the long term, all other players must rely on differentiation. Finally, the star framework was presented. It illustrates the essential features of organizational design and how they result in behavior, which, in turn, produces performance and culture. The analyst seeks to ascertain the consistency and degree of alignment between organizational design features. Strategy gets the glory, structure gets the time, but people, processes, and rewards are what really drive execution. Great strategy buttressed by appropriate structure will crash and burn without sufficient roles for the other three “points” in the star. These tools are logical, coherent, and practical. They offer us more and better ways to understand and describe the company whose equity is being valued. They enhance our ability to assess and defend investment-specific risk and fundamental adjustments. Most important, they guide us in answering the question that is the sine qua non of competent analysis: Why is the subject company’s value X?
Afterword: Competitive Analysis Business is war without bloodshed. So it is not surprising that much of current thinking about competitive analysis relies on military strategy. The earliest writing on the subject was Chinese strategist Sun Tzu’s The Art of War, circa 500 B.C.32
32 Of the several translations released in recent years, the most readable is D.E. Tarver’s The Art of War By Sun Tzu: In Plain English (Lincoln, NE: Writers Club Press, 2002). For the complete work, see The Art of Strategy: A New Translation of Sun Tzu’s Classic, translated by R.L. Wing (New York: Doubleday, 1988).
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Clausewitz’s On War was published in 1832, a year after he died. It is required reading for senior military officers and serious military historians. Unfortunately, it was incomplete.33 A business-oriented version focusing narrowly on strategy, Clausewitz on Strategy: Inspiration and Insight from a Master Strategist,34 comes from authors affiliated with the Boston Consulting Group. The market leader in competitive analysis is Sharon Oster’s Modern Competitive Analysis (3d ed.).35 A list of chapters on analytical techniques is in Fleisher and Bensoussan’s Strategic and Competitive Analysis: Methods and Techniques for Analyzing Business Competition.36 Porter’s Competitive Strategy also includes a chapter on competitive analysis.37
33 Be careful about which translation you get. The best one is the hardback version in the Everyman’s Series; even then, only Books 1 through 3 and 8 are worth the read. 34 By Tiha von Ghyczy, et al. (New York: John Wiley & Sons, 2001). 35 New York: Oxford University Press, 1999. 36 Upper Saddle River, NJ: Pearson Education Inc., 2003. 37 However, analysts should not confuse competitive analysis with competitive intelligence. Those with an interest in the latter should contact the Society of Competitive Intelligence Professionals (www.scip.org).
Chapter 13 Differences between Economic Damages Analysis and Business Valuation* Michael K. Dunbar and Michael Joseph Wagner
Introduction Value the Whole or Just a Part? Use All Valuation Approaches? Damages Before or After Taxes? The Income Tax–Affect Procedure Complications to the Tax-Affect Procedure Typical Lost Profits Claim Value Only the Future? Know Only the Past? Background for the Ex Ante and Ex Post Discussion Expectancy versus Outcome Damages Advantages and Disadvantages of the Ex Ante Analysis Advantages and Disadvantages of the Ex Post Analysis Hybrid Analysis Projected or Expected Cash Flow Differences in Reporting Requirements Use of Legal Precedent Conclusion
* This chapter relies on material presented in a chapter written by John R. Phillips and Michael
J. Wagner and published in The Handbook of Advanced Business Valuation, Robert F. Reilly and Robert P. Schweihs, eds. (New York: McGraw-Hill, 1999).
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Introduction The estimation of economic damages often involves the application of business valuation principles and procedures. This is particularly true when the economic damages analysis involves the estimation of business lost profits. However, there are a number of differences between estimating economic damages in a litigation matter and estimating the value of a business in a transactional matter. This chapter will explain some of the differences, as well as many of the similarities. A few of the differences between estimating economic damages and estimating business value are summarized in Exhibit 13.1. Economic damages are usually calculated as the difference between (1) what a plaintiff business would have earned from its business operations but for the legal violations of the defendant and (2) what the plaintiff business actually did earn or will earn. Therefore, unlike the case in typical business valuation assignments, the damages analyst typically prepares at least two different damage analysis/valuation scenarios. One damage analysis quantifies what the affected business would be worth (or would earn) in a hypothetical world but for the legal violations. The second damage analysis quantifies what the affected business is worth (or will earn)—given the actual impact of the legal violations on the plaintiff’s business. Probably the most common method used to calculate a plaintiff’s lost profits is to estimate the difference between (1) the plaintiff’s cash flow (or other measure of economic income) in the “but-for” world and (2) the plaintiff’s cash flow (or other measure of economic income) in the “actual” world. The difference between these two estimates of economic income is discounted to a present value—either to the date of the legal violation or to the estimated date of judgment. The basic valuation method of discounted cash flow (DCF) analysis is frequently used in economic damage analyses, just as it is used in business valuation. One major difference between economic damage analyses and business valuation analyses is that the damages calculations are typically performed some time after the damages event has occurred. As a result, financial and operational information Exhibit 13.1
Differences between Economic Damages Analysis and Business Valuation Analysis Procedural Differences
Economic Damages Analysis
Business Valuation Analysis
Scope of valuation
Difference between “but-for” and actual profits
Entire business enterprise
Time of performance of analysis
Performed after the “damages event,” backward and forward looking
Forward looking
Information subsequent to the valuation date
Generally available
Not available
Guidelines for the analysis
Driven by law, varies by jurisdiction, few published cases addressing technical issues
Governed by generally accepted practice
Duration of analysis
Usually limited duration
Generally perpetual
Consideration of mitigation
Generally necessary
Not applicable
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subsequent to the damage event (i.e., valuation date) is available to the analyst. Unlike in most valuation analyses, this ex post information is often used in the calculation of economic damages. Courts generally permit the use of information that becomes available after the damage event date. Relying on this subsequent information is sometimes referred to as using the “book of wisdom.” This use of the book of wisdom may cause the resulting economic damages analysis to be a more accurate estimate of the plaintiff’s actual loss. Therefore, information between the damage event date and the trial date is often considered in developing assumptions as to what would have happened to the plaintiff’s business if the legal violation had not occurred. Another difference between economic damage analyses and business valuation analyses is the nature of the written report. In many state jurisdictions, a written report of the damages expert witness opinion is not required. In these jurisdictions, the attorney who retains a damages expert should give the analyst instructions as to the nature of the report, if any, that the attorney expects. In most federal courts, there is a requirement for a damages expert to submit a written report. The content of the damages expert’s report is controlled by the Federal Rules of Civil Procedure, particularly Rule Number 26. However, there is no legal requirement that a business valuation used in a damages analysis report comply with Uniform Standards of Professional Appraisal Practice (USPAP) (promulgated by the Appraisal Foundation) or with the standards of any other professional organization. A much-confused concept in economic damages analysis is the income tax effect of the present value discount rate applied against the “but-for” estimate of economic earnings. The intended result of this income tax effect treatment is to make the plaintiff “whole.” The general principle in business valuation is to match the nature of the discount rate with the nature of the cash flow. In other words, analysts use pretax discount rates to present value pretax cash flow and use after-tax discount rates to present value after-tax cash flow. However, this principle is not automatic in economic damage analyses. This is because, in most instances, the award of economic damages is a taxable event to the plaintiff. Therefore, to make the plaintiff “whole,” the analyst should consider the impact of the payment of income taxes on the damage award. One important consideration when using business valuation methods to estimate economic damages is the duration of the damage period. If the damages analyst determines that the loss to the plaintiff is permanent and irreplaceable, then perpetuity business valuation methods may be appropriate to estimate the lost profits to the plaintiff. However, if the damage period is limited in time, then business valuation methods based on the premise that the business will continue in perpetuity may not be appropriate. Often, economic damages do not last forever. The plaintiff may have had a delay in earnings or may have lost some current business. However, it is often assumed that the plaintiff will be able to mitigate future damages and return at some future point to the economic position where the plaintiff would have been, had the defendant not violated the plaintiff’s legal rights. The damages analyst should make an assumption as to whether the plaintiff can recover—and how long it will take the plaintiff to recover—to the level of profitability in the actual world as the plaintiff would have been in the but-for world. Last, a key difference in the two types of analyses is that, in the economic damages analysis, it is necessary to consider whether the economically injured party was or will be able to mitigate the damages. Neither the consideration of possible mitigation nor the impact of mitigation is an issue in the typical business valuation assignment.
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Value the Whole or Just a Part? Economic damages analyses frequently focus on just part of a business—the part alleged to be damaged or lost. For example, let’s assume a multiproduct manufacturer has legal problems with a critical part supplier on only one of the many products that the manufacturer produces and that this product line makes up only 20 percent of the manufacturer’s business. Under this scenario, the entire business of the manufacturer is not damaged. Although a material portion of the manufacturer’s business is affected, it is usually not necessary or appropriate to value the entire business for purposes of estimating economic damages. In contrast, business valuations often focus broadly on the entire business enterprise—even when the goal is to arrive at a value of a noncontrolling ownership interest in the business. However, business valuation methods can be used even when the defendant’s actions or inaction affects only a portion of the plaintiff’s business. An estimate of the damage suffered by only one of a manufacturer’s many products can be accomplished by performing a DCF analysis for that one product line. A common mistake when valuing only the damaged or lost part of a business is to omit or exaggerate elements of expense or capital investment. As a result, the plaintiff may attempt to claim that damages equal the gross profit on lost sales, improperly ignoring incremental selling and general and administrative expenses as well as the cost associated with incremental investments. The correct profit margin to apply to lost sales is the incremental profitability of the lost sales. As such, all expenses incremental to the lost sales should be deducted from revenues. And, all expenses that are fixed for the quantity of lost sales should not be deducted from revenues. Business valuation methods provide useful reasonableness checks on economic damages analyses. An appropriate application of business valuation methods to estimate damages is to prepare two models of the entire business: one actual or damaged, and the other but-for the violation or undamaged. The undamaged entity may be modeled by making an adjustment for the incremental revenues and expenses on the actual financial statements of the damaged company. By comparing the two financial models, a damages analyst may conclude whether the undamaged statement of operations and the undamaged financial position of the whole company appear reasonable. For example, the damages analyst can conclude whether profit margins and turnover ratios for the undamaged entity fall within a reasonable range for the industry. Similarly, the damages analyst can conclude whether the undamaged entity provides for sufficient capital investment to support the projected sales growth, in comparison to the industry. It is usually useful for the damages analyst to compare the projections for the damaged and undamaged companies. One worthwhile test is to check that the projections differ only to the extent the plaintiff is unable to mitigate or avoid damages (without incurring undue burden or risk), after (1) the cessation of the violations and (2) the receipt of a compensatory award for past damages. Although the plaintiff has the duty to mitigate or avoid damages, the defendant may bear the burden of proving the reasonable extent of mitigation. Related to mitigation, the damages analyst should reach a conclusion regarding the period required for the plaintiff’s recovery. The damage estimate limitation on the projection of future performance contrasts with a business valuation projection of future performance in perpetuity. In the example above, when the analyst compares the damaged and undamaged financial projections, eventually they converge, leaving no further damage. A projection of
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Exhibit 13.2
Excerpts from Case Law INDU CRAFT, INC. v. BANK OF BARODA, 47 F.3d 490, 495–496 (2d Cir. 1995) Breach of Contract Indu Craft concedes that it proffered no evidence with respect to fixed costs. Decisional law analyzing the role of fixed costs in damages calculations is sparse since most breaches of contract in a business setting do not result in the termination of a business. Plaintiff relies on our decision in Linblad Travel, 730 F.2d at 93, for its view that overhead costs need not be deducted from income to calculate damages. That reliance is misplaced. Linblad determined that fixed costs should not have been included in the damages calculation where plaintiff was an ongoing business whose fixed costs were not affected by the breach. Id. In the present case, plaintiff's cessation of business may very well have reduced or eliminated fixed overhead costs. Such savings, resulting from the Bank’s breach, are properly offset from lost profits. Hence, the failure to deduct fixed costs when utilizing lost profits to calculate damages renders such measurement too imprecise for judicial use. However, proof of lost profits is but one method of proving the amount necessary to restore plaintiff to the economic position he would have been in absent the breach. An alternative methodology, extrapolating the value of a business as an ongoing entity from the company's past earnings, establishes a plaintiff’s damages without suffering the same defect. By resorting to past earnings, this methodology already incorporates the necessary deduction of fixed and variable costs, providing an accurate measurement of plaintiff’s loss as adjusted for savings resulting from the breach. In fact, when the breach of contract results in the complete destruction of a business enterprise and the business is susceptible to valuation methods, such an approach provides the best method of calculating damages. Cf. Sharma v. Skaarup Ship Management Corp., 916 F.2d 820, 825 (2d Cir.1990) (“where the breach involves the deprivation of an item with a determinable market value, the market value at the time of the breach is the measure of damages”), cert. denied, 499 U.S. 907, 111 S.Ct. 1109, 113 L.Ed.2d 218 (1991). The methodology of determining a business’s earnings and applying an earnings multiplier to fix the value of a business that was completely terminated is one we have approved. See Lamborn v. Dittmer, 873 F.2d 522, 533-34 (2d Cir.1989).
FISHMAN v. ESTATE OF WIRTZ and ILLINOIS BASKETBALL, INC. v. ESTATE OF WIRTZ, 807 F.2d 520, 552 (7th Cir. 1986) Sherman Act and Illinois Law In this connection, defendants first object to the district court’s approach by arguing that damages must be computed as of the date of the injury— in this case, as of July 1972. While this rule may generally govern simple contract damages, it is not necessarily controlling in cases such as the one before us where the injury is continuing or where damages from the injury continue to accrue. . . . The Bulls did not go out of business but instead continued in business in the hands of CPSC, giving the court, as we have noted, an exceptionally helpful guide to IBI’s damages. Defendants argue that the going-concern value of the Bulls in July 1972 represents a full recovery for IBI because that going-concern value—that is, what a willing buyer given all available information would have paid for the team in 1972—is by definition a future income stream discounted to present value. The district court’s valuation, on the other hand, is based on actual gain experienced by the Bulls over ten years. (The 1972 going-concern value was affected by a number of ex ante predictions, which were proved either true or false and were reflected in the 1982 value). We do not understand defendants’ objection to using this adjusted value (which is not speculative, cf. Farmington Dowel Products, 421 F.2d 61) because we know of no case that suggests that a value based on expectation of gain is more relevant and reliable than one derived from actual gain. “To correct uncertain prophecies . . . is not to charge the offender with elements of value non-existent at the time of his offense. It is to bring out and expose to light the elements of value that were there from the beginning.” Sinclair Refining Co. v. Jenkins Petroleum Process Co., 289 U.S. 689, 698, 53 S.Ct. 736, 739, 77 L.Ed. 1449 (1933) (citations omitted); see also A.C. Becken Co. v. Gemex Corp., 314 F.2d 839, 840 (7th Cir.), cert. denied, 375 U.S. 816, 84 S.Ct. 49, 11 L.Ed.2d 51 (1963) (“a forecast of tomorrow's weather is always subject to confirmation or modification by tomorrow’s observation”) (emphasis in original); Twentieth Century-Fox Film Corp. v. Brookside Theatre Corp., 194 F.2d 846, 856 (8th Cir.), cert. denied, 343 U.S. 942, 72 S.Ct. 1035, 96 L.Ed. 1348 (1952) (passage of time permits better proof of extent of harm).
NOTE: These excerpts are from the published opinion without editorial comment or modification by the authors (except as specifically noted).
damages in perpetuity, as in a business valuation DCF analysis, is inherently a conclusion that some portion of the plaintiff’s business has been permanently destroyed. In some cases, the entire business is permanently destroyed. In this circumstance, damages may be limited to the fair market value of the business on the date of the damages event.1 The courts have come down on both sides of the issue of whether or not damages for a destroyed business are capped at the fair market value of the business as of the date of the bad act. The arguments are summarized in the following excerpts from case law, which are presented in Exhibit 13.2.
1 Robert
L. Dunn, Recovery of Damages for Lost Profits, 5th ed. (Westport, CT: Lawpress Corporation, 1998), p. 500.
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Use All Valuation Approaches? Business valuation standards emphasize that (1) all generally accepted valuation approaches should be considered and (2) the reasons for the inclusion or absence of each approach should be explained. Accordingly, some valuation analysts tend to estimate economic damages using the traditional asset-based, market, and income approaches. There is also a temptation for valuation analysts to weight the damages approaches mechanically within the asset-based, market, and income approaches. Depending on the facts and data available, more than one approach may be used to estimate economic damages. However, there is no legal requirement to do this. As a reasonableness check on the primary damages calculation, the analyst may choose to use a secondary approach. This secondary approach typically is described as a reasonableness check and not as an alternative damages figure to be awarded by the trier of fact. Damages analyses do not focus on the breadth and weight given to multiple valuation approaches. In a civil damages suit, the trier of fact focuses on three elements of proof: 1. That a violation of a legal right has occurred 2. That this violation caused damages to occur 3. That the amount of the damage caused by the violation has been estimated with reasonable accuracy Business valuation methods are often relevant to estimating the amount of the economic damages. However, the key question to address in estimating the amount of damage is: “Do the assumptions and methods used accurately portray the full extent of the changes caused by the violation, consistent with the findings of fact and law by the court?” Using business valuation methods to reduce these changes to a present value (or a fair market value) is only a part of—but not the principal focus of—the estimation of economic damages. What do we mean by the terms “valuation approach” versus “damages approach?” Business valuation approaches include all the various methods available to benchmark a defined value of a business enterprise. Business valuation approaches take the financial position of the subject business enterprise as a given. These approaches encompass all of the methods within the asset-based approach, the market approach, and the income approach. On the other hand, damages approaches include the methods used to demonstrate the fact and amount of injury in the first place. There are three basic categories for damages approaches: 1. The before and after approach 2. The yardstick approach 3. The economic modeling approach To apply the before and after approach, the analyst may compare the plaintiff’s experience during the damage period (1) to plaintiff’s prior experience, (2) to plaintiff’s subsequent experience, or (3) to the defendant’s subsequent experience.2 To apply the yardstick approach, the analyst may compare plaintiff’s experience during the damage period (1) to the plaintiff’s experience at other undamaged locations or 2 Ibid.,
pp. 396–401, 416–421.
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in other undamaged product markets, (2) to the comparable experience of others, (3) to industry averages, and (4) to projections prepared prior to the legal violations.3 To apply the economic modeling approach, the analyst develops an economic model of the affected entity. The analyst uses this model to estimate actual and but-for cash flows by adjusting those model inputs that are impacted by the damages event. In a damages analysis, the methods used to reduce the damages to present value are often not of primary importance. The primary focus in the examination of the damages analyst at trial is usually on the inputs to the approach or approaches, not on which approach or approaches are used.
Damages Before or After Taxes? The Income Tax–Affect Procedure Investors generally estimate the market value of a business after adjusting for any income taxes payable by the business. In other words, investors typically value the net after-tax cash flow available to them. In a business valuation, to calculate this value (which is after corporate level income taxes) using either a direct capitalization method or a DCF method, the analyst discounts after-tax cash flow by an aftertax rate of return. In some cases, the analyst may discount before-tax cash flow by a before-tax rate of return. However, after-tax rates of return are more readily observed in the market. Either way, in a business valuation, the income tax status of the cash flow should always match the income tax status of the discount rate or the capitalization rate. In contrast to the after-tax status of a business valuation, a damage award typically includes the taxes payable on the award. In other words, because most damage awards are taxable to the plaintiff, in order to restore the after-tax loss of value sustained by the plaintiff, the damage award should include both the after-tax loss of value and the taxes payable (if any) on the award. One way that this may be achieved in practice is to mismatch the tax status of the cash flow and the discount rate. This may appear to be counterintuitive, but it is theoretically sound. Exhibit 13.3 illustrates how this procedure works. Let’s assume that 1 year after the date of trial, before-tax lost profits are projected to equal $100. If income taxes will be paid at a marginal rate of 40 percent at the end of this year, after-tax lost profits will equal $60. Next, as shown in column 4, let’s assume that the subject company’s lost project is expected to earn an after-tax rate of return of 12 percent, as presented in column 1. Moving to the top of column 2, the after-tax rate of return is converted to a pretax reinvestment rate for the project. Now, what before-tax amount should be awarded at trial to reimburse the plaintiff for the $60 after-tax loss suffered 1 year after trial? The amount, $89.29, at the top of column 1, should be awarded. One can check the amount by following the calculation along the arrows from $89.29. Income taxes will be paid on the award at 40 percent, resulting in a net aftertax award of $53.57, at the bottom of column 1. In turn, this amount would be invested at a before-tax reinvestment rate of 20 percent to produce $64.29 before tax at the end of the year, at the top of the column 3. At the end of the year, income taxes 3 Ibid.,
pp. 401–416, 422–427.
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Exhibit 13.3
Before-Tax vs. After-Tax Economic Damages Analysis Column 1
Column 2
Column 3
Column 4 Lost Profits Damages
Taxable Award for Future Loss Amount Awarded Today
Rate of Return (%)
Future Value of Award in 1 Year
Future Loss in 1 Year
Before-tax amount
$ 89.29
20.00
$ 64.29
$ 100.00
Income tax rate
40.00%
40.00
40.00%
40.00%
After-tax amount
$ 53.57
12.00
$ 60.00
=
$ 60.00
are only paid on the increase in value from $53.57 to $64.29 (40% × ($64.29 − $53.57) = $4.29). The amount that remains after income tax at the end of the year is $60 ($64.29 − $4.29). This $60 amount is equal to the loss to be reimbursed, the projected after-tax loss at the end of the year. Now in Exhibit 13.4, let’s substitute algebraic variable names in the place of the previous amounts. Working through the algebra, let’s solve for the before-tax amount of the award, at the bottom of Exhibit 13.4. In our example, if income tax rates do not change, then the before-tax amount of the award equals the amount of the future before-tax loss, discounted by the after-tax rate of return. This is an acceptable procedure for economic damages: “Discount before-tax cash flow by an after-tax rate of return.” You may also have heard the procedure stated more succinctly, “Never consider income taxes in damages analyses.”
Complications to the Tax-Affect Procedure The above tax-affect procedure is almost always followed in state superior courts and in federal courts. The following passage from Hall v. Chicago & N.W. Railway Company,4 explains the legal reasoning that supports the rule of thumb: It is a general principle of law that in the trial of a lawsuit the status of the parties is immaterial. Thus, what the plaintiff does with an award, or how the defendant acquires the money with which to pay the award, is of no concern to the court or jury. Similarly, whether the plaintiff has to pay a tax on the award is a matter that concerns only the plaintiff and the government. The tort feasor has no interest in such questions. And if the jury were to mitigate the damages of the plaintiff by reason of income tax exemption accorded him, then the very Congressional intent of the income tax law to give an injured party a tax benefit would be nullified. The procedure, “Never consider income taxes in damages analyses,” is adequate for most commercial damages cases. However, depending on the facts and 4 Hall
v. Chicago & N.W. Railway Company, 5 Ill. 2d 135, 125 N.E. 2d 77 (1955).
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Exhibit 13.4
General Case of Before-Tax vs. After-Tax Economic Damages Analysis Lost Profits Damages
Taxable Award for Future Loss
Before-tax amount Income tax rate After-tax amount
Amount Awarded Today
Rate of Return
AWARD0
(1 + k0)
Future Value of Award in 1 Year
Future Loss in 1 Year
AWARD0 (1 − t0)(1 + k0)
t0
t1
t1
AWARD0 (1 − t0)
(1 + k0(1 − t1))
AWARD0(1 − t0)(1 + k0(1 − t1))
Solution:
AWARD0 = (CF1 ((1 − t1) / (1 − t0))) / (1 + k 0(1 − t1))
CF1 t1 =
CF1 (1 − t1)
If t0 = t1, AWARD0 = CF1 / (1 + k 0(1 − t1))
circumstances, the court may weigh evidence concerning the real economic effect of income taxes, regardless of the common legal practice. Legal counsel may want to consider the opportunity to argue for exceptions to the rule. Keep in mind that a damages award based on this procedure will resemble the actual economic loss, plus actual income taxes payable on the award, only when certain assumptions are met. First, as noted in the formulas at the bottom of Exhibit 13.4, a damages award based on this procedure resembles the actual economic loss, plus actual income taxes payable, only when permanent income tax rates remain constant over time. However, income tax laws and permanent income tax rates sometimes change over time. In Polaroid Corporation v. Eastman Kodak Company,5 Kodak presented the argument that the plaintiff’s damage calculations overcompensated Polaroid for its economic loss. This was because of the change in income tax rates during the damage period. Kodak’s experts pointed out that the plaintiff’s pretax losses would have been taxed at higher permanent rates than existed at the date of trial. Thus, the plaintiff actually would pay less in income tax than the amount of tax included in the pretax award, providing Polaroid with a windfall of approximately $80 million. The court rejected Kodak’s argument in this case. However, when large amounts are at stake, defense counsel will likely again consider making this argument for an exception to the tax-affect procedure. Second, to complicate the procedure further, damages are not always taxable. Damage awards for personal physical injuries are exempt from income tax.6 For businesses, in those rare instances where the taxpayer can support the treatment of damages as a recovery of capital, then damages are exempt from income tax to the extent of the taxpayer’s basis in the lost capital asset.7 Third, our analysis of this procedure assumes that the plaintiff is a C corporation. In Exhibit 13.3, when the plaintiff is a C corporation, the after-tax rates of return are the same rates used in a typical business valuation assignment. In other words, the rates of return are those available to investors in the financial markets after corporate income taxes. However, if the plaintiff in Exhibit 13.3 is an individual, a partnership, or an S corporation, the rates of return earned on investments in the 5 Polaroid
Corporation v. Eastman Kodak Company, 16 U.S.P.Q. 2d 1481 (D. Mass., 1990, as corr. 1991). U.S. Master Tax Guide (Chicago: CCH Incorporated, 1997), para. 702, p. 193. 7 Robert W. Wood, Taxation of Damage Awards and Settlements (San Francisco: Tax Institute, 1991), p. 4–4. 6 1998
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market may be viewed as before-personal-tax rates of return. The true after-tax rate of return for an individual may best be expressed after deducting personal income taxes as well as corporate income taxes. Fourth, not all areas of law treat income taxes in this same way. For example, damages for personal injury are treated differently if brought under a federal statute than if brought under state law. In Norfolk & Western Railway Co. v. Liepelt,8 the Supreme Court ruled that, in calculating damages in a Federal Employer’s Liability Act (FELA) case, earnings should be estimated on an after-tax basis.9 In Jones & Laughlin Steel Corp. v. Pfeifer,10 the court ruled that, since earnings are estimated in after-tax terms, the discount rate should be the after-tax rate of return.11 Note that, in the FELA cases above, the personal injury awards were exempt from federal income tax. However, the interest income accumulating on the award was taxable. Therefore, in Shaw v. U.S.,12 the Ninth Circuit Court of Appeals ruled that, since income taxes are deducted from earnings, the award should be increased to pay the income taxes on the award. In another example, recall that the after-tax rates of return for damages to an individual may be best expressed after deducting personal taxes as well as corporate taxes. However, in Trevino v. U.S.,13 the Ninth Circuit ruled that tax-free municipals are a suspect surrogate for after-tax yield.14 Remember that these cases all involve personal injuries and tax-exempt damage awards. Finally, a more direct way to insure that a plaintiff is made whole would be (1) to estimate all of the cash flows on an after-tax basis, (2) to use an after-tax discount rate to bring the cash flow to present value, and (3) to “gross up” the after-tax damage amount to a pretax damage award using the plaintiff’s current effective or marginal income tax rate. It is not correct to assume that if the economic damage award should be pretax, you can completely ignore income taxes by using pretax cash flow and discount this cash flow at a pretax discount rate in order to make the plaintiff whole. Although this appears to make sense intuitively, it is not supported in practice. The plaintiff will not be in the same position after the plaintiff pays taxes on the damage award as the plaintiff would have been if the legal violation had never occurred. However, let us return to the typical, taxable lost profit claim and the tax-affect procedure.
Typical Lost Profits Claim For the typical lost profits claim, the damage award is taxable and the court will generally follow the procedure, “Discount before-tax cash flow by an after-tax rate of return.” Given these restrictions, what is the correct way to define both the pretax loss and the after-tax rate of return? This question is addressed below with another example. Exhibit 13.5 presents an income and cash flow statement for a hypothetical lost project. The loss is assumed to occur in a single period, 1 year after the date of trial. The example is constructed so that the after-tax net present value of the project at the date of trial is $1,200. The cost of debt is 8 percent, and cost of equity is 15 percent.
8 Norfolk
& Western Railway Co. v. Liepelt, 444 U.S. 490 (1980). Determining Economic Damages, p. 8–2. 10 Jones & Laughlin Steel Corp. v. Pfeifer, 462 U.S. 523 (1983). 11 Harold R. Dilbeck, “The Time Value of Money,” Litigation Services Handbook, Peter B. Frank, Michael J. Wagner, and Roman L. Weil, eds. (New York: John Wiley & Sons, 1997), p. 38.2. 12 Shaw v. U.S., 741 F.2d 1201 (9th Cir. 1984). 13 Trevino v. U.S., 804 F.2d 1201 (9th Cir. 1986). 14 Martin, Determining Economic Damages, p. 8–3. 9 Martin,
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Exhibit 13.5
Lost Project Economic Damages Example For Period Ending at the Date of Statement of Cash Flows
Assumptions
Trial
Future Loss
Cash Flow from Operating Activities: Revenue Cash operating costs Depreciation
$10,000 (7,001) (750)
Earnings before tax Interest expense Earnings before tax Taxes
2,249 (24) 2,225 (890)
tc = 40%
Net income Add back depreciation (Increase) decrease in working capital
1,335 750 –
Subtotal—cash flow from operations
2,085
Cash Flow from Investing Activities: Proceeds from sale of fixed assets Investment in fixed assets
– (750)
Subtotal—cash flow from investing
(750)
Cash Flow from Financing Activities: kd = 8% ke = 15%
Debt Equity Subtotal—cash flow from financing Net Cash Flow
$300 900
(300) (1,035)
1,200
(1,335)
$1,200
$–
We can solve the problem by starting with the after-tax definitions of cash flow and the after-tax cost of capital used in a typical business valuation assignment. There are several possible combined definitions of cash flow and cost of capital that will produce a correct after-tax value. However, we have selected the most common definitions. First, for the definition of the after-tax rate of return, let’s select the after-tax weighted average cost of capital (WACCAT). Written in algebraic symbols, we combine the cost of debt (kd), the cost of equity (ke), the market value of debt (D), and the market value of equity (E), in the formula for WACCAT: D + WACCAT = kd (1 − tax rate) × D + E
k × D e D + E
Valuation analysts typically use the after-tax definition of net cash flow—that is, the earnings before interest and tax (EBIT) times the quantity, one minus the income tax rate, plus depreciation, minus the increase in working capital, and minus the required future capital investment. Below, written in algebraic symbols, we combine EBIT, depreciation (depr), the decrease (increase) in working capital (WC), and future investment (I), in the formula for after-tax net cash flow: After-tax net cash flow = [EBIT(1 − t)] + depr ± WC − I
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However, for economic damages purposes, we need a definition for the beforetax net cash flow in order to follow the tax-affect procedure. To create this definition, we divide both sides of the equation above by one minus the income tax rate (1 − tax rate). The result is the equation for before-tax net cash flow. Before-tax net cash flow = EBIT +
depr WC I ± − (1 − t ) (1 − t ) (1 − t )
The formula is considerably simplified if we make two assumptions. First, let’s assume, as in our example in Exhibit 13.5, that the lost project encompasses a complete operating cycle. Then, the net change in working capital is equal to zero. Second, let’s assume, as in Exhibit 13.5, that the amount of depreciation is equal to the amount of required future investment. In this case, these terms cancel one another. After making these assumptions, all that remains of the formula above is before-tax net cash flow = earnings before interest and tax (EBIT). Now we can apply these formulas to our example in Exhibit 13.5 and demonstrate that they work. In Exhibit 13.6, we discount earnings before interest and tax, $2,249, by the weighted average cost of capital, 12.45 percent. The result is the proper amount of a before-tax damages award, $2,000. In Exhibit 13.6, after income taxes are paid on the award at 40 percent, the after-tax proceeds from the damages award, $1,200, exactly match the after-tax present value of the lost project at the date of trial in Exhibit 13.5. In other words, given our assumptions, the plaintiff is restored to the same position as if the legal violation had never occurred. This is not the only way that damages may be correctly computed. In the example above, we assume that the marginal capital for the lost project was comprised of both debt and equity in this particular blend. Under different facts and circumstances,
Exhibit 13.6
Present Value of Future Lost Profits For Period Ending at Date of Calculation of Economic Damages Award
Assumptions
Trial
Future Loss
Before-Tax Loss Earnings before interest and tax Add depreciation/(1 − tc)
$2,249 1,250
Decrease (increase) in working capital/(1 − tc) Less cash flow for future investing activities/(1 − tc)
– (1,250)
Before-tax net cash flow
$2,249
After-Tax Discount Rate Weighted average cost of capital (WACC) = ke [Equity/(Debt + Equity)] + kd (1 − tc) [Debt/(Debt + Equity)] Amount of the Award Less income taxes on award After-tax proceeds from award Repay debt Repay equity Net gain (loss) from loss and award
WACC = 12.45% tc = 40%
$2,000 (800) 1,200 (300) (900) $–
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Exhibit 13.7
Alternative Definitions of Cash Flow and Cost of Capital Definition of Cash Flow
Definition of Weighted Average Cost of Capital
ASSUMING LOSSES ARE REALIZED AT OR BEFORE TRIAL (OR BUSINESS VALUATION) [Earnings before Interest and Tax (EBIT) × (1 − tax rate)]
k d (1 – t) [D/(D + E)] + k e [E/(D + E)]
+ Depreciation +/− Investment Net Income + Depreciation +/− Investment
Same as above
+ [(1 − tax rate) × Interest Expense] Net Income + Depreciation +/− Investment
k d [D/(D + E)] + k e [E/(D + E)]
+ Interest Expense Net Income + Depreciation +/− Investment
ke
+/− Debt Principal ASSUMING LOSSES ARE UNREALIZED
ke
Earnings before Tax + Depreciation +/− Investment
Description of Symbols: k d = marginal cost of debt, market yield to maturity k e = marginal cost of equity D = market value of debt E = market value of equity t = marginal income tax rate
an analyst may find that the marginal capital for the lost project was comprised entirely of the lost market value of equity. The choice of an equity value versus an enterprise (or invested capital) value is a question of fact to be determined by the analyst. If an equity value is appropriate, then the after-tax cost of capital is equal to the cost of equity (ke) alone. The definition of the before-tax loss will remain the same. However, when discounted by the cost of equity alone, the amount of the award will usually be lower. In addition, we could have started with different definitions for the cost of capital and the after-tax net cash flow that, after adjustment to a before-tax basis, produce the same amount. Examples of possible matched pairs of definitions for the cost of capital and the after-tax net cash flow are presented in Exhibit 13.7. These factors can easily be adjusted to a before-tax basis.
Value Only the Future? Know Only the Past? Damages claims differ from business valuations in another respect. In a typical business valuation, the analyst values only the future economic benefits associated with the business as of the valuation date. On the other hand, to estimate damages, the
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Exhibit 13.8
Past and Future Economic Damages, Ex Ante and Ex Post Damages $400 EX ANTE DAMAGES Discount losses to the date of injury using a risk-adjusted rate, rP .
$350
Add prejudgment interest to the date of trial at the risk-free rate, rf , or at the defendant’s borrowing rate, rD .
NET CASH FLOW
$300
Discount future losses to the date of trial using a riskadjusted rate, rP .
EX POST DAMAGES Replicate lost investment opportunities to the date of trial.
$250 $200
FUTURE LOSSES
BUT-FOR NET CASH FLOW
$150
PAST LOSSES ACTUAL NET CASH FLOW
$100 $50 Date of Injury
$− −5
−4
Date of Trial
−3
−2
−1
0
1
2
3
4
5
TIME
analyst should (1) estimate both the past and the future losses and then (2) estimate the total amount of loss as of the date of trial. This procedure raises a host of issues that are usually not considered in a typical business valuation assignment. First, analysts do not always agree on how past damages should be handled. There are three competing schools of thought on this subject. One school of thought claims that damages should be valued as of the date of injury. This type of damages analysis is called ex ante damages. Ex ante means “from before.” To compute total damages, to the value at the date of injury, the analyst may add interest damages, at the prejudgment interest rate, up to the date of trial.15 The second school of thought claims that damages should be valued at the date of trial.16 This type of damage calculation is called ex post damages. Ex post means “from after.” Ex post damages (1) use all information available to the date of trial and (2) replicate the lost cash flow from the project up to the date of trial. In an ex post damages analysis, the analyst calculates the actual loss in each year and adds interest damages at the prejudgment interest rate up to the date of trial. The third school of thought uses a hybrid of the ex ante and ex post analyses. The ex ante and ex post analyses are illustrated in the chart in Exhibit 13.8.
15 Within
this school of thought, there is disagreement about what the prejudgment interest should be. One faction argues that the defendant’s unsecured borrowing rate is the correct prejudgment interest rate. See James M. Patell, Roman L. Weil, and Mark A. Wolfsen, “Accumulating Damages in Litigation: The Roles of Uncertainty and Interest Rates,” Journal of Legal Studies, June 1982, pp. 341–364. Another faction argues that the short-term risk-free rate is the correct prejudgment interest rate. See Franklin M. Fisher and R. Craig Romaine, “Janis Joplin’s Yearbook and the Theory of Damages,” Journal of Accounting, Auditing & Finance, Winter 1990, pp. 145–157. 16 Konrad Bonsack, “Damages Assessment, Janis Joplin’s Yearbook, and the Pie-Powder Court,” George Mason University Law Review, Fall 1990, pp. 1–26.
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Background for the Ex Ante and Ex Post Discussion17 Because of the time it takes to initiate and complete a lawsuit, there can be a significant delay between the damages event date and the date that the plaintiffs are compensated. During this time lag, information about the value of the illegal act becomes available, which can change the parties’ perception of the damages. For example, let’s assume that you buy a lottery ticket for $1. Then, let’s assume that someone steals it from you before the lottery winner becomes known. Let’s assume that on the damages event date all lottery tickets have an equal chance of winning and there is no shortage of tickets available for $1. Time passes and it turns out that the ticket stolen from you is the lottery winner and it is now worth $32 million. How much should the thief pay you to make you whole? Does the thief owe you the expected value of the ticket (about 12 cents), called the ex ante, or expected value before the event? Or, does the thief owe you the fair market value of the stolen ticket ($1)? Or, does the thief owe you the amount that you would have made had you owned the winning ticket ($32 million), its ex post value, or value after the event? Surely you could argue that if you paid $1 for a ticket with an expected value of only 12 cents, you were not planning to try to resell it for $1 before the winner was announced. If you didn’t intend to hold onto the ticket until the winning numbers were announced, you would have been better off not buying it at all. On an ex post basis (i.e., after the fact) we know with certainty that you would have won the lottery had the thief not stolen your ticket. One could also argue that the $1 price of the ticket is the risk-adjusted value of that ticket and reflects the value of the low probability of a particular ticket winning. Given these circumstances and considering that, at the time of the theft, you could have simply bought another ticket with an equal probability of winning for $1, there should be little disagreement that on the date of the theft, the damages were no greater than $1. After the lottery ends, however, and the ticket becomes worth $32 million, few juries would feel that having the thief give you back the risk-adjusted value taken from you ($1 of the $32 million in winnings) is a just resolution, even if you granted the argument that the thief took the risk of the ticket not winning. After all, it is unlikely that a case like this would go to trial if the ticket had not won. And, therefore, the thief took a very small risk of having to pay any restitution at all.
Expectancy versus Outcome Damages18 A pure ex ante analysis would use only information available at the time of the illegal act to estimate damages. Therefore, ex ante analysis is based on the expectancy that an analyst would have if the damage caused by the illegal act were analyzed contemporaneously with the occurrence of the illegal act.
17 This
section is adapted from Chap. 5A, “Ex Ante versus Ex Post Damages Calculations,” by Michael J. Wagner, Michael K. Dunbar, and Roman L. Weil in Litigation Services Handbook, 3d ed., 2003 Cumulative Supplement (New York: John Wiley & Sons, 2003), p. 5A-2. 18 Ibid., pp. 5A-2–5A-3.
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Exhibit 13.9
Differences between Ex Ante and Ex Post Analyses Procedural Difference
Ex Ante Analysis
Ex Post Analysis
Information
Use information known or knowable on the date of the illegal act; ignore subsequent events
Use all available information
Measurement date
Date of illegal act
Date of analysis
Discounting
Discount all cash flows back to the date of illegal act. Calculate prejudgment interest on the net present value of damages from the date of the illegal act to the date of trial
Discount future damages to the date of trial. Calculate prejudgment interest on past damages
SOURCE: Chap. 5A, “Ex Ante versus Ex Post Damages Calculations,” by Michael J. Wagner, Michael K. Dunbar, and Roman L. Weil in Litigation Services Handbook, 3d ed., 2003 Cumulative Supplement (New York: John Wiley & Sons, 2003), p. 5A-3.
A pure ex post analysis uses all the information that is available up to the date of the analysis. It is an outcome analysis, in that it considers facts such as how the market developed over time, what competitors did subsequent to the illegal act, how interest rates may have changed, and the like. One could also perform an analysis that is a hybrid between ex post and ex ante. For example, one commonly sees analyses that use subsequent information but discount post-illegal act cash flows back to the date of the illegal act at a riskadjusted discount rate. The differences between ex post and ex ante analyses lie in what information subsequent to the illegal act will be used, the date from which damages will be measured, and how future damages will be discounted. At the two extremes are (1) a pure expectancy damages analysis that uses information only available at the time of the illegal act and (2) a pure outcome analysis that uses all available information up to the date of judgment. Exhibit 13.9 highlights the differences between the two types of analyses.
Advantages and Disadvantages of the Ex Ante Analysis19 Proponents of the ex ante analysis argue that it properly accounts for risk. Contemporaneously conducted analyses capture the probability of the entire spectrum of outcomes. Awarding the plaintiff all the benefits of a successful project without the plaintiff having to take the project risk would overcompensate the plaintiff. In fact, such an award gives the plaintiff an incentive to seek to be harmed. Better that I should induce you to deprive me of the right to drill for oil on a site that is likely a dry hole than that I should spend the, say, $1 million to drill for myself. If I can induce you to deprive me of the right to drill, then I can save the $1 million of drilling costs. But, I still collect the value of the oil if, contrary to expectation, it turns out the well would have been a gusher.
19 Ibid.,
pp. 5A-6–5A-7.
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Additionally, the results of an ex ante analysis are independent of when the trial occurs. Therefore, a plaintiff has no incentive to attempt to “game” the court system by timing a potential lawsuit to maximize damages awards. Another advantage of ex ante analysis is that it does not penalize the plaintiff for either pursuing or not pursing mitigation. The ex ante analysis has the disadvantage that it may require a complex reconstruction of the world at the time of the illegal act, likely impaired by a shortage of contemporaneous information. The analyst will often need to construct both actual and but-for situations, neither of which actually occurred. The actual situation is composed of the cash flow from the next best alternative given the illegal act. The but-for situation is composed of future cash flows that would have followed but for the illegal act. Ex ante analyses also have the nuance of using the contemporaneous market for valuation at the time of the illegal act. The notion that the market value at any given time reflects the present value of future cash flow assumes efficient markets and complete information. Complete information rarely exists, however. In fact, proponents of the ex ante analysis agree that private information relating to the value at the illegal act date is relevant. And, therefore, the market (without complete information) is not the ultimate arbitrator of value.20 Moreover, even with complete information, market forecasts could be wrong.
Advantages and Disadvantages of the Ex Post Analysis21 The ex post analysis may appeal to one’s sense of justice. If someone steals your lottery ticket that becomes worth $32 million, then even an unskilled lawyer would be expected to persuade jurors to award you $32 million in damages, not the $1 cost of the ticket. Proponents of the ex ante analysis argue that an ex ante analysis makes the victim whole as of the date of the illegal act. Proponents of the ex post analysis argue the ex post analysis makes the victim whole at any time. The ex post analysis also provides a social deterrent to violating the legal rights of others that is absent when using the ex ante analysis. With the ex ante analysis, the high transaction costs of going to court will deter plaintiffs from seeking appropriate redress in the many cases where the outcome was not bright as of the date of the bad behavior. Only cases with significant, demonstrable damages will go to trial. For example, no one will bring a case to trial for a stolen lottery ticket whether or not that ticket won the jackpot. Therefore, the ex ante analysis fosters an incentive to violate the legal rights of others. This is because the wrongdoer will not be brought to justice when the likely outcome of such a trial is either small or negative. Moreover, when wrongdoers enjoy highly positive outcomes, they will have to pay only the lesser, expected value of damages. Among the disadvantages of the ex post analysis is that when measuring damages, the damages amount may change over time as new data become available. Because the changing environment constantly influences ex post damages, this analysis arguably provides incentive for timing litigation to maximize or minimize damages.
20 Ibid., 21 Ibid.,
p. 5A12. pp. 5A-17–5A18.
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For example, a party may choose to intentionally delay proceedings until the stock market recovers. Second, as discussed above, the ex post analysis unquestionably gives the plaintiff the benefit of the proceeds from a risk that he did not bear. Also, there is a risk that the plaintiff will be overcompensated. In particular, if the plaintiff is allowed to choose between an ex post and an ex ante remedy, the plaintiff is overcompensated for risks taken when the ex post damages exceed ex ante damages. Likewise, a defendant will argue that the court should use the analysis that yields the lower damages figure.
Hybrid Analysis22 Analysts frequently blend different aspects of the ex ante and ex post analyses in a hybrid approach. A common hybrid between a pure ex ante and a pure ex post analysis uses ex post information but an ex ante measurement date. Analysts will discount the lost cash flow back to the date of the illegal act, using a risk-adjusted discount rate that is based on the actual volatility of the returns in the ex post period. Advocates of the hybrid analysis reason that if all parties know what the lost cash flow would actually have been, no rationale exists for ignoring that information. Certainly, what actually happened was one of the plausible outcomes at the time of the illegal act. The hybrid approach may also appeal to one’s sense of justice. This is because it uses the real world as a basis for the calculation of damages as opposed to a hypothetical expectation based on what was known and knowable at the time of the illegal act. It eliminates some speculation as to what the but-for cash flow would have been. Advocates of this analysis argue that the actual cash flow should be discounted to reflect the business risk of earning those cash flows. If the analysis does not discount actual cash flow at a risk-adjusted rate, as occurs in a pure ex ante analysis, the plaintiff is in a superior economic position than he would have been but for the illegal act. This may not fully account for business risk. Consider the situation in which an investor has a choice between earning cash flows that are associated with some uncertainty, and holding a free call option on his or her future cash flow. The investor would invariably choose the call option because with a call he or she avoids downside risk. Likewise, pursuing a pure ex post result in court is akin to giving the plaintiff a free call on his or her future lost cash flow. This is because to obtain this cash flow, but for the illegal act, the plaintiff would have had to suffer through some level of uncertainty that was subsequently avoided. Discounting the ex post cash flow back to the date of the illegal act at the appropriate risk-adjusted discount rate moves the pure ex post result closer to a position that is at risk parity with what would have happened but for the illegal act. Typically, when using the hybrid analysis, an appropriate discount rate would incorporate information from guideline companies in the market. A reasonable estimate of the risk premium would be the market risk premium multiplied by the beta of the selected guideline companies for a period as closely paralleling the damages period as feasible. 22 Franklin M. Fisher and R. Craig Romaine, “Janis Joplin’s Yearbook and the Theory of Damages,” Journal of Accounting, Auditing and Finance, Winter 1990, pp. 145–157.
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The analyst frequently calculates the beta over at least 60 months. A beta calculated over a period significantly shorter than 60 months is likely to be less reliable. The hybrid analysis should calculate prejudgment interest as in the ex ante analysis from the date of the illegal act to the date of restitution. Therefore, an analyst would first discount future lost cash flow to the date of the illegal act. Then, the analyst would apply prejudgment interest to both future and past lost cash flow from the date of the illegal act. When the statute does not specify a prejudgment interest rate, a reasonable rate would be the defendant’s borrowing rate.
Projected or Expected Cash Flow There are areas of potential abuse that apply both to business valuation and to economic damages. One such abuse is to value projected cash flow without truly reflecting the likelihood that these projections actually will be achieved. To comply with the assumptions used in the economic model for present value, the projected cash flow being discounted should be adjusted to reflect the expected values of the future cash flow from the project. The effect is illustrated in the example in Exhibit 13.10. In Exhibit 13.10, the projected cash flow does not equal the expected value of the cash flow, because the product development only had a 20 percent chance of success.
Exhibit 13.10
Risk Parity, Expected Cash Flow, Expected Rate of Return, and Time, Ex Post Economic Damages Fact Pattern In period 0, the Defendant destroyed the Plaintiff ’s opportunity to pursue the lost project, after Plaintiff had invested $500, but before any product development had been conducted. The trial is held at the end of period 2. The statutory prejudgment interest rate is 5%. How would ex post economic damages be calculated? Projected Cash Flow at Date of Trial Phase I Ex Post Economic Damages at Date of Trial
0 Date of Injury
Phase II 1
2 Date of Trial
3
4
5
Terminal Value
$300
$ 400
$ 500
$3,333
20%
20%
20%
Projected cash flows
$ (514)
$100
$200
×
100%
20%
20%
$ (514)
20
40
60
80
100
667
100.00%
100.00%
86.96%
75.61%
65.75%
65.75%
$ 20
$ 40
$ 52
$ 60
$ 66
$ 438
$1
$-
Probability of success at time 3
Expected value of cash flows at end of period 2 ×
Present value factor for 15% Present value of lost project at end of period 2 Prejudgment interest at 5% Total economic damages at date of trial
$ 678
20%
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If the plaintiff offers the projected cash flow as evidence of loss at trial, and the actual success of the product development cannot be determined without speculation, then the projected cash flow should be reduced to its expected value. The plaintiff can exaggerate economic damages by assuming the product development in Phase I was successful and ignoring other possibilities.
Differences in Reporting Requirements Expert reports concerning economic damages have reporting requirements that are set by the court. State and federal courts have different rules. Each court may have local rules that differ from other jurisdictions. The most uniform and widely used rules are those applied in federal courts. These rules are specified in the Federal Rules of Civil Procedure (FRCP). Under the FRCP, an expert in either economic damages or business valuation should provide a written report that describes the opinions that the expert will offer at trial. Generally, the rules require that the expert list all the opinions to be rendered at trial and all the bases for these opinions in the report. A literal reading of the rules requires that each and every reason that the expert has for each opinion should be explained. Otherwise, the expert runs the risk of not being allowed to testify about any unlisted reason at trial. The bases for an expert’s opinion may include all the assumptions the expert is making to reach his or her conclusions. The bases may also include all the facts that support the assumptions used in reaching the expert’s conclusions. If the only basis for the expert’s opinion is the judgment of the expert, then this should be disclosed. The FRCP also requires the report to contain a list of all the documents considered by the expert in reaching his or her opinions. The operative word in this requirement is “considered.” This is a broader concept than documents “relied upon.” The most complete disclosure would be a list of any document the expert looked at in connection with the assignment whether it was relied upon or not. There is no requirement that the documents be produced with the report, particularly if they are documents that have been previously produced by one of the other parties to the litigation. Frequently documents produced by parties in litigation are stamped with a unique number so that each document can be uniquely identified. One typical numbering system is called the “Bates Stamp.” If the documents considered by the expert are Bates Stamped, then a listing of a description of the documents and the documents’ Bates Stamp numbers will satisfy the disclosure requirement. If the damages analyst has instead considered documents not produced by a party but collected independently by the analyst, there should be a sufficient description of the documents so that the opposing side can understand what the analyst did consider in reaching his or her opinions. It is a good practice to produce these documents with the expert report, particularly if the documents are not publicly available. In that way, a proper foundation can be laid for the expert opinions. The FRCP also requires disclosure of a list of (1) all cases in which the expert has testified in either deposition or trial in the last 4 years and (2) all publications authored by the expert in the last 10 years. Finally, the expert is required to disclose how much he or she has been paid to prepare the report. Some attorneys and experts interpret this last requirement to only require a disclosure of the billing rate of the expert.
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There is no legal requirement, in either the FRCP or any state rules of civil procedure, that expert reports comply with (1) the Uniform Standards of Professional Appraisal Practice put forward by The Appraisal Foundation or (2) the standards propounded by other professional organizations, such as the American Institute of Certified Public Accountants (AICPA), the American Society of Appraisers, the Institute of Business Appraisers, or the National Association of Certified Valuation Analysts. The question of how professional standards should be addressed in litigation has been a topic of concern for all of these organizations. For example, the AICPA Professional Standards provide an exemption from certain other standards for work prepared for litigation. The AICPA exempts experts in litigation from other standards because experts in litigation are subject to thorough examination by all the parties at interest. In contrast to the litigation setting, other AICPA standards apply to situations where other parties may use a report without the opportunity to fully examine the expert. A similar debate is currently taking place in the valuation profession. Many valuation analysts are concerned about the provisions in USPAP, especially those concerning departure from compliance. Many valuation analysts are also concerned that USPAP and appraisal standards, in general, do not clearly distinguish between, or define (1) a valuation that constitutes an appraisal, subject to USPAP and other professional appraisal standards and (2) a valuation prepared for a financial analysis that does not constitute an appraisal, nor is subject to these standards. Certain portions of the record-keeping provisions in the Ethics Rule of USPAP, as follows, also concern analysts: The workfile must include . . . true copies of any written reports, . . . summaries of any oral reports or testimony, or a transcript of testimony. . . . An appraiser must retain the workfile for a period of at least five (5) years after preparation or at least two (2) years after final disposition of any judicial proceeding in which testimony was given, whichever period expires last. . . .23 It is not common practice for damages analysts to keep copies of their reports, their prior deposition transcripts, or trial testimony transcripts (except to comply with the FRCP 4-year requirement), after the final disposition of a litigation matter. By final disposition, we mean that the parties have reached a binding settlement, or the court has issued a verdict and judgment and no avenues remain for appeal. Documents are always retained with matters that are pending; however, these are confidential due to the ongoing nature of the disputes. Typically, document retention is governed by the client’s instructions and by confidentiality agreements. It appears, however, that, in the absence of any legal proscription against the release of these documents, any damages study that an analyst claims to have prepared in accordance with USPAP will need to be kept available in compliance with the Ethics Rule. In any subsequent litigation, opposing counsel may demand that these documents be produced. In the case of an expert report concerning economic damages, although the substantive requirements of USPAP may be useful or constitute good practice, compliance is not required. The principal problem with USPAP compliance in an expert report on damages is that some of USPAP’s specific requirements may be less
23 Uniform
Standards and Principles of Appraisal Practice (USPAP) (Washington, DC: The Appraisal Foundation, 2003).
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relevant, or of a lower priority, than the principal issues of fact to be decided by the trier of fact. For example, under the proposed revisions to USPAP, Standards Rule 10-2 requires that every Appraisal Report and Restricted Use Appraisal Report “state information sufficient to identify the business or intangible asset appraised.”24 In contrast to USPAP, the inclusion of this information in an expert report on damages is not a requirement and the expert’s judgment may be that this information is not pertinent to the opinion and needlessly distracts from the opinion. A common abuse of valuation standards, used by some damage analysts, is to make an unspecified blanket claim that an opposing expert’s damage study fails to meet professional standards because it does not comply with USPAP. However, even if the legal process devoted the time necessary to determining that a specific step in the expert’s analysis was a failure to strictly comply with USPAP in a particular litigation situation, the consequence may be trivial to the outcome. For example, any report that does not explicitly state its compliance with USPAP is, by definition, not in compliance with USPAP. In contrast, a reasonable use of USPAP in rebuttal would be to point out how specific omissions or departures from USPAP have resulted in a substantive error in the opinion. In one example, an expert used a selection of valuation pricing multiples from purportedly “comparable” sales transactions to argue that plaintiff had not, as claimed, overpaid for the purchase of the formula, trademarks, and trade dress of a brand of shampoo. An examination of these sales transactions found that they comprised a hodge-podge that grouped together sales of entire, going-concern enterprises with (1) sales of equity, (2) sales of various collections of assets, and (3) sales of various intangible assets. Generally accepted valuation practice, as evidenced by USPAP Standards Rule 9-1, is to carefully define the property being valued. And, the failure to follow this practice in the expert’s selection of comparable sales had produced a misleading analysis. The extent to which the analysis was misleading was demonstrated by using more complete information about the comparable sales. The failure to define the property produced a substantive error in this instance, not just a failure to comply with USPAP. Many damages analyses that purport to comply with USPAP, in fact, do not comply with USPAP. For all the legal time and effort that can be spent interpreting standards and whether they apply in a specific litigation situation, it is, perhaps, more effective to simply not mention USPAP in an economic damages expert report. If the standards of performance that are identified by USPAP are appropriate in any specific expert witness situation, they will speak for themselves.
Use of Legal Precedent Many business valuations are prepared for taxation-related purposes. The tax practitioners who engage valuation analysts in these matters are themselves experts in tax law. Tax practitioners rightfully try to be advocates for their client’s legal positions and interpretations of tax law. As a result, business valuations prepared for tax purposes tend to emphasize legal precedent as justification for various factual 24 Ibid.
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positions, such as the adjustments made for discounts. For example, a business valuation prepared for tax purposes may apply certain valuation discounts and/or premiums and may cite cases in which these adjustments were allowed. However, in a damages report, it may be more effective to provide empirical evidence that the selected discounts and/or premiums are of an appropriate size and are independent and additive, so that the aggregate discount concluded in the report is found to be reasonable. Generally, when prepared for most taxation-related purposes, business valuations that result in lower values usually result in lower taxes due. Consequently, arguments for business valuation methods and types of discounts that result in lower values and lower taxes may tend to be emphasized in taxation-related business valuation assignments. Implied advocacy, however, creates problems in damages testimony if the damages analyst provides services for both plaintiffs and defendants. For example, assume that a damages expert is proving a damages estimate for a plaintiff in litigation. The defendant’s attorney may introduce prior inconsistent testimony or approaches used by that expert in a previous litigation in an effort to impeach the damages expert. If the damages analyst finds it appropriate to take an opposite position or to use an inconsistent approach, then the analyst should be prepared to explain the rationale for such change in his or her opinion. The change may not be an inconsistency, but rather a result of the different factual situations of the two cases. The difference in approach may be deliberate as a result of the further learning of the damages analyst. And, the analyst may be willing to admit that had he or she possessed this knowledge in the earlier case, he or she may have used a different approach in that prior case. Different jurisdictions may have different statutes or case law that affect the appropriate measure of damages in a particular litigation. It may be appropriate for the analyst and counsel to discuss what statutes or case law may affect the analyst’s choice of damages approaches or measures. Analysts may use case precedent to understand the required legal tests, but should use empirical data to determine the fact and amount of damages. There is little case law or statutory authority as to what is an acceptable method or approach to estimate economic damages. The method or approach used by the damages analyst is generally considered by the courts to be a question of fact that is unique to the particular case in question. Generally, the courts are reluctant to generate procedures as to how to compute economic damages. This is because there are so many unique factual situations that make it nearly impossible to arrive at procedures that will apply in every situation. In the Daubert decision, the U.S. Supreme Court provided guidance to federal judges to reject expert testimony that is “junk science.”25 The Daubert decision is used to exclude damages expert testimony because the method or approach of the expert was considered inappropriate science. The science of damages analysis is a soft science. It may be a blend of many disciplines, including economics, statistics, marketing, accounting, and finance. There are no peer-reviewed journals related to damages analysis except, perhaps, in the employment damages area. Therefore, it is difficult for a federal judge to know whether the expert’s peers would generally accept a damages expert’s approach and assumptions or not. It is an infrequent
25 Daubert v. Merrill Dow Pharmaceuticals, Inc., 509 U.S. 579 (1993). This case was extended to other “technical” and “other specialized” knowledge by Kumho Tire Ltd, et al. v. Patrick Carmichael, et al. 119 S.Ct. 1167 (March 23, 1999).
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situation where a damages expert’s opinion is excluded under Daubert. In addition, not all state courts follow Daubert. Rather, they may have their own guidelines for admission of scientific evidence.
Conclusion Economic damages often require—or may benefit from the use of—generally accepted business valuation approaches and methods. Both disciplines rely particularly heavily on income approach valuation methods. This chapter discussed many of the important differences between economic damages analysis and business valuation analysis. Damages analysts need not consider more than one approach or method. And, they need not limit their examination to data that were available prior to the valuation date. The preparation of the work product of an economic damages assignment is not necessarily governed by the Uniform Standards of Professional Appraisal Practice. It is more likely governed by the legal rules of the jurisdiction in which the testimony will be heard. Economic damages are typically suffered during a distinct period of time. Therefore, the damages analysis does not usually rely on the perpetuity assumption that is typically part of a business valuation analysis. Furthermore, the treatment of income taxes in the damages analysis may be different from that in the business valuation. Any valuation analyst who is asked to express an opinion regarding economic damages should be careful to recognize the many differences between these two disciplines.
Part IV
Intellectual Property Valuation Issues
Chapter 14 Intellectual Property Income Projections: Approaches and Methods Jacquelyn Dal Santo
Objective of Intellectual Property Income Projection Reliability of Income Projections Alternative “Scenario” Income Projections Extrapolation Methods Linear Extrapolation Method Multicollinearity Curvilinear Extrapolation Method Multiple Regression-Based Extrapolation Method Tabula Rasa Methods Life Cycle Analyses Product Life Cycle Stages Product Life Cycles Vary in Length Sensitivity Analyses Simulation Analyses Judgmental Methods Summary and Conclusion
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Objective of Intellectual Property Income Projection The income approach to intellectual property valuation/damages/transfer price analyses focuses on the income-producing capability of the intellectual property. The value/damages/transfer price of an intellectual property can be measured as the present value of the economic benefit or the economic loss to the owner/operator over the intellectual property’s expected remaining useful life. The economic benefit or loss is usually measured as either the net income or the net cash flow that is received or lost by the owner/operator over the expected remaining useful life of the intellectual property. The income approach provides a systematic framework to estimate intellectual property value, economic damages, or transfer price. This systematic framework is based on either the direct capitalization or the yield capitalization (i.e., the present value) of future economic income from the use, forbearance, license, or other exploitation of the intellectual property. One of the most important—and complex—procedures in the income approach is the projection of economic income subject to either direct capitalization or yield capitalization. This chapter is devoted to understanding the different models that can be used by the analyst either (1) to develop a projection of intellectual property economic income or (2) to review a projection prepared by others. According to Valuation of Intellectual Property and Intangible Assets, the total value of an intellectual property is based on three components:1 1. The current and/or anticipated applications of the intellectual property 2. Logical extensions of the intellectual property 3. Speculative extensions of the intellectual property As an illustration, let’s assume that it is 1980, and Microsoft Corporation is still in the early stage of its corporate development. At that time, the value of the Microsoft trademark may include the already existing market for the Microsoft operating system language. A logical extension of the Microsoft trademark may involve the production and distribution of application software. And, further, more speculative extensions of the Microsoft trademark may encompass the production and distribution of business-specific computer programs. Since each of the three components of the Microsoft trademark value relies heavily on future expectations, the associated economic income projection should be as accurate and as well supported as possible. In this section, we will examine methods commonly used by analysts (1) to project future intellectual property economic income and (2) to test these projections for validity. Many of these methods are quantitative in nature. Accordingly, the reader may have to refer back to a college statistics textbook to fully explore the mathematics of some of these methods. We have attempted to extract the practical application of these methods to intellectual property analysis—without getting bogged down with the theorems and formulas underlying the statistical modeling. As mentioned above, the economic income projections should reflect the commercialization strategy for the subject intellectual property, including any product extensions and/or alternative usage for the property. For example, the Italian fashion
1 Gordon V. Smith and Russell L. Parr, Valuation of Intellectual Property and Intangible Assets, 3d ed. (New York: John Wiley & Sons, Inc., 2000), pp. 271–275.
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designer Versace created a line of China tableware based on its design of a gown worn by actress Jennifer Lopez at the annual Grammy Awards. Also, the Eddie Bauer Company allowed its name to be placed on a special edition of a sports utility vehicle manufactured by the Ford Motor Company. In the Versace example, the value of the Versace trademark is not only associated with designer fashion, it is now being commercially exploited in the housewares industry. In the value/economic damages/transfer price analysis of the Versace trademark, the analyst would consider likely future marketing and product extension programs. Such consideration would likely include an analysis of the respective profitability and probability of success or failure of each likely product or program extension. The analyst may confer with the intellectual property owner/operator when considering the effects of these factors on future economic income: •
•
•
•
Economic climate—including the cyclicality of the business of which the subject intellectual property is a part, the outlook of the relevant industry and economic sector, expected inflation trends, expected product/service demand, expected product/service pricing pressures, etc. Profitability—income generation for all intellectual property services, including use/license of patents or trademarks; use/license of software and other copyrights; and use of customer lists, databases, operational systems and procedures, and other trade secrets. For example, consider a company that manufactures and sells digital cameras. The company may protect the product’s innovations by patenting the camera design. The profit of this company is derived from the revenues from the product sales (1) less the expenses necessary to create/ maintain the innovative design of the camera and (2) less all normal manufacturing, marketing, and administration expenses. Competition—strategies of owner/operators that use competing intellectual properties can limit the amount, duration, and trend of future economic income of the subject property. Changes in capital investment—increased capital investments may be needed for new plant, property, and equipment in order to commercially exploit an intellectual property. Or, the intellectual property may involve a new streamlined production or distribution process that reduces expected expenditures for plant, property, and equipment.
The fundamental components of an intellectual property economic income projection include the following: • • •
The absolute amount of the future income stream The growth (or decline) rate of the future income stream The timing of the future income stream
The typical methods used in intellectual property economic income projections include the following: • • • • • •
Extrapolation Tabula rasa Life cycle analyses Sensitivity/scenario analyses Simulation analyses—Monte Carlo Judgmental methods Each of these methods will be described and illustrated in this chapter.
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Once the initial income projection is made, the next step in any intellectual property income approach analysis involves the interpretation of the projection results. This procedure can be difficult due to the analytical complexity of some income projection methods. However, this procedure is important because it allows the analyst to develop confidence in the income projections. In this procedure, the analyst will apply reasoned judgment to weight the facts, perceived trends, and owner/operator-provided information in the process of finalizing the income projection. The analyst will typically spend considerable time and effort in preparing and supporting the intellectual property income projection. Income projections developed using commonly used models and methods will be validated and compared in the following section of this chapter.
Reliability of Income Projections As with any analysis, the quality of the supporting resources will influence the quality of the intellectual property income projection. It is the analyst’s responsibility to obtain or develop relevant and reliable information and data in order to produce a comprehensive and supportable income projection. The projected income or loss related to intellectual property value/damages/transfer price is often developed by reference to information provided by the property owner/operator. That information may include historical income statements, financial projections and budgets, new product/project analyses, marketing forecasts, strategic plans, and so on. The information provided by the owner/operator is combined with the analyst’s (1) independent research on the appropriate marketplace, (2) assessment of the economic outlook of the relevant industry and geographical region, and (3) understanding of the subject intellectual property and its income-generating potential. Before preparing any projections, the analyst should consider how the subject intellectual property generates income. An intellectual property can generate income in the following ways: 1. The use of the property 2. The ownership of the property 3. The forbearance of use of the property How an intellectual property generates income may influence the selection of the analytical method and/or the measure of economic income used in the analysis. The concept of an intellectual property generating income through its use is easy to understand. For example, the use of patents, copyrights, trademarks, and trade secrets is common in the operation of a going-concern business. In addition, the owner of an intellectual property can generate economic income by licensing the use of the property to other business operators. The typical intellectual property income projection will consider both sources of income: operating income to the property operator and licensing income to the property owner. The analyst will examine the historical income generation of the subject intellectual property. However, the historical intellectual property income generation may or may not be a reasonable predictor of the property’s future income-generating capacity. This is because in intellectual property licenses, sales, and other transfers, the hypothetical investor is buying the future, not the past.
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The analyst will also consider the time period over which to project the intellectual property income. The reliability of the projection may be affected by the selected time frame used in the analysis. This is because many intellectual properties do not have a residual value at the end of the discrete income projection period. For example, if a pharmaceutical product patent has 12 years remaining of its legal life, the analyst may or may not consider the income potential over the entire remaining 12-year life. Depending on the facts and circumstances of the case, the periodicity of the projection period (i.e., monthly, quarterly, semiannual) may affect the analysis of the value/damages/transfer price. For example, consider an intellectual property that will generate a level of income that is substantially disparate from month to month. In this case, the use of monthly periods in the discrete projection may improve the accuracy of the economic income projection. The projection of intellectual property economic income can be subject to several types of forecast errors. First, projections of economic income are subject to bias, including (1) the use of unrealistically optimistic or pessimistic expectations of a biased owner/operator and (2) the misuse of economic variables or comparative sale/license transaction data. For example, analysts often use royalty rate or license fee transactional data from arm’s-length licenses of guideline intellectual property in valuation/damages/transfer price analyses. Without the appropriate due diligence analysis and normalization adjustments, the guideline intellectual property royalty rates may not be applicable to the subject analysis. Second, income projections are subject to unintentional forecast errors (i.e., honest mistakes). It is relatively easy for an analyst to make an honest mistake with regard to an income projection variable. However, the resulting forecast error can have a material impact on the final value/damages/transfer price conclusion. Third, the economic conditions in effect at the time of the guideline intellectual property sale/license transactions may not reflect the economic conditions in effect as of the analysis date. Accordingly, the analyst should consider adjusting guideline transactional data for changes in economic conditions. Once all the income projection data (both qualitative and quantitative) are gathered, it is useful to assess the probability associated with each projection. This probability assessment procedure is related to the final selection of the income projection variables and may be either explicit or implicit. This probability assessment procedure is useful in any income approach analysis for two reasons: (1) it helps to ensure a complete itemization of all of the economic income variables and components of the projection and (2) it helps the analyst to convert qualitative factors into quantitative income projection variables. Consideration of probability-adjusted, riskweighted values to each projection variable also involves the selection of alternative data inputs for purposes of performing a sensitivity analysis. The use of sensitivity analysis in an intellectual property income approach analysis will be discussed later.
Alternative “Scenario” Income Projections In an income approach intellectual property analysis, economic income is often projected for many years. Depending on the purpose of the analysis, the projection period can be the term of a license, remaining useful life of the property, the period of actual or expected lost profits, or some other period. Almost certainly, the analyst’s
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specific intellectual property income projection will never actually be realized. For this reason, the analyst may analyze several alternative income projection scenarios. The most common alternative scenario analysis is to prepare and compare the “most likely,” “best case,” and “worst case” income projection scenarios. The procedures related to the development of alternative income projection scenarios are discussed below. First, the analyst will develop the “most likely” income projection scenario. In this scenario, the analyst will consider many factors affecting the projection including, but not limited to, the following: 1. The general economic and industry market conditions 2. The most likely effect of the defined commercialization strategy of the subject intellectual property 3. All relevant historical financial/operational information 4. The owner/operator’s pro forma financial budgets or projections The result of the “most likely” scenario is the analyst’s best estimate of income projection for the subject property. Second, starting with the “most likely” scenario as a benchmark, the analyst will develop alternative income projection scenarios. The analyst will consider alternative general economic market conditions (such as inflation rates), competitive environments, industry trends, and so on. The analyst may also consider alternative owner/operator intellectual property commercialization strategies in the income projection scenarios. The analyst may also consider changes in intellectual property development/marketing management, the probability of achieving various levels of market penetration, the effect of various cost/volume/profit relationships, and so on. The development of alternative scenarios—with corresponding alternative income projections—allows the analyst to estimate (1) the maximum potential upside income projection (i.e., best case) as well as (2) the maximum potential downside income projection (i.e., worst case). For example, Exhibit 14.1 presents three alternative income projection scenarios related to an illustrative patent. These alternative scenarios were created based on alternative owner/operator decisions regarding how much to spend on sales and Exhibit 14.1
Creative Patent Company Income Statement ($000s) Alternative Income Scenarios for Very Important Patent #501 Most Likely Scenario Total revenues Cost of goods sold Gross profit Operating expenses Selling and marketing General and administrative Interest expense Total operating expenses Operating income Income tax provision (35%) Net income
%
Best Case Scenario
%
Worst Case Scenario
%
55,000 27,150 27,850
100 49 51
66,000 31,000 35,000
100 47 53
44,000 23,000 21,000
100 52 48
4,200 1,925 800 6,925 20,925 7,324 13,601
8 4 1 13 38 13 25
4,500 1,825 700 7,025 27,975 9,791 18,184
7 3 1 11 42 15 28
3,500 2,150 900 6,550 14,450 5,058 9,393
8 5 2 15 33 11 21
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marketing, product sourcing, administrative expenses, financing costs, and so on. This example presents a simple but useful tool for creating an income projection model, without the use of the more rigorous statistical models discussed in the following sections.
Extrapolation Methods Income projection extrapolation methods are typically based on (1) the identification of historical trends and (2) the extrapolation of these trends into the future. These observations regarding extrapolation methods are true for income projections related to intellectual properties, as well as income projections related to other types of assets, properties, and business interests. These observations regarding extrapolation methods are also true for income projections performed for purposes of valuation, economic damages, and transfer price analyses. Most extrapolation methods extend historical trends into the future based on the following relationships: 1. A linear relationship between projection variables 2. A curvilinear relationship between projection variables 3. Multivariate relationships between two or more projection variables We will discuss the practical implications of these three common relationships for purposes of extrapolating historical trends in an intellectual property income projection.2
Linear Extrapolation Method When two projection variables—let’s call them X and Y—relate to one another (as in the equation below), we say that the relationship is linear and deterministic. A linear relationship can be illustrated by the example of a simple supply curve. Supply decisions typically depend on profit potential. Because profit is the simple difference between revenues and production/operating costs, supply is likely to react to both changes in revenues and changes in production/operating costs. Therefore, typically we can observe a linear relationship between (1) the quantity of a good or service supplied and (2) the price of the good or service. This linear relationship can be expressed mathematically in the following equation: Y = b0 + b1X where Y = the point on the fitted line that corresponds to a specific X value b0 (Intercept) = the estimated value of variable Y when variable X is equal to 0 b1 (Slope) = the variable Y changes by b1 each time variable X is increased or decreased by 1 unit, while holding all other variables constant X = the independent projection variable 2 Jay B. Abrams, Quantitative Business Valuation: A Mathematical Approach for Today’s Professionals (New York: McGraw-Hill, 2001), pp. 22–55.
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For example, in Exhibit 14.2, let’s consider the supply curve for ABC Software Company. ABC Software Company produces a copyrighted proprietary software product. As the price of the subject software increases, ABC will supply (i.e., produce and distribute) more software packages. The slope of the supply curve is positive. For illustrative purposes, let’s assume that the equation for this ABC Software Company supply curve is: Y = 10 + 4X where Y = quantity (i.e., number of units) of ABC software packages supplied to the marketplace b0 = 10 (i.e., the Y intercept) b1 = 4 (i.e., the slope of the projection line) X = the unit price of the ABC software product Based on this linear relationship, the corresponding quantity of software products supplied at various unit prices can be projected. For example, based on this illustrative linear extrapolation model, the ABC software product supply projection follows: If X = $10 price per unit, then Y = 50 software product units supplied. If X = $20 price per unit, then Y = 90 software product units supplied. If X = $50 price per unit, then Y = 210 software product units supplied. In the above example, there is a deterministic linear relationship between product price and quantity of product supplied. Therefore, for any given product unit price, a corresponding quantity of product units supplied can be estimated using the indicated linear extrapolation relationship. When projecting income generated by an intellectual property, analysts often find linear extrapolation to be an effective projection method. For example, in analyzing alternative income projection scenarios, an analyst may use the linear extrapolation method as illustrated below. Exhibit 14.2
Description of a Simple Linear Relationship—Supply Curve for ABC Software Y
Quantity (units)
Y = β0 + β1X
Slope = β1
Intercept
Price ($)
X
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Let’s assume that Sweet Heart is a producer of angioplasty devices. As a result of a patent infringement by one of its competitors, Sweet Heart is unable to implement its plan to use a new cost-saving component in the manufacture of its patented device. Further, let’s assume that there has been a recent breakthrough in medical procedures that would increase the demand for the Sweet Heart angioplasty device. As part of an infringement-related economic damages calculation, let’s assume the analyst will estimate the amount of income (measured here as cost savings) lost by Sweet Heart as a result of the patent infringement. In this example, the analyst has concluded that there is a linear relationship between cost savings and production volume. The analyst has quantified that linear relationship as presented in the following equation: Y = b0 + b1X where Y b0 b1 X
= = = =
dollar amount of cost savings $50,000 (i.e., the Y intercept of the extrapolation line) 2 (i.e., the slope of the linear extrapolation line) quantity (i.e., number of units) produced
Accordingly, the actual linear relationship between the cost savings Y and the amount of production volume X (in units) is represented by the following expression: Y = 50,000 + 2X Based on the expected level of demand for the angioplasty device, the Sweet Heart marketing manager estimates various levels of production volume. Using (1) the linear extrapolation method and (2) the specific algebraic expression indicated above, the analyst estimates the amount of lost income (i.e., lost cost savings) under various alternative production volume scenarios. For example, if X = 100,000 units produced, then Y (dollar amount of cost savings) = $250,000 and, if X = 150,000 units produced, then Y (dollar amount of cost savings) = $350,000. Using the linear extrapolation method of income projection, the analyst should first identify the existence of a relationship between the dependent variable and the independent variable. In the linear extrapolation method, the analyst should be able to determine the line of “best fit.” The line of “best fit” can be drawn on a graph of observed data points and will provide an estimate for the “true” relationship between the two (i.e., the dependent and the independent) variables. As the “best fit” extrapolation line, the analyst will typically select the line that minimizes the sum of the squares of all the vertical deviations. (See Exhibit 14.3.) The linear extrapolation method is particularly useful as an income projection method where there is a well-established historical relationship between the dependent variable and an independent variable. The linear extrapolation method may appear to be a simple method for projecting intellectual property income. As with any income projection method, the naïve application of the linear extrapolation method can result in forecast errors. The application of the linear extrapolation method is often limited, since more than one variable (such as industry, product, or service competition; owner/operator marketing strategies; or technological/functional obsolescence) may influence the projected income—that is, the dependent variable. For example, assume that the income earned by BIG Pharmaceutical Company is influenced by both the amount of company research and development (R&D)
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Exhibit 14.3
Scatter Diagram Y Y = β0 + β1X
u Slope = β1 β X
expenditures and the level of expertise of the scientists employed by the company. Thus, if Y = company income and X = company R&D expenditures, then income is a function of (1) the slope of the extrapolation line times company R&D expenditures and (2) some level of fixed cost (i.e., the Y intercept of the extrapolation line) and (3) a disturbance factor (called the random variable). The disturbance factor incorporates the amount of intellectual property income resulting from the expertise of company scientists. Based on this assumed set of facts, the equation below presents the linear relationship that an analyst can use to extrapolate the income earned by BIG Pharmaceutical Company. Y = b0 + b1X + u where Y b0 b1 X u
= = = = =
income the Y intercept of the extrapolation line the slope of the extrapolation line company R&D expenditures the random variable (in this example, the level of company scientific expertise)
For this example, assume that the analyst has collected the historical data presented in Exhibit 14.4. The analyst first plots the X and Y data points on a twodimensional grid. The analyst can then observe from this scatter diagram the degree (strength) and nature (form) of the historical relationship between X and Y variables. However, in the equation presented above, the value of the Y variable is not entirely deterministic, or not completely determined by the independent X variable alone. In the above equation, Y is determined in part by the independent variable X and in part by the random disturbance term, u. Therefore, in the above example, BIG Pharmaceutical Company income (i.e., the Y variable) is determined in part by (1) the amount of R&D expenditures (i.e., the X variable) and by (2) the output and/or creative ability of the scientists employed (i.e., u). Since u is a random variable, there will not be a single value for the Y variable
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Exhibit 14.4
Alternative Values of Y for a Given Value of X When the Relationship Is Y + 10 + 2X + u and u Is a Random Variable Number of Historical Data Observations
Value of Independent Variables X (R&D Expenditures) (Millions)
B0
1 2 3 4 5 6 7 8 9 10
5 5 5 5 5 5 5 5 5 5
10 10 10 10 10 10 10 10 10 10
B1
Value of Random Factor u (Scientific Output)
Value of Dependent Variable Y (Revenue Millions)
2 2 2 2 2 2 2 2 2 2
1.5 0.0 0.5 3.0 0.9 2.5 2.0 −1.0 4.0 5.0
21.5 20.0 20.5 23.0 20.9 22.5 22.0 19.0 24.0 25.0
SOURCE: Moshe Ben-Horim and Haim Levy, Statistics: Decisions and Applications in Business and Economics (New York: Random House, 1984), p. 572.
corresponding to a specific value for the X variable. Rather, there will be an entire probability distribution of Y variable values corresponding to any specific value for the X variable. Accordingly, the application of the extrapolation method in an actual intellectual property income projection problem requires a rigorous and thorough analysis of the relationships between all of the income projection variables.
Multicollinearity When making income projections using either an extrapolation method or a regression method, there is often more than one explanatory (or independent) variable that can predict the value of the dependent variable. When the association between the explanatory variables increases, the confidence we have in the estimated slope coefficients decreases. In other words, the greater the association between the X1 and X2 variables, the greater are the standard errors for each observation. This means also that when the association between the explanatory variables increases, the confidence we have in the estimated slope coefficients decreases. This is because their values depend more heavily on the particular observations that happen to be in the sample. Therefore, when the association between the X1 and X2 variables is very high (a condition called multicollinearity), the analyst may be better off including only one of the independent variables in the extrapolation or regression analysis (and ignoring the other independent variable). For example, if (1) Y equals the BIG Pharmaceutical Company income, (2) X1 equals the number of scientists employed, and (3) X2 equals the total expense for the scientists’ wages, it is likely that independent variables X1 and X2 will be highly associated. In this situation, a multicollinear relationship exits. The inclusion of
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both the X1 and X2 independent variables in a regression analysis could decrease the statistical significance of the regression results. We can further illustrate a multicollinearity relationship by describing actual research results. It is axiomatic that a positive relationship exists between the rate of return that an investor expects on a stock and the risk associated with the stock. In other words, the greater the investment risk involved, the greater the rate of return the investor expects to obtain from the investment. While there is general agreement concerning this investment principle, there is less agreement regarding the best way to measure investment risk. Two common measures of investment risk are (1) the variance of the annual rates of return (s 2) and (2) the beta coefficient (b). Beta measures the relationship of a security’s rate of return to the average rate of return on the entire market. Let’s consider a sample of 100 securities. For each security, let’s assume we calculate in three separate regression analyses: (1) the average annual rate of return over a period of 20 years and (2) the two above-indicated measures of investment risk—variance and beta. In each regression analysis, let’s first use each investment risk measure by itself. Then, let’s combine the two investment risk measures and determine the statistical significance of the estimated slope coefficients. Let’s assume that the equation for each of the three regression analyses is as follows: 1. Average 20-year rate of return = b0 + b1(RISK1) 2. Average 20-year rate of return = b0 + b1(RISK2) 3. Average 20-year rate of return = b0 + b1(RISK1) + b2(RISK2) The statistical significance for each equation is calculated as follows: 1. Statistical significance for s 2 = 5.1 2. Statistical significance for b = 7.7 3. Statistical significance for combined s 2 and b = 0.90 The principal reason why the statistical significance in the third regression equation decreases is the association between the variables s 2 and b. The correlation coefficient between s 2 and b is +0.69. We recall from principles of statistics that if two variables are independent, their correlation coefficient equals zero. The more the correlation coefficient approaches 1.0, the more closely the variables are correlated. The analyst should recognize that if there is a strong association between explanatory variables (i.e., multicollinearity exists), then a careful examination of the significance of the regression coefficients should be performed. In such instances, the analyst may consider the exclusion of an independent variable that is highly correlated with other independent variables.3
Curvilinear Extrapolation Method The curvilinear extrapolation method is useful when a scatter diagram of data points indicates a nonlinear relationship between the dependent variable and the independent variable. In other words, the analyst needs to fit a curve (and not a straight
3 Moshe Ben-Horim and Haim Levy, Statistics, Decisions and Applications in Business and Economics (New York: Random House, 1984), pp. 676–678.
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line) to the observed data points. The curvilinear extrapolation method is based on a relationship between the dependent variable and one or more explanatory independent variables that is described by a polynomial function. The polynomial function is capable of the type of curvature presented in Exhibit 14.5. For example, let’s assume that the company Soft ’n Bake, Inc., produces six types of computer software programs used to manage bakeries. Soft ’n Bake sells primarily Program F, the least expensive of all the software packages, via the Internet. The Soft ’n Bake marketing director thinks that Program F is purchased primarily by smaller local bakeries and by home-based bakeries. The marketing director believes that the price of Program F is a strong determinant of sales. She believes that as the price increases, potential customers will perceive the need to see a product demonstration and will meet with a Soft ’n Bake sales representative. The Soft ’n Bake market research department recently conducted a study on the usage of Program F to determine average product price and bakery sales. The results of that study are presented in Exhibit 14.6. The relationship between product price and bakery sales presented in Exhibit 14.6 is illustrated in Exhibit 14.7. This relationship does not appear to be linear. Rather, the relationship is curvilinear. The shape of the relationship is parabolic. The equation below is the formula for a parabola. This type of equation is often referred to as a quadratic function. In regression analysis, this type of equation is called a second-order polynomial equation with one independent variable. Y = b0 + b1X1 + b2X2 The curvilinear extrapolation method may be appropriate for projecting expected income when the data point scatter diagrams depict nonlinear shapes. In some cases, the relationship between the independent variables themselves may not be linear. When that occurs, a graph of the relationship between the independent variables will depict a curve instead of a straight line. If there is a curvilinear relationship between two or more independent variables, then a simple linear extrapolation method is not appropriate. Rather, a curvilinear regression model may be appropriate to define the relationship between the dependent (e.g., income projection) variable and the independent variables. Polynomial regression can be used to fit a regression line to a curved set of data points. Contrary to the implications of its name, the curvilinear regression method uses a linear model to fit a curved line to a curved set of data points. Curvilinear regression uses various transformations of variables to achieve a fit to the regression line. The reader may want to consult an intermediate level principles of statistics textbook to learn more about curvilinear regression analysis and methods.
Exhibit 14.5
Curvilinear Graphs
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Exhibit 14.6
Number of Units Sold and Product Price for 35 Sales of Program F Sale No.
Product Price X
Number of Units Sold Y
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
$1.95 $3.20 $21.30 $12.95 $8.00 $11.00 $1.00 $27.45 $5.95 $17.00 $4.90 $25.00 $6.95 $17.00 $9.95 $23.00 $14.10 $20.00
123 137 105 181 160 158 92 20 178 144 143 70 155 130 170 79 150 120
Sale No. 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35
Product Price X
Number of Units Sold Y
$4.35 $5.00 $16.00 $10.00 $30.00 $15.00 $11.00 $12.00 $28.00 $22.00 $9.00 $5.00 $16.00 $11.95 $9.50 $4.55 $15.95 $456.00
158 164 157 161 —– 140 177 155 2 82 155 150 150 163 158 134 144 4565
Exhibit 14.7
Scatter Diagram, Number of Sales and Product Price for Soft ’n Bake Software 200 180
Number of Unit Sales Y
160 140 120 100 80 60 40 20 0 $0
$5
$10
$15
$20
Product Price X
$25
$30
$35
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Multiple Regression-Based Extrapolation Method Regression analysis is a quantitative procedure to assist in the estimation of functional relationships between quantitative variables. In such an analysis, the analyst is attempting to predict the value of the Y variable given a specific value for the X variable. By using regression analysis, the analyst can determine whether a relationship exists between the dependent variable and independent variable. In addition, a regression analysis will indicate both (1) the direction of change and (2) the amount of the change that can be expected in the dependent variable when the independent variable changes. Regression analysis also provides the means of assessing the magnitude of the sampling error of the dependent variable estimate. In other words, regression analysis may be used to make statistical inferences. Since projections of intellectual property income may be quite complex, accuracy in the estimation of the dependent variable can often be achieved only if more than one explanatory variable is considered in the analysis. For example, the royalty rate paid to license a patent for a new pet care product may depend on several factors including (1) the exclusivity of use in a specific territory, (2) the price of the new pet care product in relation to the price of competitive products, (3) the market penetration of the subject patented product, and (4) the profitability of the patented product. In the following example, multiple regression analysis will be used to estimate the appropriate royalty rate for Primo Pet Care Company to charge for the license of its new pet care product. In multiple regression analysis, the dependent variable is linearly related to a set of explanatory or independent variables, as illustrated in the following equation: Y = b0 + b1X1 + b2X2 + … + bkXk where Y = the dependent variable X1, X2,…, Xk = the independent variables b0, b1, b2 … bk = the parametric regression coefficients In this example, as presented in Exhibit 14.8, there are 11 observations of actual royalty rates associated with the license of pet care products. In each observation, the independent variables (i.e., profit margin, market penetration, price differential, and territorial exclusivity) are tracked and regressed against the actual royalty rate observed. Using the parametric regression coefficients calculated in the Summary Output section of Exhibit 14.8, the predicted royalty rate for each observation is calculated. Using (1) these same parametric regression coefficients and (2) the independent variable related to Primo Pet Care Company patent, a royalty rate can be estimated for the subject product license. For example, if the Primo Pet Care Company product has a 15 percent profit margin, a 10 percent market penetration, a negative 5 percent price differential with its competitive products, and Primo will not grant an exclusive territory license, then the estimated royalty rate for a license of the Primo product is 4.26 percent. Most multiple regression analyses with two or more independent variables involve too much calculation for a pencil and paper calculation. For this reason, the analyst is advised to use a software application that is designed for multiple regression analysis. A software application can assist the analyst in projecting intellectual property income where two or more explanatory variables predict the value of a dependent
370
15.00 35.00 20.00 6.00 12.00 10.00 50.00 5.00 14.00 12.00 8.00
14.00 20.00 18.00 8.50 12.00 9.50 11.00 7.00 20.00 12.50 9.00
Variables Intercept X Variable 1 X Variable 2 X Variable 3 X Variable 4
Coefficients 0.214475395 0.2445053 0.050875728 0.026271125 0.39969232
10.00 5.00 −5.00 −10.00 3.00 −2.50 4.00 −2.00 5.00 −8.50 6.00
Price Differential %
Regression Statistics Multiple R 0.998456649 R Square 0.996915681 Adjusted R Square 0.994859468 Standard Error 0.118577077 Observations 11
Summary Output
Market Penetration % 1 1 0 1 0 1 0 0 1 1 0
Exclusive 1 = Yes 0 = No 5.00 7.50 5.50 2.75 4.00 3.50 5.50 2.00 6.25 4.00 3.00
Royalty Rate %
Y
5.06 7.42 5.50 2.74 3.84 3.38 5.55 2.13 6.35 4.06 2.98
Predicted Royalty Rate % 15
Profit Margin % 10
Market Penetration % −5.0
Price Differential % 0
Exclusive 1 = Yes 0 = No
Primo Pet Care Company Patent Royalty Rate Estimation Example
Multiple Regression Analysis, Primo Pet Care Company, Patent Royalty Rate Example
Actual Market-Derived Patent License Data X2 X3 X4
Profit Margin %
X1
Exhibit 14.8
4.26
Royalty Rate %
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variable. It may be helpful to refer to a principles of statistics textbook for a more in depth discussion of all of the factors involved in multiple regression analysis. Both extrapolation and regression analysis use historical observations to estimate future trends. These methods can be useful in projecting intellectual property income related to a value/damages/transfer price analysis. These statistical estimation methods, however, require a rigorous analysis of (1) each income projection variable and (2) the relationship of each variable to each other variable. These statistical methods represent one set of tools an analyst can use to project the future income potential of an intellectual property. As discussed in the next several sections, there are a variety of nonstatistical methods an analyst can also use to project the future income potential of an intellectual property.
Tabula Rasa Methods Tabula rasa is a Latin term that means “clean slate.” The idea of tabula rasa derives from the fourth century B.C. Greek philosopher Aristotle, who said, “The mind is a clean tablet upon which experience writes.” During the economic analysis of an intellectual property (particularly a development stage property), the analyst may be presented with a tabula rasa. Let’s assume, for example, that the subject analysis is to value a copyright that will be licensed or sold by the owner/developer to a third party. The copyright covers the content of video tapes and training manuals on how to operate a health club. In the initial meeting with the owner/developer, the analyst learns that the owner has never commercialized the copyrighted materials. In fact, there is no historical or projected financial information related to the subject intellectual property. The copyrighted materials were used exclusively by the owner/developer for internal training purposes with regard to the owner’s health club. Nonetheless, the intellectual property owner/developer believes that the copyrighted materials could be commercialized in the health club industry and could generate rental or royalty income. The analyst is now faced with the question of where to begin. In this situation, there is effectively a clean slate. There is no income history and no available income projections related to the subject intellectual property. The first procedure for the analyst may be to conduct extensive interviews with the owner/developer. Next, the analyst may interview the health club employees who have used the copyrighted materials for internal training purposes. The analyst may begin the investigation with questions such as the following: 1. What are the intellectual property rights subject to analysis? What are the intellectual property components and functional attributes of the property? 2. What are the operational and/or economic benefits of the intellectual property to the current owner/operator? Are those benefits different from the benefits available to a third-party buyer or licensee? Are those benefits different from the benefits expected by typical participants in the general marketplace for such an intellectual property? 3. What effect will a certain set of circumstances or events have on the utility of the intellectual property? How would the utility of the intellectual property change in response to changes in market conditions?
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4. How is the utility of the intellectual property expected to change over time? Will it change at a slow and predictable pattern or will it change suddenly, based upon a particular event? What events could cause a change in the utility of the intellectual property? What is the expected operational and/or economic life of the intellectual property? How is that expected useful life measured? What are the operational/economic consequences of a longer or shorter useful life? 5. Should the subject intellectual property be analyzed as an individual or discrete, economic entity? Or, should the subject property be analyzed as an integral part of a larger economic entity—for example, as part of a going-concern business enterprise? Does the utility of the subject intellectual property depend on the use of other assets or on the operation of a business enterprise? 6. What is the highest and best use of the intellectual property? How can the property’s highest and best use be defined? How can a third-party buyer or licensee achieve the highest and best use of the intellectual property? Will there be an adequate economic return on the required investment by a third-party buyer or licensee? 7. What is the reasonable sale price, license fee, royalty rate, or transfer price for ownership or use of the subject intellectual property? Will the reasonable sale price or license fee be different for different potential buyers/licensees? Will the reasonable sale price or license fee be different for different potential uses of the subject intellectual property?4 While this list of questions is not exhaustive, it gives the analyst a starting point for understanding the intellectual property and the factors that may affect its value. The next procedure for the analyst is to understand the marketplace in which the intellectual property will be used. The analyst should perform a detailed review of the industry in which it will operate. In particular, the analyst should consider all of the commercialization opportunities available within the industry. These commercialization opportunities include licensing the subject intellectual property through (1) geographic expansion (i.e., in new territories), (2) industry expansion (i.e., into new industries), and (3) product/service expansion (i.e., into new products or services). The analyst should examine the appropriate marketplace to determine if comparative intellectual properties have been commercialized. If so, the analyst may be able to gather information about the comparative properties in order to formulate income scenarios for the subject intellectual property. Now that the analyst’s “clean slate” is filling up with data and research, the next procedure is to use the data and research to prepare an income projection. The analyst will likely use one or more of the income projection methods that will be discussed in later sections of this chapter. For example, the analyst may use product life cycle analysis. Such an analysis would be based on information obtained (1) from interviews with the owner/developer and/or (2) from research of comparative intellectual properties currently in the marketplace. The analyst may use sensitivity analyses to test data and develop the best case, worst case, and most likely case scenarios with regard to income projections. The analyst may use simulation methods, such as Monte Carlo analysis, to test interrelated assumptions so as to determine their effect on value. The analyst may also use judgmental methods, such as rules of thumb, to test the reasonableness of income projection assumptions.
4 Robert
F. Reilly and Robert P. Schweihs, Valuing Intangible Assets (New York: McGraw-Hill. 1999), pp. xxvi–xxvii.
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The tabula rasa method requires rigorous investigation and detailed questioning of the owner/developer and of the current/potential users of the subject property. This is because the analyst is starting with a clean slate—that is, there is little or no historical information regarding the income-generating capacity of the intellectual property. This method may be combined with the other methods discussed below to assist the analyst in preparing an income projection for the subject property.
Life Cycle Analyses All intellectual properties are associated with some product or service. That product or service is the source of the economic benefits or losses by which the value/damages/ transfer price of the property can be measured. Therefore, it is necessary to associate the intellectual property with a product or service. The expected life of that product or service is an important variable to the estimation of the intellectual property value/damages/transfer price. The process of estimating the product/service life involves, first, identifying all of the factors that bear on its income-producing life in a given competitive environment. Second, the process involves making a judgment as to which factors increase or decrease the product/service life and, thereby, increase or decrease the property’s value/damages/transfer price.5 Exhibit 14.9 illustrates a typical product life cycle curve. While this income projection method is typically referred to as “product life cycle” analysis, it is applicable to income projections related to both products and services. Product life cycle theory assumes a typical pattern containing five distinct stages. These five stages are listed below: 1. 2. 3. 4. 5.
Invention/development Introduction Growth Maturity Decline
During the introductory stage, sales volume is usually low. And the price per unit of the product or service is usually high. Consumers may not be well informed as to the benefits associated with the new product/service, and a consumer education process may be required. Once proved, the product/service gains acceptance in the marketplace, and increased sales volume is generated. Product/service production techniques are improved as economies of scale from larger production volume are achieved. With patent or other intellectual property protection, above-average profits can be expected from the product/service. Without patent protection, competitive pricing pressures during the growth stage may deteriorate the above-average profit margins that would otherwise be enjoyed during the introductory stage. At the maturity stage, the overall market for the product/service is well established. At that stage, further market penetration by the product/service is expected to be slow. At the maturity stage, competitive pricing pressure becomes significant, unless there is patent or other intellectual property protection. The decline stage can begin as advances in technology introduce new product or other intellectual property service offerings that erode demand for the established product/service. Competitive pricing 5 Smith
and Parr, Valuation of Intellectual Property and Intangible Assets, p. 296.
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Exhibit 14.9
Product Life Cycle Product Development
Intro
Growth
Maturity
Decline
Volume
Sales
Profit
Time
pressure and reduced consumer demand can cause the product/service to take on the economic characteristics of a commodity.6 Of course, few products or services exactly follow such a prescriptive cycle. And, the length of each stage in the product life cycle can vary from as little as 18 months (e.g., a consumer fad like the Pet Rock) to over 100 years (e.g., gasolinepowered automobiles). The term of the typical intellectual property life cycle varies by industry and by product/service. In addition, industry-specific innovations, customer market needs, and the level of competition may change during the subject intellectual property life cycle. Also, the function of the subject intellectual property may also change during its life. For example, the Coffee-mate brand of coffee whitener was originally developed as a powder for coffee drinkers unable to keep milk refrigerated. Later on, the Coffee-mate brand was reapplied in a liquid form to meet the needs of coffee drinkers who prefer a milk substitute. When estimating the value/damages/transfer price of intellectual property, the analyst should consider both the entire product life cycle and the current stage of the product/service in its life cycle. For example, the analyst should consider: Is the product/service in a fast growing, introductory stage or in the crowded, commodity-oriented, decline stage? And, the analyst should consider how long the intellectual property-related product/service will live in each stage.
Product Life Cycle Stages Many technological, economic, and company-specific factors can affect a product/ service life cycle position. The marketing mix of the owner/operator company may 6 Ibid.,
pp. 262–263.
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change during the typical product life cycle. Customer attitudes and needs may change during the product life cycle. And, the intellectual property–related product/service may be marketed to entirely different audiences at different stages of its life cycle. For example, an automobile is a product that provides personal transportation. However, each individual’s personal choice of the preferred size and vehicle style changes as individual needs and situations change.7 The product life cycle concept can apply to a product class (e.g., gasoline-powered automobiles), a product form (e.g., station wagons), or a brand (e.g., the Ford Taurus). The product life cycle concept applies differently in each case. Generally, however, the product life cycle is used to describe industry revenues and profits for a product/service within a particular market. The revenues and profits of an individual product, model, or brand may not (and often do not) follow the typical life cycle pattern. Revenues and profits of an individual product/service may vary throughout the product life cycle—sometimes moving in the opposite direction of industry revenues and profits trends. Further, an individual product/service may be in a different life-cycle stage in several different markets. The product development stage begins when the company finds and develops a new product/service idea. This development process involves (1) translating trends in the macroenvironment, (2) taking diverse pieces of information, and (3) incorporating them into a product/service concept. Product/service concepts typically undergo several iterations (involving considerable time and money) before they are exposed to target consumers in test markets. Concepts that survive test market scrutiny are ready for market introduction. The “time to market,” or the amount of development time necessary to move from product concept to finished product, can be critical. This is particularly true when competitors are working on similar products. During the product development stage, revenues are typically zero and profits are typically negative (e.g., anticipated future profits are being invested in product development). In the market introduction stage, revenues are low as the new product/service is first introduced to the market. Customers are not necessarily looking for the new product/service. Customers may not be aware of the benefits or advantages of the new product/services as compared to the current market offerings. In fact, potential customers may not even know about the new product/service. Informative promotion activities are typically needed to teach potential customers about the new product/ service concept. Even though the company promotes its new product/service, it takes time for customers to learn that the product/service is available. The subject company invests funds to develop the market in anticipation of earning future profits. Operating losses are common during the introduction stage of the life cycle. This is because substantial expenditures are made in promotion, marketing, and placement. In the market growth stage of the life cycle, industry revenues increase quickly. However, industry profits first increase and then start to decrease. In the market growth stage, the company begins to make significant profits as more and more customers buy the new product/service. During this stage, competitors often perceive the market opportunity and decide to enter the market. Some competitors may just copy the new product/service. Other competitors may try to improve on the new product/service in order to compete more successfully. Typically, new competitive entries in the market provide significant product/service differentiation to customers.
7 William D. Perrault Jr. and E. Jerome McCarthy, Essentials of Marketing: Global-Managerial Approach, 8th ed. (Chicago: McGraw-Hill, 2000) pp. 204–212.
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The market growth stage is where industry profits are the greatest. However, it is also the stage when industry profits begin to decline. This occurs because increased competition typically creates downward pressure on product/service prices. The market maturity stage occurs when industry revenues level off. Industry competition increases as aggressive competitors enter the market in pursuit of profits. Industry profits continue to decrease during the market maturity stage. This is because (1) promotion costs typically increase and (2) competitors typically continue to reduce product/service prices in order to attract more business. New companies may still enter the market during this life cycle stage. These late market entries skip the early life cycle stages, including the profitable growth stage. These new market entries typically try to take market share away from the established companies in the market. Such a competitive strategy is typically difficult and expensive in a flat, saturated market. Customers who are satisfied with their current product/ service provider are not particularly interested in switching to an unknown provider. In the United States, the markets for most cars, boats, television sets, and household appliances are in the market maturity stage of their product life cycles. This life cycle stage may continue for many years. The market maturity stage may last until a new product/service comes along that makes the old product/service concept obsolete. During the life cycle market maturity stage, less efficient companies typically can’t compete with the increasing pressure on product/service prices. Accordingly, these less efficient companies typically drop out of the market during the market maturity stage. The market maturity stage for an entire industry may continue for many years. This is true even though individual product/service brands may come and go. During the life cycle sales decline stage, new products/services typically replace the old products/services. Price competition from declining products/services becomes more vigorous. However, companies with superior products/services continue to make profits until the end of this stage. This is particularly the case for companies that have successfully differentiated their products/services. These companies may also maintain revenues by appealing to the most loyal customers or to customers who are slow to try new ideas. Even these loyal customers will eventually switch to new products/services, ultimately smoothing the revenue decline curve. How easy it is to identify and quantify product life cycles depends on how broadly the analyst defines the subject market. About 90 percent of all U.S. households own microwave ovens. This fact would lead some analysts to conclude that microwave ovens are at the maturity stage of the life cycle market. In many countries, however, microwave ovens are still early in the life cycle growth stage. In many developing countries, for example, microwave ovens enjoy a household penetration level of less than 10 percent. Accordingly, U.S. microwave manufacturers can extend their product life cycles by expanding their distribution to include developing country markets. If a market is defined broadly enough, there may appear to be many competitors. And, the market may appear to be in the market maturity life cycle stage. On the other hand, if the analytical focus is on a narrow submarket, and on a particular way of satisfying customer needs, then an analyst may observe much shorter life cycles. This is because improved product/service ideas come along to replace the old product/service ideas. Shorter life cycles mean that companies must constantly develop new products in order to stay in business. Further, companies must offer product/service marketing mixes that make the most of the market growth stage. This is the life cycle stage when profits are highest. It is noteworthy in the typical product life cycle that revenues and profits often do not move together over time. In some cases, industry profits decline while industry revenues are still increasing.
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Analysts can make use of the product life cycle concept when making intellectual property income projections. Such an income projection will follow the pattern of high initial growth from a small base in the early life cycle years, with decreasing growth in the later life cycle years. This pattern is depicted in the S-curve presented in the product life cycle illustration in Exhibit 14.9. This follows the typical life cycle pattern of a product/service where (1) profits are negative in the invention/development and introduction stages, (2) profits increase rapidly during the growth stage, (3) profits level off during the maturity stage, and (4) profits decrease during the decline stage. As long as the assumptions underlying the subject life cycle analysis are realistic, this type of analysis is useful (1) for preparing intellectual property income projections and (2) for estimating economic useful life, stage of marketplace, and time to market. Furthermore, the intellectual property value/damages/transfer price is sensitive to the remaining time period over which income from the product/service exploitation will be received—as well as to the amount, growth, and timing of the economic benefits.
Product Life Cycles Vary in Length The term of a product’s life cycle, and the length of each cycle stage, varies across products and services. In general, however, product life cycles have been getting shorter in recent years. This phenomenon is partly due to rapid changes in technology. This is because one new technology may be used to replace many old products/ services. For example, developments in electronic microchips have resulted in hundreds of new products, from handheld calculators and digital watches to microchipcontrolled valves in artificial hearts. A change in an intellectual property owner/operator’s strategy, marketing, operations, or research efforts can change the position of a product/service in its life cycle. For example, an owner/operator can move a product/service from the maturity stage to the decline stage by implementing a price-cutting strategy. Not all products/services go through each life cycle stage. In fact, some products/services go directly from the introduction stage to the decline stage. It is sometimes difficult for an analyst to identify the life cycle stage of the product/service. However, product life cycle analysis is a frequently used tool for developing intellectual property income projections. Assume, for example, that an owner/operator is applying for a commercial loan and that the owner/operator will pledge its trademarks as collateral against the loan commitment. Let’s assume that the owner/operator owns 40 commercial trademarks that fall into 21 different product groups. Some of the 40 trademarks are already functioning to protect currently successful consumer products. Some of the trademarks relate to consumer products that are not yet generating income streams. Let’s assume that (1) the analyst’s assignment is to estimate the value of the portfolio of 40 trademarks and (2) the analyst has gathered empirical data regarding royalty rates for the licenses of comparative trademarks. Accordingly, the analyst decided to use the relief from royalty method to estimate the value of the subject trademarks. In order to estimate royalty payments, the analyst should first estimate the future revenue associated with the trademark products. Continuing our example, three of the trademarks relate to a home dry cleaning product that was just introduced into the marketplace. While it is the only product of its kind available, the trademark owner/operator expects a competitive product to be introduced within the next 12 months. The product is currently in the introductory
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phase of its life cycle. The home dry cleaning product trademark has a remaining life of 12 years. The owner/operator projected revenues for the trademark products for the next 3 years. The analyst projected product revenues for 9 years beyond the 3-year projection prepared by the owner/operator. The analyst projected product revenues beyond the third year by increasing revenue by 5 percent each year. The owner/ operator and the analyst reviewed the product revenue projections in light of expected competition and consumer response to the product. In this review, the owner/operator and the analyst considered the subject product life cycle analysis. Other trademarks relate to a powdered kitchen and bathroom cleanser with exceptional nonabrasive cleansing ability. This product is in the decline stage of its product life cycle. While the trademark associated with this product has a 10-year expected remaining life, the product revenue projections for this product are flat for the next 10 years. The intense competition in the household cleanser market and the addition of spray, gel, and premoistened cloth cleansers has pushed this product into the decline stage. Product unit sales are flat because, while new cleansers are gaining market share, there will always be consumers who prefer powdered cleansers. Other trademarks cover household products that have not yet been introduced to the marketplace. These trademarks are associated with fully developed products that have not been introduced because of lack of financial resources for marketing and product introduction. These trademarks have less than a 5-year expected remaining useful life. However, there are currently no plans to introduce these products into the marketplace. The analyst will consult with the trademark owner/operator and review industry information to determine if these products will ever leave the development stage (i.e., if they will ever generate any income). In this valuation, the analyst will review the varying product life cycles associated with each trademarked product in order to estimate the value of the entire portfolio of trademarks. The use of product life cycle analysis requires the analyst to develop a thorough understanding of the product, the industry, the competition, the innovative and technological history in the product’s marketplace, and the economy. Estimating the length of a product’s life cycle is a challenging task. And, the possibility of extending the life cycle of a consumer product by introducing product line extensions can make the product life cycle analysis even more complicated. Nonetheless, an accurate estimation of the length of a product’s life cycle is often an important component of the intellectual property income projection.
Sensitivity Analyses Regardless of the type of valuation/damages/transfer price analysis, it is always difficult to project future events. And, the farther into the future the analyst projects, the less accurate these projections are likely to be. To help identify and quantify possible projection errors, analysts often conduct sensitivity analyses. In these sensitivity analyses, analysts change the assumptions underlying the subject income projections. Generally, the sensitivity analysis will result in “optimistic,” “most likely,” and “pessimistic” projections. A sensitivity analysis of these alternative projections can be synthesized into an overall projection of intellectual property income.8 8 Glen
R. Koller, Risk Modeling for Determining Value and Decision Making (Florida: CRC Press LLC, 2000), pp. 300–308.
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A sensitivity analysis can also be used to identify the elements of risk that are most important and those that are least important to the calculation of value/damages/ transfer price. The income projections often serve as the foundation for the value/ damages/transfer price analysis. The sensitivity analysis often aids in simplifying the analysis assumptions. In addition, sensitivity analysis is a useful tool for anticipating how a change in one analysis variable may affect other analysis variables in a complex income projection. Intellectual property income projections may vary significantly in response to changes in some parameters and may not vary very much at all in response to changes to other parameters. For example, a 20 percent change in the projected product/service unit price may result in a significant change in the income projection. As another example, the value/damages/transfer price of the subject intellectual property may be very sensitive to changes in the discount rate used in the income approach analysis. On the other hand, a 20 percent change in projected advertising expense or R&D expense may have very little impact on the income projection. The mathematical procedures for an income projection sensitivity analysis are simple. First, the analyst changes one variable in the income projection model and obtains a new income projection result. Second, the analyst records each new income projection result in order to generate a table listing the range of possible income projections. Exhibit 14.10 presents an example of an income projection sensitivity analysis. There is one practical drawback to the type of sensitivity analysis where one analysis variable is changed while all other analysis variables are held constant. The practical drawback is that this is not a realistic premise in most intellectual property income projections. As mentioned earlier, in the development or commercialization of intellectual properties, there are few truly linear relationships among the value/ damages/transfer price variables. The true influence on an individual analysis variable depends on its interaction (or correlation coefficient) with all other analysis variables. The Monte Carlo method described in the next section accommodates this particular practical drawback. To illustrate this point, consider a situation where two analysis variables are related: (1) product/service price and (2) market penetration. If the product/service price is changed while all other analysis variables are held constant (e.g., the product/services continues to penetrate the market at the same rate), then that sensitivity analysis may produce an unrealistic income projection. The analyst should realize that changing one variable may require a corresponding change in another variable until a more realistic estimate is reached. This process of corresponding changes in analysis variables can be accomplished by using the Monte Carlo analysis. Exhibit 14.10
Income Projections Sensitivity Analysis—Change in Present Value of Cash Flow Caused by Changes in Profit Margin and Discount Rate Increase in Discount Rate Profit Margin (%) 20 35 40 45
10%
12%
15%
$2,500 3,375 3,500 3,625
$2,000 2,700 2,800 2,900
$1,750 2,363 2,450 2,538
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Simulation Analyses Monte Carlo analysis is often used in an income projection sensitivity analysis. In each Monte Carlo simulation, one or more analysis variables are changed. An income projection is prepared based on each individual simulation. A probability is assigned to each individual simulation. And, the final income projection outcome is the mathematical expectation (i.e., the weighted average) of the results of each simulation. Monte Carlo simulation is particularly useful in predicting the overall outcome of a series of related events when the probability of each component event is known. Accordingly, a Monte Carlo analysis can be used to develop the projection of intellectual property income. In each simulation, the analyst will create a scenario by changing such projected variables as revenue, cost of goods sold, depreciation expense, income taxes, and rate of return. In each simulation, all the analysis variables are simultaneously adjusted according to individual probability distributions. The product of the various simulations is an overall distribution of possible income projection outcomes. Monte Carlo analysis once involved time-consuming and costly calculations. Today, a variety of software packages (including Microsoft Excel) and Web services use Monte Carlo analysis as part of their platform. The name “Monte Carlo” was coined during the Manhattan Project of World War II. This name was selected because of the similarity of statistical simulation to games of chance. At that time, Monte Carlo, the capital of Monaco, was the center of gambling in the world. In this analogy, the “game” is the income projection, and the analyst may “win” a solution for the particular projection problem. To understand how Monte Carlo analysis works, consider an intellectual property valuation analysis example where the analyst uses Monte Carlo analysis in the discounted cash flow projection. Let’s assume that a trade secret is valued using the income approach and, specifically, the discounted cash flow method. Also, let’s make the following assumptions: 1. No current income projections are available regarding the trade secret. 2. Historical financial information exists regarding the use of the trade secret, but the historical information does not indicate a stable trend of income. 3. The trade secret has a 5-year expected remaining useful life. 4. The analyst projects the growth rate of revenues to be zero percent; however, the trade secret owner/operator believes that the revenue growth rate may vary from 3 to 20 percent. 5. Current revenues and COGS (cost of goods sold) are known to be $1,000 and $700, respectively, while all other costs are known to be equal to 5 percent of revenue. 6. Other operating expenses may vary from 5 to 10 percent. 7. COGS may vary from year to year between 60 and 80 percent. 8. For purposes of the net present value calculation, the analyst concludes that a discount rate of 15 percent is appropriate. To simplify this illustration, only three variables (i.e., revenues, COGS, and other operating expenses) will be subject to change. Monte Carlo analysis can address these income projection variations. In the Monte Carlo simulation, draws of random variables are made from a defined distribution of variable assumptions. Random variables are generated independently for each variable for each period. The pattern of each variable may vary. For instance, COGS may be high in one year, low in the next, then low again, and so forth. The random draws of the variables allow for the repeated calculation of the discounted
14 / Intellectual Property Income Projections: Approaches and Methods
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Exhibit 14.11
Monte Carlo Analysis, Income Projection for a Software Valuation Projection Period Scenario
2003 ($000s)
2004 ($000s)
2005 ($000s)
2006 ($000s)
2007 ($000s)
Low Best estimate High
1,000 1,000 1,000
1,033 1,118 1,235
1,067 1,250 1,526
1,102 1,398 1,885
1,139 1,563 2,328
Cost of sales
Low Best estimate High
600 717 850
622 802 998
645 900 1,197
668 1,002 1,478
693 1,124 1,826
Other expense (% of revenue)
Low Best estimate High
50 73 100
52 82 116
54 92 139
56 103 166
58 115 202
Valuation Variable Revenue
Income tax rate 30% Discounted cash flow
Low Best estimate High
134 599 1,134
Exhibit 14.12
Valuation Financial Model Based on “Best Case’’ Scenario Valuation Variables from a Monte Carlo Analysis Projection Period Valuation Variable
2003 ($000s)
2004 ($000s)
2005 ($000s)
2006 ($000s)
2007 ($000s)
Revenue Cost of sales
1,000.0 717.0
1,118.0 803.0
1,250.0 900.0
1,398.0 1,002.0
1,563.0 1,124.0
Gross profit Other expense
283.0 73.0
315.0 82.0
350.0 92.0
396.0 103.0
439.0 115.0
Operating profit Pretax profit Income taxes
210.0 210.0 (63.0)
233.0 233.0 (69.9)
258.0 258.0 (77.4)
293.0 293.0 (87.9)
324.0 324.0 (97.2)
Net income PV factor
147.0 0.9
163.1 0.8
180.6 0.7
205.1 0.6
226.8 0.5
Present value Fair market value
127.8 599.9
123.3
118.7
117.3
112.8
cash flow model. The results of each random draw are compiled. The average of the outcomes is a result of not only the means of the random variable used, but also the distributions and variances from those random variable draws.9 Exhibits 14.11 and 14.12 present the results of 10,000 separate trials using a range of values for each of the three variables in the model. 9 Benjamin C. Alamar, Ph.D., “Monte Carlo Simulation in the Valuation of High Risk Businesses,” Business Valuation Review, Decem-
ber 2002, pp. 186–189.
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In this example, the analyst used a Monte Carlo analysis to estimate the value of the subject trade secret in terms of a value distribution implied by the 10,000 separate trials. The Monte Carlo trials produced a range of indicated values from $134,000 to $1,100,000, with a median indicated value of $599,000. While any point in this range of values is equally possible, the point most representative of the range (the best estimate), in this example, is the median value indication of $599,000.
Judgmental Methods Depending (1) on the commercialization history of the subject intellectual property or (2) on the state of the industry in which the property is used, there may not be enough data either to develop an historical trend or to develop a pro forma income projection. Also, even in cases where adequate information is available, the analyst may not have enough time to generate a detailed comparison of alternative income projections. In such instances, simple “rule of thumb” methods may be useful tools for the preliminary analysis of an intellectual property. The rules of thumb often distill the actual economic value drivers into a simplified relationship. Often, an experienced analyst can use a rule of thumb to prepare a preliminary estimate of value, economic damages, or transfer price. Of course, the experienced analyst will have to rely on practiced judgment to assess the reasonableness of the rule of thumb. And, the analyst should confirm that the so-called “rule of thumb” is both widely accepted in the subject industry and ultimately (albeit simplistically) extracted from empirical transactional data. It is unlikely that a rule of thumb will withstand a contrarian’s examination in a court of law. In addition, the results of a rule of thumb analysis would not generally be appropriate as the basis for decision making regarding an actual investment, transaction, or financing arrangement. Nonetheless, let’s consider the illustrative use of a rule of thumb analysis. Let’s say there are three new copyrighted software products at Research-Tech. The company is negotiating a license of its newly developed products with Market-Tech, a major software marketing company. The orientation of Research-Tech is more toward academic research and computer software development than it is toward marketing. On the other hand, Market-Tech’s specialty is the marketing and distribution of the software products on a global basis. Research-Tech is trying to estimate the appropriate profit split related to the transfer of its product copyrights to Market-Tech. One often-cited norm, or rule of thumb, for calculating royalties is the so-called “25 percent criterion.” This rule of thumb states that the majority of the incremental profits created by the license, or about three quarters, ought to go to the licensee— while the licensor should receive royalties totaling 25 percent of the incremental profit. The rationale for this rule of thumb profit split is because the licensee company—in this case, Market-Tech—makes the capital investment, soldiers the marketing battle, and bears the investment risk. The licensor, it is argued, is only the passive collector of royalties and fees—should the venture succeed. The licensor’s risks are limited to receiving no royalties in the event of failure. The fact remains, however, that such rules of thumb have no economic basis. They have no theoretical justification apart from the observation that the party that bears the higher risk (Market-Tech in the above example) should be eligible for a larger share of the incremental value created by the intellectual property transfer.
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In practice, the facts and circumstances surrounding the license agreement will determine the actual split of incremental profit. Hence, rules of thumb merely reflect past tradition and industry averages. They have no theoretical merit. However, because they are sometimes referenced by negotiators, courts, and taxation authorities, they serve as benchmarks, which owner/ operators should not ignore.10 Over the years, the courts have accepted a number of other methods related to the formation of income projections for intellectual property valuation, economic damages, and transfer price analyses. These methods are also referred to as judgmental methods. We will discuss these income projection methods from the perspective of the relevant judicial precedent. Several income projection considerations have been addressed in litigation. These income projection considerations include (1) factors affecting the profits to the potential licensee/infringer if the infringer were to obtain a license and (2) the profits that the infringer expects to earn from the use of the intellectual property. Specifically, cases have addressed the effect that the nature and scope of the intellectual property license (e.g., exclusive versus restricted license rights) have on the income projection. These cases also have considered the factors that would influence the bargaining power that each party brings to the intellectual property negotiation. For example, in Panduit Corp. v. Stahlin Bros. Fibre Works (Panduit),11 the U.S. Court of Appeals for the Sixth Circuit added two additional considerations to the income projection process. First, the Court ruled that the hypothesis of voluntary negotiations between a willing licensor and a willing licensee was not necessary. The Panduit Court provided a market-based test under which the subject patent holder could (for the first time) prove entitlement to historical lost profits—as opposed to prospective royalty payment damages. The Panduit decision recognized that patent infringement may, under certain circumstances, cause damages in the form of lost profits. The Panduit decision suggests that an analyst should consider both the opportunity to the licensor and the licensee with regard to relative license negotiating power and relative income expectations at the time of intellectual property infringement. The Panduit Court provided a four-point test under which the intellectual property (in this case, a patent) owner could prove economic damages based upon lost profits. To prove lost profit damages, the intellectual property owner should demonstrate the following: 1. Demand for the intellectual property (protected product/service) 2. An absence of acceptable noninfringing substitutes 3. The marketing and manufacturing capability to exploit the product/service demand 4. The amount of income the owner/operator would have earned absent the subject intellectual property infringement Under this Panduit test, however, the award of intellectual property damages is an all or nothing proposition. If the intellectual property owner can prove all four points of the Panduit test, then lost profits damages may be awarded. However, if the intellectual property owner cannot prove any one of the four points in the Panduit
10
Farok J. Contractor, Valuation of Intangible Assets in Global Operations (Westport, CT: Quorum Books, 2001), pp. 14–15. Corp. v. Stahlin Bros. Fibre Works, Inc., 575 F.2d 1152 (6th cir. 1978), rev’g and rem’g C.A. Nos. 4935 and G293-71 (W.D. Mich. Sept. 15, 1975). 11 Panduit
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test, then damages may be limited to reasonable royalty compensation for future infringements. The Panduit court considered lost profits resulting from lost revenues during the historical infringement period. In addition, the Panduit court also considered lost profits resulting from product/service price erosion. For example, the Panduit patent owner’s product sales during the historical infringement period may have been made at prices lower than it would have charged absent the intellectual property infringement. It should be noted, of course, that the ultimate test in such intellectual property litigation is whether the owner/operator can prove causation of lost profits due to the subject infringement. The analyst should research and review relevant published judicial decisions to better understand the particular courts’ acceptance of judgmental methods of analysis. One conclusion that can be drawn from such a review of judicial precedent is that it is sometimes necessary to “think outside of the box.” In other words, the analyst should consider all relevant factors related to intellectual property income projections—even if those factors are not specifically articulated in one of the traditional analytical methods. Fundamental economic principles should be the conceptual underpinning of any intellectual property analysis. While rules of thumb and judicial precedent do provide insight (and perhaps alternative scenarios for value/damages/transfer price analyses), these judgmental methods are best used in combination with other income projection methods.
Summary and Conclusion An intellectual property value/damages/transfer price can often be expressed as the present value of some future income stream of economic benefits or losses. The income approach is often used to estimate those future benefits or losses. However, there are many individual methods available within the income approach, all of which involve some type of intellectual property income projection. The income projection methods include statistical methods such as regression analysis, qualitative methods such as the rule of thumb methods, and many other alternative methods. Which income projection method, or combination of methods, should be used to estimate value/damages/transfer price related to any particular intellectual property analysis will depend on (1) the facts and circumstances of the assignment, (2) the analyst’s professional judgment, and (3) the quantity and quality of available data regarding the subject intellectual property.
Chapter 15 Intellectual Property Discount Rates and Capitalization Rates Timothy J. Meinhart
Introduction and Overview Discount Rate versus Capitalization Rate Valuation of an Intellectual Property Using a Discount Rate Valuation of an Intellectual Property Using a Capitalization Rate Sensitivity Analysis Using Alternative Discount Rates and Growth Rates Using Discount Rates to Quantify Economic Damages and Transfer Prices Economic Damages Example Transfer Price Example Estimating Discount Rates and Capitalization Rates for Intellectual Property Capital Asset Pricing Model The Build-Up Model The Discounted Cash Flow Model Arbitrage Pricing Theory Model Weighted Average Cost of Capital Using the WACC to Estimate Discount Rates for Intellectual Properties Summary Suggested Reading
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Introduction and Overview In this chapter, we will discuss the estimation and use of discount rates and capitalization rates in intellectual property economic analyses. We will also discuss some of the fundamental differences—with regard to discount rates and capitalization rates—between intellectual property analysis and business enterprise analysis. These fundamental differences relate to three factors: (1) only a portion of a company’s total business enterprise income is typically attributed to intellectual property; the remaining portion is attributed to financial assets, real estate and tangible personal property, and general intangible assets; (2) intellectual properties typically have a limited remaining useful life (RUL) whereas a business enterprise typically is assumed to have a perpetuity RUL; and (3) investments in intellectual properties are generally more risky than investments in a business enterprise. However, when comparing intellectual properties to general intangible assets, intellectual properties typically (1) have a more definable income-generating capacity, (2) have a more definable RUL, (3) are more liquid, (4) have more commercialization/expiration/license potential, and (5) have greater legal protection and judicial recognition. With regard to discount and capitalization rates, these factors typically mean that investors expect lower rates of return on an investment in intellectual properties than on an investment in general commercial intangible assets. In addition, investors expect higher rates of return on investments in intellectual properties than on investments in general business enterprises. This chapter will also demonstrate how discount rates and capitalization rates affect all three fundamental types of intellectual property economic analyses: valuation, economic damages, and transfer pricing.
Discount Rate versus Capitalization Rate In the economic analysis of an intellectual property or a business enterprise, the terms “discount rate” and “capitalization rate” are often used interchangeably. The terms discount rate and capitalization rate, although related, are not synonyms. However, the terms (1) discount rate, (2) present value rate, (3) present value discount rate, and (4) yield capitalization rate are all synonyms. And, the terms capitalization rate and direct capitalization rate are synonyms. The experienced analyst should fully understand the important distinction between the terms discount rate and capitalization rate as well as how to properly use each “rate of return” within a selected analytical approach and method. Within any income approach analysis, the analyst may routinely use either a discount rate or a capitalization rate to convert some projected level of economic income to an estimate of value, value decrement (i.e., damages), or transfer price. Before we discuss how a discount rate or a capitalization rate is used with respect to intellectual property analysis, we will first review (1) how a discount rate differs from a capitalization rate and (2) when it is appropriate to use each. Next, we will discuss the different methods for estimating discount rates and capitalization rates. Finally, we will provide examples of how these rates of return impact intellectual property analysis. In general, both a discount rate and a capitalization rate represent a risk-adjusted rate of return on a given investment that an investor would expect to receive. Both rates
15 / Intellectual Property Discount Rates and Capitalization Rates
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of return should take into account the risks and uncertainties associated with the economic income stream that is projected for the subject asset, property, or business interest. Although these two different rates of return are used in two different income-based analytical methods, the two methods should produce complementary results—when properly applied. A discount rate is often thought of in the context of a discounted cash flow (DCF) analysis. In a DCF analysis, the analyst typically projects a stream of cash flow (or a similar measure of economic income) to be generated by the subject asset, property, or business interest. In the case of an intellectual property, this economic income stream is typically projected over the subject’s expected RUL. In the analysis of a going-concern business enterprise, the projection of the economic income stream may extend beyond a discrete projection period. This residual (or terminal) value calculation is intended to capture the incremental/decremental amount of economic income that extends beyond the discrete projection period. This residual value calculation reflects the fact that a business enterprise normally has a perpetual RUL. In contrast, an intellectual property normally has a finite RUL. An income approach analysis of an intellectual property may incorporate a residual value analysis. However, that analysis should reflect the finite life of the intellectual property instead of the infinite life of the business enterprise. A DCF analysis is performed by discounting the projected stream of economic income for the discrete projection period and the terminal effect at the conclusion of the discrete projection period. The present value of both the discrete projection and the terminal effect as of the analysis date is arrived at by use of a required rate of return, or a discount rate. In using a discounted economic income analysis, it is important to note that: •
•
The discount rate reflects the required annual rate of return that a hypothetical investor would expect to earn on the projected economic income stream to support the indicated value, damages, or transfer price estimate. The discount rate does not incorporate a constant rate of growth for the projected economic income stream; rather, this rate of growth, which may vary during the projection period, is reflected in the periodic economic income projections.
One of the primary benefits of using the DCF analysis is that it allows for the value/damages/transfer price analysis of an intellectual property that has economic income that is projected to vary over time. Different scenarios reflecting alternative projected levels of economic income can be analyzed with a selected discount rate in order to estimate the most reasonable amount, or range of amounts, of the subject intellectual property value/damages/transfer price. Unlike a discount rate, a capitalization rate is used in the analysis of an economic income stream that is projected either to remain constant or increase at a constant rate over time. In instances where the projected economic income stream is expected to increase at a constant rate over time, the capitalization rate is equal to the discount rate minus the expected growth rate. For example, if the appropriate discount rate is 20 percent, and the expected economic income growth rate is 5 percent, then the corresponding capitalization rate is 15 percent. In other words, the algebraic relationship between these two rates is: discount rate minus expected growth rate equals capitalization rate. In this example, the algebraic relationship is expressed as 20% − 5% = 15%. In instances when the projected economic income stream is expected to decrease at a constant rate over time, the capitalization rate is equal to the discount rate minus the negative growth rate. For example, if the appropriate discount rate is 20 percent and the expected economic income growth rate is minus 5 percent (meaning an
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Exhibit 15.1
Discounted Cash Flow Analysis, Trademark Valuation Example Present value discount rate Expected long-term growth rate in economic income
15% 3%
Projected economic income Present value factor using 15% discount rate Present value over the discrete projection period Present value of terminal value Cumulative present value
Period 1
Period 2
Period 3
Period 4
Period 5
$100 0.8696
$103 0.7561
$106 0.6575
$109 0.5718
$113 0.4972
$87
$78
$70
$62
$56
Terminal Value $966 0.4972 $480
$833
annual decrease of 5 percent), then the corresponding capitalization rate is 25 percent. In this example, the algebraic relationship is expressed as 20% − (−5%) = 25%. Of course, in a situation with declining economic income, there may be other factors to consider in the analysis, especially the RUL of that income stream. In instances when the projected economic increase stream will remain constant over time, then the capitalization rate is equal to the discount rate. The following intellectual property valuation examples illustrate (1) the application of a discount rate and a capitalization rate and (2) how alternative methods using the two rates of return produce an identical result when the expected economic income growth rate is held constant.
Valuation of an Intellectual Property Using a Discount Rate Exhibit 15.1 assumes that an intellectual property, a trademark, will generate $100 of economic income in period 1. This level of economic income is projected to increase at a constant rate of 3 percent per year in each of the next four periods. Let’s assume this income growth rate is supported by the expected increases in royalty income the intellectual property owner/operator will earn from licensing the trademark. For purposes of this example only, let’s further assume that the trademark is unique in that it has an indefinite RUL. After period 5, let’s assume that the economic income (i.e., royalty income) earned on the trademark license will continue to increase by 3 percent per year in perpetuity.1 This incremental value beyond the 5-year discrete projection period will be reflected as the terminal value. Let’s assume that 15 percent is the appropriate risk-adjusted discount rate to use in the valuation of the subject trademark. Therefore, the projected economic income and the terminal value will be discounted to a present value using the 15 percent discount rate. In other words, 15 percent is considered to be the required rate of return needed to compensate a hypothetical investor for assuming the risks and uncertainties associated with the trademark license projected economic income stream. 1 While patents generally have an ascertainable RUL, for illustrative purposes, we will assume that the subject trademark has an indefinite life.
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Based on (1) an initial $100 license royalty annual income, (2) an expected economic income annual growth rate of 3 percent in perpetuity, and (3) a discount rate of 15 percent, the present value of the economic income for the 5-year discrete projection period is added to the present value of the terminal value to arrive at a trademark value indication of $833.
Valuation of an Intellectual Property Using a Capitalization Rate Much like Exhibit 15.1, Exhibit 15.2 also assumes (1) that the trademark will generate $100 of economic income (in the form of a license royalty) in period 1 and (2) that the trademark economic income is expected to increase at the rate of 3 percent per year in perpetuity. Given that the projected level of economic income in Exhibit 15.2 is expected to increase at a constant rate in perpetuity, the analyst can use a direct capitalization method to value the trademark. This analysis is performed by capitalizing (i.e., dividing) the projected period 1 economic income by an appropriate capitalization rate. In this example, the capitalization rate is equal to the appropriate discount rate of 15 percent less the expected economic income growth rate of 3 percent. In other words, the corresponding capitalization rate is 12 percent (i.e., 15% – 3% = 12%). As presented in Exhibit 15.2, the indicated value of the subject trademark is the same regardless of whether (1) a DCF method and a discount rate is used or (2) a direct capitalization method and a capitalization rate is used. However, it is important to ensure the proper matching of the appropriate valuation method with the corresponding rate of return.
Sensitivity Analysis Using Alternative Discount Rates and Growth Rates Exhibits 15.1 and 15.2 illustrate how a discount rate and capitalization rate are used to value an intellectual property. Within the two income approach valuation methods, it is important to understand what effect a change in the discount rate and the expected growth rate will have on the value of the intellectual property. All other factors being equal, an increase in the present value discount rate will lower the value indication of the intellectual property. In other words, an investor will typically seek to earn a higher rate of return on a subject asset by paying a lower price for the subject asset’s projected stream of economic income. Conversely, Exhibit 15.2
Direct Capitalization Method, Trademark Valuation Example Present value discount rate Expected long-term growth rate in economic income
15% 3%
Derived direct capitalization rate
12%
Projected normalized economic income in period 1 Direct capitalization rate
$100 12%
Estimated value
$833
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Exhibit 15.3
Discounted Cash Flow Analysis, Increase in Discount Rate, Trademark Valuation Example Present value discount rate Expected long-term growth rate in economic income
18% 3%
Projected economic income Present value factor using 18% discount rate Present value over the discrete projection period Present value of terminal value Cumulative present value
Period 1
Period 2
Period 3
Period 4
Period 5
Terminal Value
$100 0.8475
$103 0.7182
$106 0.6086
$109 0.5158
$113 0.4371
$773 0.4371
$85
$74
$65
$56
$49 $338
$667
when an investor considers the subject asset to be less risky, then he or she will expect a lower expected rate of return of an investment in that asset. And, a lower expected rate of return—that is, a lower discount rate—results in a higher present value (or a higher purchase price). All other factors being equal, an increase in the expected growth rate of the intellectual property economic income will increase the present value of the asset. In contrast, all other factors being equal, a decrease in the expected growth rate of the intellectual property economic income will decrease the present value of the intellectual property. The following exhibits illustrate the impact of a change in the discount rate and the capitalization rate on the estimated value of an intellectual property. Exhibit 15.3 illustrates the change in value that results from increasing the discount rate used in Exhibit 15.1 to 18 percent from 15 percent. As indicated in Exhibit 15.3, if an investor expects an 18 percent rate of return on the trademark projected economic income, rather than 15 percent, the value of the trademark would decrease to $667 from $833. In contrast, if an investor expects a rate of return on the trademark projected economic income of only 12 percent, rather than the 15 percent included in Exhibit 15.1, then the value of the trademark would increase to $1,111 from $833. This DCF value calculation is illustrated in Exhibit 15.4. Exhibit 15.4
Discounted Cash Flow Analysis, Decrease in Discount Rate, Trademark Valuation Example Present value discount rate Expected long-term growth rate in economic income
12% 3%
Projected economic income Present value factor using 12% discount rate Present value over the discrete projection period Present value of terminal value Cumulative present value
Period 1
Period 2
Period 3
Period 4
Period 5
Terminal Value
$100 0.8929
$103 0.7972
$106 0.7118
$109 0.6355
$113 0.5674
$1,288 0.5674
$89
$82
$76
$69
$64 $731
$1,111
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391
Exhibit 15.5
Direct Capitalization Method, Increase in the Capitalization Rate, Trademark Valuation Example Present value discount rate Expected long-term growth rate in economic income
18% 3%
Derived direct capitalization rate
15%
Projected normalized economic income in period 1 Direct capitalization rate
$100 15%
Estimated value
$667
The impact on value that is caused by a change in the discount rate can also be illustrated using the direct capitalization method. If the discount rate is increased to 18 percent from 15 percent, then the corresponding capitalization rate will increase to 15 percent from 12 percent (assuming the same expected 3 percent growth rate). This change in the capitalization rate, as illustrated in Exhibit 15.5, results in the same trademark value indication as indicated in Exhibit 15.3. Likewise, if the discount rate is decreased to 12 percent from 15 percent, one would expect the same DCF method value indication that is presented in Exhibit 15.4. Decreasing the discount rate to 12 percent from 15 percent results in a capitalization rate of 9 percent (assuming the same 3 percent expected growth rate). This decreased capitalization rate of 9 percent results in a value indication for the trademark of $1,111. This direct capitalization calculation is illustrated in Exhibit 15.6. The DCF method and the direct capitalization method can also be used to illustrate how a change in the expected growth rate impacts the intellectual property value conclusion. Let’s assume that the expected growth of the trademark economic income (i.e., license royalty income) in Exhibit 15.1 is understated at 3 percent and that a more realistic expected growth rate is 5 percent. The impact on value of this change in the expected growth rate is illustrated in Exhibit 15.7. As indicated in Exhibit 15.7, increasing the expected growth rate to 5 percent from 3 percent results in an increase of the trademark value to $1,000 from $833.
Exhibit 15.6
Direct Capitalization Method, Decrease in the Capitalization Rate, Trademark Valuation Example Present value discount rate Expected long-term growth rate in economic income Derived direct capitalization rate Projected normalized economic income in period 1 Direct capitalization rate Estimated value
12% 3% 9% $100 9% $1,111
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Exhibit 15.7
Discounted Cash Flow Analysis, Increase in Expected Long-Term Growth Rate, Trademark Valuation Example Present value discount rate Expected long-term growth rate in economic income
15% 5% Period 1
Projected economic income Present value factor using 15% discount rate Present value over the discrete projection period Present value of terminal value Cumulative present value
Period 2
Period 3
Period 4
Period 5
Terminal Value
$100 0.8696
$105 0.7561
$110 0.6575
$116 0.5718
$122 0.4972
$1,276 0.4972
$87
$79
$72
$66
$60 $635
$1,000
In contrast, if the expected growth rate on the trademark economic income is only 1 percent, then the trademark value will be less than $833, or only $714. This DCF value calculation is illustrated in Exhibit 15.8. The change in the expected economic income growth rate can also be illustrated using the direct capitalization method. Since the capitalization rate is the discount rate minus the expected growth rate, one would expect the corresponding capitalization rate to be 10 percent, if the expected growth rate is increased to 5 percent from 3 percent. As presented in Exhibit 15.9, this change in the expected growth rate leads to the same trademark value conclusion as that reached by the DCF method. Likewise, if the expected growth rate is decreased to 1 percent from 3 percent, then the trademark value decreases to $714, as indicated in Exhibit 15.10.
Exhibit 15.8
Discounted Cash Flow Analysis, Decrease in Expected Long-Term Growth Rate, Trademark Valuation Example Present value discount rate Expected long-term growth rate in economic income
15% 1% Period 1
Projected economic income Present value factor using 15% discount rate Present value over the discrete projection period Present value of terminal value Cumulative present value
Period 2
Period 3
Period 4
Period 5
Terminal Value
$100 0.8696
$101 0.7561
$102 0.6575
$103 0.5718
$104 0.4972
$751 0.4972
$87
$76
$67
$59
$52 $373
$714
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Exhibit 15.9
Direct Capitalization Method, Increase in Expected Long-Term Growth Rate, Trademark Valuation Example Present value discount rate Expected long-term growth rate in economic income
15% 5%
Derived direct capitalization rate
10%
Projected normalized economic income in period 1 Direct capitalization rate
$100 10%
Estimated value
$1,000
While the DCF method and the direct capitalization method are both commonly used income approach valuation methods, the DCF method is a more flexible analytical tool, because it allows for • • •
A projection of economic income over a discrete time period, usually equal to the RUL of the subject intellectual property Varying expected economic income growth rates during the discrete projection period Varying discount rates during the discrete projection period
The following valuation example illustrates the flexibility of the DCF method as an analytical tool. Let’s assume that we are conducting a valuation analysis of a trade secret that is estimated to have a 10-year RUL. This particular trade secret relates to a unique and innovative technology that was recently developed. If the intellectual property owner decided to license the technology, the licensor could earn approximately $120 per year in license income for each of the next 5 years. Let’s further assume that after year 5, we anticipate that a new technology will be introduced that will gradually replace the subject technology. With the introduction of the new technology, we expect that the trade secret license income will decrease $20 per year until the end of year 10. At the end of year 10, the trade secret will be obsolete and worthless. In other words, a license of the technology trade secret will generate no license income after year 10. Lastly, let’s assume that the appropriate discount rate for the trade secret license income is 15 percent in years 1 through 5. In this discrete period, the technology is Exhibit 15.10
Direct Capitalization Method, Decrease in Expected Long-Term Growth Rate, Trademark Valuation Example Present value discount rate Expected long-term growth rate in economic income
15% 1%
Derived direct capitalization rate
14%
Projected normalized economic income in period 1 Direct capitalization rate
$100 14%
Estimated value
$714
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Exhibit 15.11
Discounted Cash Flow Analysis, Varying the Discount Rate, Trade Secret Valuation Example Discount rate (years 1 through 5) Discount rate (years 6 through 10)
15% 20% Period 1
Period 2
Period 3
Period 4
Period 5
Period 6
Period 7
Period 8
Period 9
Period 10
$120 0.8696
$120 0.7561
$120 0.6575
$120 0.5718
$120 0.4972
$100 0.3349
$80 0.2791
$60 0.2326
$40 0.1938
$20 0.1615
Present value of economic income for each projected period
$104
$91
$79
$69
$60
$33
$22
$14
$8
$3
Cumulative present value
$483
Projected economic income Present value factor
new and there is no significant competition. In years 6 through 10, we assume (1) that the competitive landscape will increase and (2) that there will be a significantly greater amount of risk in the expected license income related to the subject technology. As a result, the increase in the level of risk related to the projected license income warrants an increase in the discount rate to 20 percent. Based on the economic variables discussed above, we can conduct a trade secret valuation using the DCF method. This valuation analysis is presented in Exhibit 15.11. As presented in Exhibit 15.11, the DCF method allowed for the anticipated stable level of license-related economic income in periods 1 through 5 followed by expected annual declines in license-related economic income in periods 6 through 10. Furthermore, this valuation analysis incorporates two present value discount rates. A discount rate of 15 percent is used to estimate the present value of the expected trade secret license income for years 1 through 5. A discount rate of 20 percent is used to estimate the present value of the expected trade secret license income for years 6 through 10. This higher discount rate in years 6 through 10 reflects the increased risk associated with the license-related economic income during that period.
Using Discount Rates to Quantify Economic Damages and Transfer Prices While Exhibits 15.1 through 15.11 illustrate how discount rates and capitalization rates are used in intellectual property valuation, these rates of return are also used in intellectual property analysis for purposes of economic damages and transfer pricing. Since the analysis of economic damages often involves a projection of the estimated (or potential) economic income that was affected—either positively or negatively—by a certain event or series of events, an income approach analysis using a discount rate or a capitalization rate is particularly useful.
Economic Damages Example The following example illustrates how a discount rate may be used in an intellectual property economic damages analysis.
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For purposes of this example, assume that Company Alpha owns a patent that allows it to produce a particular type of golf club. This golf club is considered to be the most innovative product of its kind currently on the market. Unlike most other golfing products, which have a lifecycle as short as one season, the subject golf club—the Wonder Club—is so revolutionary that the expected RUL of the design patent is 8 years. Company Alpha was very successful in the introduction year of the Wonder Club. The company achieved its budgeted expectation of selling 2,000 clubs at a price of $200 per club. As presented in Exhibit 15.12, the expenses incurred by Company Alpha to manufacture, market, and sell the Wonder Club are 20 percent of total revenues. As a result, Company Alpha generated $320,000 of economic income (measured as operating income) in year 1 related to the sale of the patented Wonder Club. In the beginning of year 2, Company Alpha discovered that Company Beta (a competitor) was infringing on Company Alpha’s patent. Company Beta was manufacturing a club nearly identical to the Wonder Club. In fact, Company Beta was manufacturing/distributing a “me too” golf club that looked exactly like the Wonder Club. However, Company Beta was selling the copycat golf club for only one-half of the Wonder Club price, or $100 per unit. As one would expect, the less expensive copycat golf club produced by Company Beta cannibalized the sales of the patented Wonder Club in year 2 and year 3. More specifically, Company Alpha only sold 500 and 400 units of the Wonder Club in year 2 and year 3, respectively. This actual sales volume was well below the projected sales level of 1,700 and 1,500 units of Wonder Club in year 2 and year 3. Exhibit 15.12
Discounted Cash Flow Analysis, Valuation of Wonder Club Patent, Economic Damages Analysis Example Year
Year
Year
Year
Year
Year
Year
Year
1
2
3
4
5
6
7
8
Actual financial performance Actual number of golf clubs sold
2,000
500
400
600
700
800
500
200
Price per golf club
$ 200
$ 100
$ 100
$ 100
$ 100
$100
$ 80
$ 75
400,000
50,000
40,000
60,000
70,000
80,000
40,000
15,000
80,000
10,000
8,000
12,000
14,000
16,000
8,000
3,000
$ 320,000
$ 40,000
$ 32,000
$ 48,000
$56,000
$ 64,000
$ 32,000
$ 12,000
2,000
1,700
1,500
1,000
1,000
800
500
200
$ 200
$ 180
$ 150
$ 140
$ 120
$100
$ 80
$75
400,000
306,000
225,000
140,000
120,000
80,000
40,000
15,000
Total revenues Operating expense @ 20% of revenues Actual economic income
Budgeted financial performance Estimated number of golf clubs that would have been sold Price per golf club Total revenues Operating expense @ 20% of revenues
80,000
61,200
45,000
28,000
24,000
16,000
8,000
3,000
$ 320,000
$244,800
$180,000
$112,000
$ 96,000
$ 64,000
$ 32,000
$12,000
$ 204,800
$148,000
$ 64,000
$ 40,000
-
0.8621
0.7432
0.6407
0.5523
Present value of economic income difference for each projected period
$ 176,552
$109,988
$ 41,002
$ 22,092
Estimated amount of economic damages due to patent infringement
$ 349,634
Projected economic income
Net difference in economic income Present value factor @ 16% discount rate
Estimated amount of economic damages due to patent infringement (rounded)
$ 350,000
-
-
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In addition, due to the competition from Company Beta, Company Alpha was forced to lower its unit selling price on the Wonder Club to $100 per unit in year 2 and year 3. Company Alpha accepted this unit selling price decrease in order to compete with the less expensive copycat golf club while it pursued its patent infringement claim legal rights. Had the patent infringement not occurred, Company Alpha management estimates that it would have sold each Wonder Club unit in year 2 for $180 and in year 3 for $150. At the end of year 3, Company Alpha was successful in obtaining a court-ordered injunction that enjoined Company Beta from producing its copycat of the Wonder Club. Nevertheless, Company Alpha has already suffered economic damages related to this patent infringement. Even after the injunctive relief, Company Alpha unit sales recovered only slightly in year 4 and year 5 to 600 clubs and 700 clubs, respectively. Again, this level of unit sales was below the budgeted level of sales of 1,000 Wonder Clubs in each of year 4 and year 5. Furthermore, Company Alpha was forced to maintain the reduced unit sales price of $100 per club, knowing that any increase in the unit price of the club (over the price charged in year 2 and year 3) would not be tolerated by the market. This unit price reduction compounded the amount of economic damages associated with the loss in Company Alpha unit volume. This is because Company Alpha management had projected a price per club of $140 and $120 in year 4 and year 5, respectively, absent the effect of Company Beta’s infringement. Due to the patent infringement, it was not until year 6 that Company Alpha was able to meet its sales projections of 800 units for the Wonder Club. In year 7 and year 8, Company Alpha continued to meet its sales and income projections. After year 8, Company Alpha discontinued production of the Wonder Club. This management decision was due primarily to Company Alpha’s introduction of a new, superior product at the end of year 8. Company Alpha management anticipated that their superior replacement clubs would make the Wonder Club virtually obsolete. The objective of our analysis is to estimate the economic damages suffered by Company Alpha at the time of the patent infringement: the end of year 1. Based on the information provided above and summarized in Exhibit 15.12, we are able to quantify the decrement to the economic income earned by Company Alpha as a direct result of the patent infringement by Company Beta. After the Wonder Club’s successful introduction year, the actual economic income earned by Company Alpha was below management’s projection of expected income. Of course, management’s projection of expected revenues and income was made before any consideration of the effects of the patent infringement. The difference between the actual economic income earned and the budgeted economic income (had the infringement not occurred) is discounted to the end of year 1. This present value calculation is one measure of the amount of economic damages. After consideration of (1) the measure of economic income used in the analysis (in this case, operating income) and (2) the risk (measured by the uncertainty) of the economic income projection, we concluded that a 16 percent discount rate is appropriate. Using a discount rate of 16 percent, the indicated amount of economic damages associated with the Wonder Club patent infringement is $350,000. Of course, this analysis only quantifies one measure of possible economic damages to Company Alpha—that is, lost profits during the expected useful life of the Wonder Club product. To simplify this example, among other things this analysis did not consider (1) legal and administrative expenses incurred by Company Alpha to litigate against Company Beta, (2) any permanent decrease in value to Company Alpha’s reputation, goodwill, or business enterprise associated with the patent infringement,
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(3) increased market expenses associated with repairing the damaged reputation of Company Alpha, or (4) income taxes.
Transfer Price Example As previously mentioned, a discount rate can also be used to quantify an intellectual property transfer price. While intellectual property transfer prices are often thought of in the context of a royalty rate or use/user license fee, discount rates and capitalization rates can also be used to estimate the appropriate transfer price to be paid between related (or unrelated) parties. The use of a discount rate in the estimation of an intellectual property transfer price can be explained through the following illustrative example. For purposes of our example, Telcom is a domestic corporation that is a major provider of telecommunication services. Telcom developed proprietary computer software that allows it to offer additional communication products and services (other than basic local and long distance service) to its customers. Telcom engineers regularly assess the additional products and services Telcom is able to provide, compared to the technological advances being made by competing telecommunication companies. Based on this periodic functional/technological comparative analysis, Telcom management estimates that its proprietary, copyrighted computer software has a remaining useful life of 5 years. The software documentation represents a trade secret within the industry. And, Telcom markets its enhanced products and services under various registered trademarks, trade names, service marks, and service names. Telcom has a foreign subsidiary—Telsub—that intends to offer the same additional products and services to its local customer base by using the proprietary software developed by parent corporation Telcom. We already conducted a comprehensive search for (1) comparable software sale transactions and (2) comparable software license agreements in order to estimate the appropriate royalty rate—or license fee—that Telsub should pay to Telcom for the use of the subject proprietary software and related intellectual property rights. However, due to the uniqueness of the subject software, we were unable to find comparable software sale transactions or comparable software license agreements that could be used as a basis for establishing the appropriate intercompany transfer price. Due to the lack of market-derived transaction data, we will address the transfer price question through the use of an income approach method—using a discount rate. Specifically, we will analyze the incremental economic income that Telsub will earn over the next 5 years related to the use of the transferred proprietary software. We will estimate the present value of the incremental economic income and allocate that present value over the RUL of the transferred software. This analysis will result in an estimate of the appropriate intercompany transfer price that Telsub should pay to Telcom for the use of the software and the associated intellectual property rights. As presented in Exhibit 15.13, Telsub management projects that, through the use of the transferred proprietary software, it will be able to generate revenues from enhanced services that are equal to 10 percent of its basic service revenues each of the next 5 years. Furthermore, due to (1) the low operating cost and (2) the premium pricing associated with the enhanced services, these software-related services will generate a higher profit margin than the profit margin generated by Telsub’s basic telephone services. Based on Telsub management’s 5-year business plan, the projected
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Exhibit 15.13
Discounted Cash Flow Analysis, Valuation of Proprietary Computer Software, Transfer Pricing Analysis Example
Telsub
Year
Year
Year
Year
Year
1
2
3
4
5
$50,000
$60,000
$65,000
$70,000
$80,000
Total revenues Basic services Enhanced, software-related services @ 10% of basic services Total revenues of Telsub
5,000
6,000
6,500
7,000
8,000
55,000
66,000
71,500
77,000
88,000
42,500
51,000
55,250
59,500
68,000
Operating expenses Expenses relating to basic services @ 85% basic revenue Expenses relating to enhanced services @ 55% enhanced
2,750
3,300
3,575
3,850
4,400
Total operating expenses
45,250
54,300
58,825
63,350
72,400
Total economic income of Telsub
$9,750
$11,700
$12,675
$13,650
$15,600
Economic income related to basic services
$7,500
$9,000
$9,750
$10,500
$12,000
Economic income related to enhanced services
$2,250
$2,700
$2,925
$3,150
$3,600
Present value factor @ 17% discount rate
0.8547
0.7305
0.6244
0.5337
0.4561
1,923
1,972
1,826
1,681
1,642
Present value of incremental cash flow related to enhanced, software-related services Cumulative present value of the incremental cash flow related to the enhanced, software-related services
$ 9,045
Transfer price average annual allocation
$1,809
$1,809
$1,809
$1,809
$1,809
Transfer price average annual allocation (rounded)
$1,800
$1,800
$1,800
$1,800
$1,800
margin on the enhanced, software-related services is 45 percent, while the projected margin on the basic telephone services is only 15 percent. Based on these economic relationships, we are able to estimate the present value of the economic income expected to be earned by Telsub by (1) using the transferred proprietary software and (2) offering the enhanced, software-related services. Assume that a discount rate of 17 percent is appropriate, given the risk associated with the projection of Telsub incremental income to be earned on the enhanced services. Using a 17 percent discount rate, the present value of the incremental income from the enhanced, software-related services is $9,045. Next, the present value of the software-related incremental income of $9,045 may be “amortized” over the 5-year remaining useful life of the proprietary software in order to estimate the transfer price (or use fee) that Telcom should charge to Telsub. Based on a straight-line amortization of the $9,045 present value to each period in the 5-year remaining useful life of the software, the indicated intercompany transfer price for the proprietary software and the related intellectual property rights is $1,800 (rounded) per year.
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Estimating Discount Rates and Capitalization Rates for Intellectual Property While appropriately noting the important difference between a discount rate and a capitalization rate, we have yet to discuss the importance of matching the discount rate or capitalization rate to the selected measure of economic income. Generally, the empirical market data used to estimate the discount rate or capitalization rate will influence the selected measure of economic income to use in the analysis. In other words, if the discount rate is extracted from market data regarding the net cash flow of guideline intellectual property sale/license transactions, then it is appropriate to apply the selected discount rate to the net cash flow of the subject intellectual property. In contrast, if the discount rate is extracted from market data regarding the net income of guideline intellectual property sale/license transactions, then it is appropriate to apply the selected discount rate to the net income of the subject intellectual property. When analyzing an intellectual property, it is common to focus on net cash flow as the appropriate measure of economic income. This is because most of the empirical market evidence used to estimate discount rates and capitalization rates is calculated based on net cash flow. To develop a better understanding of how these empirical market data are used in estimating discount rates and capitalization rates, we will next discuss various methods for estimating a discount rate. If a market-derived discount rate (i.e., a rate extracted from arm’s-length intellectual property sale/license transactions) is not available, the discount rate applicable to a business enterprise intellectual property owner/operator is often used as a proxy for the appropriate rate of return. The intellectual property and the business enterprise owner/operator are assumed to be similar in that much of their value (in the case of the intellectual property, all of its value) is intangible in nature. In order to compensate an investor for the level of risk associated with owning an intellectual property, analysts often use either a cost of equity capital or a weighted average cost of capital related to a business enterprise as a proxy for the appropriate intellectual property discount rate.
Capital Asset Pricing Model There are several methods available for estimating the cost of equity capital for use as a discount rate in an intellectual property economic analysis. The first, and probably the best-known, method is the capital asset pricing model (CAPM). The CAPM, developed by William Sharpe in 1964, is viewed as a significant breakthrough in modern financial economics. The CAPM was designed to predict the relationship between the risk of an asset and its expected return. While the CAPM was originally developed for the analysis of marketable securities, analysts over the past four decades have found the CAPM to be a practical method for estimating the expected rate of return for assets that do not trade in a public marketplace. The CAPM recognizes that every investment carries two distinct risks: systematic risk and unsystematic risk. Systematic risk is the risk associated with the market in general, or in other words, a risk that cannot be eliminated through diversification. As will be explained in the following paragraphs of this chapter, this
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measure of systematic risk is often referred to as “beta.” The second type of risk— unsystematic risk—is specific to the particular investment or asset. In contrast to systematic risk, unsystematic risk can be mitigated through diversification. While the CAPM is relatively easy to apply, an analyst should understand the underlying assumptions that are built into the model. These assumptions are as follows: 1. Investors are risk averse. 2. Rational investors seek to hold efficient portfolios—in other words, portfolios that are fully diversified. 3. All investors have identical time horizons. 4. All investors have identical expectations about expected rates of return. 5. All investors pay no taxes on returns and incur no transaction costs. 6. The rate received for lending money is the same as the cost of borrowing money. 7. The market has perfect divisibility and liquidity. The CAPM is based on the premise that a rational investor expects to earn a rate of return greater than a risk-free rate of return when investing in an asset, property, or business interest that has greater risk than a risk-free investment. This incremental rate of return that compensates the investor for accepting a greater level of investment risk is called a risk premium. The CAPM was originally developed—and is most often used—to analyze and estimate rates of return on investments in capital market equity securities. Therefore, in the statement of the CAPM, this investment risk premium is most often called an equity risk premium. The CAPM equation is expressed as follows: E(Ri) = Rf + B(RPm) where E(Ri) = Expected rate of return (cost of equity capital for an equity security) for a given asset, property, or business interest investment i Rf = Rate of return on a risk-free investment b = Beta RPm = Risk premium for the market in which the subject investment trades (e.g., an equity risk premium is based on the capital market for equity securities) The risk-free rate of return is often represented by the yield on a U.S. Treasury bond, which is considered to have virtually no default risk. The equity risk premium is one measure of the incremental return needed to compensate an investor for assuming a level of investment risk greater than that of a risk-free investment. Within the CAPM, this equity risk premium is adjusted by beta (b)—a measure of systematic, marketwide risk. The beta coefficient in the CAPM takes into account the sensitivity of the return on the subject investment to movements in the returns of the marketplace as a whole. Beta, the measure of systematic risk, is a function of the relationship between the return on an individual security and the return on the market as measured by a broad market index such as the Standard & Poor’s 500, the New York Stock Exchange Composite, the Russell 1000, Russell 2000, and so on. Given that there are multiple data sources used for estimating beta—and no single accepted source—often there are problems with beta comparability and beta measurement. These measurement problems result from different data sources, measurement intervals, and measurement
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Exhibit 15.14
Beta Measurement Characteristics of Common Financial Reporting Services Financial Reporting Service CompuServe Media General Financial Services Merrill Lynch S&P Compustat Tradeline Value Line Wilshire Associates
Market Index S&P 500 Media General Composite Index S&P 500 S&P 500 S&P 500 NYSE Composite S&P 500
Measurement Interval Weekly Per market movement of 5% Monthly Monthly Weekly Weekly Monthly
Measurement Time Period 5 years No set time span 5 years 5 years 3 years 5 years 5 years
time periods. Exhibit 15.14 presents several of the commonly used financial reporting services that calculate betas and the characteristics that are incorporated in their beta calculations. Due to the differences in how the various services calculate beta, it is common to have two (or more) financial reporting services calculate a different beta for the same security at any point in time. When using the CAPM to estimate the required rate of return for an intellectual property, the analyst is confronted with the problem of identifying a reasonable measurement of the beta for the subject property. The analyst has a number of solutions to solve this problem. These solutions include the following: 1. The analyst can use the beta of the company that owns the intellectual property as a proxy for the beta that should be used in the intellectual property economic analysis. Obviously, this method of estimating a beta assumes that the subject intellectual property is owned by a company that has publicly traded equity securities. Furthermore, it assumes that the publicly traded securities are traded frequently enough to allow for the calculation of a beta. 2. The analyst can rely upon a composite beta for publicly traded companies that (a) operate in the same industry as the company that owns the subject intellectual property and (b) have similar intellectual properties. 3. The analyst can rely upon a composite beta for publicly traded companies that own a significant number of intellectual properties that are similar to the subject intellectual property, even though these publicly traded companies may not necessarily operate in the same industry as the subject company. While all of the situations described above assume that the subject intellectual property is owned and operated by a company, there are situations where the intellectual property is owned or operated by an individual. In these situations, it is not possible to assess a beta for the individual intellectual property owner/operator. As a result, the analyst is often required to research the overall systematic risk that is inherent in the publicly traded companies that are the logical users of the subject intellectual property. This analysis would involve an evaluation of the betas of the publicly traded companies that could benefit from licensing the subject patent, copyright, trademark, or trade secret.
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The most widely used market risk premium that is incorporated in the CAPM is the long-horizon equity risk premium calculated by Ibbotson Associates.2 The risk premium is calculated as the difference between the historical large company stock total return and the historical income return on long-term government bonds. The equity risk premium is expressed as follows: RPm = TRlcs − IRltb where RPm = Risk premium for the market in which the subject investment trades (e.g., an equity risk premium is based on the capital market for equity securities) TRlcs = Total return on large company stocks IRltb = Income return on long-term U.S. government bonds For purposes of this calculation, Ibbotson Associates measures the return on large company stocks as the historical total return on the S&P 500. The measurement for the income return on long-term government bonds relates to the historical income return generated by U.S. government bonds with a maturity near 20 years. Ibbotson Associates estimated the long-horizon equity risk premium to be 7.0 percent (rounded) as of December 31, 2002.3 The risk premium was calculated by subtracting (1) the historical arithmetic average income return on long-term U.S. government bonds for the period of 1926 through 2002 of 5.2 percent from (2) the historical arithmetic average total return on large company stocks for the period of 1926 through 2002 of 12.2 percent. As the name suggests, the equity risk premium equates to the estimated incremental return—above the return on a risk-free investment—that is necessary to entice an investor to invest in a risky asset. The following example illustrates the estimation of a required rate of return using the CAPM. Let’s assume that we need to estimate the required rate of return on the equity securities of a publicly traded company as of December 31, 2002. Let’s further assume that (1) the risk-free rate of return—as measured by the 20-year U.S. Treasury bond—is 4.8 percent as of December 31, 2002, and (2) the company is as large as many of the companies included in the S&P 500. Let’s also assume that the company equity is as risky as the market as a whole and, as a result, its beta is estimated to be 1.0. Based on these assumptions, we can use the CAPM to estimate a required rate of return for the hypothetical company equity. The calculation would be as follows: E(Ri) = 0.048 + 1.0(0.07) E(Ri) = 12.0% where E(Ri) is the expected rate of return for the equity of company i. While the CAPM is particularly useful in estimating rates of returns on publicly traded equity securities, the model has limitations when used to estimate the required
2 The most widely used equity risk premium is included in two different Ibbotson Associates publications: (1)
Stock, Bonds, Bills, and Inflation, Annual Yearbook and (2) Stock, Bonds, Bills, and Inflation, Valuation Edition Yearbook. Both publications are updated on an annual basis. 3 Stock, Bonds, Bills, and Inflation, Valuation Edition 2003 Yearbook (Ibbotson Associates), p. 66.
15 / Intellectual Property Discount Rates and Capitalization Rates
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rate of return on an intellectual property investment. Some of these CAPM limitations include the following: •
•
•
The CAPM was developed for purposes of the valuation/pricing of publicly traded securities—principally equity securities; the CAPM was not developed for use in performing economic analyses of non-publicly-traded intellectual properties. A fundamental component of the CAPM is beta, which can be easily measured from readily available capital market pricing data when valuing/pricing an equity security. In contrast, there are no comparable market data for use in the measurement of the beta associated with an intellectual property. The CAPM is based on the premise that an investor expects to earn an equity risk premium associated with an investment in an equity security that has greater risk than a risk-free investment. The measurement of this equity risk premium is usually based on the historical rates of return of a broad index of equity securities. While this equity risk premium is appropriate for the analysis of a business enterprise equity security, an additional risk premium may be appropriate if the subject intellectual property has greater risk than the equity of a business enterprise that owns/operates the intellectual property.
While the above equation represents the CAPM in its basic form, the model has been refined over the years to reflect the additional risk normally associated with investments other than publicly traded equity securities. Such model refinements include adding various risk premiums for (1) the size of the subject investment, (2) the illiquidity of the subject investment, and (3) various investment-specific, nonsystemic risk factors. For purposes of an intellectual property analysis, the basic CAPM may be expanded to include consideration of a risk premium associated with an investment in an intellectual property. Such an intellectual property–related risk premium should be based on • • • • • • • • •
The type of the subject economic analysis (i.e., valuation, damages, or transfer pricing) The type of intellectual property subject to analysis (i.e., copyright, patent, trademark, trade secret, etc.) Industry factors related to the current or expected use of the intellectual property The RUL of the subject intellectual property Competition related to the availability/use of alternative intellectual properties Competition related to the development/commercialization of new intellectual properties Competition for the business enterprise owner/operator of the intellectual property Innovation/obsolescence of the subject intellectual property (and vis-à-vis potential or actual competitive intellectual properties) Other relevant factors
By considering these and other factors that may influence the intellectual property risk premium, the basic CAPM equation is expanded as follows: E(Ri) = Rf + B(RPm) + RPip where E(Ri) = Expected rate of return for a given investment i Rf = Rate of return on a risk-free investment B = Beta
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RPm = General equity risk premium, extracted from the general capital markets RPip = Additional risk premium associated with intellectual property– specific factors An Ibbotson-derived equity risk premium may be sufficient for use in the CAPM when estimating the required rate of return on an equity security, but it may not capture all of the incremental risk (and resulting high required return) that is inherent in an intellectual property. As a result, an analyst will routinely incorporate an additional risk premium that is specific to the subject intellectual property. Based on a comparison of the characteristics of an intellectual property and a typical equity security, it is often the case that an intellectual property will warrant a required rate of return that is higher than the rate of return derived for a publicly traded equity security. While this concept seems intuitive, the quantification of the exact intellectual property–specific risk premium is not so straightforward. Intellectual properties, unlike equity securities, have limited useful lives and are generally considered to be more risky than equity securities. In contrast, the (1) commercialization and license potential and (2) legal protection/judicial standing associated with intellectual properties generally makes them less risky than other intangible assets. As a result, the required rate of return for an intellectual property normally ranges from a low that is equivalent to the required rate of return on the equity securities of the company that owns the intellectual property to a high that is equivalent to the required rate of return on the company’s other intangible assets. It is important to note that there is no specific model or formula for quantifying the exact intellectual property–specific risk premium. Ultimately, the adjustment to the required rate of return is based on the analyst’s research, experience, and judgment. The following example illustrates the application of the CAPM in estimating an intellectual property discount rate and capitalization rate. Let’s assume we are conducting a valuation of a copyright owned by Gamma Company. As part of the analysis, it is necessary to estimate the appropriate discount rate. At the time of the analysis, let’s assume that U.S. Treasury bonds yield 6 percent and Gamma Company reports a beta (related to its publicly traded common stock) of 1.1. At the time of the analysis, the general equity risk premium for a company the size of Gamma Company is 8 percent. Based on these data, and using the CAPM, we can estimate the cost of equity capital for Gamma Company as follows: E(RGamma) = 0.06 + 1.1(0.08) E(RGamma) = 14.8% Accordingly, an investor would expect to earn 14.8 percent on an investment in Gamma Company equity securities. Therefore, Gamma Company management would estimate its cost of equity capital at 14.8 percent. Assume that the subject copyright is well protected and is not subject to any significant competitive pressures. Accordingly, the subject copyright is secure from both a legal and a commercial perspective. After a thorough analysis of these and other factors, let’s assume that the secure position of the copyright supports an intellectual property–specific risk premium of only 2 percent. Based on these factors, we
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can estimate the appropriate discount rate—or investors’ expected rate of return— on the copyright as follows: E(Rcopyright) = 0.06 + 1.1(0.08) + 0.02 E(Rcopyright) = 16.8% Based on the data presented in this example, the discount rate of 16.8 percent would be appropriate to use in an income approach valuation/damages/transfer price analysis of the subject copyright. The CAPM estimates a cost of equity capital. Therefore, a discount rate derived from the CAPM would correspond to the measure of economic income available to an investor in equity securities—that is, aftertax net income. A CAPM-derived discount rate should be applied to this measure of economic income even if the basic CAPM is expanded to encompass an intellectual property–specific risk factor. Accordingly, when a CAPM-derived discount rate is used in an intellectual property analysis, the appropriate measure of economic income is the after-tax net income generated by the intellectual property. The CAPM-derived discount rate may be converted to a capitalization rate, and used in a direct capitalization analysis, if (1) the economic income of the copyright is estimated to either remain unchanged or change at a constant rate during the capitalization period and (2) the copyright RUL is expected to be so long that the projected economic income can be analyzed as an annuity in perpetuity. If we assume that the two above-mentioned factors are true with regard to the subject copyright and that the economic income of the subject copyright is expected to increase at the rate of 1.5 percent per year in perpetuity, then the appropriate capitalization rate would be 15.3 percent. This 15.3 percent capitalization rate is calculated as the CAPM-derived discount rate of 16.8 percent less the expected income growth rate of 1.5 percent. Algebraically, the derivation of the capitalization rate from the discount rate is 16.8% discount rate − 1.5% expected growth rate = 15.3% capitalization rate.
The Build-Up Model A second method for estimating the discount rate for an intellectual property analysis is the build-up model. The build-up model is a conceptual cousin to the CAPM in that it includes (1) a risk-free rate of return and (2) many of the same equity risk premium components as the CAPM. A primary difference between the two methods is that the build-up model does not include a beta factor to capture the element of systematic risk. Algebraically, the build-up model is expressed as follows: E(Ri) = Rf + RPm + RPs + RPip where E(Ri) = Expected rate of return (e.g., cost of equity capital for an equity security) for a given investment i Rf = Rate of return on a risk-free investment RPm = Risk premium for the market in which the subject investment trades RPs = Risk premium related to size RPip = Risk premium related to intellectual property–specific factors
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The above build-up model equation includes a risk premium related to investment size. While the basic CAPM equation does not include this size-specific risk premium, it should be noted that the basic CAPM has been modified over the years to include consideration of a risk premium for investment size, when appropriate. Analysts typically incorporate a risk premium for investment size when valuing the equity securities of small capitalization companies. However, such a size-related risk premium is not as commonly used in an intellectual property economic analysis. Given the conceptual similarities between the CAPM and the build-up model— and ignoring the risk premium related to investment size—it is noteworthy that the two methods produce identical discount rate conclusions when the beta factor (explicit in CAPM, implicit in build-up model) is equal to one. The following example illustrates the application of the build-up model in estimating an intellectual property discount rate and capitalization rate. Let’s assume we are conducting a valuation of a trade name owned by Sigma Company. As part of the analysis, it is necessary to estimate the appropriate discount rate. At the time of the analysis, let’s assume that U.S. Treasury bonds yield 7 percent and Sigma Company is similar in size to the publicly traded companies used to estimate the general equity risk premium. At the time of the analysis, the general equity risk premium for a company the size of Sigma Company is 8 percent. Based on these data, and using the build-up model, we can estimate the cost of equity capital for Sigma Company as follows: E(RSigma) = 0.07 + 0.08 E(RSigma) = 15% Accordingly, an investor would expect to earn a 15 percent rate of return on an investment in Sigma Company equity securities. Assume that the Sigma Company trade name is well regarded throughout the industry and has been in existence for many decades. Furthermore, let’s assume that the trade name has a significant presence in the market that it is expected to continue over the next several years. Based on these factors—namely the expected longevity of the trade name—we estimate that the trade name is subject to an intellectual property–specific risk premium of only 1 percent. Given these factors, we can estimate the appropriate discount rate (or expected rate of return) on the trade name as follows: E(Rtrade name) = 0.07 + 0.08 + 0.01 E(Rtrade name) = 16% Based on the data presented in this example, the discount rate of 16 percent would be appropriate to use in an income approach valuation/damages/transfer price analysis of the subject trade name. Much like the CAPM, the build-up model estimates a cost of equity capital. Therefore, a discount rate derived from the build-up model would correspond to the measure of economic income available to an investor in equity securities. In order to be consistent in our matching of the discount rate and the stream of economic income, it is crucial that the discount rate derived from the build-up model be applied to the appropriate stream of economic income (i.e., after-tax cash flow). This would also hold true if the build-up model is expanded to encompass an intellectual property–specific risk factor. As with a CAPM-derived discount rate, a build-up model discount rate may be converted to a capitalization rate and used in a direct capitalization analysis.
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As previously mentioned, the use of a direct capitalization rate—as opposed to a discount rate—would be appropriate in situations where (1) the economic income of the trade name is estimated to either remain unchanged or change at a constant rate during the capitalization period and (2) the RUL of the trade name is expected to be so long that the projected economic income can be analyzed as an annuity in perpetuity. If we assume the subject trade name has an RUL that exceeds 50 years and its economic income will increase at a constant rate of 2 percent per year, then the appropriate capitalization rate would be 14 percent. This 14 percent capitalization rate is calculated as the build-up-model-derived discount rate of 16 percent less the expected economic income annual growth rate of 2 percent. Algebraically, the derivation of the capitalization rate from the discount rate is 16% discount rate − 2% expected growth rate = 14% capitalization rate. It is noteworthy that the sources used to estimate the equity risk premium in the CAPM are identical to the sources used to estimate the equity risk premium in the build-up model. As previously mentioned, the most widely used sources for this particular risk premium are the Ibbotson Associates publications. The application of an intellectual property–specific risk premium when using the build-up model is identical to the application when using the CAPM. In both cases, it is important to note that there is no specific model or formula for quantifying the exact intellectual property–specific risk premium. As a result, the adjustment to the required rate of return is based on the analyst’s experience and judgment. In recent years, Ibbotson Associates has made advances in modifying the buildup model to include an industry-specific risk factor. The modifications include using beta information from companies that participate in a particular industry to evaluate the risk characteristics of that particular industry. The Ibbotson Associates calculations resulted in a series of industry risk premiums that are categorized by standard industrial classification (SIC). These risk premiums, as reported in Stock, Bonds, Bills, and Inflation Yearbook, Valuation Edition, are used—in conjunction with the build-up model—to estimate the cost of capital on equity securities. Algebraically, the build-up model, as modified for an industry-specific premium, is expressed as follows: E(Ri) = Rf + RPm + RPs + RPi + RPip where E(Ri) = Expected rate of return (e.g., cost of equity capital for an equity security) for a given investment i Rf = Rate of return on a risk-free investment RPm = Risk premium for the market in which the subject investment trades RPs = Risk premium related to size RPi = Risk premium related to industry RPip = Risk premium related to intellectual property–specific factors The following example illustrates the application of the modified build-up model in estimating an intellectual property discount rate and capitalization rate. Let’s assume we are conducting an economic damages analysis. The economic damages relate to an infringement suit that arose from the unauthorized use of a drug-related patent owned by Kappa Company, a developer and manufacturer of pharmaceutical products. At the time of the analysis, assume that U.S. Treasury bonds yield 5.5 percent and Kappa Company is similar in size to the publicly traded companies used to estimate the general equity risk premium. At the time of the
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analysis, the general equity risk premium for a company the size of Kappa Company is 8.5 percent. Also, let’s assume that the Ibbotson-derived industry risk premium for companies in the pharmaceutical industry is 2.5 percent. Based on these data, and using the modified build-up model, we can estimate the cost of equity capital for Kappa Company as follows: E(RKappa) = 0.055 + 0.085 + 0.025 E(RKappa) = 16.5% Based on this analysis, an investor would require a 16.5 percent rate of return on an investment in the Kappa Company equity. In estimating the intellectual property–specific risk premium related to the subject patent, let’s assume that the patent will expire in 3 years. However, due to competitive pressures from more advanced drugs that are going to market, the estimated RUL of the Kappa Company patent is estimated to be only 9 months. Based on these factors, we have estimated that the patent would be subject to an intellectual property–specific risk premium of 5 percent. Given these factors, we can estimate the appropriate discount rate on the patent as follows: E(Rpatent) = 0.055 + 0.085 + 0.025 + 0.05 E(Rpatent) = 21.5% Based on the data presented in this example, a discount rate of 21.5 percent would be appropriate to use in an economic damages analysis of the subject patent using an income approach. The relatively short RUL of the subject patent would necessitate the use of a discount rate within the income approach when quantifying economic damages. As previously mentioned, a capitalization rate—which assumes that the subject intellectual property will produce a stream of economic income into perpetuity—would not be appropriate for the economic analysis of an intellectual property that has an expected income-generating capacity of less than 1 year.
The Discounted Cash Flow Model In addition to the CAPM and the build-up model, there are other discount rate estimation models for intellectual property analyses. These models are not as commonly used, however, because each has a number of practical application limitations. These methods include (1) the DCF model and (2) the arbitrage pricing theory (or APT) model. Unlike the CAPM model and the build-up model, which use historical empirical market data to derive a discount rate, the DCF model uses current market prices and security analysts’ earnings projections to derive a discount rate. In the DCF, the analyst essentially rearranges the basic income approach valuation formula to solve for the discount rate, rather than to solve for the present value of the economic income projection. An example of this relationship of the DCF model to the basic income approach formula can be illustrated using the direct capitalization method. The direct capitalization method equation is presented as follows: E (V ) =
NCF1 E ( R) − g
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where E(V) = Estimated present value for a given investment NCF1 = Expected normalized net cash flow in period 1 (i.e., for one period beyond the analysis date) E(R) = Expected rate of return (i.e., discount rate) for a given investment g = Expected long-term growth rate in future net cash flow for a given investment The direct capitalization method equation can be rearranged to solve for the discount rate, if all other formula variables are known. For example, let’s assume that a publicly traded stock has a price of $25, an expected net cash flow in period 1 of $5, and an expected long-term growth rate in net cash flow of 3 percent. Based on these variables, we can solve for the discount rate—or the expected rate of return—of the subject security using the following equations: NCF1 + g = E ( R) E (V ) $5 + 3% = 23% $25 20% + 3% = 23% This DCF model for estimating a discount rate is also useful in estimating the required rates of return on an intellectual property investment. By analyzing the terms of sale/license empirical market transactions involving intellectual properties, we can compute the implied rate of return for each transaction. For example, assume that the objective of our analysis is to estimate the value of a trademark. Assume we have developed a projection of the economic income expected to be earned by the trademark over its expected RUL. The next procedure in an income approach analysis is to estimate the required rate of return applicable to the subject trademark. Assume that there are three recent guideline trademark sale transactions. Our analysis indicates that these transactions were negotiated at arm’s length and the three trademarks are comparable enough to the subject trademark to provide us with meaningful guidance with regard to how the market would respond to the subject. Based on our research of the specific terms of these three guideline trademark sale transactions, we know the following: Guideline Transaction 1 • • •
Guideline trademark number 1 sold in fee simple interest in an arm’s-length transaction between two owner/operators for $1,400. The transaction buyer expected that the trademark had an RUL of 3 years at the time of the transaction. The transaction buyer estimated that the trademark would generate $1,000 of economic income in year 1, decreasing to $250 in year 3.
Guideline Transaction 2 • •
Guideline trademark number 2 sold in fee simple interest in an arm’s-length transaction between two owner/operators for $30,000. The transaction buyer estimates that the guideline trademark had an RUL of 3 years at the time of the transaction.
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•
The transaction buyer projected that the economic income earned from the use of the guideline trademark would increase from $10,000 in year 1 to $15,000 in year 2. In year 3 through year 5, the buyer projected the trademark–related economic income to decrease from $5,000 in year 4 to $1,000 in year 5.
Guideline Transaction 3 • • •
Guideline trademark number 3 was sold in fee simple interest between two owner/operators for $11,200 cash. The transaction buyer estimated that the guideline trademark had an RUL of 4 years at the time of the transaction. The transaction buyer projected the guideline trademark economic income to be $5,500 in each of year 1 and year 2 and $2,000 in each of year 3 and year 4.
Based on the terms of the three guideline sale transactions, we are able to estimate the discount rate—or internal rate of return—implicit in each sale transaction. As presented in Exhibit 15.15, the implicit guideline transaction discount rates ranged from a low of 15.7 percent to a high of 17.2 percent. Based only on the information presented above, these market-derived data suggest that 16 percent may be an appropriate discount rate to use in the valuation of the subject trademark. Of course, the ultimate selection of a subject-specific discount rate from a range of market-derived discount rates would be influenced by many factors, including relative historical growth rates, relative expected growth rates, relative returns on investment, relative ages/life, relative competitive position, and relative size of the trademarked product/service.
Arbitrage Pricing Theory Model The APT model can be viewed as a conceptual extension of the CAPM. This is because the APT model recognizes a variety of investment risk factors rather than the single investment risk factor that CAPM analyzes—that is, systematic risk relative Exhibit 15.15
Fair Market Value of Trademark, Present Value Discount Rate Estimation, Extraction of Discount Rate from Guideline Sale/License Transactions Year 1
Year 2
Year 3
Year 4
Year 5
Guideline Sale Transaction 1 Projected economic income Trademark sale price Implied internal rate of return
$1,000
$500
$250
$1,400 15.70%
Guideline Sale Transaction 2 Projected economic income Trademark sale price Implied internal rate of return
$10,000 $15,000 $12,000
$5,000
$30,000 17.20%
Guideline Sale Transaction 3 Projected economic income Trademark sale price Implied internal rate of return
$5,500 $11,200 16.10%
$5,500
$2,000
$2,000
$1,000
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to the market as a whole. While the APT model does not specify what the specific risk factors are, most applications of this discount rate estimation model focus on macroeconomic factors such as investment yield spreads, interest rate risk, business outlook risk, and expected inflation rate risk. The basic APT model formula is expressed as follows: E(Ri) = Rf + (Bi1K1) + (Bi2K2) + … + (BinKn) where E(Ri) = Expected rate of return on an investment in the subject asset, property, or business interest i Rf = Rate of return on a risk-free security K1,…, Kn = Risk premium associated with risk factor K Bi1,…, Bin = Sensitivity of rate of return on investment i to each risk factor K Given that the basic APT model has numerous undefined variables, the application of this discount rate model tends to be rather complex. For this reason, the APT model is less frequently used in the practical application of intellectual property economic analyses. While the APT model may be complex to use in practice, the model has a great deal of conceptual appeal. Many analysts believe the APT model is more flexible than either the CAPM or the build-up model. This is because the APT model allows for the simultaneous consideration of numerous investment-specific risk factors. In contrast, the CAPM and the build-up model typically incorporate the consideration of investment risk only through the use of beta and—in some instances—through a size-adjustment risk premium. Given its analytical flexibility, the APT model may be particularly useful in intellectual property economic analysis. As previously discussed, it is not uncommon for an intellectual property to have an expected rate of return that is different from the expected rate of return of the owner/operator business enterprise. By considering the different risk attributes of the individual intellectual property, and then incorporating these risk attributes in the APT model, an analyst can effectively quantify the additional investment risk associated with the subject intellectual property. Each of the discount rate models discussed above—the CAPM, the build-up model, the DCF model, and the APT model—were developed for the purpose of estimating investment rates of return on publicly traded equity securities. From a conceptual perspective, the models all serve as a good starting point for estimating the discount rate applicable to intellectual property analysis. However, as previously discussed, the models often need to be expanded to include investment-specific factors that either increase or decrease the equity security discount rate to make it more applicable to intellectual property analysis. Exhibit 15.16 summarizes some of the primary economic differences between intellectual property and publicly traded equity securities. The exhibit also indicates the directional effect that each indicated difference has on the intellectual property discount rate. All of the aforementioned discount rate models may be used to estimate a discount rate for an intellectual property economic analysis where an individual property is analyzed on an in-exchange or stand-alone basis. That is, these models conclude a discount rate that estimates the expected rate of return on an equity security. To this equity-related discount rate, investment-specific risk premiums may be added in order to reflect the incremental investment risk of an intellectual property—compared to an equity security. Therefore, an equity security–derived discount rate is appropriate
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Exhibit 15.16
Differences between Intellectual Property and Publicly Traded Company Stock, Comparison of Discount Rate/Capitalization Rate Intellectual Property Illiquid Unregulated market Limited remaining useful life Limited access to financial data Significant federal and state protection statutes Easy to apportion ownership rights
Publicly Traded Company Stock
Effect on Intellectual Property Discount Rate/Capitalization Rate
Liquid Regulated market Unlimited remaining useful life Access to most financial data Some federal and state protection statutes Difficult to apportion ownership rights
Higher Higher Higher Higher Lower Lower
for the analysis of a discrete intellectual property separate from the analysis of a going-concern business enterprise. The discount rate model discussed below is more applicable to a valuation/damages/transfer price analysis that uses a weighted average return on all tangible and intangible assets as part of an intellectual property analysis. In such an analysis, the subject intellectual property is assumed to operate as part of a going-concern business enterprise. This analytical premise assumes that the individual intellectual property will function as one part of a mass assemblage of tangible and intangible assets. Accordingly, the discount rate appropriate for such an analysis is one that reflects the use of the intellectual property within the context of an operating, going-concern business enterprise. Therefore, the discount rate should be one that is associated with the overall business enterprise that owns/operates the intellectual property. This business enterprise–related discount rate is discussed in the following section.
Weighted Average Cost of Capital The weighted average cost of capital (WACC) is a measure of the required rate of return on a particular assembled bundle of operating assets. As the name suggests, the WACC is a weighted average of the expected rates of return on each type of asset within the total bundle of assets—or of each capital component within the total sources of capital—of a business enterprise. A discount rate derived from a WACC is most commonly used within the context of business enterprise valuation or economic damages analysis. As a result, the theory and application of the WACC estimation is easiest to explain in the context of a business enterprise analysis. After discussing the derivation of the WACC components, we will discuss how the WACC can be used in an intellectual property economic analysis. The WACC reflects investors’ expectation of the average (or blended) rate of return on the total capital of a business enterprise. This total business enterprise capital will typically include both debt and equity components, such as common equity, preferred equity, and long-term, interest-bearing debt. As shown below, the two primary components of the WACC are (1) the individual cost—or expected rate of return—associated with each type of capital and (2) the respective weight of each type of capital in the business enterprise total capital structure.
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The WACC formula is expressed as follows: WACC = (ke × We) + (kp × Wp) + (kd[1 − t] × Wd) where WACC = Weighted average cost of capital ke = Cost of common equity capital We = Percentage of common equity in the business enterprise total capital structure kp = Cost of preferred equity capital Wp = Percentage of preferred equity in the business enterprise total capital structure kd = Pretax cost of interest-bearing debt capital t = Effective income tax rate Wd = Percentage of interest-bearing debt in the business enterprise total capital structure The following example demonstrates the estimation of a WACC for a business enterprise that is the intellectual property owner/operator. Let’s assume that the subject business enterprise has a total current market value of all outstanding classes of capital of $10 million. The total capital structure of the subject business enterprise consists of the following types of capital: Type of Capital Component
Estimated Current Market Value ($)
Percent of Each Capital Component in the Total Capital Structure (%)
Common equity Preferred equity Interest-bearing debt
7,000,000 1,000,000 2,000,000
70 10 20
10,000,000
100
Total capital
Next, let’s assume a required rate of return for each type of capital in the total capital structure as follows: •
•
•
The current cost of the common equity capital is estimated to be 20 percent. This particular capital component cost is estimated using an equity-related discount rate method such as the CAPM, the build-up model, or the APT model. The current cost of the preferred equity capital is estimated to be 10 percent. This capital component cost is based on (1) the $1 per share annual dividend paid on the preferred stock and (2) the current market value of $10 per share for the preferred stock. The current cost of debt capital is estimated to be 8 percent. This capital component cost is based on the current yield to maturity of the company’s outstanding publicly traded debt capital.
Based on an assumed combined federal and state effective income tax rate of 40 percent, the WACC for the subject business enterprise is calculated as follows: weighted cost weighted cost weighted cost WACC = of common equity + of preferred equity + of debt WACC = (0.20 × 0.70) + (0.10 × 0.10) + [(0.08 × 0.20) × (1 − 0.40)] WACC = 16%
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This WACC may be an appropriate discount rate to use in the economic analysis of an intellectual property owned by the subject business enterprise. Of course, the appropriateness of the WACC would depend on several factors. First, the analysis should involve a measure of economic income available to all of the stakeholders of the business (i.e., both the stockholders and the debtholders)—and not a measure of economic income that would be available to the business equityholders only. Second, there should be consistency in the income tax treatment of the discount rate and the income measure. That is, the discount rate and income measure should both be estimated on either a pretax basis or an after-tax basis. And third, the premise of the subject analysis should consider the intellectual property as a component of the total business enterprise (and not as a stand-alone property independent of the total business enterprise). Another way of estimating the WACC is to consider it as the weighted average rate of return on the total assets of the business enterprise. In this context, the WACC reflects the expected rate of return on each individual asset category of the total business enterprise weighted by each individual asset category’s percentage of the total asset value of the subject business enterprise. Typically, the individual asset categories included in the WACC estimation include the following: 1. Financial assets or net working capital (e.g., accounts receivable, prepaid expense, and inventory less accounts payable and accrued expenses) 2. Real estate (e.g., land, land improvements, buildings, leasehold interests) 3. Tangible personal property (e.g., machinery and equipment, transportation equipment, office and computer equipment) 4. Intangible personal property or intangible assets (e.g., assembled workforce, contract rights, licenses and permits, customer relationships, goodwill) Under this alternative analytical procedure, first, the WACC is estimated by quantifying the expected rate of return on each individual asset category of the business enterprise. Second, the value of each individual asset category is estimated and then expressed as a percentage of the total business enterprise value. Third, these individual asset category percentages are multiplied by the respective expected rate of return of each individual asset category. Using the same example as presented above, let’s assume (1) that the subject business enterprise has a current market value of $10 million and (2) that the $10 million business enterprise value is allocated to each individual asset category as follows: Type of Asset Category Financial assets Real estate Tangible personal property Intangible personal property Total business enterprise assets
Market Value ($)
Percent of Total Assets (%)
3,000,000 1,000,000 1,000,000 5,000,000
30 10 10 50
10,000,000
100
Next, let’s assume an expected rate of return for each individual asset category as follows: •
The expected return on the financial assets (i.e., net working capital) is estimated to be 5 percent. This expected rate of return is based on the short-term investment time horizon of the net working capital assets. Net working capital
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•
•
415
assets typically consist of (1) current assets, such as cash, accounts receivable, and inventories and (2) current liabilities, such as accounts payable and accrued expenses. A benchmark for the expected rate of return on financial assets may be the current yield on short-term investment instruments such as a 30-, 60-, or 90-day U.S. Treasury bill. To include an expected rate of return component for default risk, the analyst may decide to use a higher expected rate of return than a risk-free rate of return; a rate of return that reflects some default risk is the current yield on short-term corporate commercial paper instruments. The expected rate of return on real estate and tangible personal property will usually relate to a creditor’s interest rate on a line of credit that is secured by the subject tangible assets. By their very nature, real estate and tangible personal property assets such as land, buildings, leasehold improvements, equipment, and fixtures, are assets that lending institutions are willing to use as collateral for a term loan or a secured line of credit. The current interest rate on the credit instrument that is secured by the tangible assets is often a reasonable proxy for the expected rate of return on the tangible assets. In this example, let’s assume that the subject business enterprise can borrow—pledging its real estate and tangible personal property as collateral—at a rate of 10 percent per annum. For purposes of this example, let’s assume that the expected rate of return on the subject business enterprise intangible assets is 25 percent. This expected rate of return may be estimated based on a method such as the CAPM, buildup model, or APT model. This expected rate of return also considers that the intangible assets of the subject business enterprise are typically a more risky investment instrument than the common equity of the business. This additional investment risk suggests an increase over the expected rate of return for the subject common equity (from 20 to 25 percent) to include the appropriate expected rate of return for the subject intangible assets.
Based on the variables presented above, we can estimate the subject business enterprise WACC using the following formula: WACC = (kwc × Wwc) + (kta × Wta) + (kia × Wia) where WACC = Weighted average cost of capital kwc = Expected rate of return on financial assets (e.g., net working capital) Wwc = Percentage of the financial asset category to total business enterprise value kta = Expected rate of return on real estate and tangible personal property Wta = Percentage of the real estate and tangible personal property asset category to total business enterprise value kia = Expected rate of return on the intangible personal property asset category Wia = Percentage of the intangible personal property asset category to total business enterprise value WACC = (0.05 × 0.30) + (0.10 × 0.20) + (0.25 × 0.50) WACC = 16% As indicated above, the subject business enterprise WACC is 16 percent. This 16 percent WACC conclusion is reached regardless of whether the WACC components are analyzed as (1) expected costs of each business enterprise capital component or as (2) expected rates of return on an individual business enterprise asset category.
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Using the WACC to Estimate Discount Rates for Intellectual Properties The WACC may be useful when estimating the appropriate discount rate for an intellectual property economic analysis. The WACC is a particularly useful discount rate estimation if all of the WACC components are known except for the expected rate of return on the business enterprise intangible assets. The following example demonstrates how the WACC formula can be used to estimate the expected rate of return (or discount rate) on an intellectual property component of a business enterprise total asset structure. Assume the Delta Company, the owner/operator of an important patent, was recently sold for $10 million in a cash for assets transaction. Also assume that a significant portion of its value was attributed to the patent—its sole intellectual property. Furthermore, by performing a DCF analysis using the $10 million purchase price and management projections of the company’s economic income, we are able to conclude that the business enterprise has an implied WACC of 15 percent. In other words, 15 percent is the discount rate that results in a present value of the projected economic income of Delta Company of exactly $10 million as of the analysis date. Let’s further assume that the Delta Company $10 million purchase price is allocated among the acquired company assets as follows: Delta Company, Allocation of Purchase Price, with One Acquired Intangible Asset Type of Acquired Asset Net working capital Real estate and tangible personal property Intellectual property—patent Total assets
Allocated Fair Market Value ($)
Percent of Total Assets Acquired (%)
1,000,000 3,000,000 6,000,000
10 30 60
$10,000,000
100
Based on (1) this relative asset weighting and (2) the previously estimated expected rates of return on net working capital and tangible assets (i.e., real estate and tangible personal property), we can rearrange the WACC equation to solve for the expected rate of return on the intellectual property as follows: kip = kip =
weighted return on weighted return on WACC − net working capital − tangible assets weighting of intellectual property [ WACC − ( kwc × Wwc ) − ( kta × Wta )] Wip
or: [0.15 − (0.05 × 0.10) − (0.10 × 0.30)] 0.60 kip = 19.2% kip =
where kip = Expected rate of return on the acquired intellectual property WACC = Weighted average cost of capital for the business enterprise
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kwc = Expected rate of return on the acquired net working capital Wwc = Percentage of acquired net working capital to total business enterprise value kta = Expected rate of return on the acquired tangible assets Wta = Percentage of acquired tangible assets to total business enterprise value Wip = Percentage of acquired intellectual property to total business enterprise value Using this slightly rearranged WACC formula, we are able to estimate the discount rate (or the expected rate of return), for the subject intellectual property—that is, the Delta Company patent—of 19.2 percent. The above procedure becomes a little more complex if the subject company has more than one type of intangible asset. In that case, the WACC may have to be expanded so as to segregate the expected rate of return on each individual type of intangible asset of the subject business enterprise. For illustrative purposes, continue to assume that Delta Company was sold for $10 million cash. Just as before, assume that $1 million of the purchase price was allocated to net working capital and $3 million of the purchase price was allocated to tangible assets (i.e., real estate and tangible personal property). Now, let’s assume that only $5.5 million of the purchase price is allocated to the patent. Also, let’s assume that we are unable to identify any other discrete intangible asset owned by Delta Company to which we can allocate the remaining $500,000 of purchase price. As a result, the residual $500,000 of the purchase price will be recorded as purchased goodwill. As previously indicated, the expected rates of return on the net working capital, tangible assets, and goodwill are 5, 10, and 25 percent, respectively. Based on (1) the relative weightings of the acquired assets and (2) the expected rates of return summarized below, we can rearrange the WACC equation to solve for the expected rate of return on the Delta Company patent. Delta Company, Allocation of Purchase Price, with Multiple Acquired Intangible Assets Type of Acquired Asset
Allocated Fair Market Value ($)
Net working capital Real estate and tangible personal property Purchased goodwill Intellectual property—patent Total assets
Percent of Total Assets Acquired (%)
Expected Rate of Return (%)
1,000,000 3,000,000
10 30
5 10
500,000 5,500,000
5 55
25 ?
10,000,000
100
The rearranged WACC equation can be used to conclude the expected rate of return on the Delta Company patent, as follows: kip =
[ WACC − ( kwc × Wwc ) − ( kta × Wta ) − ( kgw × Wgw )] Wip
where kip = Expected rate of return on the acquired intellectual property WACC = Weighted average cost of capital for the business enterprise
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kwc = Expected rate of return on the acquired net working capital Wwc = Percentage of acquired net working capital to total business enterprise value kta = Expected rate of return on the acquired tangible assets Wta = Percentage of acquired tangible assets to total business enterprise value kgw = Expected rate of return on the acquired goodwill Wgw = Percentage of acquired goodwill to total business enterprise value Wip = Percentage of acquired intellectual property to total business enterprise value Using the rearranged WACC formula, and a business enterprise WACC of 15 percent, we are able to solve for the expected rate of return on the Delta Company patent as follows:
kip =
WACC −
weighted return on weighted return on weighted return on − − net working capital tangible assets purchased goodwill weighting of intellectual property
[0.15 − (0.05 × 0.10) − (0.10 × 0.30) − (0.25 × 0.05)] 0.55 kip = 18.6%
kip =
The expected rate of return for the Delta Company patent of 18.6 percent appears to be reasonable, given the indicated rates of return on the other acquired assets. Since the acquired patent is likely to be a more risky asset than the Delta Company net working capital and tangible assets, one would anticipate that the expected rate of return on the patent will exceed the expected rates of return on the acquired financial assets and tangible assets. In contrast, due to its (1) legal protection, (2) definable RUL, and (3) commercial licensing potential, the Delta Company patent is likely to be a less risky asset than the purchased goodwill. This lower level of risk provides support for why the expected rate of return on the purchased goodwill exceeds the expected rate of return on the Delta Company patent.
Summary This chapter explored many of the issues related to the development of a discount rate or capitalization rate to be used in an intellectual property valuation, damages, or transfer price analysis. This discussion presented many of the fundamental analytical differences between an intellectual property and a going-concern business enterprise. This discussion also presented many of the fundamental analytical differences between an intellectual property and other types of commercial intangible assets. This chapter also described how these analytical differences impact the estimation of a discount rate or a capitalization rate to be used in an intellectual property economic analysis. Finally, this chapter discussed several of the models that are commonly used to estimate a discount rate and capitalization rate for purposes of intellectual property valuation, damages analysis, or transfer pricing. This chapter also demonstrated
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how the discount rate or capitalization rate estimated using these models can be used in the typical intellectual property economic analysis.
Suggested Reading Bodie, Zvi, Alex Kane, and Alan J. Marcus. Investments, 2d ed. New York: McGraw-Hill, 1993. Pratt, Shannon P. Cost of Capital: Estimation and Applications, 2d ed. New York: John Wiley & Sons, Inc., 2002. Reilly, Robert F., and Robert P. Schweihs. Valuing Intangible Assets. New York: McGraw-Hill, 1999. Smith, Gordon V., and Russell L. Parr. Valuation of Intellectual Property and Intangible Assets, 3d ed. New York: John Wiley & Sons, Inc., 2000. Stocks, Bonds, Bills, and Inflation—Valuation Edition 2002 Yearbook. Chicago: Ibbotson Associates, Inc. 2002. Stocks, Bonds, Bills, and Inflation: 2002 Yearbook. Chicago: Ibbotson Associates, Inc. 2002.
Chapter 16 Intellectual Property Life Estimation Approaches and Methods Pamela J. Garland
Introduction Importance of Life Estimation Performing a Life Estimation Analysis Topics Covered in This Chapter Reasons to Perform a Life Estimation Analysis Valuation Economic Damages Transfer Price/Licensing Intellectual Property Life Measurements Statutory Life Contract Life Judicial Life Economic Life Technological Life Analytical Life Other Life Measurements Data Used in Intellectual Property Life Estimation Registration Documents Contracts Judicial Decisions/Orders Financial Statements Usage Data Operational Documents Technology Data Age/Life Data Summary Definitions and Analytical Methods Age Average Life Total Life Probable Life Average Remaining Useful Life
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Survivor Curve Probable Life Curve Survivor Curve and Probable Life Curve Example Turnover or Retirement Rate Expected Decay or Depreciation Iowa-Type Curves Weibull Curves Technology Forecasting Illustrative Examples Patent Infringement Example Trade Secret Valuation Example Trademark Licensing Example Copyrighted Software Example Summary and Conclusion Suggested Reading and Resources
Introduction Importance of Life Estimation The expected remaining useful life (RUL) of an intellectual property is a factor to be considered in any intellectual property economic analysis. RUL consideration influences intellectual property analyses that are performed for valuation, economic damages estimation, transfer pricing, licensing royalty rate, and other purposes. RUL analysis is an integral component of any cost, income, or market approach to intellectual property analysis. When a cost approach analysis is used, intellectual property RUL should be considered in the estimation of obsolescence. When an income approach analysis is performed, intellectual property RUL should be considered in determining the term of the income projection period. When a market approach is used, intellectual property RUL is a factor (1) in assessing the comparability of the guideline transactions to the subject property and (2) in estimating any adjustments to make the guideline transactions more comparative to the subject property. There are a variety of factors that may affect the RUL of intellectual properties. Even though some intellectual properties effectively have an unlimited legal life, they often have a shorter economic life. This limited life of intellectual properties is a fundamental factor that distinguishes intellectual property analyses from business enterprise analyses. A company is dynamic, generally evolving over time. Though one product line may disappear, another is likely to take its place. While one of a company’s patents may expire, new patents may be added. For this reason, an analyst would typically perform an economic analysis related to a successful going-concern business enterprise by projecting an unlimited life. For example, an analyst estimating a company’s business enterprise value using a discounted cash flow (DCF) method would typically project cash flow for some discrete number of periods and then add a residual value representing the cash flow to be generated in perpetuity. An analyst performing an economic analysis related to a 9-year-old patent may project profits or cost savings over the patent’s remaining legal term or over a shorter
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period, depending on various factors that affect the economic life of the patent. These factors could include the following: 1. 2. 3. 4.
The existence of competitive patented or unpatented technology Market demand for products dependent upon the patented technology Economic factors that could affect the profitability of patent-dependent products The likelihood of the development of newer technology that could make the subject patent obsolete
Performing a Life Estimation Analysis Remaining useful life estimation may be an unfamiliar procedure to analysts whose experience is limited to business enterprise analyses. Accordingly, many experienced analysts often perform intellectual property economic analyses using either (1) a perpetual life or (2) a legal, tax, or accounting life—without any attempt to estimate the property’s expected RUL. A variety of life measures—or life determinants—should be considered in estimating both the life and the RUL of an intellectual property. Statutory, contractual, judicial, economic, technological, and analytical factors all affect the intellectual property RUL estimation conclusion. Analytical life estimation typically involves (1) the observation of the longevity and/or decay patterns of a group of assets over time, (2) the quantification of the liferelated phenomena, and (3) the application of any pattern or statistical results to the subject asset group in order to estimate the RUL (or the expected attrition) of assets within the group. The actuarial tables used by life insurance companies are the result of this type of analysis performed with respect to human life. In fact, actuarial statistics provides a good example of why a thorough understanding of life estimation analysis can generally enable an analyst to reach a more reliable RUL conclusion. Consider an actuarial study that concludes an average life expectancy of 72 years for human males and 79 years for human females. This means that the life expectancy of a newborn baby boy is 72 years and that of a newborn baby girl is 79 years. The naïve application of this information may result in the estimation of the expected remaining life of a 60-year-old man to be 12 years (i.e., 72 − 60 years). However, the actuarial tables would, in fact, indicate the estimated remaining life of a 60-year-old man to be about 18 years. A practical explanation of this phenomenon is that the 72-year life expectancy estimate was computed using data that include (1) infant mortality rates and (2) teenage drug, alcohol, traffic, and crime/gang-related deaths. Having already survived infancy and his teen years, the 60-year-old man is expected to surpass an average life expectancy that includes these factors. Similarly, a simplistic estimate of the remaining life of an 80-year-old woman may be zero. However, an actuarial table would indicate an estimated remaining life of 9 years. Having been strong, healthy, careful, and/or lucky enough to survive until the age of 80 years, it is likely that the subject woman has a decade or so left of her life. Clearly, all 80-year-old women won’t live until they are 89. In fact, some 80-year-old women may not live to be 81. But, other 80-year-old women may live to be 95. It follows that an intellectual property economic analysis using an estimated RUL will be more accurate if this gradual “mortality” or “decay” is factored into the analysis. An economic analysis that assumes that each intellectual property will survive exactly the same length of time will be less accurate.
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Another lesson that can be learned from the human actuarial analysis example is that subgroups of a population sometimes demonstrate different survival behaviors. In the preceding example, the total group (of humans) was divided into two subgroups according to gender. Further group stratification (e.g., smoker/nonsmoker) may provide even more precise life estimates. With respect to intellectual properties, for example, one may find that trademarks that include stylized drawings, such as logos or pictures, tend to have shorter (or longer) lives than trademarks related only to phrases or brand names. Naturally, the reliability of an RUL estimation analysis depends on the quantity and quality of available data for analysis. There will be instances when subjective, qualitative judgments must be factored into the RUL analysis and conclusion. And, there will be instances when subjective judgment must be used in the absence of quantitative data. However, a thorough understanding of RUL estimation analysis methods will assist the analyst in reaching accurate intellectual property value, damages, and transfer price conclusions.
Topics Covered in This Chapter First, we will discuss the typical reasons to perform a life estimation analysis. For each of the primary types of intellectual property economic analysis (i.e., valuation, damages, transfer pricing, and licensing), there are several reasons to perform an RUL estimate analysis. Second, we will discuss the various life measurements applicable to intellectual properties. We will describe these life measurements. And, we will explain how each measurement may affect the different types of intellectual property economic analyses. Third, we will describe the types of data that may be used in an intellectual property RUL estimation analysis. And, we will explain how these data may be included in a life estimation analysis. Fourth, we will define various terms used in life estimation analysis, such as average life, probable life, remaining useful life, survivor curve, and turnover rate. Graphs and tables demonstrating life analysis theory and analytical methodology will be presented to help define—and illustrate the relationships between—these terms. Finally, we will provide illustrative examples of RUL estimation analyses, including the use of analytical methods.
Reasons to Perform a Life Estimation Analysis There are a number of reasons to perform a life estimation analysis as part of an intellectual property economic analysis. The reasons vary depending on the type of analysis to be performed. Therefore, we will discuss the typical reasons for each of the primary types of intellectual property analysis.
Valuation Intellectual property RUL is a factor that can have a significant effect on the value conclusion, regardless of which of the three valuation approaches is used. In an income approach analysis, the number of periods to project income will typically be limited
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by the intellectual property RUL (see Chap. 17, Intellectual Property Residual Value Analysis, which addresses value not included in the RUL). A longer RUL normally results in a higher value. This is because there is more economic income to be capitalized. Because the expected future economic income is discounted to the present, the value conclusion is more sensitive to changes in RUL at shorter projection periods. In an income approach analysis, another life-related factor to consider is the rate of decay over time of an individual intellectual property or of a group of intellectual properties. For example, a life estimation analysis can be performed to estimate (1) the decay in the number of income-generating copyrights over time or (2) the decay in the amount of income associated with the copyrights over time. The results of such analyses could be used to estimate the decreasing intellectual property–related income over the income projection period. A cost approach analysis should include an estimation of any obsolescence associated with the intellectual property. Though a number of subjective factors may be considered in the estimation of obsolescence, a life estimation analysis may provide quantitative measures of obsolescence. For example, consider a group of engineering drawings (as the embodiment of trade secrets) for which historical creation and retirement data are available. Let’s assume that an analysis of these data indicates an average life for engineering drawings of 8 years. The RUL for 6-year-old drawings may be estimated to be 2 years (i.e., 8 – 6 years), and the obsolescence of the subject drawings may be estimated to be 75 percent (6/8 years). If a more detailed life analysis is performed, the historical retirement data—as well as data related to the ages of the “active” drawings—are used to match the survival pattern of the drawings to standard survivor curves. These survivor curves result in RUL estimates similar to the way that human actuarial tables work. Obsolescence can then be estimated as the ratio of age to total expected life. For example, even though the entire group of drawings has an estimated average life of 8 years, the expected life for a 6-year-old drawing may be 9 years, indicating obsolescence of 66.7 percent (6/9 years)—rather than the more simplistic 75 percent (6/8 years). Regardless of the data available and the sophistication of the life estimation model, the RUL estimate will affect the estimate of obsolescence and, therefore, the value concluded from a cost approach analysis. When a market approach is used, the age and RUL of the subject intellectual property are compared to the age and RUL of the guideline properties for two reasons. First, differences in these life characteristics may be used to make adjustments to the comparative guideline transactions (to make the transactions more comparable to the subject). Second, the age and RUL of the subject property may be a basis for eliminating certain guideline transactions from the analysis or, possibly, for rejecting the market approach altogether.
Economic Damages Commercial damage litigation may involve judicial rulings related to a number of issues. These issues include (1) economic damages to date (e.g., from the time an intellectual property infringement first occurred through the present time), (2) future economic damages (i.e., from the analysis date through the cessation of the expected effects of the infringement), (3) a fair royalty rate, (4) the expected term of future damages, (5) any damage (i.e., decrease) to the life of the intellectual property, and (6) the appropriate discount rate.
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Intellectual property economic damages estimations typically involve some form of income approach analyses. The estimation of historical economic damages generally does not require an estimation of the intellectual property RUL. This is because it is already known whether the intellectual property is still useful as of the analysis date. The estimation of future economic damages is more likely to include an RUL analysis. One of the factors generally considered in the estimation of a fair royalty rate is the expected term of the license agreement. And, in an economic damages analysis, the expected term of the license agreement is usually related to the RUL of the intellectual property. The intellectual property expected RUL is an important consideration when estimating the term of future economic damages. Furthermore, an RUL analysis is an important component to the owner/operator’s claim of damage (i.e., decrease) to the life of the intellectual property.
Transfer Price/Licensing There are several methods generally used when estimating an intercompany or a third-party transfer price or license assignment royalty rate. These intellectual property transfer price methods include the comparable uncontrolled transaction, the comparable profits, the profit split, and the excess earnings methods. Though the age or the RUL of the intellectual property may not be included directly—and quantitatively—in these transfer price analyses, these age/life considerations are still relevant. This is because the intellectual property age and/or RUL may affect the term of the license agreement and the transfer price or license royalty rate conclusion. With respect to the term of the license agreement, for example, it is unlikely that a licensor would sign a 10-year use license related to a patent that will expire in 2 years. The effect of the intellectual property age and/or RUL on the transfer price/royalty rate conclusion is more likely to be qualitative than quantitative. For example, let’s assume that royalty rates indicated by the various transfer price methods fall into a range from 8 to 12 percent. The analyst may conclude a reasonable royalty rate toward the upper end of that range for an intellectual property with a particularly long expected RUL. Or, conversely, the analyst may conclude a reasonable royalty rate toward the lower end of that range for an intellectual property with a particularly short expected RUL. Of course, the analyst would also consider a number of other qualitative factors when concluding the transfer price/royalty rate.
Intellectual Property Life Measurements There are a number of different life measures that are typically considered when performing an intellectual property economic analysis. All relevant life measures should be examined before reaching an RUL conclusion. Generally, the shortest of the relevant RUL indications is the appropriate life measure for intellectual property valuation, damages, or transfer price analyses.
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Statutory Life The statutory life of an intellectual property is the term of the property’s legal registration as defined by law. For example, the statutory life of a patent generally begins on the date the patent is granted and ends 20 years after the date the patent application was filed. Prior to June 8, 1995, the term of a patent was generally 17 years from the date the patent was granted. Design patents have a shorter registration term (i.e., 14 years) than utility and plant patents. As of the 1998 amendment to the Copyright Act of 1976, the statutory life of a copyright created on or after January 1, 1978, generally lasts 70 years beyond the death of the author (or last surviving author). For certain works (such as anonymous/pseudonymous works and works made for hire), the term of the copyright will be the lesser of (1) 95 years from first publication or (2) 120 years from creation. Copyright terms run through the end of the calendar year in which they would expire. For older works, other copyright terms—and rules related to copyright renewal—may apply.1 Trademarks may be renewed indefinitely, if all required paperwork is filed on a timely basis. A declaration of use must be filed between the fifth and sixth year following the trademark registration in order for the trademark registration to remain valid. In addition, a declaration of use must also be filed with a renewal application within the year prior to every 10-year period following registration in order for the trademark registration to remain valid. Prior to November 16, 1989, the trademark registration renewal period was 20 years. Trade secrets do not require either federal or state registration. Therefore, trade secrets do not have statutory limits with respect to their legal registration term.
Contract Life The term of a commercial contract associated with an intellectual property may affect the intellectual property economic analysis. Examples of such commercial contracts include (1) use, development, and exploitation contracts; (2) inbound and outbound licenses; and (3) transfer price agreements. Any stated contract renewal terms and the party’s history of contract renewals should also be considered as part of the contract life determinant.
Judicial Life For our purposes, the term judicial life refers to the life—or the term of economic damages—as awarded or ordered by a judge or similar authority. For example, a judge may order that (1) certain copyright infringement damages commenced on a specific date and ended on a specific date (as a measure of historical damages) or (2) a reasonable royalty rate must be paid to the copyright owner for a specified time period after the order (as a measure of future damages).
1 The Sonny Bono Copyright Term Extension Act, which became law on October 27, 1998, was upheld by the U.S. Supreme Court in Eric Eldred, et al. v. John D. Ashcroft, 537 U.S. 186 (2003).
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Economic Life An economic life is determined by the ability of an intellectual property to generate an adequate amount of economic income to justify its continued use. Economic life is influenced by many factors, including factors outside of the control of the intellectual property owner/operator. For example, let’s assume that the patent related to a proprietary product has a remaining legal life of 15 years. However, if the materials needed to manufacture the product become scarce and more costly, the demand for the more expensive product (and the profit margin on the manufactured product) may be adversely affected. This change in the manufacturing cost of the product could reduce the economic life of the product—and the associated economic life of the patent. In fact, an intellectual property economic life can be affected by a coincidental change in consumer perception. For example, consider the effect on the RUL of the trademarks associated with AYDS appetite suppressant candy when the medical community began referring to acquired immune deficiency syndrome as AIDS.
Technological Life The technological life of an intellectual property is influenced by changes in technology. Newer technology may allow for a product or service that is better, faster, or cheaper than was possible with the older technology. When a new technology is developed that is preferable to the subject intellectual property technology, technology/market substitution will likely take place. For example, the owner of a patent on a portable cassette player with a single earphone probably experienced reduced demand for that product after the introduction of the Sony Walkman with stereo headphones. Decreased demand for a patented product could make the patent technologically obsolete years before the legal term of the patent expires.
Analytical Life An analytical life is based on the quantitative analysis of the historical survival/mortality characteristics of similar intellectual properties. RUL analyses typically examine the historical placement and retirement of intellectual property “units” (e.g., the effective usage start dates and stop dates of similar trademarks, engineering drawings, etc.). The observed survival/mortality patterns can be used to estimate the average life, remaining useful life, and expected future retirements of a group of related intellectual properties. RUL analyses may also examine the historical decay of dollar volume or unit volume associated with similar intellectual properties (e.g., the pattern of royalty income associated with copyrighted songs). One of the most common quantitative life estimation analysis methods is the sumof-least-squares (SLS) curve fitting. In the SLS process, the observed percent surviving (of either dollars or units) over time is compared to several families of survivor curves developed at Iowa State University (i.e., Iowa-type curves). A similar life estimation method uses regression analysis to estimate the geometric parameters that define the Weibull-type curve that best fits the observed survivor curve. Both of these analytical life estimation methods will be described in further detail later in this chapter.
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Where sufficient data are not available to perform an Iowa-type curve or a Weibull-type curve analysis, a simple turnover rate analysis may be performed. In this simplified analytical life method, the analyst projects future property turnover/ retirements (as a percentage per time period) based on historical turnover/retirement statistics. Technology-related intellectual properties often exhibit a similar life cycle. This technology life cycle generally consists of three phases: (1) the introduction or new invention phase, (2) the rapid adoption or growth phase, and (3) the saturation or maturity phase. Eventually, newer technology may force the mature technology into a decline phase, as the market begins to adopt the newer technology. An examination of the life cycles of prior technology-related intellectual properties—or of the products/services associated with those intellectual properties—may provide information that can be used to estimate RUL, technological obsolescence, and future utility of the subject intellectual property. Future utility may be measured using revenues, unit volume, or market share for associated products/services. Various technology-related S-curves (so named because the shape of the curve resembles the letter S) have been developed to define the technology life cycle. Statistical methods are available to project the technology life cycle based on an analysis of historical data.
Other Life Measurements Physical life generally refers to the estimated time it is expected to take for an asset to physically wear out or to be used up. This RUL measurement is not particularly applicable to intellectual property. Although intellectual properties may have some physical evidence of existence (e.g., a copyright registration document), the destruction of this physical evidence typically does not diminish the life of the intellectual property. Functional life refers to the length of time that an asset is expected to be able to perform the function for which it was intended. With respect to intellectual property, the functional life is typically less restrictive than the other life measurements. For example, the formula for a popular soft drink may be a valuable trade secret up until a link is found between one of the beverage ingredients and the occurrence of cancer. Although the soft drink formula may still function, sales of the beverage product will decrease drastically. Accordingly, the economic life of the trade secret will be adversely affected. And, economic life will become the limiting life determinant of the beverage formula trade secret. Similarly, a patent related to a particular product may be functional (i.e., able to perform the function of keeping competitors from using the patented technology) throughout its statutory life. However, if newer technology makes the patented product functionally obsolete, the longer legal term of the patent registration becomes moot.
Data Used in Intellectual Property Life Estimation Depending on the type of intellectual property, a variety of data may be used in the life estimation analysis.
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Registration Documents Intellectual property registration documents include (1) patent application and issuance documents; (2) trademark application, registration, and renewal documents; and (3) copyright application and certificate of registration documents. In addition to the registration documents for the intellectual property, the analyst may review registration documents (or summary information from such documents) related to similar active and/or cancelled/abandoned intellectual properties. In addition to evidencing the existence of the intellectual property, the registration documents provide dates that may be used to estimate the intellectual property life.
Contracts Any commercial contracts related to the subject intellectual property may be useful in an RUL estimation analysis. Examples of such contracts include (1) use, development, or exploitation contracts; (2) inbound and outbound license agreements; and (3) transfer price agreements. Information related to historical intellectual property contract renewals would also be relevant to the RUL analysis.
Judicial Decisions/Orders In a damages analysis, judicial decisions or orders regarding the term of historical damages (i.e., from the first damage until the trial) are relevant. The judge may also rule on the term of any future damages (i.e., damages from the trial date going forward). These orders are particularly relevant in economic damages cases where the litigation has been bifurcated into a liability phase and a damages phase. In the liability phase of the litigation, the judge (or other finder of fact) may rule on relevant time periods that could affect the analyses prepared for the damages phase of the litigation. For example, a judge may order that the infringing party may have to pay for any historical damages suffered by the intellectual property owner as well as a fair royalty rate for the future use of the intellectual property.
Financial Statements Financial statements may be used in a variety of ways in an intellectual property analysis. Clearly, an income approach analysis may rely on historical financial statements of the intellectual property owner/operator. In the case of economic damages analysis, financial statements of both the intellectual property owner/operator and the infringing party may be relevant. More detailed statements of revenues and expenses—including product line sales, royalty amounts, advertising expenses, research and development costs, and so forth—may be used in valuation, damages, and transfer price analyses. The historical revenues related to an intellectual property, or to a group of intellectual properties, may provide data relevant to estimating the intellectual property RUL. In addition to historical financial statements, projected financial statements of the owner/operator (including any budgets, strategic plans, or financial forecasts) may be relevant to the analysis.
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Usage Data Intellectual property usage data are often used in the RUL estimation analysis. These data include advertising placements, unit production volume, unit sales volume, number of displays, use on product packaging, number in a library, number in an archive, unit rentals, number in a distribution system, units printed, and any contracts or correspondence referring to usage. As with financial statement data, projected intellectual property usage data may be as relevant as historical usage data.
Operational Documents With respect to operational documents, the analyst will typically gather data including inventories or lists of identification numbers, dates, and descriptions of items such as engineering drawings, mylars, schematics, blueprints, product/process flowcharts, manuals, lines of computer software source code, memos, procedures, policies, packaging materials, or contracts. Relevant document dates may include creation date, revision dates, and cancellation/retirement date.
Technology Data Relevant data related to technology include information about prior related technologies and competitive technologies. Technology information may be found in patents, patent applications, marketing materials, technical journals, internal or third-party analyst reports, or conference proceedings. Start dates and stop dates of prior generations of technology may be useful in estimating the RUL of the subject technology. In addition, any quantitative life cycle or technology replacement data may be relevant.
Age/Life Data Summary Some of the age/life data used in intellectual property RUL estimation are used qualitatively, as background information to assist in making life estimates based on professional judgment. However, when quantitative age/life data such as intellectual property placement and retirement data—or start dates and stop dates—are available, these data can be used in a quantitative actuarial-type analysis. Also, data related to intellectual property decreasing or increasing historical/projected revenues (or unit sales volumes) may be used to perform additional quantitative analyses.
Definitions and Analytical Methods In order to understand the methods used in—and any conclusions drawn from—a quantitative RUL estimation, it is important to define some of the terms commonly used in such an analysis.
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Age While it seems fairly obvious that the term “age” refers to how old something is or how long it has been in existence, as of a certain date, the analyst should be very specific in using this term. For example, is the age of a patent to be measured from the date of the patent application or the date the patent was granted? The answer may vary depending on the data available, the “as of” date of the analysis, the purpose of the analysis, and how any RUL conclusions will be used in the analyses. However, it is important (1) to select the best definition of age, given the facts and circumstances of the case; (2) to document how age is defined; and (3) to consistently use the same definition of age throughout the analyses. Analysts often refer to “vintage age groups” when describing RUL estimation analyses. Most often, a vintage age group consists of members of the population that came into existence during the same 1-year time frame. For example, trademarks that were registered between 3 and 4 years prior to the analysis date may be referred to as the 3–4-year vintage age group (or as the 3.5-year age group).
Average Life The average life conclusion of an RUL estimation analysis represents the expected average life for a new unit or member of the group. Referring to our actuarial analysis of human life expectancy example earlier in this chapter, the average life conclusion of 72 years for human males represents the expected average life of a newborn baby boy.
Total Life Total life for a group generally refers to the age at which the last member of the group is expected to retire/expire. Total life for a group of people, to return to our actuarial example, is clearly finite. We may estimate the total life for a group of people to be 105 or 115 years. And, we can be fairly certain that the total life of a group of people will not be as long as 150 years. The total life for a group of trademarks may be more difficult to estimate. This is because there is no natural upper limit to the total life of intellectual property.
Probable Life The probable life for a particular age group of surviving members is the average expected life of those surviving members. For example, the probable life of a group of 80-yearold women may be 89 years. This 89-year estimate represents an average of the expected lives of the members of the group. A certain percentage of the women is expected to survive to age 81, a certain percentage is expected to survive to age 82, and so on.
Average Remaining Useful Life The average RUL for a particular age group of surviving members is equal to the probable life for that group less their age. The RUL represents the expected time the group, or a member of the group, is expected to survive after the analysis date. For example,
16 / Intellectual Property Life Estimation Approaches and Methods
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if the analytical method indicates that the probable life of a group of 7-year-old engineering drawings was 12 years, then the RUL for 7-year-old drawings would be 5 years. This may be true even if the average life of the engineering drawings is 10 years.
Survivor Curve A survivor curve represents the relationship between age and percent surviving for a population. A survivor curve for a group of intellectual properties can be determined if sufficient placement and retirement data (i.e., start dates and stop dates) are available. The curve starts with 100 percent surviving at age zero, with the percent surviving (of the total population) decreasing over time.
Probable Life Curve A probable life curve represents the relationship between age (or percent surviving) and probable life. The probable life of an intellectual property when its age is zero (and the percent surviving is 100 percent) is equal to its average life.
Survivor Curve and Probable Life Curve Example Exhibit 16.1 presents the O4 Iowa-type survivor curve and related probable life curve.2 The curve to the left is the survivor curve. At age zero, the percent surviving is 100 percent. As age (as a percent of average life) increases, the percent surviving decreases. If an analysis is performed that concludes a 10-year average life, then the long vertical dotted line would represent 10 years (i.e., 100 percent of the 10-year average life). The curve to the right is the probable life curve. The probable life at age zero (or at 100 percent surviving) is equal to the average age. In this example, at age 20 (or at 200 percent of the average life of 10 years), the percent surviving is approximately 17 percent and the corresponding probable life is approximately 311 percent of average life (or 31.1 years). Therefore, the expected RUL at 20 years is 10.1 years (i.e., the probable life of 31.1 years minus the age of 20 years). This RUL can also be measured by calculating the total shaded area under the survivor curve and dividing the total shaded area by the percent surviving. The indicated total life of the group is approximately 44 years (i.e., 440 percent times 10 years).
Turnover or Retirement Rate In many cases, data related to the retirement of intellectual properties are limited. For example, the analyst may know (1) how many computer programs the owner/ operator had at the beginning of the last 3 years and (2) how many programs were purged from the program libraries in each of these 3 years. However, the analyst may not know the age of any of these deleted/retired programs. The ratio of the 2 As defined by Robley Winfrey (and revised by Harold Cowles) in Statistical Analyses of Industrial Property Retirements (Ames, IA: Engineering Research Institute, Iowa State University, 1967), pp. 177–204.
434
IV / Intellectual Property Valuation Issues
Exhibit 16.1
Illustrative Survivor Curve and Probable Life Curve O4 Curve 110 100 90 80
% Surviving
70 60 50 40 30 20 10 0 0
25 50
75 100 125 150 175 200 225 250 275 300 325 350 375 400 425 450 475 Age % of Avg Life/Probable Life % of Avg Life
Average Life Age Remaining Life
Survivor Curve
Probable Life Curve
number of retired programs to the number of programs at the beginning of the year is the turnover or retirement rate. For example, if the owner/operator had 300 programs at the beginning of the year and 60 of the programs were deleted during the year, that would indicate a turnover rate of 20 percent. In order to estimate the future turnover rate (and the average life of the property), turnover rates are often calculated for several years and averaged. Annual turnover rates may also be assigned different weights, depending on (1) interviews with the owner/operator or (2) the experience/judgment of the analyst, to estimate future turnover, and average life. Exhibit 16.2 presents the calculation of an average retirement rate for 3 years. The approximate RUL for the group of intellectual properties is equal to the reciprocal of the average retirement rate.
Expected Decay or Depreciation The decay or depreciation for an intellectual property—or group of intellectual properties—is the expected loss in number or utility over time. This could mean the expected decrease in royalty revenues for a copyrighted publication over time. It could also mean the expected cancellations of trademarks over time. It could mean the decreasing sales volume of patented products, over time. Ideally, the estimation of future decay for a group of intellectual properties considers the age of each individual intellectual property.
16 / Intellectual Property Life Estimation Approaches and Methods
435
Exhibit 16.2
Turnover/Retirement Rate and RUL, Based on Retirement Rate Retirement Rate Factors Units active at beginning of the year Units retired during the year Retirement rate (%) Average retirement rate, rounded (%) Estimated remaining useful life = 1/Retirement rate
1998
1999
2000
213 41
250 53
300 59
19.25
21.20
19.67 20 5 years
The expected decay of the intellectual properties in Exhibit 16.2 is presented in Exhibit 16.3. In this example, the number of active property units at the beginning of year 2001 is 284. The number of property units at the beginning of a year is equal to (1) the number of property units at the beginning of the previous year, (2) less the unit retirements during the year, and (3) plus the number of new property units added (none, in this example) during the year. Additionally, in this exhibit, the average RUL is calculated using both mid-year and end-of-year unit retirement assumptions. Note that the end-of-year retirement calculation is equal to the approximate RUL calculated in Exhibit 16.2. When data are available to perform a more comprehensive analysis (i.e., when start dates are known for all active properties and start dates and stop dates are known for several years for retired properties), an actual survivor curve can be calculated. This actual survivor curve may be matched to the standard survivor curves (e.g., Iowa-type curves, Weibull-type curves, etc.) to find the best-fitting curve type and average age. The decay of the group can then be estimated as a composite of the decay of each age group over time, given the survivor curve type and the average life. An example of the calculation of such a composite decay curve will be presented later in this chapter.
Iowa-Type Curves The curves generally referred to as the “Iowa-type curves” are the 22 survivor curves described in Statistical Analyses of Industrial Property Retirements.3 This book provides the mathematical equations—as well as the percent surviving and probable life tables—for each of these curves. In addition, various methods for analyzing retirement data are described. The Iowa-type curves include seven symmetrical curves (S0–S6), five rightmodal curves (R1–R5), six left-modal curves (L0–L5), and four origin-modal curves (O1–O4). In a typical RUL analysis using Iowa-type curves, the observed survivor curve (based upon historical property placements and retirements) is compared to each Iowa-type curve over a reasonable range of average lives. Ideally, a least-squares curve-fitting program is used to select the Iowa-type curve that best fits the actual survivor curve. In the absence of such a program, it is possible to visually compare the curves using the graphing capabilities of a spreadsheet program such as Microsoft
3
Ibid. These curves are discussed throughout the book.
436
IV / Intellectual Property Valuation Issues
Exhibit 16.3
Survivor Decay Rate, Based on Constant Retirement Rate Decay/Depreciation
Year
Number of Survivors Beginning of Year
Retirement Rate (%)
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
284 227 182 146 117 94 75 60 48 38 30 24 19 15 12 10 8 6 5 4 3 3 2 2 1 1 1 1 1
20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20
Number of Survivors Retirements End During Year of Year 57 45 36 29 23 19 15 12 10 8 6 5 4 3 2 2 2 1 1 1 0 1 0 1 0 0 0 0 1
Mid-Year Calculation
End-of-Year Calculation
Age at Retirement
Number Retiring Times Age
Age at Retirement
Number Retiring Times Age
0.5 1.5 2.5 3.5 4.5 5.5 6.5 7.5 8.5 9.5 10.5 11.5 12.5 13.5 14.5 15.5 16.5 17.5 18.5 19.5 20.5 21.5 22.5 23.5 24.5 25.5 26.5 27.5 26.5
28.5 67.5 90.0 101.5 103.5 104.5 97.5 90.0 85.0 76.0 63.0 57.5 50.0 40.5 29.0 31.0 33.0 17.5 18.5 19.5 —– 21.5 —– 23.5 —– —– —– —– 26.5
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 27
57 90 108 116 115 114 105 96 90 80 66 60 52 42 30 32 34 18 19 20 —– 22 —– 24 —– —– —– —– 27
227 182 146 117 94 75 60 48 38 30 24 19 15 12 10 8 6 5 4 3 3 2 2 1 1 1 1 1 0
Total number of survivor units retiring times age Divided by total number of survivor units at t = 0 Estimated average remaining useful life (in years) of intellectual property units
1,275.0 284
1,417 284
4.5
5.0
Excel. Once the best-fitting Iowa-type curve is selected, the analyst will (1) know the average life of the property group, (2) be able to predict the percent surviving past the time period for which actual property survivor data exists, and (3) be able to calculate the probable life of any property age group.
Weibull Curves Weibull curves are a family of curves developed by Waloddi Weibull. They are defined by two parameters: (1) shape and (2) scale. (A third Weibull parameter, location, is not used for survivor curve fitting.) When the shape parameter is equal to one, the resulting Weibull curve is an exponential curve. When the shape parameter
16 / Intellectual Property Life Estimation Approaches and Methods
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is equal to two, the resulting Weibull curve is a Rayleigh curve. The equation for a Weibull survivor function is % surviving = exp(−(age/scale)shape) Note that the shape exponent is to be applied before the negative sign. In some spreadsheet programs, an additional set of parentheses may need to be used so that the mathematical operations are performed in the correct order. Once this Weibull survivor function equation is algebraically transformed into a linear form, a regression analysis can be performed using actual survival data. A full discussion of the conversion of the Weibull survivor function to a linear expression can be found in Valuing Intangible Assets by Robert F. Reilly and Robert P. Schweihs.4 The linear form of the Weibull survivor function equation is ln(ln(1/s)) = B ln(t) + c where s B t c
= = = =
percent surviving at time t the shape parameter time, or age the y-intercept such that exp(c) = (1/a)B, where a is the scale parameter
This regression analysis can be performed using a standard spreadsheet program such as Microsoft Excel. An example is presented in Exhibit 16.4. The shape parameter is equal to the x-coefficient or slope. The scale parameter is calculated by solving the exp(c) = (1/a)B equation for a (where c is the y-intercept from the regression analysis): a = exp(c)(–1/B) Once the shape and scale parameters are determined, the percent surviving values for the Weibull curve can be calculated. These values can be used to predict the percent surviving after the time period for which actual survivor data are available for the intellectual property group. The mean, or average, life can be computed as the scale multiplied by the gamma function of (1+1/shape); the mean, or average, life can also be computed using the gammaln function in Microsoft Excel, as follows: mean = a exp(gammaln(1 + 1/B)) One practical problem with the use of Weibull curves in RUL analysis is that the curves often “flatten out.” That is, the percent surviving indicated by the Weibull curve may not reach zero percent in any meaningful time frame. This may result in unusually long RUL estimates (as calculated using the area under the curve to the right of age divided by the percent surviving) as the age of the property increases.
Technology Forecasting There are a number of technology forecasting RUL methods available using technology substitution and technology trend analyses. Common technology forecasting models include the Fisher-Pry, Gompertz, and Pearl-Reed models. There is a
4
Robert F. Reilly and Robert P. Schweihs, Valuing Intangible Assets (New York: McGraw-Hill, 1998), p. 231.
438
100.00 70.42 55.33 41.50 29.81 24.74 22.06 19.70 16.12 13.97 11.17 7.45
df 1 9 10
Coefficients −0.6767491 0.64790827
Regression Residual Total
Intercept X Variable 1
ANOVA
X
p-value 3.047E-08 4.604E-10
0
1
3
4
5
6 Age
7
8
9
10
Lower 95.0% −0.76459392 0.595549261
Upper 95.0% −0.588904333 0.700267287
% Surviving = exp(−(Age/Scale)^Shape)
3.896944623 Scale × gamma (1 + 1/Shape) or Scale × exp(gammaln (1 + 1/Shape))
0.647908274 (1 = exponential, 2 = Rayleigh) −0.676749127 2.84201637 exp(c)^(−1/Shape)
2
Weibull Curve Compared to Actual Survivor Curve
Upper 95% −0.588904333 0.700267287
Mean = Avg Life:
Shape (x coeff): c = intercept: Scale:
110% 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%
Weibull Analysis
Lower 95% −0.76459392 0.595549261
F Significance F 783.59266 4.6044E-10
t Stat −17.42749 27.992725
MS 3.5676058 0.0045529
Standard Error 0.038832283 0.023145595
SS 3.567605785 0.040975948 3.608581733
−1.0479 −0.5246 −0.1284 0.1909 0.3343 0.4130 0.4853 0.6018 0.6772 0.7846 0.9544
Y
Regression Variables ln(t) ln(ln(1/s))
−0.6931 0.4055 0.9163 1.2528 1.5041 1.7047 1.8718 2.0149 2.1401 2.2513 2.3514
Regression Statistics Multiple R 0.99430622 R Square 0.98864486 Adjusted R Square 0.98738318 Standard Error 0.06747506 Observations 11
SUMMARY OUTPUT
0 0.5 1.5 2.5 3.5 4.5 5.5 6.5 7.5 8.5 9.5 10.5
t
Actual Data s Actual Percent Age Surviving
Exhibit 16.4
% Surviving
11
12
Age 0 0.5 1.5 2.5 3.5 4.5 5.5 6.5 7.5 8.5 9.5 10.5
Weibull Percent Surviving 100.000 72.298 51.635 39.841 31.840 26.006 21.571 18.102 15.332 13.086 11.241 9.710
Weibull
Actual
16 / Intellectual Property Life Estimation Approaches and Methods
439
technology forecasting software product called tf.Innovate that facilitates the use of these three models.5
Illustrative Examples Patent Infringement Example Let’s assume that Owner Company, which operates in a rapidly changing industry, owns a large number of patents. Due to a competitor’s unauthorized use of several of the company’s patents, Owner Company has filed a complaint. The complaint seeks a judicial order for the competitor to cease the infringement of the Owner Company patents. As an alternative basis of judicial relief, the complaint seeks a judicial order requiring the competitor to pay a royalty to Owner Company for the continued use of the company patents. As support for its claim for court-ordered future royalty payments, the Owner Company retains an analyst to estimate the RUL of the company patents. As part of the RUL due diligence process, the analyst conducts interviews with Owner Company management. Based on information gleaned from the management interviews, the analyst concludes that an appropriate way to estimate the RUL of the patents is to examine the length of time that the engineering drawings related to the patents have been in use at Owner Company. The company maintains records related to each engineering drawing used in the manufacturing process. The engineering drawing records indicate (1) the creation date and (2) the usage stop date for each active and inactive drawing. Therefore, the analyst will only consider engineering drawing placements and retirements within the most recent 3-year experience band time period. Exhibit 16.5 presents the calculation of a survivor curve based on the creation dates and the retirement dates of the Owner Company engineering drawings. The number of drawings created and retired in each year are tallied in the large table on the left of Exhibit 16.5. Looking at the first row of the table, 20 engineering drawings were created in 1990. Of those 20 drawings, 4 engineering drawings were retired in 1990, leaving 16 drawings still in use at the beginning of 1991. Of those 16 drawings, 3 engineering drawings were retired in 1991, leaving 13 drawings still in use at the beginning of 1992, and so on. In order to construct the survivor curve for these drawings, the analyst will add the number of drawings exposed to retirement and retired in each year—not calendar year, but age-interval year. The analyst makes this calculation using a 3-year experience band (i.e., the shaded area) and adding the numbers in the diagonals of the table. For example, to compute the retirement rate at the 3–4-year age interval, the analyst (1) adds the number of drawings exposed to retirement in this interval (i.e., 29 + 24 + 20 = 73) and then (2) adds the number of drawing retirements in this interval (i.e., 11 + 7 + 1 = 19). This procedure results in a retirement rate in the 3–4-year interval of 19/73 or 26.03 percent. Applying the survival rate (i.e., 1 minus the retirement rate) for one interval to the percent surviving (from the survivor curve) for the previous interval yields the next percent surviving value. For the 3–4-year interval, 73.97 percent (i.e., 1 minus 26.03 percent) times 44.94 percent equals 33.24 percent. 5 tf.Innovate was developed by BCRI, Inc. (Barreca Consulting & Research International) and is marketed by them and also by Technology/Engineering Management, Inc. (TEMI). Information about tf.Innovate and some interesting articles related to technology forecasting and related topics can be found on the web sites of each company (www.bcri.com and www.temi.com).
440
36
33
42
58
60
66
72
75
81
1993
1994
1995
1996
1997
1998
1999
2000
2001
597
30
1992
Total Balance Retired
24
1991
Placements No. of Year Units 1990 20
Exhibit 16.5
20
1990 20
4
4
40 8
62 13
85 18
100 25
117 22
153 23
190 35
221 61
Experience Band (Upper Left = Exposed to Retirement and Lower Right = Retired) 1991 1992 1993 1994 1995 1996 1997 1998 16 13 11 10 10 9 7 6 3 2 1 0 1 2 1 2 24 19 15 13 12 10 9 8 5 4 2 1 2 1 1 1 30 23 15 9 7 7 7 7 8 6 2 0 0 2 36 29 19 15 13 12 7 10 4 2 1 1 33 25 20 17 15 8 5 3 2 1 42 34 32 29 8 2 3 11 58 45 36 13 9 12 60 42 18 15 66 16
232
72
50
27
24
18
14
11
5
7
7
7
2
1
2
1
0
0
46
15
11
1999 4
261
75
57
39
20
17
16
13
9
4
7
1
8
1
3
2
2
2
0
1
1
44
23
2000 4
Owner Company Patent Infringement Example, Illustrative Survivor Curve Construction
298
81
52
56
31
19
14
14
11
7
4
6
Active No. of Units 2001 3
Survivor Curve Construction (Exp. Band of 1998–2000) Age Exposures to Retirement Survivor Interval Returement Retired Ratio (%) Curve (%) 10–11 4 25.00 10.51 1 9–10 11 9.09 14.01 1 8–9 17 11.76 15.41 2 22 18.18 17.46 7–8 4 6–7 31 19.35 21.35 6 5–6 42 9.52 26.47 4 50 12.00 29.26 4–5 6 73 26.03 33.24 3–4 19 2–3 102 26.47 44.94 27 1–2 149 18.12 61.12 27 213 25.35 74.65 0–1 54 0 100.00
16 / Intellectual Property Life Estimation Approaches and Methods
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Once the survivor curve is constructed, the analyst can find the best-fitting Iowatype curve using a sum-of-least-squares curve-fitting program. The result of this curve fitting is an O4 curve with a 4-year life. Exhibit 16.6 presents a graph of the illustrative constructed survivor curve and of the O4 curve with a 4-year life. From this analysis, the analyst can conclude that the average life of a new patent is 4 years, based on this analysis of the Owner Company historical engineering drawing placement/retirement activity.
Trade Secret Valuation Example In this example, let’s assume that Goodfood Corporation, a food manufacturer, owns a group of food recipes. Let’s also assume that these food recipes qualify as trade secrets. As part of a valuation analysis, the analyst needs to estimate the average RUL of these food recipe trade secrets. The analyst performs a survivor curve–fitting analysis in a manner similar to the previous example. Based on the analytical method procedures described above, the best-fitting curve is an R3 curve with a 10-year average life. Exhibit 16.7 presents the calculation of the weighted average RUL of the 353 food recipes. A description of the columns in Exhibit 16.7 and of their use in the calculation is given in the exhibit. As an example, the food recipes in the 3.5-year age group (3–4year age group) are at 35 percent of their average life (i.e., 3.5 divided by 10). If the analyst looks at 35 percent in the “age as a percent of average life” column in the R3 table, the indicated probable life as a percent of average life is 101.63005 percent. The RUL as a percent of average life is equal to the probable life as a percent of average life less age as a percent of average life (i.e., 101.63005% – 35% = 66.63005%). This number (as a percent) times the average life of 10 years indicates an RUL of 6.66 years. As calculated in Exhibit 16.7, the weighted average RUL of this group of food recipes is 7.86 years. Instead of estimating a weighted average RUL, the analyst could also estimate the likely retirement (or decay) of the group of food recipe/trade secrets over time. Exhibit 16.8 presents the calculation of the composite decay (or expected attrition) Exhibit 16.6
Owner Company Patent Infringement Example, Illustrative Survivor Curve and Best-Fitting Iowa-Type Curve 110 100 90
% Surviving
80 70 60
Actual Survivor Curve
50
Iowa O4 Curve
40 30 20 10 0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 Age (in years)
442 98.57396 97.88368 96.98056 95.83169 94.40602 92.67565 90.61418 88.18463 85.32735 81.95924 77.98427 73.31231 67.88278 61.68902 54.79929 47.37036 39.64975 31.96276 24.68228 18.17891 12.75178 8.54418 5.45808 3.16479 1.52141 0.51666 0.07308 0.00000
30 35 40 45 50 55 60 65 70 75 80 85 90 95 100 105 110 115 120 125 130 135 140 145 150 155 160 165
102.94124 103.77725 104.73329 105.80632 106.99765 108.31810 109.78732 111.42969 113.26927 115.32584 117.61279 120.13688 122.89916 125.89626 129.12074 132.55817 136.17725 139.90743 143.61243 147.14050 150.58516 154.08932 157.65651 161.30551 165.00000
102.22631
101.14676 101.63005
R3 Iowa-Type Curve Age as % Probable Life of Average Percent as % of Life Surviving Average Life 0 100.00000 100.00028 5 99.94867 100.05019 10 99.85318 100.13849 15 99.69592 100.27647 20 99.44840 100.48208 25 99.08466 100.76782 Totals
C Age as % of Average Life 5 15 25 35 45 55
10 E Remaining Life as % of Average Life 95.05019 85.27647 75.76782 66.63005 57.94124 49.73329
F Remaining Life in Years (rounded) 9.51 8.53 7.58 6.66 5.79 4.97
Weighted average remaining useful life (years)
Divided by total number of food recipes
D Probable Life as % of Average Life 100.05019 100.27647 100.76782 101.63005 102.94124 104.73329
C = A/Average Life (i.e., 10 years, in this case), as a percentage D = Lookup of Probable Life on R3 Iowa-type Curve for Age % C E=D−C F = E × Average Life (i.e., 10 years, in this case) G=B×F
353
A B Ages of Active Units Age # of Group Recipes 0.5 92 1.5 89 2.5 67 3.5 48 4.5 35 5.5 22
Average Life (in years):
Goodfood Corporation Trade Secrets Valuation Weighted Average Remaining Useful Life Calculation
7.86
2,773.62 353
G Remaining Useful Life Weighted by # of Food Recipes 874.92 759.17 507.86 319.68 202.65 109.34
NOTE: The data for the R3 Iowa-type curve are from Robley Winfrey, Statistical Analyses of Industrial Property Retirements, as revised by Harold Cowles (Ames, IA: Engineering Research Institute, Iowa State University, 1967).
Exhibit 16.7
443
Time (Years in Future) 0.5 1.5 2.5 3.5 4.5 5.5 6.5 7.5 8.5 9.5 10.5 11.5 12.5 13.5 14.5 15.5
16.5
Projection Period
17
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Time (Years in Future) 0.5 1.5 2.5 3.5 4.5 5.5 6.5 7.5 8.5 9.5 10.5 11.5 12.5 13.5 14.5 15.5 16.5
Projection Period
Average Life (years):
10
-
Age Group 0.5 92 92 92 91 89 87 83 79 72 62 50 36 23 12 5 1 -
Age Group 0.5 99.94867 99.85318 99.44840 98.57396 96.98056 94.40602 90.61418 85.32735 77.98427 67.88278 54.79929 39.64975 24.68228 12.75178 5.45808 1.52141 0.07308 0.00000
Age Group 1.5 89 89 88 87 84 81 76 70 61 49 35 22 11 5 1 -
Age Group 1.5 99.69592 99.44840 98.57396 96.98056 94.40602 90.61418 85.32735 77.98427 67.88278 54.79929 39.64975 24.68228 12.75178 5.45808 1.52141 0.07308 0.00000
Age Group 4.5 95.83169 94.40602 90.61418 85.32735 77.98427 67.88278 54.79929 39.64975 24.68228 12.75178 5.45808 1.52141 0.07308 0.00000
Age Group 2.5 67 67 66 64 61 58 53 46 37 27 17 9 4 1 -
Age Group 3.5 48 48 46 44 42 38 33 27 19 12 6 3 1 -
Age Group 4.5 35 34 33 31 28 25 20 14 9 5 2 1 -
# of Units Surviving by Age Group
% Surviving Since Placement Age Group Age Group 2.5 3.5 99.08466 97.88368 98.57396 96.98056 96.98056 94.40602 94.40602 90.61418 90.61418 85.32735 85.32735 77.98427 77.98427 67.88278 67.88278 54.79929 54.79929 39.64975 39.64975 24.68228 24.68228 12.75178 12.75178 5.45808 5.45808 1.52141 1.52141 0.07308 0.07308 0.00000 0.00000
Age Group 5.5 22 22 20 19 16 13 9 6 3 1 -
Age Group 5.5 92.67565 90.61418 85.32735 77.98427 67.88278 54.79929 39.64975 24.68228 12.75178 5.45808 1.52141 0.07308 0.00000
Composite Total 353 352 345 336 320 302 274 242 201 156 110 71 39 18 6 1 -
99.90446 99.49947 98.62458 97.03037 94.45450 90.66072 85.37117 78.02432 67.91764 54.82743 39.67011 24.69496 12.75833 5.46088 1.52219 0.07312 0.00000
Age Group 0.5 99.48458 97.87646 95.27814 91.45127 86.11560 78.70469 68.50988 55.30552 40.01603 24.91029 12.86958 5.50850 1.53546 0.07376 0.00000
99.07735 96.44715 92.57333 87.17219 79.67035 69.35046 55.98409 40.50701 25.21593 13.02748 5.57609 1.55430 0.07466 0.00000
98.51232 94.55555 89.03876 81.37629 70.83542 57.18285 41.37436 25.75586 13.30643 5.69549 1.58759 0.07626 0.00000
97.77561 92.07095 84.14753 73.24770 59.13019 42.78335 26.63297 13.75958 5.88944 1.64165 0.07886 0.00000
Age Group 5.5
If there are 35 units in the 4–5 year age group at time 0, we expect 57.18285% × 35 or 20 units to survive at time 5.5 years.
The percentage of the group surviving at time 0 that are still surviving at time 5.5 is 54.79929/95.83169 or 57.18285 percent.
Looking up 100% on the R3 Iowa-type Curve, 54.79929% of the units placed 4–5 years ago will survive at time 5.5 years.
In the 6th projection period, the average age of this group will be 10 years (4.5 + 5.5) or 100% of average life.
Looking up 45% on the R3 Iowa-type Curve, 95.83169% of the units placed 4–5 years ago survive at time 0.
The 4–5 year age group (4.5) at time 0 is at 45% of average life (4.5 years/10).
Sample Calculation:
99.75173 98.87462 97.27636 94.69397 90.89056 85.58760 78.22213 68.08983 54.96643 39.77068 24.75756 12.79067 5.47473 1.52605 0.07330 0.00000
% Surviving Relative to % Surviving at Time 0 Age Group Age Group Age Group Age Group 1.5 2.5 3.5 4.5
Goodfood Corporation Trade Secrets Valuation Calculation of Composite Decay
NOTE: The data for the R3 Iowa-type curve are from Robley Winfrey, Statistical Analyses of Industrial Property Retirements, as revised by Harold Cowles (Ames, IA: Engineering Research Institute, Iowa State University, 1967).
Age % of % Avg Life Surviving 0 100.00000 5 99.94867 10 99.85318 15 99.69592 20 99.44840 25 99.08466 30 98.57396 35 97.88368 40 96.98056 45 95.83169 50 94.40602 55 92.67565 60 90.61418 65 88.18463 70 85.32735 75 81.95924 80 77.98427 85 73.31231 90 67.88278 95 61.68902 100 54.79929 105 47.37036 110 39.64975 115 31.96276 120 24.68228 125 18.17891 130 12.75178 135 8.54418 140 5.45808 145 3.16479 150 1.52141 155 0.51666 160 0.07308 165 0.00000
R3 Iowa-type Curve
Exhibit 16.8
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of the group of recipes. This calculation uses (1) the average life of 10 years and (2) the percent surviving data for the R3 curve. The survival percentages are applied to each vintage age group of recipes, relative to their starting point on the survivor curve. A sample calculation to estimate the number of recipes in the 4.5 year (4–5 year) age group at time 0 (i.e., as of the analysis date) that will still be around in the sixth year of the projection period is presented on the exhibit. Both (1) the distribution of the food recipes by age group and (2) the composite decay (as evidenced by the composite units surviving over the projection period) of all 353 food recipes are indicated in the shaded area. The composite units surviving is simply the sum of all surviving Goodfood recipes for each vintage age group in each projection period.
Trademark Licensing Example Let’s assume it is the year 2007 and Electronics Company owns a trademark, 3DVD, related to an innovative three-dimensional digital video disc. This digital video disc product is still gaining acceptance in the marketplace. Other companies want to license this trademark and manufacture compatible discs and disc players. In order to estimate a fair royalty rate for such a third-party trademark license agreement, the analyst performs various DCF analyses and estimates future sales of the 3-DVD products. As a part of this analysis, the analyst needs to estimate the 3-DVD share of the total DVD market over the next few years. The analyst assembled market share statistics over the last few years, and the analyst reviewed Electronics Company management projections for the current year. Let’s assume the analyst will use the Fisher-Pry market substitution model to estimate market share for 3-DVD in the future. The actual market share figures and the market share figures projected by the Fisher-Pry model are presented in Exhibit 16.9.
Exhibit 16.9
Electronics Company Trademark License 3-DVD Market Share Figures
Year 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Actual Market Share (%)
Projected Market Share (%)
1 3 6 13 22
1.83 3.54 6.74 12.45 21.88 35.54 52.05 68.13 80.80 89.23 94.23 96.98 98.44 99.20 99.59
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Exhibit 16.10
Electronics Company Trademark License 3-DVD Market Share Graph 100 90
% Market Share
80 70 60 Actual Curve Projected S Curve
50 40 30 20 10
17 20
15 20
13 20
11 20
09 20
07 20
05 20
20
03
0
Year
The graph of the actual market share data and the projected market share data are presented in Exhibit 16.10. The curve is S-shaped as is typical of technology substitution curves. Using these projected market share figures, along with historical DVD sales figures and with projected growth rates in the overall DVD industry (derived from other industry sources), the analyst should be able to project 3-DVD sales for purposes of the DCF analysis.
Copyrighted Software Example Let’s assume that Software Development Company (SDC) owns several copyrights related to computer software products that it licenses to its customers. The principal shareholder of SDC requests an estimate of value of the copyrighted software products for estate planning purposes. Most of the SDC software products sell well in a competitive marketplace. The SDC software products are written in popular programming languages and are compatible with state-of-the-art operating systems. However, one software product, a payroll accounting package written in BASIC, does not work on some newer operating systems. Due to periodic tax law changes, the programs need to be updated each year, and SDC has to keep a BASIC programmer on the staff for this product only. New sales of the software product are minimal. However, there are several long-time customers who are very happy with the product and who say that they plan to continue to use the product—and pay their annual maintenance fees—for the next 5–10 years. Based upon this information, the analyst could perform a DCF analysis related to the payroll accounting software package using (1) a 5–10-year projection period, (2) projected maintenance fees with some new license fees as revenues, and (3) a projected overall expense allocation or profit margin. However, the analyst’s due diligence investigation indicates that the costs associated with this software product are higher than average for SDC. The reason for the higher than average product costs is the need to make annual software updates by the BASIC programmer. The analyst concluded
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that the actual profit margin on this software product is lower than the profit margin on other SDC software products. The payroll accounting software product may still earn a profit, but the limited resources of SDC could be put to better use supporting the company’s other software products. The RUL of the payroll accounting software product could be 20 or 30 years if the programs were periodically updated with tax changes and with occasional product enhancements. However, the economic life of the payroll accounting software product—and the associated copyright—is only as long as the product can earn an adequate rate of return to the copyright owner, SDC.
Summary and Conclusion An RUL analysis is an integral part of any intellectual property economic analysis. In an RUL analysis, all applicable life determinants should be examined. Analytical, quantitative RUL methods may be used when relevant data are available. Technology forecasting and technology life cycle analysis should be considered when applicable. Sometimes, RUL estimation conclusions cannot be used quantitatively in the intellectual property economic analysis. In such cases, the intellectual property RUL may be considered qualitatively through the analyst’s professional judgment related to the selection of the economic analysis variables. The RUL of an intellectual property (or of a group of intellectual properties) is an important component of any valuation approach. The intellectual property RUL is a component of economic damages analyses, particularly with respect to estimating the term of future damages/lost profits. For transfer pricing and licensing/royalty rate analyses, intellectual property RUL is relevant, if only as a qualitative component of the analysis. In this chapter, we discussed the reasons to perform a life estimation analysis, we described the data used in such analyses, we defined terms and described the analytical methods often used in life estimation analyses, and we provided illustrative examples of several types of life estimation analyses.
Suggested Reading and Resources Asthana, Praveen. “Jumping the Technology S-Curve,” IEEE Spectrum, June 1995, pp. 49–54. Barreca, Stephen L., “Technology Life-Cycles and Technological Obsolescence,” copyright, BCRI Inc., 1998–2000, may be downloaded from the company’s Web site: www.bcri.com. Dodson, Bryan. Weibull Analysis. Milwaukee, WI: ASQ Quality Press, 1994. Ellsworth, Richard K. “Letter to the Editor,” Valuation, Spring 1998 (Published by the American Society of Appraisers), pp. 3–5. Mignogna, Richard P. “Popularity of Technology Forecasting Methods.” May be downloaded from Technology/ Engineering Management, Inc., Web site: www.temi.com. Nelson, Wayne. Applied Life Data Analysis. New York: John Wiley & Sons, Inc., 1982. Reilly, Robert F., and Robert P. Schweihs. Valuing Intangible Assets. New York: McGraw-Hill, 1999. Smith, Gordon V., and Russell L. Parr. Valuation of Intellectual Property and Intangible Assets, 3d ed. New York: John Wiley & Sons, Inc., 2000. Winfrey, Robley (revised by Harold A. Cowles). Statistical Analyses of Industrial Property Retirements. Ames, IA: Engineering Research Institute, Iowa State University, 1967. United States Library of Congress, Copyright Office Web site: www.loc.gov/copyright. United States Patent and Trademark Office Web site: www.uspto.gov.
Chapter 17 Intellectual Property Residual Value Analysis Robert F. Reilly
Introduction Importance of Residual Value Analyses Valuation Analysis Intellectual Property Liquidation Value Alternative Types of Liquidation Analyses Intellectual Properties within a Bankruptcy Context Summary and Conclusion
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Introduction As we have illustrated in other chapters, many intellectual property economic analyses involve some form of income analysis. In these analyses, a specifically defined measure of economic income is studied. The periodic flows of income are usually studied over a discrete prior or future time period. This discrete time period could be the number of years during which the property was created, the period since the property was first commercialized, the term of a license or transfer price agreement, the period over which economic damages/lost profits occurred, the length of an industry’s typical business cycle, the remaining useful life (RUL) of the property, and so forth. In any event, there is often some amount of economic income that is earned/lost by the subject intellectual property either before or after the discrete period of analysis. Examples of such economic income include the following: 1. The initial costs incurred to create the property before detailed development time/cost records were instituted 2. The expected income loss to a property owner after the expiration of a license that is the continuing result of a breach of the license agreement 3. The enhanced value of a property caused by the transferee’s successful marketing efforts at the conclusion of a transfer price agreement 4. The remaining income potential of a property after reaching the conclusion of its expected RUL Residual income is any amount of economic income earned/lost by an intellectual property either before or after the discrete time period of the subject analysis. Sometimes other terms are used for residual income, such as “remainder income,” “residuum income,” and “terminal income.” Remainder income is an appropriate term because it connotes that some amount of income remains to be considered in the analysis. The remainder income flow can occur either before the inception of the discrete period of analysis or after the conclusion of the discrete period of analysis. In either case, this remainder income has not been captured in the discrete period but still should be included in the subject analysis. Residual income is sometimes also referred to as residuum income. The term “residuum” usually indicates that the residual flow of income have been accumulated into a total amount or an account balance. Examples of a residuum include (1) total accumulated expenditures prior to a specified date; (2) total unamortized or unrecovered costs at the conclusion of a license, agreement, or contract; (3) a property’s expected value at the cessation of the damage-causing activities or at the conclusion of damage remediation activities; and (4) total income-generating capacity at the conclusion of a patent/copyright/trademark registration period. Multiple or periodic measurements of residuum income are called residua. As an example, an analyst could estimate a property’s residua future income losses at the end of each coming year in a damages analysis if infringement activities are not terminated. Residual income is sometimes also called terminal income. This synonym is frequently used in the analyst’s vernacular and in the professional literature. The term is perfectly applicable in analyses of income flow from a going-concern business enterprise, a corporate debt or equity security, or a real estate project. This is because most income analyses of these types of assets are exclusively forward-looking. In such analyses, any income that is not captured in the analysis discrete time period does occur at the end (or terminus) of the discrete period. It is appropriate to refer
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to income flow expected after the termination of a specified period as terminal income. However, in an intellectual property analysis, sometimes the noteworthy income flow occurred before the start of the discrete period. For this reason, the term “terminal income” is not as generally applicable to intellectual property analysis as it is to the analysis of other types of income-producing properties. Residual value is the amount of a defined value for an intellectual property (1) that has accumulated at the inception of a discrete period or (2) that remains at the conclusion of a discrete period. In other words, residual value is the amount of a property’s defined value either at the start of or at the end of the discrete period of analysis. A common procedure to quantify residual value is (1) the future value of historical residual income calculated up to the start of the discrete analysis period or (2) the present value of expected future residual income calculated back to the end of the discrete analysis period. As will be discussed, there are numerous procedures for estimating an intellectual property’s residual value. However, in this chapter, we will focus on the capitalization of residual income procedure. Corresponding to the terminology for residual income, residual value is also referred to as “remainder value,” “remaining value,” or “terminal value.” In this chapter, first we will consider why the estimation of residual value is important to all types of intellectual property economic analyses. Second, we will consider the common types of (or definitions of) residual value. Third, we will consider the common types of residual income that are included in residual value analyses. Fourth, we will review the mathematical procedures for the capitalization of residual income. As we will see, the capitalization of residual income provides an estimate of residual value. Fifth, we will explore RUL considerations in the estimation of intellectual property residual value. Sixth, we will discuss the effects of intellectual property maintenance expenditures on residual value. And, last, we will examine the concept of intellectual property salvage value as an alternative measure of residual value.
Importance of Residual Value Analyses To some extent, a residual value calculation affects all types of intellectual property economic analyses: valuation, damages, and transfer pricing. The effects of residual value calculations are more obvious in intellectual property valuation and damages analyses. However, there is an influence of the residual value estimation—albeit more subtle—on intellectual property transfer price analyses. These influences, both subtle and obvious, will be discussed below. It is often difficult to discretely project economic income over the entire life of an intellectual property. As with any projection of any type of income, the longer the discrete projection period, the greater the uncertainty encompassed in the projection. This is true whether the projection is prospective or historical. The economic analysis of most property types almost always involves projections of prospective income. For certain types of intellectual property analyses, however, we are also interested in projections of historical events. For historical events documented by factual data, such projections are simply recitations of factual quantities. Examples of such factual recitations include (1) revenues from sales of a copyrighted consumer software program, (2) royalty payments earned from the license of a patent, and (3) annual market share percentages associated with a trademarked product.
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For some historical events, it is not that easy for the analyst to assemble or rely on historical data. This could be because the historical event was hypothetical. Or, this could be because the relevant historical event was caused by—but was two or three steps removed from—the intellectual property. In such cases, the intellectual property owner/operator may not have maintained historical data on the relevant event. Or, the intellectual property owner/operator may not have measured the intellectual property’s influence on the historical event. Examples of such historical data constraints include (1) estimates of what historical market share a trademarked product would have achieved absent an actual trademark infringement, (2) the increased throughput capacity of an oil refinery that resulted from a patented process change, and (3) the royalty payments that would have been earned by a domestic developer of a patented wonder drug if the foreign pharmaceutical company had honored its license responsibility to use best efforts to manufacture/ sell the drug internationally. Each of these scenarios involves instances where the analyst cannot simply rely on recorded historical income data. In these cases, the analyst has to rely on “projections” of the economic income earned/lost as a result of historical events. Whether the projection is historical or prospective, it becomes increasingly difficult to accurately project income over extended time periods. It is difficult to project historical income backward in cases where actual intellectual property income earned (or lost) was not measured. But, at least in these instances, other historical data are known with certainty. For example, the analyst may have factual historical data on the size of the subject industry; the total number of units produced or consumed; the relative competitive positions, industry cost/price levels; the total amounts of industry expenditures on research and development, advertising, promotion, and so on; property-specific expenditures on research and development, advertising, promotion, and so on; and similar indirect economic analysis factors. Even with these factual historical data, it is often difficult to project property-specific economic income backward for an extended period of time. Typically, it is even more challenging to project property-specific economic income forward for an extended period of time. Of course, prospective, or forwardlooking, projections are the more traditional form of economic income projections. However, when making prospective property-specific income projections, the analyst will not have “actual” industry, volume, competition, pricing, marketing/maintenance expenditures, or other similar factors to rely on. This is, of course, because these factors are not yet known. Just like the intellectual property–specific income, these factors have to be projected into the future as well. The degree of forecast uncertainty varies for each individual factor subject to projection. In general, the longer the projection period, the greater the degree of forecast uncertainty. This direct relationship of time and forecast risk holds for virtually all economic analysis factors. And, this direct relationship certainly holds for prospective projections of intellectual property–specific economic income. There are two variables in the residual income timeline that directly affect forecast uncertainty: 1. At what time period in the future (or in the past) does the residual income projection begin; in other words, how far from the current time does the discrete projection period end (or begin)? 2. How long is the intellectual property RUL when the residual income projection begins; in other words, how much of the subject property RUL is left at the conclusion of the discrete projection period?
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If the discrete income projection period is long, and the residual income does not occur for many periods in the future, there will be greater forecast uncertainty. If the discrete income projection period is short, and the residual income occurs very soon in the future, there will be less forecast uncertainty. For example, if the analyst prepares a 10-year discrete income projection, there will be greater uncertainty in the year 11 residual income estimate. Of course, this uncertainty is caused by the fact that the residual income will not be earned/lost until after 10 years from the date of the analysis. On the other hand, if the analyst prepares a 3-year discrete income projection, compared to the 10-year projection, there will be less uncertainty in the year 4 residual income estimate. This reduced uncertainty is caused by the fact that the residual income will be earned/lost after only 3 years from the date of the analysis. If the intellectual property RUL is long at the time the residual income begins, there will be greater forecast uncertainty. If the property RUL is relatively short at the time the residual income begins, there will be less forecast uncertainty. For example, if a trade secret expected RUL is 14 years at the end of the discrete projection period, there will be greater uncertainty in the residual income projection. This is because the analyst will have to project an annuity flow of income for a 14-year period. And, that 14-year annuity period doesn’t start until the end of the discrete projection period. On the other hand, if the trade secret RUL is only 4 years at the end of the discrete projection period, compared to the 14-year period, there will be less uncertainty in the residual income projection. This is because the analyst will only have to project an annuity flow of income for a 4-year period. Even though the 4-year annuity period doesn’t start until the conclusion of the discrete projection period, there is still less forecast risk in a 4-year residual income projection than in a 14-year residual income projection. Another issue with regard to the consideration of residual value is the uncertainty surrounding the intellectual property RUL estimation. The estimation of RUL is an important procedure with regard to the analysis of all four types of intellectual property. Directly or indirectly, the estimation of RUL influences all types of intellectual property economic analyses: valuation, damages, and transfer price. Common approaches, methods, and procedures related to intellectual property RUL estimation are discussed in Chap. 20. However, as with other components of the intellectual property analyses, there is the possibility of error with regard to RUL estimation. And, the greater the uncertainty with regard to the RUL estimate, the greater the uncertainty with regard to the residual value. The RUL estimate can affect the residual value estimate in two ways. First, if the RUL estimate is incorrect, the analyst could also conclude an incorrect residual value. For example, let’s assume that the analyst estimates that (1) the RUL for a theatrical movie copyright is 10 years and (2) the residual value of the copyright is $20 million. If the correct RUL for the copyright is in fact 15 years, then the correct residual value may be much less than $20 million—say $10 million. During the last 5 years of the correct 15-year RUL, the film copyright will earn income from various distribution sources (e.g., foreign theatrical, domestic rerelease, foreign and domestic video, foreign and domestic television). At the end of the 15-year life, there will likely be less income earning/loss potential left for the subject copyright—compared to the potential at the end of the 10-year life. Accordingly, a miscalculation of the property RUL may in turn cause a miscalculation of the property residual value, determined as of the end of the discrete projection period.
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Second, if the RUL estimate is incorrect, the analyst could still calculate a correct residual value estimate. However, the present value of the residual value would likely be misstated as a result of the incorrect estimate of the present value discount period. For example, let’s assume that the analyst estimates that the RUL of a literary copyright is 10 years when the correct RUL of the copyright is 15 years. Let’s further assume that the analyst correctly estimates that the residual value of the copyright is $1 million, regardless of whether the RUL is 10 years or 15 years. Let’s say that the analyst has concluded that a literary collector would pay $1 million to own the subject copyright, even if there is no expected royalty income from future publication/reprints, and other sources. While the $1 million residual value estimate may be equally correct after year 10 as it is after year 15, the present value of the residuum will change based on the two different life periods, as illustrated below: 1. The present value of a $1 million residual value at the end of year 10, assuming a 20 percent discount rate and a year-end compounding convention: Residual value, end of year 10 × present value interest factor at 20% for 10 years = present value of residual value $1,000,000 × 0.1615 = $161,500 2. The present value of a $1 million residual value at the end of year 15, assuming a 20 percent discount rate and a year-end compounding convention: Residual value, end of year 15 × present value interest factor at 20% for 15 years = present value of residual value $1,000,000 × 0.0649 = $64,900 Accordingly, the uncertainty (or the risk of possible error) in the intellectual property RUL can directly affect the property residual value, at least on a present value basis. Even if the intellectual property RUL is known with certainty, there is still uncertainty with regard to the residual value estimate. Clearly, it is easier to estimate the value of an intellectual property today (i.e., at the beginning of a discrete income projection period) than it is to estimate the value of the same property at the conclusion of its RUL. Of course, the current value quantitative procedures are no less challenging than the residual value quantitative procedures. The difference is that there is less forecast uncertainty (or the risk of possible error) in the contemporaneous valuation of a property than in the valuation of a property many years into the future. Residual value estimates affect the valuation, damages, and transfer price analysis of an intellectual property. The following paragraphs will present and illustrate how the residual value affects each of these three types of analyses.
Valuation Analysis The impact of residual value on intellectual property valuation is obvious. Residual value answers the question: What is the defined value of the property at the end of a specified time period? The specified time period relates to the period of the discrete economic income projection for the property. If the analyst makes a discrete income projection for 10 years, the residual value is the estimated value of the
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subject property at the end of the 10th year. If the analyst makes a discrete income projection for 12 years, the residual value is the estimated value of the subject property at the end of the 12th year. Regardless of what residual value estimation methodology is selected, the analyst will have to consider the expected change in the intellectual property value over time. That is, at the end of the discrete projection period, will the subject property value increase, decrease, or remain the same? Of course, the answer to that question is influenced in good measure by the answer to this question: At the end of the discrete projection period, will the subject property residual income increase, decrease, or remain the same? The residual income for most intellectual property decreases over time. The subject property typically becomes obsolete and may be replaced by a newer/better property. The subject property becomes less commercially viable as customer tastes change or as customer demand is satisfied. Often, the expiration of legal protection allows a competitor to introduce direct competition to the subject property for the first time. And without having to incur the expenditures to develop or maintain the subject intellectual property, the competitor’s good/service is often lower priced than the subject good/service. The competitor gains market share, the intellectual property owner/operator loses market share, and the subject property residual income decreases over time. This is the most common scenario related to the expected change in intellectual property residual income. However, this scenario is not inevitable. Intellectual property owner/operators may maintain (or even increase) residual income based on the effectiveness of any (1) maintenance expenditures, (2) RUL extension procedures, (3) new product introductions/product line extensions, (4) product/service repositioning, or (5) other technological/marketing competitive tactics. First, let’s consider the effects of expected change in residual income (in both direction and amount) on residual value. Second, let’s consider the effects of intellectual property maintenance expenditures and other procedures on a property’s residual value. Let’s assume that we expect a license on a patent to generate the following flow of royalty income payments during a 5-year discrete projection period: 5-Year Discrete Projection Period Expected royalty income: Time period (years): t = 0
$1,000 1
$2,000 2
$3,000 3
$2,000 4
$2,000 5
Based on this discrete economic income projection, we can quantify (1) a value estimate (if the income flow is positive) or (2) a damages estimate (if the income flow represents negative or lost income). If we assume (1) a 16 percent present value discount rate, (2) a mid-year compounding convention, and (3) a positive flow of income to the patent owner, the value of this discrete income projection is presented in Exhibit 17.1. Based on the assumptions presented in the exhibit, the present value of the discrete royalty income projection is $6,816. If (1) the expected RUL of the patent is 5 years as of the analysis date and (2) the patent is expected to have no residual value at the end of the discrete 5-year projection period, then the indicated value of the subject patent is $6,816. The present value interest factors can be determined by (1) using any business/financial calculator that has a present value function, (2) looking up the factors
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Exhibit 17.1
Expected Income During Discrete Projection Period Time Period (Year)
Projected Royalty Income ($)
Compound Period (Year)
Present Value Interest Factor
1 2 3 4 5
1,000 2,000 3,000 2,000 2,000
0.5 1.5 2.5 3.5 4.5
0.9285 0.8004 0.6900 0.5948 0.5128
989 1,601 2,070 1,190 1,026
3.5265
6,816
Total
Present Value of Discrete Royalty Income ($)
on the present value interest factor tables that are included as appendixes in most college level finance textbooks, or (3) using the following present value interest factor formula: PVIFr , n =
1 (1 + r )n
where r = present value discount rate n = number of time periods Because of the assumption of the mid-year compounding convention assumed in the above example, the appropriate total number of time periods to use (in the financial calculator or the present value interest factor formula) is 4.5 years (i.e., n − 0.5). Let’s expand the analysis to assume that the subject patent has an additional 5 years RUL after the conclusion of the discrete period. Let’s also assume that the patent will generate $1,000 per year of residual income (e.g., additional royalty payments) in residua periods of years 6 through 10. Accordingly, the subject patent will produce $1,000 per year income as an annuity for 5 years, beginning in year 6. Using the same analytical variables of (1) a 16 percent discount rate, (2) mid-year compounding convention, and (3) a positive income flow, the present value of this annuity income stream is as follows: Expected annuity income per year × present value annuity factor, at 16% for 5 years = present value of annuity income stream $1,000 × 3.5265 = $3,527 Based on the above-listed assumptions, the value of the 5-year annuity royalty income stream is $3,527. This represents the present value of $1,000 a year of royalty income, received annually at the midpoint of each year, at a 16 percent discount rate. The present value annuity factor can be determined by (1) using any business/ financial calculator that has either a present value function or a loan amortization
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function, (2) looking up the factor on the present value annuity factor tables that are included as appendixes in most college level finance textbooks, or (3) using the following present value annuity factor formula: n
PVAFr , n =
1
∑ (1 + r )t t =1
where r = present value discount rate t = each time period n = total number of time periods Because of the mid-year compounding convention assumed in the above example, the appropriate number of time periods to use (in the financial calculator or the present value annuity factor formula) is 5.5 years (i.e., n + 0.5). This is because we assumed that the annual royalty payments are received at the midpoints of each of the next 5 years. Of course, the above value of an annuity conclusion of $3,527 represents the present value of the annual royalty payments at the beginning of the annuity (i.e., at the beginning of year 6—or the end of year 5). However, the relevant date of the analysis is at the beginning of the discrete projection period—not at the end of the discrete projection period. So, we need to perform an additional present value procedure. This procedure will convert the residual value from a present value at t = 5 years to a present value at t = 0 years. To do this, we simply calculate the present value of $3,527 (i.e., the residual value of the royalty income annuity) at 16 percent for 5 years, as follows: Residual value of $1,000 per year at t = 5 × present value interest factor, at 16% for 5 years = present value of residual value at t = 0 $3,527 × 0.5128 = $1,804 Again, since we have assumed a mid-year compounding convention in this example, the appropriate present value interest factor is calculated based on t = 4.5 years (instead of t = 5 years). It is noteworthy that, collectively (1) the present value interest factor for the 5-year discrete projection period and (2) the present value annuity factor for the 5-year residual income period covers the entire 10-year period of royalty income flows for the subject patent. Note that the present value interest factor is based on t = 4.5 years, and the present value annuity factor is based on t = 5.5 years. So, our analysis assumes that all royalty payments are received at the midpoint of each of the 10 years related to the patent RUL. And, our analysis encompasses the entire 10-year period of the subject patent RUL. The value of the cyclical royalty income expected to be earned by the subject patent during the discrete projection period (i.e., t = 0 through t = 5) is $6,816. This value is as of the analysis date, t = 0. The value of the annuity royalty income expected to be earned by the subject patent during the residuum period (i.e., t = 6 through t = 10) is $1,804. This value is also as of the analysis date, t = 0. The total value of the royalty income expected to be earned by the subject patent is the sum of the discrete projection period value and the residual value, as follows: Total value of patent expected royalty income, at t = 0 = present value of discrete royalty income, for t = 0 → 5 + present value of residual income for t = 6 → 10 at t = 0 $8,620 = $6,816 + $1,804
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This value conclusion is based on the scenario where the residual income would remain constant, at $1,000 per year, during the residuum period. Accordingly, this scenario assumes a zero percent constant growth rate in the residual income. Let’s explore what happens to the concluded value of the subject patent if we change the scenario to assume either a negative constant growth rate in the residual income or a positive constant growth rate in the residual income. If the patent’s residual royalty income declines each year at a constant rate of, say, 10 percent, the residuum income flow will be as presented in Exhibit 17.2. Also presented in Exhibit 17.2 are the present value interest factors for a 16 percent discount rate and a mid-year compounding convention needed to conclude the present value of this annuity income stream at the beginning of the annuity period (i.e., t = 5 years). So, the present value of the annuity residual income of $1,000 decreasing at the rate of 10 percent per year is $2,978 at the beginning of the annuity (i.e., t = 5 years). In other words, the value of the patent’s annuity residual income is $2,978 as of the residual value date. The $2,978 present value of the negative 10 percent growth rate residual income is the residual value at t = 5 (i.e., the beginning of the residuum period). In order to conclude the residual value at t = 0 (i.e., the analysis date), we make the following calculation: Residual value at t = 5 × present value interest factor, at 16% for 5 years = residual value at t = 0 years $2,978 × 0.5128 = $1,527 So, the residual value of the patent with a declining royalty income flow at the analysis date is $1,527, assuming a 16 percent discount rate and the mid-year compounding convention. In order to conclude this residual value, we effectively converted a present value of an annuity procedure to a present value of a discrete income projection procedure. That is, we analyzed the patent’s residual income just as if it was earned in a second discrete projection period—that is, the discrete period from t = 6 through t = 10 years. The present value of this 5-year annuity of $1,000 decreasing at 10 percent per year is $2,978 (at the beginning of the annuity). This $2,978 present value compares to Exhibit 17.2
Residuum Income Flow, Negative Constant Rate of Change
Analysis Time Period (Year) 6 7 8 9 10 Total
Annuity Time Period (Year) 1 2 3 4 5
Expected Residual Income ($) 1,000 900 810 729 656
Constant Rate of Change
Present Value Interest Factor at 16%
Present Value of Expected Residual Income ($)
— −10% −10% −10% −10%
0.9285 0.8004 0.6900 0.5948 0.5128
929 720 559 434 336
3.5265
2,978
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457
Exhibit 17.3
Zero vs. Negative Growth Rate Present Value of Discrete Royalty Income, at t = 0 ($)
Scenario
+
Present Value of Residual Income, at t = 0 ($)
=
Total Value of Expected Royalty Income, at t = 0 ($)
Zero growth rate in residual income
6,816
+
1,804
=
8,620
Negative 10% growth rate in residual income
6,816
+
1,527
=
8,343
the $3,527 present value of a 5-year royalty income annuity of $1,000 per year (with no annual decrease) concluded in our previous scenario. Appropriately, the negative growth rate (or negative rate of change) in the annuity royalty income payments caused a decrease in the residual value of the subject patent. When added to the present value of the discrete projection period income, the negative income growth rate in the residual values causes a decrease in the total value of the patent, as presented in Exhibit 17.3. Likewise, a positive growth rate in the residual income will cause (1) an increase in the residual value and (2) an increase in the total value of the subject property. For example, let’s assume a 10 percent annual increase in the royalty income expected to be earned by the subject patent during the residuum period. The projected residual royalty income and the residual value (at t = 5 years, or at the beginning of the 6th year) are presented in Exhibit 17.4. Again, we assume the same 16 percent discount rate and mid-year compounding convention. The residual value of the patent with the positive 10 percent growth royalty in expected royalty income at t = 5 years is $4,187. This value compares to the residual value of the patent with the negative 10 percent growth rate in residual period income of $2,978. Of course, the $4,187 conclusion is the value of the annuity period royalty income at the beginning of the annuity period (i.e., at the beginning Exhibit 17.4
Residuum Income Flow, Positive Constant Rate of Change
Analysis Time Peiod (Year) 6 7 8 9 10 Total
Annuity Time Period (Year)
Expected Residual Income ($)
Constant Rate of Change %
Present Value Interest Factor at 16%
Present Value of Expected Residual Income ($)
1 2 3 4 5
1,000 1,100 1,210 1,331 1,464
10% 10% 10% 10%
0.9285 0.8004 0.6900 0.5948 0.5178
929 880 835 792 751
3.5265
4,187
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of t = 6 years). To conclude the value of the patent at the analysis date, we need to calculate the present value of the $4,187 residuum at t = 0 years. That calculation is presented below: Residual value at t = 5 × present value interest factor at 16% for 5 years = residual value at t = 0 years $4,187 × 0.5128 = $2,147 So, the residual value of the patent with an increasing royalty income flow at the analysis date is $2,147, assuming a 16 percent rate and the mid-year compounding convention. When added to the present value of the discrete projection period income, the positive income growth rate in the residual value causes an increase in the total value of the patent, as presented in Exhibit 17.5. In summary, the growth rate in the residual income (positive, negative, or zero) has a direct impact on the residual value—and the total value—of the intellectual property. Later, we will address the factors that an intellectual property owner/ operator should consider to increase the growth rate of the property residual income. First, however, let’s use a simple cost/benefit analysis to consider the economic effect of these factors on intellectual property value. There are procedures that the owner/operator can implement to extend intellectual property RUL. And, there are procedures that the owner/operator can implement to maintain a positive (or, at least, a zero percent) residual income growth rate. Most of these procedures involve undertaking some type of intellectual property “maintenance” expenditures. Usually, these expenditures relate to either operating expenses or capital expenditures. Common examples of the operating expense type of such maintenance expenditures are listed in Exhibit 17.6. In addition to incurring operating expenses to maintain a property’s RUL or residual income, the property owner/operator may also make capital expenditures. Capital expenditures are outlays for plant, property, and equipment assets—that is, tangible personal property and real estate. Such expenditures typically are for research and development–related equipment, such as laboratory, scientific product testing, or product development equipment. Or, such expenditures could include computer hardware and other data processing–related equipment. In all cases, the equipment would be used to maintain/improve the products, processes, or services, encompassed by the intellectual property. In all cases, the purpose for the equipment
Exhibit 17.5
Zero vs. Positive Growth Rate
Scenario
Present Value of Discrete Royalty Income, at t = 0
+
Present Value of Residual Income, at t = 0
=
Total Value of Expected Royalty Income, at t = 0
Zero growth rate in residual income
$6,816
+
$1,804
=
$8,620
Positive 10% growth rate in residual income
$6,816
+
$2,147
=
$8,963
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Exhibit 17.6
Illustrative Intellectual Property Maintenance Expenditures Intellectual Property Trade secret
Trade symbols: Trademarks
Illustrative Operating Expenses to Maintain Residual Income or Extend RUL 1. Expenses to maintain/improve documentation of trade secret 2. Expenses to maintain/improve security around trade secret documents, formulas, etc. 3. Advertising and promotion expenses to increase customer/consumer awareness of trade secret (e.g., advertising that promotes secret herbs and spices in a restaurant’s fried chicken recipe) 4. Legal/administrative expenses to sign employees to nondisclosure/confidentiality agreements 1. Broadcast, print, billboard, etc. advertising of trademark product 2. Production/promotion of trademark product line “extension products”—e.g., different sizes, flavors, recipes, etc. of original product 3. Production/promotion of new products using existing trademark 4. Sponsorship of athletic, entertainment, cultural, or other promotional events
Trade dress
1. Production/promotion of a family of products using some packaging, label, container, etc. 2. Production/promotion of different product sizes and/or different product formulations (e.g., liquid vs. powder vs. solid) using some packaging, label, container, etc. 3. Marketing research and industrial design expenses to update/modernize trade dress based on current consumer tastes; requires expense to register “new and improved” trade dress 4. Legal expense to prosecute others who use similar trade dress
Trade name
1. 2. 3. 4.
Use/promotion of name on multiple products, new products, product line extensions, etc. Advertising/promotion of name in various media Consistent use of name on letterhead, brochures, price lists, warranties, flyers, coupons, mailers, etc. Legal expense to prosecute others who use the same or similar name
Copyrights, including literary, musical, dramatic works, choreographic works motion picture, audiovisual works, sound recordings
1. 2. 3. 4. 5. 6.
Expenses to publicly perform/produce copyrighted work Expenses to periodically reproduce and distribute copies or recordings Expenses to prepare and distribute derivative works Advertise/promote the sale/rental of copyrighted work Produce/promote the periodic display of copyrighted work Create Web site to promote work and make creator available to public
Software/semiconductor chips
1. Expenses to compile/document/diagram computer software 2. Expenses to maintain/improve security of source code 3. Expenses to design/code periodic capability/efficiency improvements to software; requires expense to register “new and improved” software 4. Production/promotion/distribution of semiconductor chip products to customers (e.g., computer manufacturers) 5. Research and development to periodically improve capability, efficiency, speed of chip product 6. “Pull through” advertising/promotion of chip product features to ultimate consumers (e.g., computer users)
Patents, including utility patents, plant patents, design patents
1. 2. 3. 4. 5. 6. 7. 8.
Production/promotion of utility product/process/invention Trade (tradeshow/trade journal) promotion of utility patent to manufacturers/processors (customers) Advertising in all media to product/process/invention ultimate users (consumers) Research and development to maintain/improve product/process/invention; may require application for new patent Botanical research and development of new and distinction variety of plant (for plant patent) Trade advertising/promotion to agricultural industry customers (for plant patent) Promotions/use of design on new products, product line extensions, etc. Marketing research and industrial design expenses to update/modernize design to accommodate change in consumer preference, change in product, etc.; may require application for new design patent
460
IV / Intellectual Property Valuation Issues
is to improve the work covered by the current intellectual property or to create a work that will be covered by a direct replacement property. And, in this instance, the term “work” could include the product, process, or service that uses the subject property. Capital expenditures for plant, property, and equipment to produce or distribute the covered work typically are not related to the maintenance of the property RUL or residual income. For example, expenditures related to a new factory to increase the production of patented widgets would not be considered capital expenditures to maintain the residual life/income of the subject patent. The intellectual property owner/operator may make residual life/income maintenance investments that are not related to either operating expenses or capital expenditures. Such an “investment” would include the opportunity cost related to deferring the introduction or commercialization of an alternative/replacement intellectual property. To maintain the value of a trademarked product (or service marked service), the intellectual property owner/operator will frequently defer the introduction of a new but competing product (or service). If the new product cannibalizes market share, revenues, and profits from the current product, the owner/operator may intentionally delay the commercialization of the new product. The intention of the commercialization delay is to maximize the residual life/income of the existing intellectual property. This strategy of deliberately delaying the introduction of a competitive product/ service is used with regard to all four types of intellectual property. And, this strategy is used with regard to many different industries that depend on intellectual property, such as pharmaceuticals, food products, publishing, music entertainment, movie/theatre entertainment, and so forth. When considering the economic cost/ benefit of this strategy, the opportunity cost to the property owner/operator is the present value of the deferred/lost income related to the new, competitive intellectual property. The investment to maintain the residual life/income of the current property is this opportunity cost related to exploitation deferral of a new property. Many an owner/operator will incur this opportunity cost investment right up to the expiration of the legal life of the current intellectual property. At that time, the owner/operator will commercially exploit the replacement property that may have been available for years. There is little reason for the owner/operator to defer the introduction of the new property after the legal expiration of the current property. Assuming a commercially successful product/service in a successful market, it is likely that competitors will introduce their product/service after the legal protection of the subject property expires. So, the owner/operator often has to introduce a “new and improved” intellectual property as the current property legal life expires. Such a new property introduction is made to forestall competition from a current industry competitor or from a potential new entrant to the product (service) category. The current product/service will be subject to competition (probably from a new, superior product) once the property legal protection expires, anyway. So, the property owner/operator would prefer to provide its own competition to the subject property— in the form of a newly introduced property—rather than to be subject to competition from third-party competitors. Now, let’s look at the cost/benefit considerations related to these intellectual property residual life/income expenditures. As with all investments, the decision to make residual value maintenance expenditures may be considered using several alternative analyses such as net present value, internal rate of return, payback period, return on investment, and so on. However, since the topic of the current discussion is residual value, we will focus on a net present value analysis.
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The advantages of focusing on the net present value procedure are twofold. First, this procedure will work equally as well for residual value analyses of (1) operating expenses, (2) capital expenditures, and (3) opportunity cost investments. Second, the decision rule related to the results of this procedure is very straightforward. 1. If the net present value of the intellectual property residuum increases as a result of the residual maintenance expenditures, then make the expenditures. 2. If the net present value of the intellectual property residuum decreases as a result of the residual maintenance expenditures, then don’t make the expenditures. Let’s consider examples of all three types of residual value maintenance expenditures. We will use the immediately previous example of a residual value calculation as our “base case” scenario. First, we will consider the cost/benefit economics related to residual maintenance operating expenses. Second, we will consider the decision to make maintenance-related capital expenditures. Third, we will consider the opportunity cost investment analysis related to the deferral of introducing a new competitive intellectual property. The above base case example of a patent valuation was based on the economic income projection (measured by expected license royalty income) presented in Exhibit 17.7. The above example was also based on the assumptions of a 16 percent present value discount rate and a mid-year compounding convention. Since the residuum maintenance expenditures all relate to the residual period, we can ignore the income expected during the discrete projection period for purposes of this analysis. This is because all of the maintenance expenditures will occur either at the beginning of or during the residual period. And, the maintenance expenditures should either increase the residual period term (i.e., the property RUL), increase the residual period income, or both. Therefore, since there is no expected impact on the discrete projection period term/income, we can exclude the discrete projection from consideration in the instant analysis.
Exhibit 17.7
Economic Income Projection, Measured by Expected License Royalty Income Discrete Projection Period Time Period (Year)
Expected Royalty Income ($)
1 2 3 4 5
1,000 2,000 3,000 2,000 2,000
Residual Period Time Period (Years)
Expected Royalty Income ($)
6–10
1,000 per year
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In the first residuum maintenance expenditure scenario, the property owner/operator is considering incremental operating expenses, as follows: Time Period (years)
Incremental Operating Expenses ($)
6 7 8 9 10
1,600 1,800 2,000 2,200 2,400
The nature of these expenses could be incremental advertising, promotion, research and development, and so on. Whatever the nature of the planned operating expenses, they are intended to increase/prolong sales of the patented product and, thereby, increase the expected royalty income to the property owner/operator. As a result of incurring these incremental operating expenses, the property owner/operator believes that (1) the patent expected royalty income will double—from $1,000 to $2,000 per year—during the residual period and (2) the patent RUL will increase from 5 years to 7 years and the $2,000 residual income will now also be earned in years 6 and 7. Based on these data, should the property owner/operator incur the residuum operating expenses? The net present value analysis presented in Exhibit 17.8 will answer that question. The net present value of the incremental operating expense scenario is $1,853. Since the net present value is positive, it appears that the patent owner/operator should incur the operating expenses. On a net present value basis, the operating expense investment more than pays for itself. That is, the present value of the royalty income is greater than the present value of the maintenance operating expenses. However, before this investment decision is made, the $1,853 net present value of this scenario should be compared with the net present value of the do nothing scenario. Recall that the present value of the expected royalty income without incremental maintenance expenditures was $3,527. This is the do nothing scenario.
Exhibit 17.8
Residual Value Maintenance Expenditures, Net Present Value Analysis Incremental Operating Expense Scenario
Time Period (Year)
Original Scenario Expected Royalty Income
Expected Royalty Income ($)
6 7 8 9 10 11 12
1,000 1,000 1,000 1,000 1,000 — —
2,000 2,000 2,000 2,000 2,000 2,000 2,000
Net present value
Incremental Operating Expense ($)
Expected Royalty Income Net of Operating Expenses ($)
Present Value Interest Factor at 16%
Present Value of Expected Net Royalty Income ($)
1,600 1,800 2,000 2,200 2,400 — —
400 200 — (200) (400) 2,000 2,000
0.9285 0.8004 0.6900 0.5940 0.5178 0.4421 0.3811
371 160 — (119) (205) 884 762 1,853
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That is, the residual value of the expected royalty income is $3,527 if the owner/ operator does not incur the incremental operating expenses. The residual value of the expected net royalty income is only $1,853 if the owner/operator incurs the incremental operating expenses. Accordingly, assuming no difference in the risk profile between the two scenarios, the subject patent residual value decreases in the incremental operating expense scenario. Accordingly, the owner/operator should not implement the incremental operating expense program. This is because that program will cause a decrease (from $3,527 to $1,853) in the residual value of the subject patent. The program should not be implemented even though (1) the expected royalty income increases from $1,000 to $2,000 per year and (2) the patent RUL increases from 5 years to 7 years. The comparison of the incremental operating expense scenario to the original do nothing scenario indicates that there is a superior economic cost/benefit relationship to the original (no incremental maintenance expenditures) scenario. It is noteworthy that both the $3,527 original scenario residual value and the $1,853 incremental maintenance expenditure scenario residual value are estimated as of the beginning of the residual period. That is, both residual value estimates are as of t = 5 years (i.e., the end of year 5) and not as of t = 0 years (i.e., the analysis date). Accordingly, because they do not represent the value at t = 0, we could not add either $3,527 or $1,853 residual value to the discrete income projection value in order to conclude the value of the patent. However, for purposes of concluding which residual period program (do nothing or incremental expenses) yields a higher net present value, the t = 5 years value estimates are perfectly adequate. Both the relationship of the two net present values and the conclusion as to which scenario is economically superior will remain the same whether or not the net present values are restated as of t = 0 years. The selection of the economically superior scenario becomes more obvious if the maintenance expenditure analysis is performed on a totally incremental basis. A totally incremental basis means that the analysis would only consider (1) the incremental expected royalty income (compared to the original scenario) and (2) the incremental operating expense (compared to the original scenario). A net present value analysis of the same maintenance expenditure decision on a totally incremental basis is presented in Exhibit 17.9. In this analysis, we define economic income (income to the owner/operator) as incremental expected royalty income less incremental operating expenses. In years 6 through 10 of the residual period, the economic income to the intellectual property owner/operator is negative in each year. The only positive economic income occurs in years 11 and 12; this is because the maintenance expenditures have increased the subject patent RUL by 2 years. Since the net present value of the economic income is negative in the maintenance expenditure scenario, it is obvious that the incremental operating expenses program is an unacceptable investment alternative. Since all of the income and expenditures are defined on an incremental basis compared to the original (do nothing) scenario, the original scenario has a net present value (by definition) of zero. When the residual value maintenance expenditure analysis is performed on a totally incremental basis: 1. A positive net present value means that the maintenance expenditure scenario is superior to the original scenario. 2. A negative net present value means that the maintenance expenditure scenario is inferior to the original scenario. 3. A zero net present value means that the intellectual property owner/operator should be economically indifferent between the two scenarios.
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Exhibit 17.9
Residual Value Maintenance Expenditures, Net Present Value Analysis, Incremental Economic Income Basis, Incremental Operating Expense Scenario Incremental Income/Incremental Operating Expense Scenario
Time Period (Year)
Original Scenario Expected Royalty Income ($)
Expected Royalty Income ($)
1,000 1,000 1,000 1,000 1,000 — —
2,000 2,000 2,000 2,000 2,000 2,000 2,000
6 7 8 9 10 11 12 Net present value
Incremental Expected Royalty Expense ($) 1,000 1,000 1,000 1,000 1,000 2,000 —
Incremental Operating Expense ($) 1,600 1,800 2,000 2,200 2,400 —
Incremental Expected Royalty Income Net of Operating Expense ($)
Present Value Interest Factor at 16%
Present Value of Incremental Royalty Income Net of Expenses ($)
(600) (900) (1,000) (1,200) (1,400) 2,000 2,000
0.9285 0.8004 0.6900 0.5948 0.5128 0.4421 0.3811
(557) (720) (690) (714) (718) 884 762 1,853
So, the investment decision regarding residual value maintenance expenditures can be analyzed by either of two methods: 1. The net present value of the maintenance expenditures scenario can be compared to the net present value of the original (do nothing) scenario. 2. The net present value of the maintenance expenditures scenario can be performed on a totally incremental basis (compared to the do nothing scenario). Both methods will also lead to exactly the same conclusion as to which scenario is superior from an economic cost/benefit perspective. The analytical benefit of the first method is that it analyzes the actual expected residual income under the maintenance expenditure scenario under consideration. The analytical benefit of the second method is its simple decision rule: (1) positive net present value means make the maintenance investment and (2) negative net present value means don’t make the maintenance investment. Again, both methods will always reach the same conclusion as to the preferred residual value maintenance investment decision. Next, let’s consider a cost/benefit analysis with respect to a proposed capital expenditure investment decision. This capital expenditure investment will be made only if it increases the subject patent residual value by either increasing residual income, increasing the duration of the residual period, or both. In this investment scenario, the patent owner/operator is considering a capital expenditure for laboratory research and development equipment. The laboratory equipment will cost $3,000. With this equipment, the patent owner/operator will develop a new form (e.g., a new powder form vs. the current liquid form) of its patented product. This product line extension has been “on the drawing board” for some time. The subject company product engineers are confident they can develop the new product form with their current level of manpower and expertise. They only need the new $3,000 laboratory equipment to perform the new product testing required by industry regulators. Coming so late in the subject’s product life cycle, the patent owner/operator does not believe the new powder form product line extension will materially increase
17 / Intellectual Property Residual Value Analysis
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the product sales. Accordingly, the residual period expected annual royalty income will not increase. However, the patent owner/operator does believe that customer convenience associated with the new powder form will extend the product’s RUL by another 6 years. Therefore, the residual period related to the expected royalty income flows will increase from (the current) 5 years to 11 years as a result of the proposed product line extension. And, the only residual value maintenance expenditure needed to add 5 years to the current residual period is the $3,000 capital expenditure. Should the patent owner/operator incur the $3,000 capital expenditure to maintain/increase the intellectual property residual value? Given the nature of this proposed investment scenario, an economic cost/benefit analysis on a totally incremental basis is the most direct method of analysis. This is because the capital expenditure scenario will cause no change at all to the expected royalty income flows during the current residual period. That is, the expected royalty income will remain at $1,000 per year for residual period years 6 through 10. If the $3,000 laboratory equipment is purchased at t = 5 years (i.e., the end of year 5), the expected annual royalty income flows in years 11 through 16 will become $1,000 (instead of zero). We present this residual value maintenance expenditure analysis in Exhibit 17.10 using the continuing assumptions of a 16 percent present value discount rate and a mid-year compounding convention. This cost/benefit analysis concludes a ($2,101) net present value for the capital expenditure program that was intended to increase the subject patent RUL by 6 years. The negative net present value conclusion means that the $3,000 laboratory equipment capital expenditure is an economically unsatisfactory investment. The preferred alternative between the residual period capital expenditure program scenario and the do nothing scenario is clearly the do nothing scenario. That is, the patent owner/operator should not make the $3,000 capital expenditure at the end of year 5 to increase the intellectual property residual income during years 11 through 16. Rather, the patent owner/operator should accept the original scenario that called for Exhibit 17.10
Residual Value Maintenance Expenditures, Net Present Value Analysis, Incremental Economic Income Basis, Incremental Capital Expenditure Scenario Incremental Income/Incremental Capital Expenditure Scenario
Time Period (year)
Incremental Expected Royalty Income ($) — — 1,000 1,000 1,000 1,000 1,000 1,000
5 6–10 11 12 13 14 15 16 Net present value
Incremental Capital Expenditure ($)
Incremental Expected Royalty Net of Capital Expenditure ($)
Present Value Interest Factor at 16%
Present Value of Incremental Royalty Income Net of Expenditure ($)
3,000 — — — — — — —
(3,000) — 1,000 1,000 1,000 1,000 1,000 1,000
1.0000 — 0.2105 0.1814 0.1564 0.1348 0.1162 0.1002
(3,000) — 211 181 156 135 116 100 (2,101)
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(1) no residual period capital expenditure and (2) a residual income flow of $1,000 annually for years 6 through 10. It is noteworthy that we did not have to conclude any of the present value calculations at t = 0 years in order to perform this maintenance expenditure cost/benefit analysis. We calculated the present value of the proposed $3,000 capital expenditure at t = 5 years (not t = 0 years) and the present value of the incremental expected royalty income flows for year 11 through 16 at t = 5 years (not t = 0 years). Of course, the magnitude of the net present value would change if we calculated all value as of t = 0 years instead of as t = 5 years. In fact, the magnitude of the values would all be smaller. This is because of the effect of the additional 5 years in the present value time period. However, the direction of the net present value would remain the same. A positive net present value would remain positive. And, a negative net present value would remain negative. If we were interested in the absolute impact of the change in residual value on the value of the subject patent, we would have to conclude all present values as of the analysis date—that is, as of t = 0 years. But, if we are only interested in cost/ benefit analysis of a residual value maintenance expenditure, then we can calculate all present values as of the beginning of the residual period—that is, at t = 5 years. And, that objective is clearly the case with the instant analysis, where the incremental capital expenditure and the incremental patent royalty income flows all occur during the residual period. We did not have to consider periodic depreciation expense in this cost/benefit analysis. The $3,000 capital expenditure for the laboratory equipment would certainly result in an annual depreciation expense for the subject company. As simplifying assumptions, let’s assume (1) the equipment has a 5-year life, (2) the equipment has no salvage value at the end of 5 years, and (3) the company uses the straightline depreciation method. The resulting annual depreciation expense would be $600. This depreciation expense would be recognized in years 6 through 10 of the residual period. Why, then, does this depreciation expense not affect the above-presented net present value analysis? The reasons are twofold. First, as with all of the above examples of residual value maintenance expenditure analysis, the measure of economic income inflow considered above is expected royalty income. That is, the patent owner/operator receives a royalty payment related to the license of the subject patent. This measure of economic income is not based on the operating or net income from the sale of patented products (services). That measure of economic income would be reduced by the amount of the annual depreciation expense. And, both operating income and net income are perfectly reasonable alternative measures of economic income related to a patent valuation. However, neither is the measure of income illustrative in the instant example. Royalty income is based on an actual or assumed third-party license of an intellectual property. So, royalty income is not affected by the recognition of depreciation expense related to the purchase of capital equipment. Second, while depreciation expense would not affect the pretax economic income related to patent royalty receipts, it may affect the after-tax economic income. Typically, depreciation is a tax deductible business expense. However, the annual depreciation expense itself does not affect the cash flow of the patent owner/operator. This is because the recognition of annual depreciation expense does not involve a cash expenditure. Consequently, depreciation is often called a “noncash” expense item. The annual depreciation expense may reduce the taxable income of the patent owner/operator. That reduction in cash outflows will result in an increase in after-tax
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economic income. As with all of the examples of residual value maintenance expenditure analysis, the analysis presented above is performed on a pretax basis. That is, both the measure of economic income and the present value discount rate are presented on a pretax basis. Residual value maintenance expenditure analyses performed on an after-tax basis are perfectly reasonable. Such analyses incorporate (1) an after-tax measure of economic income and (2) an after-tax present value discount rate. And, such analyses would be affected by the income tax expense reduction associated with depreciation expense. But, that is not the type of analysis illustrated in the above example. Therefore, the pretax net present value analysis presented above is not affected by the income tax effects of depreciation expense.
Intellectual Property Liquidation Value Whether the subject analysis is a valuation, damages estimate, or transfer price study, it is often appropriate to consider the liquidation value of the subject intellectual property. For purposes of this discussion, liquidation value is just another way to estimate residual value—that is, the value of the subject property at the end of the analysis discrete projection period. For this purpose, we will define liquidation value as “the price at which the owner/operator can sell the intellectual property at the conclusion of the discrete analysis period.” In other words, liquidation simply means the process of (1) transferring the property ownership from a seller to a buyer and (2) converting the property value into cash. With regard to the analysis of other property types (e.g., real estate, tangible personal property), liquidation value is considered to be synonymous with salvage value. And salvage value is typically considered to be a de minimis value for such property types. For example, for tangible personal property, salvage value may imply that the property is melted down to an elemental form and sold as metallic or plastic scrap. However, for intellectual property, the property’s liquidation value should not necessarily imply a salvage value or scrap value.
Alternative Types of Liquidation Analyses At the end of the discrete analysis period, the owner/operator typically has numerous alternatives as to how to liquidate (or exchange for cash) the intellectual property. The owner/operator could transfer the property through the process of an orderly disposition. That is, the owner/operator would expose the property to the relevant marketplace for whatever amount of time is necessary to obtain the highest price. Typically, during the market exposure period, the buyer would continue or expand the commercial use of the subject property. The property would be employed at its highest and best use, likely as part of the operation of a going-concern business enterprise. In this intellectual property transfer alternative, the seller is under no compulsion to transact and will wait for the buyer who will pay the highest price. Of course, during this market exposure period, the seller will have to incur the costs and efforts necessary to maintain (legally and commercially) the subject intellectual property. Alternatively, at the end of the discrete analysis period, the owner/operator could transfer the property through the process of a voluntary liquidation. In a voluntary
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liquidation, the owner/operator will expose the property to the appropriate secondary market for a normal exposure period. A normal exposure period is the amount of time required to reasonably inform the population of likely potential buyers of the planned sale of the subject property. In a voluntary liquidation, the owner/operator will wait to sell to a buyer who will likely use the subject property at its highest and best use. However, the subject property will not be sold as part of a going-concern business enterprise. It will not be sold as part of a collection of assets. Rather, it will be transferred individually, without any value enhancement or contribution due to any other transferred assets. In this intellectual property transfer alternative, the seller is under no compulsion to transact. As with the orderly disposition alternative, the seller will wait for the buyer who will offer the highest price. And, during the market exposure period, the seller will incur the cost and effort necessary to maintain (legally and commercially) the subject intellectual property. Finally, at the end of the discrete analysis period, the owner/operator could transfer the property through the process of an auction liquidation. An auction liquidation is sometimes called a forced liquidation. However, this term should not imply that the liquidation (or transfer in exchange for cash) is forced on the owner/operator. The owner/operator may voluntarily enter into an auction liquidation of the subject intellectual property. The owner/operator is not necessarily “forced” into the liquidation. Rather, it is the market exposure period that is “forced” in a liquidation. The normal market exposure period for the subject property type is artificially compressed into the defined auction period. In an auction liquidation, the subject property will be transferred on an individual basis. It will likely not transfer with any other associated assets. Accordingly, no other assets will contribute to the value of the transferred intellectual property. The buyer may or may not use the subject property at its highest and best use. The owner/operator will transfer the property to the buyer who offers the highest price during the defined auction period. Since there is an abbreviated market exposure period, the seller will incur little (or no) cost or effort to maintain (legally and commercially) the subject intellectual property. Absent any legal (or other) constraints, the owner/operator will transfer the property in the exchange alternative that results in the greatest expected net proceeds to the seller. Net proceeds take into consideration (1) the exchange selling price (2) the maintenance costs/efforts during the market exposure period, and (3) the risk of a price fluctuation during the market exposure period. The owner/operator will also consider the time value of money (specifically, the present value of the components of the net proceeds) when deciding which exchange alternative to select. Therefore, while an auction liquidation may result in the lowest property transfer sale price, it may result in the highest net proceeds to the owner/operator. It is noteworthy that the property transfer sale price (and not the net proceeds to the seller) represents the intellectual property liquidation value. When considering an intellectual property liquidation value, that is the value measure to use at the end of the discrete projection period for a valuation, damage analysis, or transfer price study.
Intellectual Properties within a Bankruptcy Context Intellectual properties are often important component assets in a corporate bankruptcy estate. Accordingly, analysts are often asked to estimate the liquidation value of intellectual properties for bankruptcy and reorganization purposes. For example,
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the intellectual properties may have been pledged by the company in bankruptcy as secured debt collateral. In that case, the secured creditors would be interested in the collateral values so they can assert a preferred position among the creditors. Similarly, the bankruptcy owner/operator’s intellectual property could serve as collateral for debtor-in-possession (DIP) financing. A sale/leaseback transaction is a common DIP financing transaction that may involve intellectual property collateral. In DIP financings, the lender usually assesses asset collateral based on liquidation values. The debtor-in-possession may also consider its intellectual property within the context of identifying spin-off opportunities. The objective of identifying spin-off opportunities is to (1) raise immediate cash and (2) enhance future cash flow for the bankruptcy owner/operator. The voluntary liquidation of the subject property would be a source of cash for the bankruptcy company. The negotiation of intellectual property licensing agreements would enhance the expected future cash flow of the bankruptcy company. When assessing spin-off opportunities, both a liquidation value analysis and a transfer price/royalty rate analysis are relevant. The overall bankruptcy plan for the owner/operator may affect the intellectual property analysis. If the bankruptcy plans contemplate an asset liquidation and corporate dissolution, then the intellectual property analysis would likely contemplate no future maintenance expenditures. If the owner/operator liquidates, then the entire bundle of the intellectual property legal rights could be sold. This bundle of rights would be sold assuming no continuing obligations on the part of the seller. In other words, the seller would not provide any continuing research and development, marketing, distribution/exhibition advertising, or legal support for the subject properties. Alternatively, if the bankruptcy plan contemplates a corporate reorganization, then the intellectual property analysis may consider a property license supported by continuing licensor maintenance expenditures. In a license agreement with the reorganized owner/operator, the licensee may expect to receive continuing technological, marketing, distribution/exhibition, product development, or other product/service support from the licensor. As this discussion illustrates, the owner/operator’s overall bankruptcy plan will likely affect the intellectual property liquidation value analysis. Expectations regarding the future economics of the owner/operator’s intellectual property are often an important component of a company’s plan of reorganization. For this reason, analysts are often asked to assess—and opine on—the reasonableness of a company’s reorganization plan. If the owner/operator’s projections regarding the use and commercialization of intellectual property are not reasonable, then the creditors—and the bankruptcy court—may not accept the debtor’s plan of reorganization. In any bankruptcy-related analysis, it is important for the analyst to realize that many intellectual properties have a liquidation value greater than zero. For an obsolete property, the liquidation value may be quite small. However, the concept of a liquidation value should be considered in any bankruptcy-related intellectual property economic analysis.
Summary and Conclusion A property’s expected residual value is an important component of all types of intellectual property economic analyses. To a greater or lesser extent, residual value considerations affect valuation, damages, and transfer price analyses. And, residual
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value considerations are relevant to all four types of intellectual properties: patents, copyrights, trademarks, and trade secrets. This discussion considered the different types of residual value. And, this discussion considered the different types of residual income that an intellectual property can generate. In particular, this discussion focused on the capitalization of income procedure to estimate intellectual property residual value. This focus is not intended to imply that the capitalization of income is the only source of intellectual property residual value. However, this focus is intended to imply that the income capitalization is a very common procedure for estimating residual value. One particularly salient difference between intellectual property residual value analysis and business enterprise residual value analysis is the finite RUL of intellectual properties. Intellectual property RUL analysis is specifically addressed in another chapter in this book. However, this discussion emphasized the importance of RUL considerations with regard to residual value analyses. This chapter described many of the strategies and tactics that owner/operators use to extend the RUL of their intellectual property. Some of these tactics involved accelerating or deferring the introduction of replacement and/or competing properties. And, some of these tactics involved incurring operating expenses and/or making capital expenditures to maintain the commercial viability of the seasoned (subject) intellectual properties. Finally, this chapter explored the factors related to intellectual property salvage value. The discussion considered the different types of intellectual property salvage value. And, the discussion considered the differences between intellectual property and tangible assets with regard to salvage value. And, the discussion introduced the salvage value considerations that affect bankruptcy-related intellectual property analysis. In conclusion, it is noteworthy that most intellectual properties have some salvage value. This salvage value may be de minimis for certain types of properties in certain types of situations. However, it is appropriate to consider salvage value as a component of every type of intellectual property economic analysis.
Chapter 18 Intellectual Property Ad Valorem Case Study Pamela J. Garland
Introduction The Case Study Problem Purpose and Objective of the Analysis Description of the Subject Intellectual Property Data and Data Sources Analytical Approaches and Methods Cost Approach Income Approach Market Approach Analytical Approaches and Methods Considered and Selected Analytical Variables Analyses and Results Cost per Person-Month COCOMO Analyses KnowledgePLAN Analyses Synthesis and Conclusion Analysis Work Product Purpose and Objective Description of the Subject Property and of the Subject Data Sources Valuation Methods and Procedures Valuation Synthesis and Conclusion Appendixes Illustrative Narrative Valuation Opinion Report Outline Schedules and Exhibits
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Introduction This case study relates to the valuation of commercial computer software and the associated intellectual property rights. Although software itself is not intellectual property, it may be subject to copyright, trade secret, or even patent protection. In this case study, the illustrative analysis is prepared to assist an industrial/commercial company in the negotiation and/or appeal of its ad valorem property tax assessment. On Track Railways (OTR or the company) is a major railroad company operating across several states. The company owns real property (e.g., land and rights-ofway) that crosses state lines and personal property (e.g., locomotives and freight cars) that physically moves from state to state. The OTR property in any given state is physically, functionally, economically, and technologically part of a fully integrated system. The company is subject to ad valorem property taxation in each state where it owns taxable property. For ad valorem property tax purposes, the assets of an industrial/commercial taxpayer may be valued using either (1) the summation valuation concept or (2) the unit valuation concept. Under the summation valuation concept, each piece of real and personal property is discretely valued and these discrete values are summed. For example, under the summation concept, a company with offices in Boston and Los Angeles would be locally assessed and would pay property taxes in both Massachusetts and California. The property taxes would be based on the total value of the individual items of taxable property actually located in each state. Under the unit valuation concept, the value of the entire taxpayer business enterprise is estimated. The values associated with any nonassessable (or exempt) properties are estimated and then subtracted from the overall taxpayer unit value. The remaining unit value is then allocated to each of the different taxing jurisdictions in which the taxpayer business operates. Railroads, airlines, utilities, and telecommunications companies are typically centrally assessed under the unit valuation concept. The allocation of the taxable unit value among the various taxing jurisdictions is based on one or more property use or property income factors, such as miles of track, kilowatt-hours generated, gross revenue, or net operating income. The value of the entire taxpayer business enterprise (unit value) typically includes both the tangible and intangible assets of the taxpayer. This is particularly true when income approach or market approach methods are used to value the taxpayer business enterprise unit. However, intangible personal property (in the form of discrete intangible assets) is not subject to ad valorem property taxation in many states. In these states, the taxpayer overall unit value should be reduced by the value of the intangible personal property in order to estimate the value of the unit of operating tangible assets subject to taxation. As a railroad, OTR is assessed for property tax purposes based on the unit valuation concept. For purposes of this case study, let’s assume that discrete intangible assets are exempt from property taxation in each of the states where the company operates. However, the company overall unit value assessment includes both tangible and intangible property. This is because the property tax assessors have relied heavily on the direct capitalization method (of the income approach) and the stock and debt method (of the market approach) in concluding the overall OTR unit valuation. OTR management wants to pay the fair amount of property taxes on the value of the company’s operating tangible assets. Accordingly, OTR management has decided to have a valuation analysis of the company’s intangible assets performed. The value of these
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intangible assets should then be subtracted from the OTR overall unit value in order to conclude the value of the unit of tangible property subject to ad valorem taxation. OTR owns a number of intangible assets, including trademarks and trade names, a trained and assembled workforce, customer contracts and relationships, favorable vendor contracts, trade secrets, computer software, and goodwill. The analyst’s due diligence investigation revealed that computer software, as the embodiment of many of the OTR trade secrets, is the most significant intangible asset of the company. Accordingly, the analyst was asked by OTR management to conduct a comprehensive valuation of the company’s proprietary computer software and related intellectual property rights. As intangible personal property, computer software and intellectual property are exempt from property taxation in the states in which OTR operates. Accordingly, company management will use this valuation to adjust/appeal its ad valorem property tax assessment. Railroads tend to invest heavily in internally developed custom software to run their operations. Unlike a wholesaler, an insurance company, or a doctor’s office, railroads generally cannot purchase commercially developed software packages for most of their data processing and management information needs. The results of years of proprietary methods of operation and information reporting are built into their software. Therefore, the OTR software contains a significant intellectual property component because it encompasses many of the operational trade secrets of the railroad. This case study illustrates two noteworthy issues. First, many corporate taxpayers subject to unit valuation recognize that an increasing percentage of their unit value consists of intangible assets. Second, a valuation of the computer software typically involves the use of software engineering models—as part of the cost approach to valuation. Software engineering models are different from the valuation methods used in the analysis of other types of intellectual property. Accordingly, this case study may be particularly instructive to corporate taxpayers/property owners and to state/local taxing authority assessors. Furthermore, the software valuation methods used in this case study may also be applicable in the economic analysis of software for other purposes. For example, the analysis of software and related intellectual property rights may be relevant for commercial damages claims, acquisition purchase price allocations, intercompany transfer pricing, intracompany intellectual property licensing, charitable contribution deductions, and other purposes.
The Case Study Problem OTR management believes that the company is paying too much property tax due to the inclusion of discrete intangible assets in its overall unit valuation. OTR is a centrally assessed Class I railroad, and the assessment is made based on the unit valuation concept. Based on the unit valuation methods employed by the assessor, the railroad unit includes the value of the entire business enterprise, including both tangible and intangible assets. In the states in which OTR pays property taxes, intangible assets are statutorily exempt from ad valorem property taxation. Locally assessed companies in these states pay property taxes only on their tangible real and personal property. Locally assessed taxpayers report their real and personal property by listing that property on an annual property rendition. Unless OTR management removes the value of its
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discrete intangible assets from the assessor’s unit value conclusion, the company would effectively pay a higher property tax rate than locally assessed taxpayers. Let’s consider a simple example where (1) the property tax rate on both tangible real and personal property is 2 percent and (2) intangible assets are exempt from ad valorem property taxation. A locally assessed corporate taxpayer will pay an effective tax rate of 2 percent on its tangible property. However, the effective tax rate for a centrally assessed corporate taxpayer would be higher if intangible assets were to be included in the taxpayer’s overall unit value. Exhibit 18.1 presents an illustrative example of the overtaxation of centrally assessed taxpayers. It is unlawful for a state—or for a local taxing jurisdiction—to discriminate against railroads by (1) assessing rail transportation property at a higher ratio of assessed value to market value than the same ratio for other commercial and industrial property or (2) applying a higher ad valorem property tax rate to rail transportation property than to other commercial and industrial property. If intangible assets are included in the overall unit value of OTR in a jurisdiction where such assets are exempt from taxation, this could result in discriminatory property taxation of OTR (as compared to locally assessed taxpayers). If (1) OTR management provides an appraisal of the railroad intangible assets to the taxing authorities and (2) that appraisal is accepted by the taxing jurisdictions, then company management would reduce the amount of the company’s property tax expense. In this case study, the objective of the analysis is to estimate the value of the OTR software as of the assessment date, January 1, 2003. OTR management will then exclude the value of the subject software from the OTR overall unit value estimate. This exclusion will result in a reduction in value of the property subject to ad valorem property taxation and will, therefore, result in an appropriate reduction in the company’s property tax expense. The taxpayer may use the software valuation analysis (1) as a negotiating tool with the state assessors or (2) as evidence in a property tax appeal administrative or judicial proceeding. Exhibit 18.1
Illustrative Example of Overtaxation of Centrally Assessed Taxpayers Value Indications Valuation Analysis Unit value Property tax rate Property tax expense
$11,000,000 2.00% $220,000
Taxpayer Assets Tangible real estate Tangible personal property Intangible personal property Total Property tax expense Divided by: Amount of tangible real and personal property (i.e., $2,000,000 real estate plus $6,000,000 tangible personal property) Equals: effective property tax rate or $60,000 per year in excess taxes
$2,000,000 6,000,000 3,000,000 $11,000,000 $220,000 $8,000,000 2.75%
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Purpose and Objective of the Analysis The objective of the analysis is to estimate the value of the OTR computer software and related intellectual property rights as of January 1, 2003. The purpose of the analysis is to provide an independent valuation opinion regarding the subject software and intellectual property in order to assist OTR management in negotiating and/or appealing its ad valorem property tax assessment. In many jurisdictions, internally developed (custom) software is more likely to be exempt from property taxation than purchased (i.e., packaged, shrink-wrapped, or canned) software. The value of custom software is typically more difficult to estimate than the value of packaged software. For example, in the state of Washington, a distinction is made between custom software, canned software, and embedded software. The state of Washington has a specific formula to estimate the value of canned software for ad valorem property tax purposes. The state of Washington does not grant an exemption for embedded software. Embedded software is software that is an integral part of the associated computer hardware, permanently residing on an internal memory device, and is generally sold or leased with the computer equipment. The computer software, including the trade secret intellectual property component, is the subject of this analysis for several reasons. First, computer software and trade secrets (as intellectual property) are exempt from ad valorem property taxation in the states in which OTR operates. Second, the software embodiment of trade secrets is an intangible asset that is more “tangible” than other intangible assets. The analyst can print the software source code and can physically examine it. The analyst can see the format of screenshots created by the subject software displayed on a monitor. And, the analyst can read the reports generated by the subject software. The subject computer programs can be copied to magnetic media. There is visual tangible evidence that the intangible computer software exists. This tangible element of software makes this intangible asset more readily understandable to property tax assessors. Third, the valuation of internally developed computer software encompassing trade secrets is relevant to our discussion of intellectual property economic analysis. This is because such software is subject to legal protection as trade secrets. There are other intellectual property rights that may be associated with software, such as patent or copyright intellectual property legal protection. The date of the subject analysis is January 1, 2003. This is because January 1 is the property tax assessment date in the states in which OTR operates. Both taxable property and exempt property are valued as of the assessment date. Accordingly, the collection of all relevant data used in the intellectual property analysis is as of January 1. The results of the subject analysis will be documented in a narrative valuation opinion report prepared for OTR management. The analyst understands that the taxpayer may include a copy of this narrative valuation opinion report with its property tax return in each state in which OTR operates. The OTR organization purchases and licenses a variety of software products and packages. These software packages range from shrink-wrapped software (such as spreadsheet and word processing products) to integrated payroll and human resources packages. Purchased software and software use licenses are generally considered to be intangible assets. However, in this case, OTR has decided to claim
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a property tax exemption only for their internally developed software. That internally developed software includes additions to and interfaces with the company’s payroll and human resources software package. Therefore, the subject analysis is limited to the customized, internally developed OTR software—and the component trade secrets and other intellectual property rights. As discussed earlier, some states specifically define “canned,” prewritten, embedded, or packaged computer software as tangible personal property subject to ad valorem property taxation.
Description of the Subject Intellectual Property The subject of the analysis is the OTR internally developed custom software and related intellectual property rights. Specifically, the related intellectual property rights include the trade secrets component of the OTR software—the component that is subject to trade secret protection. OTR has three groups of internally developed software systems. The first two groups [(1) mainframe systems and (2) client/server systems] were developed by software engineering professionals in the OTR information technology (IT) department. The third group contains systems developed primarily by non-IT employees using a fourth generation language (4GL). Fourth generation programming languages are higher-level computer programming languages. They typically use English-like instruction commands. They are particularly suited to file queries and report generation. And, these higher-level programming languages allow for rapid development of systems, often by less sophisticated users. The OTR mainframe systems run on a central mainframe computer and are written in COBOL. Most of these systems have been in existence for a long time. However, these systems have been continually modified and enhanced over the years. The following systems are included in the mainframe systems: scheduling and resource allocation, invoicing, accounts receivable, accounts payable, general ledger, and statistical and financial reporting applications. The client/server applications allow personal computers (clients) to access and update databases on the mainframe (server). The subject computer programs are written in the C, C++, COBOL, and Visual Basic programming languages. The client/server applications run on both the personal computers and on the central mainframe computer. These software systems update and provide information related to the operation of the railroad, including the following functions: movement and maintenance of cars and trains, customer inquiries, waybills, and performance statistics. These systems are newer than the mainframe systems. In fact, some of the client/server applications have replaced the mainframe systems over time. The 4GL systems are written in the Informix language by various user departments on an as needed basis. Some systems include stand-alone database systems, and other systems simply perform inquiries on and/or print reports from existing databases. OTR data processing personnel began the development of the mainframe systems more than 20 years ago in order to operate the railroad more efficiently. At the time, there were no software packages available that OTR management considered suitable for their operations. This was due to the unique needs of the railroad, including industry-specific regulatory reporting requirements. OTR management hired a contract programming company (a software house) to design and write the
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first systems. These systems were developed by the software house according to specifications defined by OTR personnel. Under the terms of the agreement with the software house, OTR retained ownership of (1) all program source code and (2) all documentation related to the systems. OTR also retained ownership of all of the software-related intellectual property, including any trade secrets and copyrights. Over time, OTR management expanded their in-house data processing staff. Eventually, OTR management phased out the use of outside software development assistance. The software created by the OTR software engineering employees was “a work made for hire.” Therefore, the copyrights related to the subject software belong to OTR. The OTR employment agreements with its software engineering personnel underscored the company’s ownership of the software, the associated copyrights, and the associated trade secrets. New software systems were added, and existing software systems were modified and enhanced over the years. From time to time, various application software systems were rewritten and replaced, with the obsolete source code being deleted from the OTR software libraries. During the late 1990s, OTR management initiated a substantial client/server software development effort on the part of company IT staff members. Some of these late 1990s client/server systems were entirely new systems, and some replaced existing mainframe systems. The client/server architecture provided a greater access to important information on the part of OTR employees as well as on the part of OTR customers. Soon thereafter, OTR non-IT employees were provided with a tool to develop new software systems for use in their respective operating departments. The software development tool was called Informix.
Data and Data Sources OTR management provided the analyst with descriptive and quantitative information related to the systems in all three subject groups of software. OTR employees demonstrated a sample of the software systems to the analyst. The analyst conducted extensive due diligence interviews with OTR IT employees responsible for one or more systems. The analyst received demonstrations and conducted due diligence interviews regarding systems in each of the three software groups. For each system, the analyst received a narrative description explaining the function of the system. The quantitative information collected by the analyst for each system included the number of programs as well as the number of lines of source code, by programming language. The nonexecutable lines of code (e.g., comment lines and blank lines) were excluded from the line-of-code counts (or were counted separately, so that they could be subtracted from the total counts). Obsolete and duplicate lines of code were excluded from the line-of-code counts. Any licensed (i.e., not internally developed and owned) software lines of code were also excluded from the code counts provided to the analyst. The analyst reviewed data related to historical costs incurred in the development of the subject software. The analyst also reviewed the amount of time (in hours, days, or months) actually spent by OTR software development personnel to develop the subject software. In addition to data collected from the OTR IT department, the analyst collected information from the OTR human resources department. The analyst reviewed
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human resources information related to OTR IT personnel salaries and bonuses, payroll taxes, fringe benefits, and overhead costs. The software application demonstrations made to the analyst served (1) to verify the existence of the systems, (2) to help explain the function of the systems, and (3) to provide evidence of the complexity and quality of the systems. As part of the application demonstration, the analyst examined samples of the actual source code. The analyst conducted interviews with a representative group of OTR system managers. These interviews encompassed many topics, including the following: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.
The function of each system The history of the development of each system The expected remaining useful life (RUL) of each system Obsolescence related to each system The line-of-code counts (e.g., what was included and what adjustments are necessary) The characteristics of each system (e.g., complexity, reliability, etc.) The software development environment (including hardware/operating system) The software development methods and practices The quality and experience of the OTR software development personnel The availability of comparable computer software in the marketplace
The analyst performed several due diligence investigation procedures in order to validate the data provided by OTR management—or, at least, to confirm that the provided data were reasonable. For example, the analyst compared the sample source code listings from the application demonstration to the line-of-code counts provided in order to check for variances. In addition, the analyst consulted salary surveys in order to determine if the salaries of OTR IT personnel were consistent with the salary survey data. The analyst consulted several independent sources of information related to commercially available software packages in order to identify any comparable or guideline software packages. These sources of information included trade publications, other professional journal articles, and the Internet. The analyst also searched for any available information related to arm’s-length market sale/license transactions involving comparable or guideline software. The sources that the analyst used for this search included periodicals, transaction databases, published court decisions, and Securities and Exchange Commission (SEC) filings. Following the collection of data, the system demonstrations, the OTR personnel interviews, and the additional research, the analyst became comfortable with the data provided to the analyst by OTR management. The analyst’s experience and expertise in performing intellectual property economic analyses also served to increase the analyst’s comfort level with the data provided by OTR management.
Analytical Approaches and Methods A number of analytical approaches and methods may be used to estimate the value of software—and related intellectual property rights. Typically, the analyst will consider all three valuation approaches: cost, income, and market. However, certain analytical approaches and methods may not be applicable depending on (1) the nature of the subject software and (2) the availability of requisite data.
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The cost, income, and market approaches may all be used in the valuation of computer software and software-related intellectual property. Within each of the three approaches, there are several different valuation methods. While each approach and method involves somewhat unique analyses, all approaches have some common fundamentals. For example, within each approach, an adjustment should be made for obsolescence, if any, associated with the subject software. Such an adjustment may be discretely made to the value indicated by the analysis or it may be embedded within other valuation procedures. The following discussion summarizes all the analytical methods that are commonly used in a software valuation.
Cost Approach Within the cost approach, two types of cost may be estimated for computer software: (1) reproduction cost and (2) replacement cost. Reproduction cost is the cost to create an exact replica of the subject software, while replacement cost is the cost to create new software that provides the same functionality or utility as the subject software. For example, a reproduction cost analysis would estimate the cost to create systems of the same size and number of programs—in the same programming languages used to develop the subject. Alternatively, a replacement cost analysis may estimate the cost to replace the subject systems with programs that contain fewer lines of source code—using a more efficient, higher-level programming language. Trended Historical Cost Method. One method used to estimate the reproduction cost of software is the trended historical cost method. When actual historical software development cost data are available, these costs are then “trended” to the appropriate valuation date using an inflation-based index factor. Historical costs should include the following: 1. 2. 3. 4.
Direct payroll costs (including all payroll-related taxes) All fringe benefit costs An allocation of the software development organization’s overhead costs Time spent on tasks related to software development by software development personnel (e.g., project managers, systems analysts, database administrators, and programmers) 5. Time spent by non–data processing employees and by contractors involved in the software development process These historical costs could also include (1) the efforts of company executives or of system users involved in feasibility studies or in the early stages of system definition or design and (2) the efforts of any system users or company support personnel involved in the system testing and documentation (e.g., the writing of system user or training manuals). In the absence of actual historical software development cost data, these development costs are often estimated by the analyst. When historical cost data are not available, the analyst will estimate development costs based on either actual development time data (if historical timekeeping records are available) or estimated development time. The actual or estimated development time indications may be expressed in person-hours, person-months, or person-years. The development time estimates are then multiplied by either (1) a personspecific cost per unit of development time (if the time estimate is prepared on a
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per person basis) or (2) a weighted average person cost per unit of time (if the time estimate is prepared on a weighted average person basis). In any event, these software development costs would be estimated in current dollars, as of the appropriate valuation date. And, the software development costs would be inclusive of all appropriate payroll taxes, employee fringe benefits, and organizational overhead costs. Software Engineering Model Method. Analysts sometimes use any of a number of commercially available software engineering models. These models have been developed primarily for use by software engineers in order to estimate the effort, time, and human resources needed to develop a new software product or system. These models may be used by analysts to estimate either the reproduction cost or the replacement cost of existing software systems. The primary input to these software engineering models is some measure of either the system size or the functionality. Size and functionality are often measured by such metrics as (1) number of lines of program source code, (2) number of function points, or (3) number of source code objects. Additional inputs to the software engineering models may include the following: • • • • • • • • •
Programming language(s) Tools used Experience and capability of the development team Complexity of the system Type of application Development/operations platform Software development practices Development time constraints Staffing constraints
These models are typically “empirical” cost estimation models. In these empirical models, system development effort is estimated by reference to a database of actual completed software development projects. Some software engineering models allow for the inclusion of—or the calibration to—the model user’s own historical projects. For valuation purposes, the amount of development effort estimated by the model (generally expressed in person-months) is then multiplied by a “fully loaded” cost per person-month. This “fully loaded” cost per person-month typically includes an average salary of the development project team members, as well as related payroll taxes, employee fringe benefits, and organizational overhead costs.
Income Approach The income approach is most applicable when there is an identifiable income stream—or identifiable cost savings stream—associated with the subject software. For example, if the subject software is sold or licensed to customers, then the income from (1) the sale of the software or (2) the license and maintenance fees would be directly attributable to the software. Using the income approach, the value of computer software and related intellectual property is estimated as the present value of the expected economic income attributable to the ownership of the software. In the present value analysis, the expected economic income is projected over the RUL of the subject software. The discounted cash flow method is often used in the valuation of product software (i.e., software that generates income when it is sold or licensed). The future
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cash flow related to product software is typically estimated by projecting revenues and expenses (excluding noncash depreciation and amortization expense) over the expected remaining life of the software. Components of the cash flow measure of economic income include future capital expenditures and expected changes in working capital requirements. In addition, a capital charge/economic rent may be included in the analysis if other assets are used or used up in the production of the projected revenues. The projected cash flow is then discounted to a present value, using an appropriate market-derived present value discount rate.
Market Approach In the market approach, the value of the software is estimated by reference to actual market transactions involving the sale or license of comparative software systems. The market approach is used less frequently than other approaches in the valuation of software. This is because empirical market data regarding sale/license transactions of comparative software are often difficult to find. This difficulty is due to two factors: (1) the lack of public disclosure on the part of software licensors/licensees and (2) the lack of direct comparability of most sophisticated commercial software applications. In addition, the market prices for commercial off-the-shelf software packages are usually not relevant when the subject software is internally developed (custom) software. However, when appropriate empirical data are available, market approach methods can effectively be used when estimating the value of software. Relief from Royalty Method. The relief from royalty method compares the actual situation where the owner/operator owns the subject software to a hypothetical situation where the owner/operator licenses—but does not own—the subject software. The fact of software ownership “relieves” the owner/operator from the requirement to inbound license comparable software systems. In the relief from royalty method, the expected cost savings that accrue to the software owner/operator—who would otherwise have to pay a license fee or royalty for the use of comparable software—are estimated. The projected royalty “relief” is typically calculated as a market-derived software license royalty rate multiplied by the projected revenues earned from the use of the subject software. With regard to industrial and commercial software applications, such royalty-based software license arrangements are fairly common. Accordingly, projected revenues, over the RUL of the software, are multiplied by a market-derived royalty rate to estimate the royalty savings or “relief.” The net royalty savings for each year in the RUL period are then discounted to a present value. This method is typically classified as a market approach method because it uses market-derived royalty rate indications. Market Transaction Method. When data for arm’s-length sale transactions related to comparative software are available, the sale transaction price is typically converted into a quantitative metric, such as dollars per line of code (or per function point). The value of the subject software is then estimated by multiplying the market-derived price, expressed as dollars per line of code, by the number of lines of code in the subject software. In the selection of the market-derived price indicator to apply to the subject, the analyst should consider differences between the subject software and the comparative software systems. Market-Derived Replacement Cost Method. This method is a variation of the cost approach replacement cost method. However, in this method, replacement cost
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indicators are extracted from empirical market data. This method analyzes the cost indicated by market transactions to replace the subject software. If there are commercial, off-the-shelf software packages that are comparative to the subject software, then the cost to purchase these packages may be used to estimate the replacement cost of the subject software. In the selection of the market-derived replacement cost indicator to apply to the subject software, the analyst should consider any significant differences between the subject software and the comparative software systems. Such adjustments may include (1) an estimate of the cost to complete any necessary customization and (2) any differences in the proprietary rights associated with the subject software versus the comparative software. When replacement cost data with regard to comparative software packages are not available, the analyst may engage commercial software developers to prepare an estimate or a “proposal bid” to develop software comparable to the subject software. The proposal bids estimate the cost to either develop an entirely custom system or to purchase/license and modify an existing package.
Analytical Approaches and Methods Considered and Selected Cost Approach Methods. For purposes of this case study, the analyst considered both the trended historical cost method and the software engineering model method. Both methods are often appropriate for the valuation (or other economic analysis) of internally developed custom software. Upon final consideration, the analyst ultimately rejected the trended historical cost method in this case. The analyst reached this conclusion because the historical cost data for the mainframe systems were simply not available. These historical cost data were not available in the instant case primarily because the systems were developed over such a long time frame. Furthermore, even the historical cost data for the systems developed more recently were not useful for the analysis. Though the OTR timekeeping system captured the total number of hours worked, timekeeping records were not maintained by individual software system development project. Accordingly, the analyst selected the software engineering model method for this valuation. The analyst selected two individual software engineering models: (1) the Constructive Cost Model (COCOMO) and (2) KnowledgePLAN. COCOMO was originally developed by Barry W. Boehm. An updated model, COCOMO II, is maintained, documented, and periodically updated by Boehm and his associates at the Center for Software Engineering (CSE) at the University of Southern California. This software engineering model is available free of charge, though there are commercial implementations of the model available from several software vendors. KnowledgePLAN is a software product that may be licensed from Software Productivity Research, LLC (SPR). These two models, along with the Software Lifecycle Management (SLIM) model used in the SLIM-Estimate and Estimate Express products offered by Quantitative Software Management, Inc., are among the best known software engineering models. In the subject analysis, the analyst selected the COCOMO and KnowledgePLAN models because the transaction data on which the models are constructed are particularly relevant to the particular valuation analysis.
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Alternative Approaches and Methods. The subject OTR software is operational software, not product software. Because the software does not have an identifiable income stream associated with it, the analyst decided not to use the discounted cash flow method. Similarly, the analyst decided not to use the relief from royalty method. This is because the subject software is not directly used to generate a revenue stream to which a royalty rate could be applied. The analyst also considered the cost savings method. The analyst concluded that this method could be used if comparative software packages were available for license in the marketplace. However, the analyst’s research uncovered only a small number of available software packages that could perform the functions provided by some of the nearly 100 OTR custom software systems involved in this case. Therefore, the analyst decided not to use this method. The analyst also considered using other market transaction methods as a test of the reasonableness of the conclusions indicated by the primary analytical methods. Finding sufficient data regarding sale/license transactions related to software is often difficult. And, it is also difficult for the analyst to assess the comparability of such software to the subject software. The analyst decided not to use the market replacement cost method, because of the large number of systems at OTR. The analyst concluded that finding comparative software packages that could provide (with or without modification) the functionality of the nearly 100 OTR custom systems would be too difficult and unreliable. In addition, the analyst knew from experience that, with so many systems, a software developer asked to provide a bid proposal for the replacement of the subject software would likely use a software engineering model (similar to those selected by the analyst). The analyst performed a search for arm’s-length market sale/license transactions involving comparative software systems. However, the search did not produce any useful market-derived pricing data. Therefore, the analyst concluded that the market transaction method could not be applied in this analysis. This conclusion is often the case with regard to custom operational software because it is rarely sold by itself. Rather, it is usually sold as part of a business and the portion of the purchase price allocated to the software is seldom disclosed. Furthermore, when a price is disclosed for a software transaction, metric data (e.g., lines of code, function points, or even number of programs) are hardly ever available.
Analytical Variables Cost per Person-Month. As one component of the cost to recreate the OTR software, the analyst estimated a fully loaded cost per person-month. This fully loaded cost includes (1) the weighted average salary of the software project development team and (2) related payroll taxes, employee fringe benefits, and organization overhead costs. Based on data collected from the OTR human resources department, the analyst estimated the fully loaded cost per person-month to be $10,400. Size Metrics. One of the primary input variables to both COCOMO II and KnowledgePLAN is a measure of system size. COCOMO II, in its most detailed PostArchitecture model, uses logical source statements (expressed in thousands) as the size metric input into the model equations. In the COCOMO model, there is a set of rules defining which lines of program source code are to be included. For example, comments or blank lines are excluded from the line-of-code count, but declaration statements are included in the line-of-code count.
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Logical lines of code, rather than physical lines of code, are counted for purposes of quantifying the software size metric. For example, two program statements on one physical line count as two logical lines of code in the line-of-code count. However, an “IF … THEN” statement spread across several physical lines may count as one logical line of code in the line-of-code count procedures. KnowledgePLAN can use one of four predefined size metrics: 1. 2. 3. 4.
IFPUG (International Function Point Users’ Group) function points SPR function points SPR feature points Lines of code (in thousands, with a definition consistent with the definition of lines of code used by COCOMO II)
In addition, the user may define a custom metric. That custom metric will then be converted into IFPUG function points for size estimation purposes. The OTR IT personnel have software tools available that allow them to count the physical lines of code (for each programming language) in their program libraries. The OTR IT personnel also counted the number of lines to exclude (e.g., blank or comment lines) from the line-of-code size metric. However, the OTR IT personnel had no reliable method available to count function points or feature points. Therefore, the analyst selected lines of code as the appropriate size metric to use for both software engineering models. In this analysis, the analyst made an adjustment to convert the physical line-ofcode counts to logical line-of-code counts. Based on (1) published empirical studies, (2) interviews with software development experts, and (3) analysis printouts of sample OTR programs, the analyst estimated that a reduction of 20–40 percent— depending on the programming language—was appropriate to convert from a physical line-of-code count to a logical line-of-code count. The analyst also made additional adjustments to the line-of-code counts in order to eliminate both obsolete and duplicate source code. For both software engineering models, the analyst estimated development effort using line-of-code counts on a system-by-system basis. However, some of the reproduction cost variables were the same for all systems within each of the three system groups (i.e., mainframe, client/server, and 4GL). COCOMO II Variables. The COCOMO II Post-Architecture model effort equation can be used to estimate the amount of development effort in person-months to develop a software system with either new code or adapted code. A breakage factor is included in the model in order to capture the amount of development effort required to create code that is discarded due to the volatility of the requirements. For the purpose of valuing the OTR custom software, the analyst concluded that all of the reproduction code should be new code. Also, the analyst did not include a breakage factor, effectively estimating the development effort required to create only the source code in existence as of the valuation date. The simplified COCOMO effort equation is presented as follows: PM = A × [KNSLOC]E ×
17
EM i II i =1
where PM = person-months A = the multiplicative constant (as of the subject valuation date, 2.94)
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KNSLOC = thousands of new source lines of code E = the exponent, a function of the scale factors (see equation to follow) EM1 through EM17 = the effort multipliers corresponding to the cost driver ratings The equation for the COCOMO effort equation exponent is: E = B + 0.01 ×
5
SF j Σ j =1
where B = the exponential constant (as of the subject valuation date, 0.91) SF1 through SF5 = the scale factors corresponding to the scale driver ratings The analyst prepared a questionnaire to assist in the rating of (1) the 17 cost drivers and (2) the 5 scale drivers for each of the three groups of systems (i.e., mainframe, client/server, and 4GL). The analyst used this questionnaire as a basis for interviews with system managers in each of the three groups of systems. The analyst rated the cost drivers—such as required software reliability, product complexity, programmer capability, and use of software tools—from very low to extra high. The corresponding effort multipliers are generally in the range of 0.75 through 1.50. The analyst rated the scale drivers—such as development flexibility and process maturity—from very low to extra high. The corresponding scale factors are generally in the range of zero to five. A description of the rating of the cost drivers and scale drivers and their corresponding factors are presented in the textbook Software Cost Estimation with COCOMO II.1 KnowledgePLAN Variables. KnowledgePLAN uses built-in proprietary algorithms to estimate the amount of effort required to develop a software project. The development effort factors are based on user inputs. During the system manager interviews, where the COCOMO questionnaire was discussed, the analyst also gathered additional information needed to define a KnowledgePLAN project for each of the three OTR system groups. The following paragraphs represent a brief description of the software development project data inputs. KnowledgePLAN first allows the analyst to specify project classification data such as scope (e.g., program or application, subsystem), topology (e.g., stand-alone, client/server), class (e.g., end-user developed, IT/MIS), and type (e.g., interactive GUI, multimedia). The analyst estimates the expected size of the system by analogy, components, or metrics. If metrics are used, the analyst may use one of several metrics, including lines of code or function points. Measurements of lines of code may be entered for each of several languages. These measurements are all converted into function points to be used in the KnowledgePLAN algorithms. Complexity ratings may also be modified by the analyst. For the OTR software valuation, the analyst used the same measurements of lines of code for each system that were used in the COCOMO analysis. These lines of code counts were broken down by programming language, and the analyst assigned complexity ratings for each of the three system groups.
1 Barry W.
Boehm, Chris Abts, et al., Software Cost Estimation with COCOMO II (Paramus, NJ: Prentice Hall, 2000).
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The analyst may also modify a large number of attribute values that describe the development personnel, development technology, development process, data processing environment, and the subject software product. Default values are typically assigned when a new software project is created. In the instant case, the analyst modified each attribute where a change from the default value was appropriate. Additionally, software development project tasks may be added or deleted and constraints may be placed on the schedule or the amount of development resources. In the instant case, the analyst did not change the project tasks or impose any additional software development constraints. Obsolescence. In the instant case, the analyst concluded that no additional adjustments for obsolescence were necessary to the replacement costs indicated by the software engineering model analyses. In this valuation, the analyst considered three types of obsolescence: functional, technological, and economic obsolescence. The analyst concluded that physical deterioration, a fourth form of obsolescence, was not applicable to the subject software. Based on interviews with OTR systems personnel, the analyst concluded that the software was continually modified and enhanced to satisfy user needs. In addition, obsolete programs were routinely purged from the libraries. Therefore, the analyst concluded that no functional obsolescence was indicated. One exception to this conclusion was that there were several mainframe systems that were in the process of being replaced. To adjust for this, the analyst reduced the line-of-code counts for those systems in order to (1) effectively eliminate any programs that were already obsolete and (2) reflect the shorter expected RUL of the other programs. Another exception that related to the obsolescence conclusion was the 4GL systems. At the analyst’s request, an analysis was performed by an OTR senior manager to estimate the percentage of the lines of code in the 4GL libraries that were either obsolete or duplicate. This analysis identified all one-time use programs and duplicate versions of the same program. The analyst then used this percentage to reduce the line-of-code count used in the software engineering models. The analyst concluded that no material amount of technological obsolescence existed with respect to the subject software. OTR managers informed the analyst that if the software were to be rewritten as of the valuation date, the same programming languages, hardware, operating systems, and utilities would be used. Though some available tools and efficient programming methods were not used historically in the development of the subject software, they would be used if the subject systems were actually replaced as of the valuation date. Therefore, the use of these tools and methods was assumed in the assignment of software engineering model variables. The conclusion of that assumption is a replacement cost estimate lower than the cost that would be estimated assuming the use of historical inefficiencies. With respect to economic obsolescence, the analyst found no evidence of obsolescence (1) due to legal or regulatory changes or (2) due to any economic or market conditions. According to OTR management, the subject software allows the railroad to operate efficiently and profitably. The analyst’s review of OTR financial statements and of industry financial ratios supported this assertion. In summary, the analyst made obsolescence adjustments to the data inputs to the software engineering models, and the obsolescence adjustments were implicit in the model variables selected by the analyst. Therefore, the analyst concluded that no additional obsolescence adjustments were needed to the cost estimates produced by the software engineering models.
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Analyses and Results Cost per Person-Month The OTR human resources manager provided the analyst with average salaries for the OTR software development personnel as of the valuation date. The average salary of the software development team was approximately $78,000 per year or $6,500 per month. OTR does not pay bonuses to its IT personnel. In addition, average payroll taxes and average cost of benefits (e.g., insurance and retirement plan contributions), as a percent of compensation, were provided by the OTR human resources manager. Based on data used for budgeting and cost accounting purposes, the OTR human resources manager estimated additional costs (i.e., training, travel, and other overhead costs) related to software development personnel. The analyst converted this additional cost estimate to a percent of salary. Based on these data, the analyst concluded that the fully loaded cost per personmonth of software development effort, as of the valuation date, was $10,400. The cost per person-month analysis is presented in Exhibit 18.2.
COCOMO Analyses As previously described, the COCOMO II Post-Architecture development effort equation contains several analytical variables that may vary by system or system group. These analytical variables included (1) effort multipliers, (2) scale factors, and (3) number of lines of code (logical, in thousands). In the instant case, the analyst assigned a different set of effort multipliers and scale factors to each of the three system groups. The cost driver and scale driver ratings, along with their associated effort multipliers and scale factors, are presented in Exhibit 18.3. For each of the mainframe systems, the analyst converted the number of physical lines of code to logical lines of code using a 20 percent reduction factor. The analyst further adjusted the logical line-of-code counts in order to reflect any obsolescence associated with the systems that are in the process of being replaced. The analyst estimated the development effort in person-months using the COCOMO effort equation. Then, the analyst multiplied the number of person-months by the cost per person-month of $10,400 to estimate the cost to recreate each system. The estimated replacement cost indicated by the COCOMO analysis for the mainframe systems is approximately $57 million. This analysis is presented in Exhibit 18.4. For each of the 4GL systems, the analyst converted the number of physical lines of code to logical lines of code using a 40 percent reduction factor. The analyst further adjusted the logical line-of-code counts in order to eliminate duplicate and/or obsolete code. Next, the analyst estimated the development effort in person-months using the COCOMO effort equation. Then, the analyst multiplied the number of personmonths by the cost per person-month to estimate the cost to recreate each system. The replacement cost indicated by the COCOMO analysis for the 4GL systems is approximately $33.7 million. This analysis is presented in Exhibit 18.5. For each of the client/server systems, the analyst converted the number of physical lines of code to logical lines of code using a 30 percent reduction factor.
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Exhibit 18.2
On Track Railways, Cost per Person-Month, as of January 1, 2003 Salary Data Number of Employees 4 42 30 20 10 4
Job Classification Documentation/Testing Programmer Analyst Project manager Senior manager Director
110
Total Annual Salaries ($) 178,618 2,814,302 2,346,010 1,722,347 1,011,512 493,217
Average Annual Salary ($) 44,655 67,007 78,200 86,117 101,151 123,304
8,566,006
Nonsalary Cost Data
Type of Cost FICA Medicare Unemployment taxes Insurance (health, life, etc.) Pension plan Total payroll taxes and benefits Overhead (including training/travel) Total loading factor
Total annual salaries Divided by: Total employees Equals: Average annual salary Divided by:
As a Percentage of Salary (%) 6.0 1.5 0.5 11.0 13.0 32.0 28.0 60.0
$ 8,566,006 110 $ 77,873 12
Equals: Average monthly salary
$ 6,489
Average monthly salary (rounded) Times: One plus loading factor
$ 6,500 1.60
Equals: Fully loaded cost per person-month
$ 10,400
The analyst estimated the development effort in person-months using the COCOMO effort equation. Then, the analyst multiplied the number of person-months by the cost per person-month to estimate the cost to recreate each system. The replacement cost indicated by the COCOMO analysis for the client/server systems is approximately $16 million. This analysis is presented in Exhibit 18.6.
KnowledgePLAN Analyses The analyst defined a project in KnowledgePLAN for each of the three system groups. This definition included project classification information, complexity ratings, and a number of attribute values that describe the actual software development
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Exhibit 18.3
On Track Railways, COCOMO Variables by System Group, as of January 1, 2003 Mainframe Effort Rating Multiplier
Cost Drivers PRODUCT FACTORS RELY Required System Reliability DATA Database Size CPLX Software System Complexity* RUSE Required Reusability DOCU Documentation Match to Life-cycle Needs COMPUTER FACTORS TIME Execution Time Constraint STOR Main Storage Constraint PVOL Platform Volatility PERSONNEL FACTORS ACAP Analyst Capability PCAP Programmer Capability PCON Personnel Continuity AEXP Applications Experience PEXP Platform Experience LTEX Language and Tool Experience PROJECT FACTORS TOOL Use of Software Tools SITE Multisite Development* SCED Required Development Schedule
Rating
4GL Effort Multiplier
N VH VL-H L L
1.00 1.28 0.98 0.95 0.91
N N L-N L VL
1.00 1.00 0.92 0.95 0.81
N N N-H L N
1.00 1.00 1.03 0.95 1.00
N N L
1.00 1.00 0.87
N N L
1.00 1.00 0.87
N N N
1.00 1.00 1.00
H H VH VH VH H
0.85 0.88 0.81 0.81 0.85 0.91
N H N H H H
1.00 0.88 1.00 0.88 0.91 0.91
N H N H H H
1.00 0.88 1.00 0.88 0.91 0.91
H H-VH N
0.90 0.90 1.00
H VH N
0.90 0.86 1.00
H N-VH N
0.90 0.93 1.00
Product of the Effort Multipliers
0.29
Scale Drivers
Rating
SCALE FACTORS PREC Precedentedness FLEX Development Flexibility RESL Architecture/Risk Resolution TEAM Team Cohesion PMAT Process Maturity Sum of the Scale Factors Exponent†
Client/Server Effort Rating Multiplier
H VL N H H
Scale Factor 2.48 5.07 4.24 2.19 3.12 17.10 1.0810
0.31 Rating H EH N H N
Scale Factor 2.48 0.00 4.24 2.19 4.68 13.59 1.0459
0.53 Rating N N N H H
Scale Factor 3.72 3.04 4.24 2.19 3.12 16.31 1.0731
* Based upon averages of more than one factor. † Exponent = 0.91 + 0.01 × Σ scale factors.
personnel, technology, process, environment, and product. The analyst included the various KnowledgePLAN reports documenting the project variables as an appendix to the valuation opinion report. The analyst used the same line-of-code counts from the COCOMO analyses (including (1) adjustments from physical to logical lines of code and (2) adjustments for obsolescence/duplication) in the KnowledgePLAN analyses. However, in a KnowledgePLAN analysis, the number of lines of code should be input for each
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Exhibit 18.4
On Track Railways Valuation Analysis, COCOMO Mainframe Software, as of January 1, 2003 Manager
System
Number of Programs
Physical Lines of Code
Logical Lines of Code*
Adjusted Lines of Code
Effort in Person-Months
Cost Indication ($)
ADAMS
ADA001† ADA004 ADA005† ADA007 ADA009 ADA013 ADA017 ADA025 ADA030 ADA042† ADA050† ADA065†
85 72 74 11 15 26 17 18 33 34 15 28
105,119 66,255 141,280 9,838 8,171 17,365 13,135 11,976 37,790 82,387 10,314 42,252
84,095 53,004 113,024 7,870 6,537 13,892 10,508 9,581 30,232 65,910 8,251 33,802
42,048 53,004 56,512 7,870 6,537 13,892 10,508 9,581 30,232 32,955 4,126 16,901
48.53 62.33 66.81 7.93 6.49 14.66 10.84 9.81 33.97 37.29 3.95 18.12
504,712 648,232 694,824 82,472 67,496 152,464 112,736 102,024 353,288 387,816 41,080 188,448
HARDING
HAR016 HAR021 HAR035 HAR040 HAR052 HAR070 HAR075 HAR083 HAR089
193 15 30 24 15 66 10 123 79
161,826 15,531 19,250 31,668 17,774 103,409 10,039 107,500 180,899
129,461 12,425 15,400 25,334 14,219 82,727 8,031 86,000 144,719
129,461 12,425 15,400 25,334 14,219 82,727 8,031 86,000 144,719
163.67 12.99 16.39 28.06 15.03 100.86 8.11 105.18 184.62
1,702,168 135,096 170,456 291,824 156,312 1,048,944 84,344 1,093,872 1,920,048
JACKSON
JAC010 JAC013 JAC020 JAC032 JAC044 JAC056
41 47 433 99 62 260
27,659 82,687 772,999 118,811 42,253 372,906
22,127 66,150 618,399 95,049 33,802 298,325
22,127 66,150 618,399 95,049 33,802 298,325
24.24 79.20 887.37 117.19 38.33 403.54
252,096 823,680 9,228,648 1,218,776 398,632 4,196,816
JEFFERSON
JEF017 JEF044
60 74
212,939 134,468
170,351 107,574
170,351 107,574
220.21 133.97
2,290,184 1,393,288
KENNEDY
KEN025 KEN040
72 38
79,474 23,322
63,579 18,658
63,579 18,658
75.88 20.16
789,152 209,664
LINCOLN
LIN008 LIN019 LIN026 LIN049 LIN053 LIN066 LIN071
87 12 296 33 80 26 40
106,356 5,091 315,921 37,718 132,677 69,039 103,999
85,085 4,073 252,737 30,174 106,142 55,231 83,199
85,085 4,073 252,737 30,174 106,142 55,231 83,199
103.97 3.89 337.31 33.90 132.05 65.17 101.48
1,081,288 40,456 3,508,024 352,560 1,373,320 677,768 1,055,392
MADISON
MAD014 MAD037 MAD055 MAD069 MAD075 MAD080 MAD099 MAD107 MAD123 MAD132 MAD144 MAD157
10 74 302 12 10 61 93 26 97 91 32 17
2,646 36,906 135,537 5,130 6,885 30,938 39,379 14,086 37,388 38,773 14,780 8,327
2,117 29,525 108,430 4,104 5,508 24,750 31,503 11,269 29,910 31,018 11,824 6,662
2,117 29,525 108,430 4,104 5,508 24,750 31,503 11,269 29,910 31,018 11,824 6,662
1.92 33.11 135.13 3.92 5.39 27.37 35.52 11.69 33.58 34.93 12.31 6.62
19,968 344,344 1,405,352 40,768 56,056 284,648 369,408 121,576 349,232 363,272 128,024 68,848 (continued)
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Exhibit 18.4
On Track Railways Valuation Analysis, COCOMO Mainframe Software, as of January 1, 2003 (Continued) Manager
System
Number of Programs
Physical Lines of Code
Logical Lines of Code*
Adjusted Lines of Code
Effort in Person-Months
Cost Indication ($)
ROOSEVELT
ROO107† ROO126† ROO135 ROO136 ROO148 ROO165† ROO173† ROO189
85 46 10 12 120 15 82 11
115,966 126,841 6,022 16,399 90,995 33,354 67,732 5,382
92,773 101,473 4,818 13,119 72,796 26,683 54,186 4,306
46,387 50,737 4,818 13,119 72,796 13,342 27,093 4,306
53.97 59.46 4.67 13.78 87.84 14.03 30.18 4.13
561,288 618,384 48,568 143,312 913,536 145,912 313,872 42,952
TRUMAN
TRU003 TRU015 TRU025 TRU031 TRU041 TRU050 TRU063
122 39 151 23 37 137 147
60,517 31,886 147,645 19,069 45,301 145,798 164,233
48,414 25,509 118,116 15,255 36,241 116,638 131,386
48,414 25,509 118,116 15,255 36,241 116,638 131,386
56.52 28.27 148.22 16.22 41.33 146.22 166.30
587,808 294,008 1,541,488 168,688 429,832 1,520,688 1,729,520
WASHINGTON WAS019 WAS021 WAS023 WAS026 WAS030 WAS035
181 63 60 40 16 55
128,614 92,464 79,293 38,528 7,986 61,197
102,891 73,971 63,434 30,822 6,389 48,958
102,891 73,971 63,434 30,822 6,389 48,958
127.68 89.37 75.69 34.69 6.33 57.21
1,327,872 929,448 787,176 360,776 65,832 594,984
WIL016 WIL032 WIL064 WIL128 WIL256
26 20 19 36 41
18,060 14,493 12,468 31,781 82,194
14,448 11,594 9,974 25,425 65,755
14,448 11,594 9,974 25,425 65,755
15.29 12.06 10.25 28.17 78.69
159,016 125,424 106,600 292,968 818,376
Mainframe Systems Total
5,162
5,847,090
4,677,671
4,387,575
5,481.56
57,008,224
WILSON
* Physical to logical line of code reduction estimated to be 20%. † Adjusted lines of code reflect obsolescence estimated at 50% because the system is in the process of being replaced.
programming language. All of the mainframe systems were programmed in COBOL, and all of the 4GL systems were programmed in Informix. The client/server systems were written in several programming languages. Therefore, the analyst used the source type to sum the number of lines of code by language for each system. For example, source types .cpy, .pco, and .cob are all COBOL language source code. Once the analyst entered the line-of-code counts, by language, into KnowledgePLAN for each system, the model could estimate the development effort in terms of person-months. The analyst prepared a complete KnowledgePLAN report documenting this development effort estimate for each system for the valuation work paper files. And, the analyst included a sample of the KnowledgePLAN reports as an appendix to the valuation opinion report. The analyst then multiplied this
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IV / Intellectual Property Valuation Issues
Exhibit 18.5
On Track Railways Valuation Analysis, COCOMO 4GL Software, as of January 1, 2003
Department Car inventory Customer service Finance Human resources IT department Legal Marketing Operations Scheduling OTR corporate finance‡ Third-party vendor‡
Member Count
Physical Lines of Code
Logical Lines of Code*
3,485 10,994 5,908 1,698 409 1,103 274 13,668 7,543 1,449 4,875
328,615 2,281,898 795,785 257,238 123,822 123,652 29,530 2,258,865 1,470,765 156,245 1,017,950
197,169 1,369,139 477,471 154,343 74,293 74,191 17,718 1,355,319 882,459 93,747 610,770
114,358 794,101 276,933 89,519 43,090 43,031 10,276 786,085 511,826 — —
129.55 983.31 326.73 100.28 46.68 46.61 10.42 972.93 621.13 — —
1,347,320 10,226,424 3,397,992 1,042,912 485,472 484,744 108,368 10,118,472 6,459,752 — —
51,406
8,844,365
5,306,619
2,669,219
3,237.64
33,671,456
Adjusted Lines of Code†
Effort in Person-Months
Cost Indication ($)
* Physical to logical line of code reduction estimated to be 40%. † Adjustment represents an estimate of 42% obsolescence/duplication. ‡ These systems relate to corporate operations not directly related to the railroad operating business of OTR, as well as licensed thirdparty software.
development effort estimate by the cost per person-month of $10,400 to estimate the cost to recreate each system. The replacement cost indicated by the KnowledgePLAN analysis for the mainframe systems is approximately $54.1 million. This analysis is presented in Exhibit 18.7. The replacement cost indicated by the KnowledgePLAN analysis for the 4GL systems is approximately $27.5 million. This analysis is presented in Exhibit 18.8. The replacement cost indicated by the KnowledgePLAN analysis for the client/server systems is approximately $19.1 million. This analysis is presented in Exhibit 18.9.
Synthesis and Conclusion In the instant case, the analyst assigned equal weight to the COCOMO and to the KnowledgePLAN value indications. Therefore, for each of the three system groups, the values indicated by the COCOMO and KnowledgePLAN analyses were averaged, and rounded, to arrive at an estimate of value. These value conclusions are presented in Exhibit 18.10. The estimated value of the OTR internally developed mainframe software and related intellectual property rights, as of January 1, 2003, is $56 million. The estimated value of the OTR internally developed 4GL software and related intellectual property rights, as of January 1, 2003, is $31 million. The estimated value of OTR internally developed client/server software and related intellectual property rights, as of January 1, 2003, is $18 million.
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Exhibit 18.6
On Track Railways Valuation Analysis, COCOMO Client/Server Software, as of January 1, 2003
Project
Source Type
ABC ABC ABC
.bas .cls .frm
DEF DEF DEF DEF DEF
.c .bas .cls .frm .h
Number of Files
Physical Lines of Code
Logical Lines of Code*
Effort in Person-Months
Cost Indication ($)
154 16 221 391
100,354 3,024 172,317 275,695
70,248 2,117 120,622 192,987
441.80
4,594,720
2 30 39 122 1 194
141 43,511 12,197 159,581 44 215,474
99 30,458 8,538 111,707 31 150,833
339.13
3,526,952
GHI GHI GHI GHI
.pc .c .cpp .h
46 33 12 50 141
66,286 8,586 3,280 3,876 82,028
46,400 6,010 2,296 2,713 57,419
120.30
1,251,120
JKL JKL JKL JKL
.pc .cpp .bas .frm
3 6 60 73 142
4,480 6,023 62,751 70,843 144,097
3,136 4,216 43,926 49,590 100,868
220.22
2,290,288
MNO MNO MNO MNO MNO
.cpp .bas .cls .frm .h
23 9 81 46 33 192
6,844 897 30,921 45,616 2,211 86,489
4,791 628 21,645 31,931 1,548 60,543
127.34
1,324,336
PQR PQR PQR
.pc .c .pco
111 3 66 180
34,183 41 32,744 66,968
23,928 29 22,921 46,878
96.77
1,006,408
95 32 122 249
41,377 10,831 11,214 63,422
28,964 7,582 7,850 44,396
91.28
949,312
18 233 2 1 1 255
4,147 67,090 44 239 6 71,526
2,903 46,963 31 167 4 50,068
103.85
1,080,040
1,744
1,005,699
703,992
1,540.69
16,023,176
STU STU STU VWX VWX VWX VWX VWX
.pc .c .h .pc .cpp .cpy .pco .cob
* Physical to logical line of code reduction estimated to be 30%.
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Exhibit 18.7
On Track Railways Valuation Analysis, KnowledgePLAN Mainframe Software, as of January 1, 2003 Manager
System
Number of Programs
Physical Lines of Code
Logical Lines of Code*
Adjusted Lines of Code
Effort in Person-Months
Cost Indication ($)
ADAMS
ADA001† ADA004 ADA005† ADA007 ADA009 ADA013 ADA017 ADA025 ADA030 ADA042† ADA050† ADA065†
85 72 74 11 15 26 17 18 33 34 15 28
105,119 66,255 141,280 9,838 8,171 17,365 13,135 11,976 37,790 82,387 10,314 42,252
84,095 53,004 113,024 7,870 6,537 13,892 10,508 9,581 30,232 65,910 8,251 33,802
42,048 53,004 56,512 7,870 6,537 13,892 10,508 9,581 30,232 32,955 4,126 16,901
33.81 44.18 53.69 3.80 3.27 8.29 4.75 4.44 22.20 25.45 2.26 9.87
351,624 459,472 558,376 39,520 34,008 86,216 49,400 46,176 230,880 264,680 23,504 102,648
HARDING
HAR016 HAR021 HAR035 HAR040 HAR052 HAR070 HAR075 HAR083 HAR089
193 15 30 24 15 66 10 123 79
161,826 15,531 19,250 31,668 17,774 103,409 10,039 107,500 180,899
129,461 12,425 15,400 25,334 14,219 82,727 8,031 86,000 144,719
129,461 12,425 15,400 25,334 14,219 82,727 8,031 86,000 144,719
155.84 7.19 9.02 14.70 8.44 85.70 3.86 89.82 178.14
1,620,736 74,776 93,808 152,880 87,776 891,280 40,144 934,128 1,852,656
JACKSON
JAC010 JAC013 JAC020 JAC032 JAC044 JAC056
41 47 433 99 62 260
27,659 82,687 772,999 118,811 42,253 372,906
22,127 66,150 618,399 95,049 33,802 298,325
22,127 66,150 618,399 95,049 33,802 298,325
12.63 64.43 1,244.15 101.20 26.26 464.95
131,352 670,072 12,939,160 1,052,480 273,104 4,835,480
JEFFERSON
JEF017 JEF044
60 74
212,939 134,468
170,351 107,574
170,351 107,574
220.21 117.28
2,290,184 1,219,712
KENNEDY
KEN025 KEN040
72 38
79,474 23,322
63,579 18,658
63,579 18,658
61.35 10.79
638,040 112,216
LINCOLN
LIN008 LIN019 LIN026 LIN049 LIN053 LIN066 LIN071
87 12 296 33 80 26 40
106,356 5,091 315,921 37,718 132,677 69,039 103,999
85,085 4,073 252,737 30,174 106,142 55,231 83,199
85,085 4,073 252,737 30,174 106,142 55,231 83,199
88.59 2.25 374.95 22.12 115.28 52.22 86.27
921,336 23,400 3,899,480 230,048 1,198,912 543,088 897,208
MADISON
MAD014 MAD037 MAD055 MAD069 MAD075 MAD080 MAD099 MAD107 MAD123 MAD132 MAD144 MAD157
10 74 302 12 10 61 93 26 97 91 32 17
2,646 36,906 135,537 5,130 6,885 30,938 39,379 14,086 37,388 38,773 14,780 8,327
2,117 29,525 108,430 4,104 5,508 24,750 31,503 11,269 29,910 31,018 11,824 6,662
2,117 29,525 108,430 4,104 5,508 24,750 31,503 11,269 29,910 31,018 11,824 6,662
1.19 21.55 118.44 2.25 2.83 14.32 23.18 6.49 21.89 22.72 6.83 3.31
12,376 224,120 1,231,776 23,400 29,432 148,928 241,072 67,496 227,656 236,288 71,032 34,424 (continued)
18 / Intellectual Property Ad Valorem Case Study
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Exhibit 18.7
On Track Railways Valuation Analysis, KnowledgePLAN Mainframe Software, as of January 1, 2003 (Continued) Number of Programs
Logical Lines of Code*
Adjusted Lines of Code
115,966 126,841 6,022 16,399 90,995 33,354 67,732 5,382
92,773 101,473 4,818 13,119 72,796 26,683 54,186 4,306
46,387 50,737 4,818 13,119 72,796 13,342 27,093 4,306
37.74 41.92 2.54 7.51 73.92 7.63 15.68 2.32
392,496 435,968 26,416 78,104 768,768 79,352 163,072 24,128
122 39 151 23 37 137 147
60,517 31,886 147,645 19,069 45,301 145,798 164,233
48,414 25,509 118,116 15,255 36,241 116,638 131,386
48,414 25,509 118,116 15,255 36,241 116,638 131,386
39.62 14.78 137.41 8.98 28.51 135.37 158.46
412,048 153,712 1,429,064 93,392 296,504 1,407,848 1,647,984
181 63 60 40 16 55
128,614 92,464 79,293 38,528 7,986 61,197
102,891 73,971 63,434 30,822 6,389 48,958
102,891 73,971 63,434 30,822 6,389 48,958
111.13 75.31 61.30 22.53 3.20 40.23
1,155,752 783,224 637,520 234,312 33,280 418,392
26 20 19 36 41
18,060 14,493 12,468 31,781 82,194
14,448 11,594 9,974 25,425 65,755
14,448 11,594 9,974 25,425 65,755
8.55 6.72 4.58 14.73 63.72
88,920 69,888 47,632 153,192 662,688
5,162
5,847,090
4,677,671
4,387,575
5,203.04
54,111,616
Manager
System
ROOSEVELT
ROO107† ROO126† ROO135 ROO136 ROO148 ROO165† ROO173† ROO189
85 46 10 12 120 15 82 11
TRUMAN
TRU003 TRU015 TRU025 TRU031 TRU041 TRU050 TRU063
WASHINGTON WAS019 WAS021 WAS023 WAS026 WAS030 WAS035 WILSON
WIL016 WIL032 WIL064 WIL128 WIL256
Mainframe Systems Total
Physical Lines of Code
Effort in Person-Months
Cost Indication ($)
* Physical to logical line of code reduction estimated to be 20%. † Adjusted lines of code reflect obsolescence estimated at 50% because the system is in the process of being replaced.
Summing the values of the three software system groups, the value of the OTR internally developed software and related intellectual property rights, as of January 1, 2003, is $105 million.
Analysis Work Product The typical work product for this type of analysis—that is, the valuation of computer software and related intellectual property for property tax purposes—is a narrative valuation opinion report. Typically, the narrative valuation opinion report would (1) state the purpose and objective of the analysis, (2) describe the
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IV / Intellectual Property Valuation Issues
Exhibit 18.8
On Track Railways Valuation Analysis, KnowledgePLAN 4GL Software, as of January 1, 2003
Department Car inventory Customer service Finance Human resources IT department Legal Marketing Operations Scheduling OTR corporate finance‡ Third-party vendor‡
Member Count
Physical Lines of Code
Logical Lines of Code*
Adjusted Lines of Code†
Effort in Person-Months
Cost Indication ($)
3,485 10,994 5,908 1,698 409 1,103 274 13,668 7,543 1,449 4,875
328,615 2,281,898 795,785 257,238 123,822 123,652 29,530 2,258,865 1,470,765 156,245 1,017,950
197,169 1,369,139 477,471 154,343 74,293 74,191 17,718 1,355,319 882,459 93,747 610,770
114,358 794,101 276,933 89,519 43,090 43,031 10,276 786,085 511,826 — —
56.01 926.21 195.05 40.70 16.07 16.06 3.22 911.93 476.62 — —
582,504 9,632,584 2,028,520 423,280 167,128 167,024 33,488 9,484,072 4,956,848 — —
51,406
8,844,365
5,306,619
2,669,219
2,641.87
27,475,448
* Physical to logical line of code reduction estimated to be 40%. † Adjustment represents an estimate of 42% obsolescence/duplication. ‡ These systems relate to corporate operations not directly related to the railroad operating business of OTR, as well as licensed third-party software.
assets subject to analysis and the data sources used, (3) explain the methods and procedures used in the analysis, and (4) present the valuation conclusion. A set of quantitative and/or descriptive exhibits are typically appended to the narrative valuation opinion report.
Purpose and Objective The purpose of a valuation analysis should be clearly stated, describing what properties and property rights are being valued. The following presents an example of a statement of the purpose of the analysis: The purpose of this analysis is to provide an independent valuation opinion regarding the OTR internally developed computer software and related intellectual property rights. This analysis is prepared in order to assist OTR management with the negotiation and/or appeal of the OTR ad valorem property tax assessment. The objective of the valuation analysis should state what the value conclusion represents. The following presents an example of a statement of the objective of the analysis: The objective of the analysis is to estimate the fair market value of OTR internally developed computer software and related intellectual property rights, as of January 1, 2003. The appropriate standard of value and premise of value will typically be included in the statement of purpose and objective of the analysis. In addition, this section of the valuation opinion report will typically include a summary description of
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Exhibit 18.9
On Track Railways Valuation Analysis, KnowledgePLAN Client/Server Software, as of January 1, 2003
Project
Source Type
ABC ABC ABC
.bas .cls .frm
DEF DEF DEF DEF DEF
.c .bas .cls .frm .h
Number of Files
Physical Lines of Code
Logical Lines of Code*
Effort in Person-Months
Cost Indication ($)
154 16 221
100,354 3,024 172,317
70,248 2,117 120,622
391
275,695
2 30 39 122 1 194
141 43,511 12,197 159,581 44 215,474
192,987
667.47
6,941,688
99 30,458 8,538 111,707 31 150,833
477.63
4,967,352
GHI GHI GHI GHI
.pc .c .cpp .h
46 33 12 50 141
66,286 8,586 3,280 3,876 82,028
46,400 6,010 2,296 2,713 57,419
83.44
867,776
JKL JKL JKL JKL
.pc .cpp .bas .frm
3 6 60 73 142
4,480 6,023 62,751 70,843 144,097
3,136 4,216 43,926 49,590 100,868
278.61
2,897,544
23 9 81 46 33 192
6,844 897 30,921 45,616 2,211 86,489
4,791 628 21,645 31,931 1,548 60,543
137.47
1,429,688
111 3 66 180
34,183 41 32,744 66,968
23,928 29 22,921 46,878
55.10
573,040
MNO MNO MNO MNO MNO PQR PQR PQR
.cpp .bas .cls .frm .h .pc .c .pco
STU STU STU
.pc .c .h
95 32 122 249
41,377 10,831 11,214 63,422
28,964 7,582 7,850 44,396
60.11
625,144
VWX VWX VWX VWX VWX
.pc .cpp .cpy .pco .cob
18 233 2 1 1 255
4,147 67,090 44 239 6 71,526
2,903 46,963 31 167 4 50,068
75.27
782,808
1,744
1,005,699
703,992
1,835.10
19,085,040
* Physical to logical line of code reduction estimated to be 30%.
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IV / Intellectual Property Valuation Issues
Exhibit 18.10
On Track Railways Internally Developed Software, Fair Market Value Synthesis, as of January 1, 2003 Software Category
Valuation Method
Value Indication (Rounded) ($)
Mainframe
COCOMO KnowledgePLAN
57,008,000 54,112,000
4GL
COCOMO KnowledgePLAN
33,671,000 27,475,000
Client/Server
COCOMO KnowledgePLAN
16,023,000 19,085,000
Fair Market Value (Rounded) ($)
56,000,000
31,000,000
Indicated fair market value
18,000,000 105,000,000
SOURCE: Exhibits 18.4 through 18.9.
(1) the subject computer software and (2) the subject trade secrets and other intellectual property rights.
Description of the Subject Property and of the Subject Data Sources In this section of the valuation report, the analyst will typically describe the subject computer software and related intellectual property rights. This description may include the following: 1. The functions performed by the three subject groups of systems 2. The types of trade secrets and other intellectual property embodied in the subject software 3. The history of the development of the subject systems 4. The hardware/operating systems on which the systems operate 5. The programming languages in which the subject systems were written 6. The number of programs and number of lines of code, and other relevant size metrics The description of the data sources used in the analysis may include the following: 1. The electronic files and/or reports provided by management related to system metrics 2. The electronic files and/or reports provided by management related to historical development costs 3. The electronic files and/or reports provided by management related to human resources data 4. Any financial statements used in the analysis
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5. Any salary survey data used in the analysis 6. Any data collected related to arm’s-length sale/license transactions of comparative software systems 7. Any data collected related to market-derived prices of commercially available comparative software packages 8. Citations to any software engineering articles or textbooks relied upon in the analysis
Valuation Methods and Procedures In this section of the valuation report, the analyst will typically explain the conceptual theories and practical applications of the three valuation approaches. Then, the analyst will explain which approach or approaches were used (and why any other approach was not used). The analyst will also describe the specific methods used in the analysis. A description of the valuation analysis variables used (and model input variables assigned) in each method will generally be included. In the case of computer software, a discussion of special issues (such as line-of-code counting methods, the analysis of duplicate code, and the analysis of obsolescence) will usually be included. For each selected valuation method used, the valuation report will typically refer to any exhibits that summarize quantitative analyses and present value conclusions.
Valuation Synthesis and Conclusion The valuation synthesis and conclusion section of the narrative report often contains a brief summary of each of the preceding sections, restating (1) the purpose and objective of the analysis, (2) the definition and premise of value, (3) the valuation methods selected, and (4) the resulting value indications. In addition, when more than one valuation method is used, there would be a synthesis of the indicated values in order to conclude a final value estimate. The narrative valuation opinion report may also include a statement regarding the analyst’s independence and references to any attached certification statement, statement of contingent and limiting conditions, and/or statement of professional qualifications of the analyst.
Appendixes The appendixes to a narrative valuation opinion report may include the following: 1. Exhibits 2. Outputs from any commercial software engineering model programs, such as KnowledgePLAN 3. Summary descriptions of the individual subject software systems/applications 4. Copies of any tables or publications used in the analysis 5. An appraisal certification 6. A statement of contingent and limiting conditions 7. A statement of the professional qualifications of the principal analysts
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IV / Intellectual Property Valuation Issues
Illustrative Narrative Valuation Opinion Report Outline Exhibit 18.11 presents a typical table of contents of a narrative valuation opinion report related to computer software and associated intellectual property rights.
Schedules and Exhibits The typical schedules and exhibits included in the analysis of computer software using a software engineering model method will list the subject software systems, showing (1) system metrics (lines of code, function points, etc.) and (2) the estimated development time and cost to recreate the subject software. In addition, adjustments for all appropriate forms of obsolescence will be shown. Supporting exhibits may
Exhibit 18.11
Sample Table of Contents for a Software-Related Intellectual Property Valuation Report I.
II.
III.
IV.
V.
VI.
Purpose and Objective of the Analysis Statement of Purpose and Objective Standard of Value and Premise of Value Summary Description of the Subject Software Summary Description of the Subject Intellectual Property Rights Intellectual Property Valuation Approaches Introduction Market Approach Valuation Methods Cost Approach Valuation Methods Alternative Types of Cost Obsolescence Analysis Income Approach Valuation Methods Property Description and Data Used in the Analysis Description of the Subject Computer Software Software Size Metrics Cost per Person-Month Estimate Obsolescence Analysis Data Sources Relied on in the Analysis Constructive Cost Model Development Effort Method COCOMO Theory and Methodology COCOMO Valuation Variables COCOMO Analysis and Development Effort Conclusions KnowledgePLAN Development Effort Method KnowledgePLAN Theory and Methodology KnowledgePLAN Valuation Variables KnowledgePLAN Analysis and Development Effort Conclusions Summary and Conclusion Purpose and Objective of the Analysis Standard of Value and Premise of Value Intellectual Property Valuation Methods Selected Value Indications Valuation Synthesis and Conclusions Summary and Conclusion
Appendixes
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document other software engineering model variables and the development of the fully loaded cost per person-month. Descriptive information related to the subject systems and outputs from any computerized model (such as KnowledgePLAN or the SLIM models) may be included as exhibits or may be included as appendixes. If another cost approach method is used, such as the trended historical cost method, the exhibits should show the historical effort and costs (if available), typically by each subject system. The “trending” of the historical development costs to the valuation date may be presented on these exhibits. Alternatively, the historical development effort may be “costed” at a fully loaded cost per person-month as of the valuation date. Supporting schedules or exhibits may present (1) the development of the fully loaded cost (or costs) per person-month and/or (2) the inflation index factors used to “trend” the actual historical costs to the valuation date. When an income approach method is used, the exhibits will typically include one or more discounted cash flow analyses. Supporting exhibits may present the development of the present value discount rate, the selected royalty rate, and/or other variables used in the income approach analysis. When a market transaction method is used, the market transaction data used in the analysis will generally be presented in an exhibit. This exhibit may present both transaction dollar amounts and some size metric (e.g., lines of code) related to the software. The calculation of a value per metric unit (e.g., dollars per line of code) will be shown in that exhibit. The application of this metric unit value to the subject software (by system or in aggregate) will generally be presented on a separate exhibit. That exhibit could also present adjustments for any differences between the subject software and the comparative software. When a market replacement cost method is used, the empirical sale/license market data related to comparative software packages (or software development bid proposals) will be presented in an exhibit. Adjustments made for any material differences between the subject software and the comparative software—including an estimate of the cost of any necessary customization and/or any differences in proprietary rights—will typically be included in an exhibit. Regardless of the valuation method or methods selected, there will usually be a summary exhibit synthesizing the conclusions of all of the analyses and presenting the final value conclusion. Sample exhibits related to the OTR computer software valuation presented in the case study are included herein for illustrative purposes.
Chapter 19 Licensing of Intellectual Property Case Study James G. Rabe
Introduction The Case Problem Overview of the Licensee Overview of the Licensor Importance of the Appropriate Royalty Rate Objective of the Analysis Description of Subject Intellectual Property Data and Data Sources Alternative Analytical Methods Considered Comparable Uncontrolled Transaction Method Comparable Profits Method Profit Split Method Summary of Royalty Rate Estimation Methods Discounted Cash Flow Method Base Case Analysis Discounted Cash Flow Method Alternative Case Analysis Discounted Cash Flow Method Synthesis and Conclusion
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IV / Intellectual Property Valuation Issues
Introduction This chapter presents a case study that estimates the fair royalty rate that a company would be willing to pay in order to enter into a patent license agreement. In this case study, Jackpot, Inc. (Jackpot or the company), a major manufacturer of computerized casino gaming products, has developed a plan to manufacture a line of slot machines that incorporates a patented technology. Due to the unique nature of this patented technology, Jackpot anticipates that the new line of slot machines will be a significant contributor to the future growth of the company. NewTech, Inc. (NewTech), a publicly traded company that is unrelated to Jackpot, developed the technology and owns the associated utility patent (the slot machine patent). Since Jackpot does not own the slot machine patent, it has entered into negotiations with NewTech to license the domestic use of the patent. Jackpot will then incorporate the licensed technology into the new slot machine product line that it will manufacture and sell. During the negotiation process, NewTech management informed Jackpot management that it is also negotiating with Jackpot’s main competitor, Slots, Inc. (Slots) for a license to use the patent. Jackpot retained Intellectual Property Financial Advisors (IPFA) to advise management regarding the contemplated patent license transaction. Specifically, Jackpot retained IPFA to provide an independent opinion regarding the fair royalty rate that Jackpot should be willing to pay for the exclusive domestic use of the slot machine patent. The purpose of this hypothetical case study is to illustrate several quantitative methods regarding intellectual property analysis. There are several analytical methods that are commonly used to estimate the appropriate royalty rate regarding an intellectual property use license. The methods used in this case study include the comparable uncontrolled transaction (CUT) method, the comparable profits method (CPM), the profit split method, and the discounted cash flow (DCF) method.
The Case Problem Jackpot management recently became aware of a new slot machine patent owned by NewTech that, when incorporated into its gaming machines, could result in a new product line with significant growth prospects. Jackpot is the North American market share leader in gaming machines. However, over the past decade, the company has continued to lose market share to its main competitor, Slots. Given (1) the perceived potential for market share gains based on the expected consumer acceptance of the new product line and (2) the desire to protect its market share, Jackpot management is interested in negotiating an exclusive domestic use license from NewTech. Jackpot management anticipates that the exclusive domestic use license would enable Jackpot to add a new product line to its portfolio of gaming machines with enough growth potential to enable Jackpot to increase its market share over the next few years.
19 / Licensing of Intellectual Property Case Study
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Jackpot management retained IPFA to estimate the fair royalty rate that it should be willing to pay to NewTech for an exclusive domestic use license of the slot machine patent.
Overview of the Licensee Jackpot is a closely held manufacturer of computerized casino gaming products and an operator of wide-area progressive systems. Since its founding in 1974, Jackpot has primarily served the casino gaming industry in the United States. The company currently manufactures its products in the United States, China, and Japan. For the fiscal year ended September 30, 2003, the company reported revenue of over $1.0 billion. The company is headquartered in Reno, Nevada. Joseph Jarrod founded Jackpot and is currently president and chief executive officer of the company. As of the analysis date, Joseph Jarrod owns a controlling interest in Jackpot. The balance of the company ownership is divided among various Jarrod family members. The company’s two lines of business include (1) the development, manufacturing, marketing, and distribution of computerized casino gaming products and systems (traditional gaming machines) and (2) the development, marketing, and operation of wide-area progressive systems (progressive gaming machines). The traditional gaming machines line of business consists of spinning reel slot machines and video gaming machines. In the North American gaming market, Jackpot holds an estimated 55 percent share of the installed base of casino gaming machines. The progressive gaming machines line of business is based on gaming machines that generate recurring revenue. In that line of business, the company participates in the revenue from the machines on either a percentage or a flat-fee basis. These systems are electronically linked, intercasino systems that connect gaming machines to a central computer. This allows the system to build a progressive jackpot with every wager made throughout the system until a player hits the top award-winning combination. In the North American gaming market, Jackpot holds an estimated 57 percent share of the installed base of recurring revenue machines.
Overview of the Licensor NewTech, founded in 1994, is a publicly traded company located in Portland, Oregon. NewTech was formed to develop patented technologies that it licenses to companies in a variety of different industries. NewTech has successfully negotiated three major use licenses for its patented technologies since its inception.
Importance of the Appropriate Royalty Rate Jackpot’s primary competitor is Slots, a closely held company with lines of business that are similar to Jackpot. In 1988, several key members of the Jackpot management team left Jackpot to form Slots. Since that time, both Jackpot and Slots have reported market share gains primarily through the acquisition of several smaller competitors. Exhibit 19.1 presents a market share comparison between the two companies as of 1992 and as of 2002 (based on the most recent available data).
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Exhibit 19.1
North American Market Share Traditional Gaming Machines Company Jackpot, Inc. Slots, Inc.
1992 (%) 45 2
2002 (%) 55 15
Progressive Revenue Machines 1992 (%) 47 1
2002 (%) 57 18
As presented in Exhibit 19.1, market share for both Jackpot and Slots increased in both traditional gaming machines and progressive revenue machines. However, Slots has reported higher market share gains relative to Jackpot. Jackpot management anticipates that the introduction of the NewTech patented technology into its new line of gaming machines will provide the company with a significant product differentiation advantage over Slots. Jackpot management does not have the internal expertise necessary to independently develop the technology. Therefore, Jackpot management is interested in licensing the use of the NewTech patent on the slot machine technology. Despite the fact that exclusive license arrangements generally require higher royalty rates, Jackpot management is interested in an exclusive license—as opposed to a nonexclusive license—for the patent. In management’s opinion, the competitive advantage provided by the new technology is sufficient to make the new slot machines incorporating the technology far superior to competing products in the market (such as those manufactured and sold by Slots). Management anticipates that this competitive advantage will result in significant market share gains by Jackpot (relative to Slots) over the next few years. Jackpot management retained IPFA to estimate a fair royalty for the company to pay to NewTech to license-in the domestic use of the slot machine patent. Since competitors are also negotiating with NewTech, knowing the maximum royalty rate that it can offer to NewTech will provide Jackpot management with critical information it needs to successfully outbid them. In addition, this royalty rate analysis should keep Jackpot management from overpaying for the patent license and, thereby, impairing the overall value of the company. Jackpot management asked IPFA to provide an opinion letter (with supporting schedules and exhibits) that presents the royalty rate it should pay for the patent exclusive use license. Several analytical methods are available to estimate the royalty rate. In this instance, based on the circumstances as described in this case study, IPFA concluded that various market approach and income approach methods are the most appropriate. Therefore, this case study will present an illustrative solution to the license fee/royalty rate problem based on these methods. The methods used in this case study include the CUT method, the CPM, the profit split method, and the DCF method. Jackpot management intends to use the information provided by IPFA during their negotiations regarding the license fee/royalty rate it will offer for the exclusive use license of the NewTech patent.
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Objective of the Analysis NewTech developed and patented a human recognition technology. When incorporated into slot machines, the technology allows casino management to both heighten casino security and track spending of key customers on an individual basis. Given the importance of both security and customer recognition to casino operators, Jackpot management believes that incorporating the NewTech technology into slot machines manufactured by Jackpot will provide the company with a product line with significant growth potential. Such slot machines will enable Jackpot to gain market share at the expense of its key competitor. The analysis date is November 30, 2003 (the analysis date). This is the date by which Jackpot management intends to finalize its patent license negotiations with NewTech. Since the intended audience of the analysis is Jackpot management, the company requested that the IPFA work product be limited to an opinion letter with supporting schedules and exhibits. Key members of the Jackpot management team involved in the NewTech negotiations will use the information provided by IPFA to ensure that the company does not overpay for the right to use the patent. The IPFA analysis will be based on a preliminary draft of the patent license agreement between Jackpot and NewTech. This preliminary draft license agreement provides (1) an overview of the patent use rights granted and the subject patented technology, (2) license fee payment requirements, (3) the obligations of the licensee and licensor, (4) the date of termination, and (5) limitations of rights and authority. The overview of the license includes the scope of the license, which is an exclusive domestic patent use license granted to Jackpot. In terms of use restrictions, Jackpot is limited to incorporating the technology into its new line of slot machines. A more detailed description of the patented technology is provided in the following section of this case study. According to the draft agreement, the licensee fee arrangement will be based on a percentage of revenues generated by the products that use the patented technology. However, the agreement is silent regarding the license fee royalty rate. This license fee is the key remaining negotiating point between Jackpot management and NewTech management. As part of the draft agreement, NewTech is expected to fulfill various technical obligations, including (1) training for Jackpot engineers regarding incorporating the technology into Jackpot products and (2) the continuation of technological development regarding the human recognition technology. According to the draft agreement, the use license will terminate 10 years from November 30, 2003. The draft agreement also outlines limitations of rights and authority of the licensor and licensee, including (1) certain warranties offered by NewTech regarding the performance of the human recognition technology and (2) certain requirements for compliance with several governmental restrictions.
Description of Subject Intellectual Property Since its inception, NewTech has developed several proprietary technologies inhouse and has licensed-out the use of these patents to companies in a variety of different industries. The subject intellectual property is the utility patent on a human
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recognition technology developed by NewTech. The technology has applications in a variety of different industries, including the casino industry. Advancements in technology have forced casinos to stay at the cutting edge of security. These technological advancements give professional criminals an advantage over casinos that have out-of-date security systems. Security remains a top management concern at casinos. Casino managements spend significant amounts of money each year on improving security measures. In addition, as the gaming business has become more competitive, casino operators have tried to capitalize on every opportunity to improve customer satisfaction to ensure that customers return to their casinos. NewTech has developed and patented a human recognition technology for slot machines that addresses both the increased security needs of casinos and casino management’s desire to improve customer satisfaction. First, the NewTech technology can be used to increase casino security. When incorporated into slot machines, the NewTech technology automatically checks faces, fingerprints, and voices of slot machine customers. The technology matches that information with retinal scans, fingerprints, and voice patterns of individuals who are recognized in the casino industry as known security risks. Security staff can then quickly remove the individuals from casino premises. Second, the NewTech technology can also be used to impress casino customers who spend a great deal of money. Based on retinal scans, fingerprints, and voice patterns, the technology (1) creates a unique record of each customer and (2) tracks the amount spent by each customer at the slot machines. This enables the casino to recognize key slot machine customers. Casino ushers can then impress these guests by offering them special treatment, including free accommodations, meals, and tickets to entertainment venues. Negotiations between Jackpot management and NewTech management regarding the technology have indicated that if an agreement can be reached, the parties intend to license the subject patent for a period of 10 years. Over that time, Jackpot will have the right to incorporate the NewTech patented technology into its gaming machines and to sell these machines on a domestic basis in the casino industry. The draft license agreement restricts Jackpot’s use of the patent to its gaming machines only. The draft license agreement does not allow Jackpot to incorporate the patent technology into any other product.
Data and Data Sources To complete the assignment, IPFA requested a variety of information from Jackpot management. IPFA ultimately received and reviewed numerous financial and legal documents regarding Jackpot. IPFA analysts concluded that the following list represents the most important documents provided by Jackpot management: •
•
Annual audited financial statements (balance sheets, income statement, statement of changes in financial position, and statements of stockholders’ equity) for the fiscal years ended September 30, 1994–2003. Detailed long-range plan as of September 30, 2003 prepared by Jackpot management, including projected annual financial statements (excluding the additional revenues and profits from Jackpot’s anticipated new product line
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•
•
509
incorporating the licensed patented technology from NewTech) for the fiscal years ended September 30, 2004–2013. Projected annual revenues for the fiscal years ended September 30, 2004–2013, including the sale of Jackpot’s anticipated new product line incorporating the licensed patent from NewTech. Preliminary draft copy of the patent use license agreement between Jackpot and NewTech.
Over the past 5 years, Jackpot management prepared a long-term business plan on an annual basis. The planning process is quite detailed, and reflects input from each of the key managers of the company. Based on the IPFA analysis, the company historically has achieved financial results reasonably close to that projected in the long-term plans. The IPFA analyst concluded that the underlying assumptions of the current long-term plan appear reasonable, given overall industry growth prospects and the company’s historical performance. Therefore, the IPFA analyst was comfortable with management projections for company operations—excluding the additional revenues and profits from Jackpot’s anticipated new product line incorporating the licensed patented technology. As part of its review of management’s projected revenues from the sale of the new product line, IPFA analysts gathered a significant amount of information in addition to what was provided by Jackpot. The additional data gathered by IPFA analysts includes the following: 1. The historical performance and the expected outlook for the casino industry in general 2. The historical performance and expected outlook for slot machine manufacturers that compete with Jackpot 3. Information regarding any technologies that would be considered competing technologies with the human recognition technology developed by NewTech 4. Historical and current licensing practices in the gaming industry For the casino industry overall, IPFA analyzed the overall market size and the historical annual growth rate of the industry. In addition, IPFA analyzed (1) the overall sales of slot machines, (2) the historical annual growth rate of sales of slot machines, and (3) factors that have influenced the trend in sales of slot machines over the past few years. IPFA analysts also collected data regarding other slot machine manufacturers that compete with Jackpot, including Slots and other smaller industry players. As part of this process, IPFA analyzed (1) the market share of industry players and (2) the competitive strengths and weaknesses of Jackpot relative to other slot machine manufacturers. IPFA analysts also investigated current industry licensing practices and searched for comparable exclusive licensing transactions. Slot machine companies frequently manufacture lines of products incorporating names of characters, television shows, or movies that require the license of these names. In addition, IPFA analysts found information on licensing transactions based on human recognition technology that would be considered generally comparable to the transaction that Jackpot is contemplating with NewTech. After analyzing documents provided by Jackpot management and performing independent research, IPFA analysts were comfortable with Jackpot management’s projected revenues from the sale of the new product line. In addition, as part of the due diligence, IPFA analysts toured the Jackpot facilities and interviewed key members of the Jackpot management team.
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Alternative Analytical Methods Considered IPFA analysts used four methods to estimate the appropriate royalty rate that Jackpot management would be willing to pay to NewTech to license-in the use of the slot machine patent. These four methods are as follows: 1. 2. 3. 4.
The comparable uncontrolled transaction method The comparable profits method The profit split method The discounted cash flow method
The next section of this case study presents a detailed description of each of the methods that IPFA analysts used to estimate the royalty rate.
Comparable Uncontrolled Transaction Method The comparable uncontrolled transaction method evaluates whether the amount charged in a controlled transaction is arm’s-length by reference to the amount charged in a comparable uncontrolled transaction.1 The results derived from applying the CUT method generally will be the most direct and reliable measure of an arm’s-length price for the controlled transaction (1) if an uncontrolled transaction has no differences from the controlled transaction that would affect the price or (2) if there are only minor differences that have a definite and reasonably ascertainable effect on price and for which appropriate adjustments are made. The factors to consider in determining the comparability of the intellectual property include the following: 1. Comparing the functions performed by a guideline license provider to the functions to be performed by the parties to this transaction (e.g., research and development and manufacturing) 2. Comparing the contractual terms offered in the guideline license transaction to the subject transaction (e.g., the form of consideration charged or paid, the scope and terms of warranties provided, and the duration of the contract) 3. Comparing the significant risks that could affect the prices that would be charged or paid, or the profit that would be earned, in the guideline license transaction to the subject transaction (e.g., market risks, risks associated with the success or failure of research and development activities, or financial risks) 4. Comparing the economic conditions that could affect the prices that would be charged or paid in the guideline license transaction to the subject transaction (e.g., the similarity of geographic markets or the relative size of each market) In the CUT method, if there are differences between the controlled and uncontrolled transactions that would affect price, adjustments should be made to the price
1 For more information on this method, see Internal Revenue Code Section 482 and Chap. 21, Intangible Asset Intercompany Transfer Pricing Analyses.
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511
of the uncontrolled transaction. Some of the examples of the factors to consider include the following: 1. 2. 3. 4. 5. 6. 7. 8.
Quality of the product Contractual terms Level of the market (wholesale, retail, etc.) Geographic market in which the transaction takes place Date of the transaction The intellectual property associated with the sale Foreign currency risks Alternatives realistically available to the buyer and the seller
Applying this method to the facts of this case study, IPFA analysts estimated the royalty rate for the slot machine patent by reference to the royalty rates actually paid for intellectual property in comparable transactions. IPFA analysts researched licensing activity involving comparable patents through a comprehensive literature search (including research of published periodicals and other journals, Securities and Exchange Commission (SEC) filings, and using several electronic databases). Based on that search, IPFA analysts found information on eight comparable transactions. Exhibit 19.2 presents detailed information regarding each of the eight comparable license transactions, including (1) the date of the transaction, (2) the function of the licensee, (3) the intellectual property that was licensed, (4) the duration of the contract, (5) the IPFA overall risk assessment of the transaction, (6) the IPFA estimate of the potential size of the market, and (7) the royalty rate.
Exhibit 19.2
Jackpot, Inc., Comparable Uncontrolled Transaction Method Patent License Agreement
Date of Transaction
Intellectual Property
Contract Duration (Years)
Overall Risk Assessment*
Market Size Potential†
Royalty Rate (%)
Manufacturing Manufacturing Manufacturing Manufacturing Manufacturing Manufacturing Manufacturing Manufacturing
Human recognition Human recognition Human recognition Human recognition Human recognition Human recognition Human recognition Human recognition
7 8 12 9 11 7 10 8
Moderate Moderate Moderate Moderate Moderate High High High
$200 million $350 million $500 million $650 million $700 million $900 million $1.0 billion $1.5 billion
12.0 13.5 14.0 15.0 15.5 16.0 16.0 17.0
Manufacturing
Human recognition
10
Moderate
$750 million
NA
Function of Licensee
Comparable Uncontrolled Transactions 1 2 3 4 5 6 7 8
4/20/98 7/15/98 5/5/99 11/25/99 12/12/01 6/5/02 8/7/02 1/5/03
Controlled Transaction Slot machine patent
11/30/03
* The IPFA overall assessment of the significant risks that could affect the prices that would be charged or paid, or the profit that would be earned, in the transaction (including market risks, financial risks, etc.). † IPFA analyst estimate. SOURCES: Research of published periodicals and other journals, SEC filings, and various electronic databases.
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IV / Intellectual Property Valuation Issues
Based on the data presented in Exhibit 19.2, a summary of the royalty rates for comparable license transactions is presented as follows:
Comparable License 1 2 3 4 5 6 7 8
License Agreement Royalty Rate Percent (as % of Revenues) 12.0 13.5 14.0 15.0 15.5 16.0 16.0 17.0
The royalty rates range from 12.0 to 17.0 percent, with a mean of 14.9 percent and a median of 15.3 percent. The IPFA analysts also computed the interquartile range of the royalty rates in the comparable transactions. The interquartile range is the range from the 25th to the 75th percentile of the results derived from the comparable transactions. Based on the data presented in the table above, the interquartile range is 13.75–16.0 percent. Therefore, based on the CUT method, the IPFA analysts concluded that a reasonable range of royalty rates based on comparable uncontrolled transactions is from 13.75 to 16.0 percent of revenues.
Comparable Profits Method The comparable profits method evaluates whether the amount charged in the subject transaction is arm’s-length based on objective measures of profitability derived from guideline companies that engage in similar business activities under similar circumstances. In this method, the earnings of a company not using the intellectual property (the tested party) are compared to the earnings of a similar company that owns the intellectual property. The excess earnings of the company using the intellectual property are assumed to be due to the economic contribution of the intellectual property. The first step in applying the comparable profits method is to determine which company will be the tested party. In this case study, since Jackpot does not currently employ the slot machine patent, IPFA analysts determined that Jackpot is the tested party. Historical financial statements and financial ratios for Jackpot are presented in Exhibits 19.3 through 19.7. The second step in the CPM is to identify and compile financial data of companies engaged in a similar business that employ the subject intellectual property. The reliability of the CPM is higher when comparables that are more similar to the tested party are used. In this case study, IPFA analysts searched for similar companies using the subject intellectual property. Since NewTech developed and patented the human recognition technology, IPFA analysts determined that NewTech is the most appropriate company to use as a comparable. Since NewTech is publicly traded, historical financial statements for the company are available to IPFA analysts.
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Exhibit 19.3
Jackpot, Inc., Historical Balance Sheets 2003 ($000) ASSETS Current assets Cash and cash equivalents Investment securities, at market value Accounts receivable, net Current maturities of long-term notes receivable Inventory Investment to fund jackpot winners Deferred income taxes Prepaid expenses and other Total current assets
2002 ($000)
2001 ($000)
2000 ($000)
As of September 30 1999 1998 ($000) ($000)
1997 ($000)
1996 ($000)
1995 ($000)
1994 ($000)
316,884 11,384 216,987
213,069 18,682 191,355
370,918 16,135 168,327
152,609 16,838 164,883
132,041 13,001 151,191
147,813 52,946 129,025
210,203 41,597 98,481
124,175 52,478 112,923
74,251 114,835 71,216
60,168 69,774 49,102
54,790 135,624 25,479 26,146 54,583 841,876
66,398 127,880 24,307 25,305 41,381 708,377
65,239 101,452 24,101 20,860 81,427 848,459
54,829 115,844 35,858 14,370 28,141 583,372
64,977 80,426 30,527 15,859 9,223 497,245
62,695 87,298 23,788 16,838 15,161 535,565
69,836 64,228 16,935 22,042 4,452 527,773
70,476 90,489 13,141 17,065 5,661 486,408
52,786 65,318 9,511 12,402 400,317
38,745 54,538 8,864 281,192
78,827
66,893
52,957
32,843
28,296
40,432
37,855
53,254
40,810
22,827
317,667 (139,016) 178,652
269,879 (124,668) 145,211
264,271 (105,830) 158,441
242,117 (95,302) 146,815
235,177 (79,903) 155,274
227,023 (72,335) 154,688
169,729 (65,940) 103,789
136,103 (51,500) 84,603
81,399 (37,139) 44,260
86,954 (34,730) 52,223
203,292 116,343 156,282 64,953 33,166 574,036
199,862 84,973 125,052 61,423 20,843 492,153
204,650 77,842 132,271 60,982 475,746
321,401 114,586 114,450 29,489 579,926
272,936 85,323 18,022 376,280
212,576 56,719 4,164 273,458
145,636 24,129 6,194 175,960
114,001 1,570 15,329 130,901
71,571 5,578 77,149
43,979 4,065 21,991 70,034
1,673,392
1,412,633
1,535,602
1,342,956
1,057,095
1,004,143
845,377
755,167
562,536
426,277
4,370 108,893 74,045 135,375
4,020 66,457 48,670 106,177
2,852 48,463 35,783 97,825
26,371 49,831 44,073 54,195
22,110 40,227 36,962 43,892
7,064 28,836 29,135 45,839
6,425 25,110 21,813 31,668
2,273 18,174 16,149 31,604
402 19,679 10,337 42,443
1,623 16,055 7,485 32,384
322,682
225,324
184,924
174,470
143,192
110,875
85,016
68,201
72,862
57,547
Long-term liabilities Long-term debt, net of current portion Long-term jackpot liabilities Other liabilities Total long-term liabilities
856,726 224,858 11,508 1,093,091
862,611 233,147 7,522 1,103,280
861,679 275,639 2,631 1,139,949
280,584 416,919 74 697,576
122,420 338,634 582 461,637
93,225 254,792 3,068 351,084
93,562 184,737 4 278,303
96,977 127,577 9,257 233,811
537 92,634 67,166 160,337
17,370 63,413 101,713 182,496
Total liabilities
1,415,774
1,328,604
1,324,873
872,046
604,828
461,959
363,319
302,012
233,198
240,043
85 317,753 1,093,694 (1,145,306) (8,607)
84 242,578 907,570 (1,057,665) (8,537)
84 227,889 771,161 (780,594) (7,810)
83 223,291 719,962 (466,143) (6,281)
83 212,237 599,079 (359,847) 715
82 206,508 493,782 (163,684) 5,498
82 201,264 402,844 (124,654) 2,523
81 197,239 335,395 (75,829) (3,731)
76 127,776 225,439 (23,953) -
71 74,458 132,172 (20,468) -
Long-term notes receivable Property, plant and equipment, net Property, plant and equipment, gross Less: Accumulated depreciation Property, plant and equipment, net Other assets Investment to fund jackpot winners Deferred tax assets Intangible assets, net Investments in unconsolidated affiliates Other assets Other assets TOTAL ASSETS LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities Current portion of long-term debt Accounts payable Jackpot liabilities Accrued expenses Total current liabilities
Stockholders’ equity Common stock Additional paid-in capital Retained earnings Treasury stock Accumulated other comprehensive loss Total stockholders’ equity TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
257,618
84,029
210,730
470,910
452,267
542,184
482,058
453,155
329,338
186,234
1,673,392
1,412,633
1,535,602
1,342,956
1,057,095
1,004,143
845,377
755,167
562,536
426,277
SOURCE: Audited financial statements for the years ended September 29, 1994 through 2003.
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IV / Intellectual Property Valuation Issues
Exhibit 19.4
Jackpot, Inc., Historical Common-Size Balance Sheets 2003 (%) ASSETS Current assets Cash and cash equivalents Investment securities, at market value Accounts receivable, net Current maturities of long-term notes receivable Inventory Investment to fund jackpot winners Deferred income taxes Prepaid expenses and other Total current assets
2002 (%)
Fiscal Years Ended September 30 2000 1999 1998 (%) (%) (%)
2001 (%)
1997 (%)
1996 (%)
1995 (%)
1994 (%)
18.9 0.7 13.0
15.1 1.3 13.5
24.2 1.1 11.0
11.4 1.3 12.3
12.5 1.2 14.3
14.7 5.3 12.8
24.9 4.9 11.6
16.4 6.9 15.0
13.2 20.4 12.7
14.1 16.4 11.5
3.3 8.1 1.5 1.6 3.3 50.3
4.7 9.1 1.7 1.8 2.9 50.1
4.2 6.6 1.6 1.4 5.3 55.3
4.1 8.6 2.7 1.1 2.1 43.4
6.1 7.6 2.9 1.5 0.9 47.0
6.2 8.7 2.4 1.7 1.5 53.3
8.3 7.6 2.0 2.6 0.5 62.4
9.3 12.0 1.7 2.3 0.7 64.4
9.4 11.6 1.7 2.2 71.2
9.1 12.8 2.1 66.0
4.7
4.7
3.4
2.4
2.7
4.0
4.5
7.1
7.3
5.4
Property, plant and equipment, net Property, plant and equipment, gross Less: Accumulated depreciation Property, plant and equipment, net
19.0 (8.3) 10.7
19.1 (8.8) 10.3
17.2 (6.9) 10.3
18.0 (7.1) 10.9
22.2 (7.6) 14.7
22.6 (7.2) 15.4
20.1 (7.8) 12.3
18.0 (6.8) 11.2
14.5 (6.6) 7.9
20.4 (8.1) 12.3
Other assets Investment to fund jackpot winners Deferred tax assets Intangible assets, net Investments in unconsolidated affiliates Other assets Other assets
12.1 7.0 9.3 3.9 2.0 34.3
14.1 6.0 8.9 4.3 1.5 34.8
13.3 5.1 8.6 4.0 31.0
23.9 8.5 8.5 2.2 43.2
25.8 8.1 1.7 35.6
21.2 5.6 0.4 27.2
17.2 2.9 0.7 20.8
15.1 0.2 2.0 17.3
12.7 1.0 13.7
10.3 1.0 5.2 16.4
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
0.3 6.5 4.4 8.1
0.3 4.7 3.4 7.5
0.2 3.2 2.3 6.4
2.0 3.7 3.3 4.0
2.1 3.8 3.5 4.2
0.7 2.9 2.9 4.6
0.8 3.0 2.6 3.7
0.3 2.4 2.1 4.2
0.1 3.5 1.8 7.5
0.4 3.8 1.8 7.6
19.3
16.0
12.0
13.0
13.5
11.0
10.1
9.0
13.0
13.5
Long-term liabilities Long-term debt, net of current portion Long-term jackpot liabilities Other liabilities Total long-term liabilities
51.2 13.4 0.7 65.3
61.1 16.5 0.5 78.1
56.1 17.9 0.2 74.2
20.9 31.0 0.0 51.9
11.6 32.0 0.1 43.7
9.3 25.4 0.3 35.0
11.1 21.9 0.0 32.9
12.8 16.9 1.2 31.0
0.1 16.5 11.9 28.5
4.1 14.9 23.9 42.8
Total liabilities
84.6
94.1
86.3
64.9
57.2
46.0
43.0
40.0
41.5
56.3
0.0 19.0 65.4 (68.4) (0.5)
0.0 17.2 64.2 (74.9) (0.6)
0.0 14.8 50.2 (50.8) (0.5)
0.0 16.6 53.6 (34.7) (0.5)
0.0 20.1 56.7 (34.0) 0.1
0.0 20.6 49.2 (16.3) 0.5
0.0 23.8 47.7 (14.7) 0.3
0.0 26.1 44.4 (10.0) (0.5)
0.0 22.7 40.1 (4.3) -
0.0 17.5 31.0 (4.8) -
Total stockholders’ equity
15.4
5.9
13.7
35.1
42.8
54.0
57.0
60.0
58.5
43.7
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
Long-term notes receivable
TOTAL ASSETS LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities Current portion of long-term debt Accounts payable Jackpot liabilities Accrued expenses Total current liabilities
Stockholders’ equity Common stock Additional paid-in capital Retained earnings Treasury stock Accumulated other comprehensive loss
SOURCE: Audited financial statements for the years ended September 29, 1994 through 2003, and analyst calculations.
Exhibit 19.8 presents historical common-size income statements for NewTech for the past three fiscal years. As presented in Exhibit 19.8, the NewTech operating profit margin increased from 55.0 to 62.0 percent over the fiscal 2001–2003 time frame. Over the same period, the company’s pretax profit margin increased from 59.0 to 67.0 percent.
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515
Exhibit 19.5
Jackpot, Inc., Historical Income Statements
Revenues Traditional gaming machines Progressive gaming operations Total revenues Cost of goods sold Cost of traditional gaming machine sales Cost of progressive gaming operations Total cost of goods sold Gross profit
2003 ($000)
2002 ($000)
2001 ($000)
Fiscal Years Ended September 30 2000 1999 1998 1997 ($000) ($000) ($000) ($000)
1996 ($000)
1995 ($000)
1994 ($000)
717,112 326,200 1,043,312
524,941 256,670 781,611
501,640 241,432 743,072
415,011 301,976 716,987
401,201 246,053 647,254
419,037 219,066 638,103
362,289 177,795 540,084
447,285 139,496 586,781
292,008 123,878 415,886
205,644 110,683 316,327
429,085 148,846
326,903 108,581
318,375 123,972
243,023 137,919
223,138 126,363
231,029 121,544
203,029 96,378
236,095 61,502
145,305 54,562
106,249 47,572
577,931
435,484
442,347
380,943
349,501
352,573
299,407
297,597
199,867
153,820
465,381
346,128
300,725
336,044
297,753
285,531
240,677
289,184
216,019
162,506
Operating expenses Selling, general, and administrative Research and development Provisions for bad debt Depreciation and amortization Impairment (recoveries) of assets and restructuring Total operating expenses
157,923 54,398 16,594 17,619
130,544 48,027 8,833 18,180
112,414 39,552 7,093 20,841
92,172 33,117 4,119 16,212
85,591 27,034 8,272 10,306
94,368 22,360 10,112 10,936
77,039 24,787 5,113 12,511
72,968 20,310 6,263 17,464
50,048 14,375 3,319 17,571
45,802 10,272 4,009 14,639
(957) 245,577
5 205,591
85,363 265,262
145,621
131,203
137,776
119,450
117,005
85,312
74,722
Earnings of unconsolidated affiliates
124,088
92,212
65,734
-
-
-
-
-
-
-
Income from operations
343,893
232,749
101,197
190,423
166,550
147,755
121,227
172,178
130,707
87,785
Other income (expense) Interest income Interest expense Gain on investments Loss on the sale of assets Other Total other income (expense)
43,343 (88,774) 381 (23) (3,479) (48,552)
44,350 (88,888) 3,961 (798) 21,764 (19,611)
48,307 (63,305) 4,731 (489) (2,229) (12,985)
39,451 (35,713) 897 8,800 184 13,620
36,312 (26,467) 11,210 (21) (2,600) 18,434
34,085 (20,475) (3,751) (690) 3,507 12,676
32,690 (17,725) (10,469) 72 150 4,718
25,692 (10,261) 813 (693) (888) 14,663
22,866 (11,092) 8,269 509 245 20,798
16,016 (9,387) (913) (2,423) 3,293
Pretax income Income taxes—current
295,341 109,217
213,139 76,730
88,212 31,390
204,043 71,415
184,984 65,579
160,431 57,756
125,945 45,341
186,841 64,652
151,505 59,652
91,078 36,021
Net income
186,123
136,409
56,821
132,628
119,405
102,675
80,604
122,189
91,853
55,057
SOURCE: Audited financial statements for the years ended September 29, 1994 through 2003.
Exhibit 19.8 also presents a comparison of the NewTech pretax profit margin to Jackpot’s pretax profit margin for 2003. As presented, the NewTech pretax profit margin of 67.0 percent was 38.7 percentage points greater than Jackpot’s pretax profit margin of 28.3 percent. This difference suggests that the patented status of the human recognition technology owned by NewTech has allowed it to generate profits that are 38.7 percent greater than Jackpot’s profit level. Therefore, the total economic contribution of the patented human recognition technology is estimated at 38.7 percent. Since Jackpot is negotiating with NewTech to license the patented technology, and Jackpot will assume the risks of commercializing this technology, Jackpot clearly expects to realize some of the incremental returns expected to be generated by the use of the patent. Therefore, IPFA analysts next estimated the split of the total intellectual property economic contribution between NewTech and Jackpot. Based on a study of technology licenses by Richard Caves and his colleagues, “the monopolistic owner of a technology cannot fully approximate market rent . . . the
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IV / Intellectual Property Valuation Issues
Exhibit 19.6
Jackpot, Inc., Historical Common-Size Income Statements
2003 (%) Revenues Traditional gaming machines Progressive gaming operations Total revenues
2002 (%)
2001 (%)
Fiscal Years Ended September 30 2000 1999 1998 1997 (%) (%) (%) (%)
1996 (%)
1995 (%)
1994 (%)
68.7 31.3 100.0
67.2 32.8 100.0
67.5 32.5 100.0
57.9 42.1 100.0
62.0 38.0 100.0
65.7 34.3 100.0
67.1 32.9 100.0
76.2 23.8 100.0
70.2 29.8 100.0
65.0 35.0 100.0
41.1 14.3
41.8 13.9
42.8 16.7
33.9 19.2
34.5 19.5
36.2 19.0
37.6 17.8
40.2 10.5
34.9 13.1
33.6 15.0
55.4
55.7
59.5
53.1
54.0
55.3
55.4
50.7
48.1
48.6
44.6
44.3
40.5
46.9
46.0
44.7
44.6
49.3
51.9
51.4
15.1 5.2 1.6 1.7
16.7 6.1 1.1 2.3
15.1 5.3 1.0 2.8
12.9 4.6 0.6 2.3
13.2 4.2 1.3 1.6
14.8 3.5 1.6 1.7
14.3 4.6 0.9 2.3
12.4 3.5 1.1 3.0
12.0 3.5 0.8 4.2
14.5 3.2 1.3 4.6
(0.1) 23.5
0.0 26.3
11.5 35.7
20.3
20.3
21.6
22.1
19.9
20.5
23.6
Earnings of unconsolidated affiliates
11.9
11.8
8.8
-
-
-
-
-
-
-
Income from operations
33.0
29.8
13.6
26.6
25.7
23.2
22.4
29.3
31.4
27.8
Other income (expense) Interest income Interest expense Gain on investments Loss on the sale of assets Other Total other income (expense)
4.2 (8.5) 0.0 (0.0) (0.3) (4.7)
5.7 (11.4) 0.5 (0.1) 2.8 (2.5)
6.5 (8.5) 0.6 (0.1) (0.3) (1.7)
5.5 (5.0) 0.1 1.2 0.0 1.9
5.6 (4.1) 1.7 (0.0) (0.4) 2.8
5.3 (3.2) (0.6) (0.1) 0.5 2.0
6.1 (3.3) (1.9) 0.0 0.0 0.9
4.4 (1.7) 0.1 (0.1) (0.2) 2.5
5.5 (2.7) 2.0 0.1 0.1 5.0
5.1 (3.0) (0.3) (0.8) 1.0
Pretax income Income taxes—current
28.3 10.5
27.3 9.8
11.9 4.2
28.5 10.0
28.6 10.1
25.1 9.1
23.3 8.4
31.8 11.0
36.4 14.3
28.8 11.4
Net income
17.8
17.5
7.6
18.5
18.4
16.1
14.9
20.8
22.1
17.4
Cost of goods sold Cost of traditional gaming machine sales Cost of progressive gaming operations Total cost of goods sold Gross profit Operating expenses Selling, general, and administrative Research and development Provisions for bad debt Depreciation and amortization Impairment (recoveries) of assets and restructuring Total operating expenses
SOURCE: Audited financial statements for the years ended September 29, 1994 through 2003, and analyst calculations.
bargaining appears to yield between one-third to one-half to the licensor with a mean of about 40 percent.”2 Exhibit 19.8 presents the indicated royalty rate based on the low, median, and high profit split percentages of 33 percent, 40 percent, and 50 percent, respectively. Applying the profit split percentages to the total intellectual contribution results in a range of royalty rates from 12.9 to 19.3 percent, with a median of 15.5 percent. Therefore, based on the CPM, the IPFA analysts concluded that a reasonable range of royalty rates is from 12.9 to 19.3 percent of revenues, with a median of 15.5 percent of revenues.
2 Richard Caves et al., “The Imperfect Market for Technology Licenses,” Oxford Bulletin of Economics and Statistics, 1983, pp. 249–267.
19 / Licensing of Intellectual Property Case Study
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Exhibit 19.7
Jackpot, Inc., Historical Ratio Analysis
2003 LIQUIDITY Current ratio Quick ratio Working capital as a % of total assets ACTIVITY Turnover Working capital Inventory Receivables Total asset Average collection period (days) Days to sell inventory Operating cycle (days) PERFORMANCE Sales/Net property, plant and equipment Sales/Stockholders’ equity
2002
2001
2000
As of September 30 1999 1998
1997
1996
1995
1994
2.6 2.3 31.0
3.1 2.7 34.2
4.6 3.9 43.2
3.3 2.9 30.4
3.5 3.1 33.5
4.8 4.3 42.3
6.2 5.7 52.4
7.1 6.6 55.4
5.5 5.2 58.2
4.9 4.7 52.5
2.1 4.4 5.1 0.7 70.5 82.1 152.5
1.4 3.8 4.3 0.5 82.8 94.8 177.6
1.4 4.1 4.5 0.5 80.7 88.4 169.1
1.9 3.9 4.5 0.6 79.4 92.7 172.1
1.7 4.2 4.6 0.6 77.9 86.4 164.3
1.5 4.7 5.6 0.7 64.2 77.4 141.5
1.3 3.9 5.1 0.7 70.5 93.0 163.5
1.6 3.8 6.4 0.9 56.5 94.2 150.7
1.5 3.3 6.9 0.8 52.1 107.9 160.0
NA NA NA NA NA NA NA
5.8 4.0
5.4 9.3
4.7 3.5
4.9 1.5
4.2 1.4
4.1 1.2
5.2 1.1
6.9 1.3
9.4 1.3
6.1 1.7
PROFITABILITY (%)∗ EBITDA margin EBIT margin Pretax profit margin Net profit margin Return on Assets Equity Investment Average assets Average equity Average investment
42.3 36.8 28.3 17.8
44.1 38.6 27.3 17.5
25.9 20.4 11.9 7.6
38.9 33.4 28.5 18.5
38.2 32.7 28.6 18.4
33.9 28.4 25.1 16.1
32.1 26.6 23.3 14.9
39.1 33.6 31.8 20.8
44.6 39.1 36.4 22.1
37.3 31.8 28.8 17.4
11.1 72.2 19.3 12.1 109.0 20.8
9.7 162.3 16.5 9.3 92.6 15.4
3.7 27.0 6.0 3.9 16.7 7.1
9.9 28.2 20.0 11.1 28.7 21.0
11.3 26.4 20.0 11.6 24.0 19.3
10.2 18.9 16.0 11.1 20.0 16.8
9.5 16.7 13.8 10.1 17.2 14.2
16.2 27.0 22.1 18.5 31.2 27.7
16.3 27.9 27.8 18.6 35.6 34.3
12.9 29.6 26.8 NA NA NA
COVERAGE AND LEVERAGE∗ Interest coverage before tax Interest coverage after tax Long-term debt/Shareholders’ equity (%) Total debt/Invested capital (%) Total debt/Total assets (%) Total assets/Shareholders’ equity (%)
4.3 3.1 332.6 89.5 51.5 649.6
3.4 2.5 1,026.6 105.0 61.3 1,681.1
2.4 1.9 408.9 91.7 56.3 728.7
6.7 4.7 59.6 46.3 22.9 285.2
8.0 5.5 27.1 24.2 13.7 233.7
8.8 6.0 17.2 15.6 10.0 185.2
8.1 5.5 19.4 17.2 11.8 175.4
19.2 12.9 21.4 18.0 13.1 166.6
14.7 9.3 0.2 0.3 0.2 170.8
10.7 6.9 9.3 9.3 4.5 228.9
* Ratios are based on adjusted pretax and after-tax income as presented on Exhibit 19.5. SOURCE: Exhibits 19.3 and 19.5 and analyst calculations.
Profit Split Method The profit split method evaluates whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is at arm’s length. The evaluation is made by reference to the relative value of each controlled entity’s contribution to that combined operating profit or loss.
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IV / Intellectual Property Valuation Issues
Exhibit 19.8
Jackpot, Inc., Comparable Profits Method Fiscal Years Ended September 30 2003 (%)
2002 (%)
2001 (%)
Revenues Cost of goods sold
100.0 30.0
100.0 32.0
100.0 33.0
Gross profit Operating expenses
70.0 8.0
68.0 12.0
67.0 12.0
Operating income Other income
62.0 5.0
56.0 4.0
55.0 4.0
Pretax income Less: Jackpot historical pretax profit margin†
67.0 28.3
60.0 27.3
59.0 11.9
Total intellectual property contribution, 2003‡
38.7 Low
Median
High
33% 12.9
40% 15.5
50% 19.3
NewTech Historical Common-Size Income Statements*
Profit split percentage§ Indicated royalty rate
* Source: 2001–2003 NewTech Forms 10-K. † Source: Exhibit 19.6. ‡ Calculated as NewTech pretax profit margin for 2003 less Jackpot pretax profit margin for 2003. § Source: G. DeSouza, “Royalty Methods for Intellectual Property,” Business Economics, April 1997.
In this case study, the profit split method requires reference to the amount of profit that the slot machine patent is expected to generate. This method is based on the split of the profit margin that a licensee would be willing to pay a licensor for the use of the slot machine patent. Jackpot management is willing to pay a split of the company profits to NewTech because the use of the slot machine patent generates operating profits that are superior to Jackpot’s otherwise-generated profits. The estimation of the appropriate profit split percentage is based on an analysis of the following factors related to the slot machine patent: (1) the product, (2) the markets, (3) the financial profitability relative to other providers in the industry, and (4) the degree of consumer recognition of the patented technology. The estimated operating profit split percentage is compared to the projected annual revenue in order to estimate the appropriate royalty rate for the slot machine patent. The actual royalty payments based on the royalty rate would then be a necessary cost of goods sold to Jackpot in order to maintain that level of operating profit. The first step in the profit split method is to estimate Jackpot’s projected income statements assuming that Jackpot does not enter into a patent use license agreement with NewTech (the base case analysis). The base case analysis income statement projections are presented in Exhibit 19.9. And, common-size base case analysis income statement projections are presented in Exhibit 19.10.
19 / Licensing of Intellectual Property Case Study
519
Exhibit 19.9
Jackpot, Inc., Base Case Analysis, Projected Income Statements Fiscal Years Ended September 30 2004 ($000) Revenues Traditional gaming machines Progressive gaming operations
2005 ($000)
2006 ($000)
2007 ($000)
2008 ($000)
2009 ($000)
2010 ($000)
2011 ($000)
2012 ($000)
2013 ($000)
767,310 345,772
821,022 366,518
878,493 388,509
931,203 411,819
987,075 436,529
1,046,300 462,720
1,109,078 485,856
1,164,532 510,149
1,222,758 535,657
1,283,896 557,083
1,113,082
1,187,540
1,267,002
1,343,022
1,423,604
1,509,020
1,594,934
1,674,681
1,758,415
1,840,979
445,233 155,831
475,016 166,256
519,471 177,380
550,639 201,453
583,678 213,541
618,698 226,353
669,872 239,240
703,366 251,202
738,534 263,762
773,211 276,147
601,064
641,271
696,851
752,093
797,218
845,051
909,112
954,568
1,002,296
1,049,358
Gross profit
512,018
546,268
570,151
590,930
626,386
663,969
685,822
720,113
756,118
791,621
Operating expenses Selling, general, and administrative Research and development Provisions for bad debt Depreciation and amortization
166,962 55,654 16,696 22,262
178,131 59,377 17,813 23,751
196,385 63,350 19,005 25,340
208,168 67,151 20,145 26,860
220,659 71,180 21,354 28,472
233,898 90,541 22,635 30,180
247,215 95,696 23,924 31,899
267,949 100,481 25,120 33,494
281,346 105,505 26,376 35,168
294,557 110,459 27,615 36,820
261,574
279,072
304,081
322,325
341,665
377,255
398,733
427,044
448,396
469,450
Earnings of unconsolidated affiliates
111,308
118,754
126,700
134,302
142,360
150,902
159,493
167,468
175,841
184,098
Income from operations
361,752
385,950
392,771
402,907
427,081
437,616
446,582
460,537
483,564
506,269
Other income (expense) Interest income Interest expense
44,523 (94,612)
47,502 (100,941)
50,680 (107,695)
53,721 (114,157)
56,944 (121,006)
60,361 (128,267)
63,797 (135,569)
66,987 (142,348)
70,337 (149,465)
73,639 (156,483)
(50,089)
(53,439)
(57,015)
(60,436)
(64,062)
(67,906)
(71,772)
(75,361)
(79,129)
(82,844)
Pretax income Income taxes—current
311,663 112,199
332,511 119,704
335,756 120,872
342,471 123,289
363,019 130,687
369,710 133,096
374,809 134,931
385,177 138,664
404,435 145,597
423,425 152,433
Net income
199,464
212,807
214,884
219,181
232,332
236,614
239,878
246,513
258,839
270,992
7.00 6.00
7.00 6.00
7.00 6.00
6.00 6.00
6.00 6.00
6.00 6.00
6.00 5.00
5.00 5.00
5.00 5.00
5.00 4.00
40.00 14.00 15.00 5.00 1.50 2.00 10.00 4.00 –8.50
40.00 14.00 15.00 5.00 1.50 2.00 10.00 4.00 –8.50
41.00 14.00 15.50 5.00 1.50 2.00 10.00 4.00 –8.50
41.00 15.00 15.50 5.00 1.50 2.00 10.00 4.00 –8.50
41.00 15.00 15.50 5.00 1.50 2.00 10.00 4.00 –8.50
41.00 15.00 15.50 6.00 1.50 2.00 10.00 4.00 –8.50
42.00 15.00 15.50 6.00 1.50 2.00 10.00 4.00 –8.50
42.00 15.00 16.00 6.00 1.50 2.00 10.00 4.00 –8.50
42.00 15.00 16.00 6.00 1.50 2.00 10.00 4.00 –8.50
42.00 15.00 16.00 6.00 1.50 2.00 10.00 4.00 –8.50
36.00
36.00
36.00
36.00
36.00
36.00
36.00
36.00
36.00
36.00
Total revenues Cost of goods sold Cost of traditional gaming machine sales Cost of progressive gaming operations Total cost of goods sold
Total operating expenses
Total other income (expense)
Base Case Projections Annual Revenue Growth Traditional gaming machines (%) Progressive gaming operations (%) % of Revenue Cost of traditional gaming machine sales (%) Cost of progressive gaming operations (%) Selling, general, and administrative (%) Research and development (%) Provisions for bad debt (%) Depreciation and amortization* (%) Earnings of unconsolidated affiliates (%) Interest income (%) Interest expense (%) % of Pretax Income Income tax rate (%)
* Excludes depreciation and amortization expense included in cost of goods sold. SOURCE: Jackpot’s September 2003 long-term business plan.
The second step in the profit split method is to estimate Jackpot’s projected income statements based on the assumption that Jackpot does enter into a patent use license agreement with NewTech (the alternative case analysis). The alternative case analysis income statement projections are presented in Exhibit 19.11. And, common-size alternative case analysis income statement projections are presented in Exhibit 19.12.
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IV / Intellectual Property Valuation Issues
Exhibit 19.10
Jackpot, Inc., Base Case Analysis, Common-Size Income Statements 2004 (%) Revenues Traditional gaming machines Progressive gaming operations Total revenues Cost of goods sold Cost of traditional gaming machine sales Cost of progressive gaming operations
2005 (%)
2006 (%)
2007 (%)
Fiscal Years Ended September 30 2008 2009 (%) (%)
2010 (%)
2011 (%)
2012 (%)
2013 (%)
68.9 31.1
69.1 30.9
69.3 30.7
69.3 30.7
69.3 30.7
69.3 30.7
69.5 30.5
69.5 30.5
69.5 30.5
69.7 30.3
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
40.0 14.0
40.0 14.0
41.0 14.0
41.0 15.0
41.0 15.0
41.0 15.0
42.0 15.0
42.0 15.0
42.0 15.0
42.0 15.0
54.0
54.0
55.0
56.0
56.0
56.0
57.0
57.0
57.0
57.0
Gross profit
46.0
46.0
45.0
44.0
44.0
44.0
43.0
43.0
43.0
43.0
Operating expenses Selling, general, and administrative Research and development Provisions for bad debt Depreciation and amortization
15.0 5.0 1.5 2.0
15.0 5.0 1.5 2.0
15.5 5.0 1.5 2.0
15.5 5.0 1.5 2.0
15.5 5.0 1.5 2.0
15.5 6.0 1.5 2.0
15.5 6.0 1.5 2.0
16.0 6.0 1.5 2.0
16.0 6.0 1.5 2.0
16.0 6.0 1.5 2.0
23.5
23.5
24.0
24.0
24.0
25.0
25.0
25.5
25.5
25.5
Earnings of unconsolidated affiliates
10.0
10.0
10.0
10.0
10.0
10.0
10.0
10.0
10.0
10.0
Income from operations
32.5
32.5
31.0
30.0
30.0
29.0
28.0
27.5
27.5
27.5
Other income (expense) Interest income Interest expense
4.0 (8.5)
4.0 (8.5)
4.0 (8.5)
4.0 (8.5)
4.0 (8.5)
4.0 (8.5)
4.0 (8.5)
4.0 (8.5)
4.0 (8.5)
4.0 (8.5)
(4.5)
(4.5)
(4.5)
(4.5)
(4.5)
(4.5)
(4.5)
(4.5)
(4.5)
(4.5)
Pretax income Income taxes—current
28.0 10.1
28.0 10.1
26.5 9.5
25.5 9.2
25.5 9.2
24.5 8.8
23.5 8.5
23.0 8.3
23.0 8.3
23.0 8.3
Net income
17.9
17.9
17.0
16.3
16.3
15.7
15.0
14.7
14.7
14.7
Total cost of goods sold
Total operating expenses
Total other income (expense)
SOURCE: Jackpot’s September 2003 long-term business plan and analyst calculations.
Exhibit 19.13 presents a summary of the profit split method based on the base case analysis and alternative case analysis projections. As presented in Exhibit 19.13, Jackpot’s revenues from the new slot machine products are projected to increase from $60.0 million in fiscal 2005 to $509.5 million in fiscal 2013. Jackpot’s pretax profit from the new slot machine products, excluding the estimated charge for royalty payments, is projected to increase from $19.6 million in fiscal 2005 to $173.2 million in fiscal 2013. Therefore, the pretax profit margin on Jackpot’s new slot machine products, excluding the estimated charge for royalty payments, is projected to range between a low of 34.0 percent and a high of 36.0 percent from fiscal 2005 to fiscal 2013, with a median of 34.5 percent. Next, IPFA analysts estimated the share or split of the projected pretax profit that Jackpot management would be willing to pay to NewTech for the use of the slot machine patent. To do this, IPFA analysts estimated the relative share of expenses of NewTech and Jackpot to create and market the slot machine technology. For NewTech, the estimated expenditures include the prorated research and development expenditures related to the development of the human recognition technology. For Jackpot, the estimated expenditures include further research and development, additional manufacturing expenses, and incremental marketing expenses to develop and sell the new line of slot machines.
19 / Licensing of Intellectual Property Case Study
521
Exhibit 19.11
Jackpot, Inc., Alternative Case Analysis, Projected Income Statements 2004 ($000) Revenues (base case) Traditional gaming machines Progressive gaming operations Total revenues (base case) Cost of goods sold (base case) Cost of traditional gaming machines sales Cost of progressive gaming operations Total cost of goods sold (base case) Gross profit (base case)
2005 ($000)
2006 ($000)
2007 ($000)
Fiscal Years Ended September 30 2008 2009 ($000) ($000)
2010 ($000)
2011 ($000)
2012 ($000)
2013 ($000)
767,310 345,772
821,022 366,518
878,493 388,509
931,203 411,819
987,075 436,529
1,046,300 462,720
1,109,078 485,856
1,164,532 510,149
1,222,758 535,657
1,283,896 557,083
1,113,082
1,187,540
1,267,002
1,343,022
1,423,604
1,509,020
1,594,934
1,674,681
1,758,415
1,840,979
445,233 155,831
475,016 166,256
519,471 177,380
550,639 201,453
583,678 213,541
618,698 226,353
669,872 239,240
703,366 251,202
738,534 263,762
773,211 276,147
601,064 512,018
641,271 546,268
696,851 570,151
752,093 590,930
797,218 626,386
845,051 663,969
909,112 685,822
954,568 720,113
1,002,296 756,118
1,049,358 791,621
-
60,000 27,600
90,000 41,400
135,000 62,100
189,000 86,940
245,700 113,022
294,840 135,626
353,808 162,752
424,570 195,302
509,484 234,362
Revenues (new products) Cost of goods sold (new products) Gross profit (new products)
-
32,400
48,600
72,900
102,060
132,678
159,214
191,056
229,268
275,121
1,113,082 601,064
1,247,540 668,871
1,357,002 738,251
1,478,022 814,193
1,612,604 884,158
1,754,720 958,073
1,889,774 1,044,739
2,028,489 1,117,320
2,182,984 1,197,598
2,350,462 1,283,720
Combined gross profit
512,018
578,668
618,751
663,830
728,446
796,647
845,035
911,169
985,386
1,066,742
Operating expenses Selling, general, and administrative Research and development Provisions for bad debt Depreciation and amortization Royalties paid to NewTech
166,962 55,654 16,696 22,262 -
187,131 62,377 18,713 24,951 12,540
210,335 67,850 20,355 27,140 18,810
229,093 73,901 22,170 29,560 28,215
249,954 80,630 24,189 32,252 39,501
271,982 105,283 26,321 35,094 51,351
292,915 113,386 28,347 37,795 61,622
324,558 121,709 30,427 40,570 73,946
349,277 130,979 32,745 43,660 88,735
376,074 141,028 35,257 47,009 106,482
Combined revenues Combined cost of goods sold
261,574
305,712
344,491
382,940
426,526
490,031
534,065
591,210
645,396
705,850
Earnings of unconsolidated affiliates
Total operating expenses
111,308
124,754
135,700
147,802
161,260
175,472
188,977
202,849
218,298
235,046
Income from operations
361,752
397,710
409,961
428,692
463,180
482,087
499,948
522,807
558,288
595,938
Other income (expense) Interest income Interest expense
44,523 (94,612)
49,902 (106,041)
54,280 (115,345)
59,121 (125,632)
64,504 (137,071)
70,189 (149,151)
75,591 (160,631)
81,140 (172,422)
87,319 (185,554)
94,018 (199,789)
(50,089)
(56,139)
(61,065)
(66,511)
(72,567)
(78,962)
(85,040)
(91,282)
(98,234)
(105,771)
Pretax income Income taxes—current
Total other income (expense)
311,663 112,199
341,571 122,966
348,896 125,602
362,181 130,385
390,613 140,621
403,125 145,125
414,908 149,367
431,525 155,349
460,054 165,619
490,167 176,460
Net income
199,464
218,606
223,293
231,796
249,992
258,000
265,541
276,176
294,435
313,707
7.00 6.00 0.00
7.00 6.00 100.00
7.00 6.00 50.00
6.00 6.00 50.00
6.00 6.00 40.00
6.00 6.00 30.00
6.00 5.00 20.00
5.00 5.00 20.00
5.00 5.00 20.00
5.00 4.00 20.00
40.00 14.00 0.00 15.00 5.00 1.50 2.00 20.90 10.00 4.00 −8.50
40.00 14.00 46.00 15.00 5.00 1.50 2.00 20.90 10.00 4.00 −8.50
41.00 14.00 46.00 15.50 5.00 1.50 2.00 20.90 10.00 4.00 −8.50
41.00 15.00 46.00 15.50 5.00 1.50 2.00 20.90 10.00 4.00 −8.50
41.00 15.00 46.00 15.50 5.00 1.50 2.00 20.90 10.00 4.00 −8.50
41.00 15.00 46.00 15.50 6.00 1.50 2.00 20.90 10.00 4.00 −8.50
42.00 15.00 46.00 15.50 6.00 1.50 2.00 20.90 10.00 4.00 −8.50
42.00 15.00 46.00 16.00 6.00 1.50 2.00 20.90 10.00 4.00 −8.50
42.00 15.00 46.00 16.00 6.00 1.50 2.00 20.90 10.00 4.00 −8.50
42.00 15.00 46.00 16.00 6.00 1.50 2.00 20.90 10.00 4.00 −8.50
36.00
36.00
36.00
36.00
36.00
36.00
36.00
36.00
36.00
36.00
Alternative Case Projections Annual Revenue Growth Traditional gaming machines (%) Progressive gaming operations (%) New products (%) % of Revenue Cost of traditional gaming machine sales (%) Cost of progressive gaming operations (%) Cost of goods sold (new products) (%) Selling, general, and administrative (%) Research and development (%) Provisions for bad debt (%) Depreciation and amortization* (%) Royalties paid to NewTech (%) Earnings of unconsolidated affiliates (%) Interest income (%) Interest expense (%) % of Pretax Income Income tax rate (%)
* Excludes depreciation and amortization expense included in cost of goods sold. SOURCE: Jackpot’s September 2003 long-term business plan and management estimate.
522
IV / Intellectual Property Valuation Issues
Exhibit 19.12
Jackpot, Inc., Alternative Case Analysis, Common-Size Income Statements 2004 (%) Revenues (base case) Traditional gaming machines Progressive gaming operations Total revenues (base case) Cost of goods sold (base case) Cost of traditional gaming machines sales Cost of progressive gaming operations
2005 (%)
2006 (%)
2007 (%)
Fiscal Years Ended September 30 2008 2009 (%) (%)
2010 (%)
2011 (%)
2012 (%)
2013 (%)
68.9 31.1 100.0
65.8 29.4 95.2
64.7 28.6 93.4
63.0 27.9 90.9
61.2 27.1 88.3
59.6 26.4 86.0
58.7 25.7 84.4
57.4 25.1 82.6
56.0 24.5 80.6
54.6 23.7 78.3
40.0 14.0
38.1 13.3
38.3 13.1
37.3 13.6
36.2 13.2
35.3 12.9
35.4 12.7
34.7 12.4
33.8 12.1
32.9 11.7
54.0 46.0
51.4 43.8
51.4 42.0
50.9 40.0
49.4 38.8
48.2 37.8
48.1 36.3
47.1 35.5
45.9 34.6
44.6 33.7
Revenues (new products) Cost of goods sold (new products)
-
4.8 2.2
6.6 3.1
9.1 4.2
11.7 5.4
14.0 6.4
15.6 7.2
17.4 8.0
19.4 8.9
21.7 10.0
Gross profit (new products)
-
2.6
3.6
4.9
6.3
7.6
8.4
9.4
10.5
11.7
100.0 54.0
100.0 53.6
100.0 54.4
100.0 55.1
100.0 54.8
100.0 54.6
100.0 55.3
100.0 55.1
100.0 54.9
100.0 54.6
Combined gross profit
46.0
46.4
45.6
44.9
45.2
45.4
44.7
44.9
45.1
45.4
Operating expenses Selling, general, and administrative Research and development Provisions for bad debt Depreciation and amortization
15.0 5.0 1.5 2.0
15.0 5.0 1.5 2.0
15.5 5.0 1.5 2.0
15.5 5.0 1.5 2.0
15.5 5.0 1.5 2.0
15.5 6.0 1.5 2.0
15.5 6.0 1.5 2.0
16.0 6.0 1.5 2.0
16.0 6.0 1.5 2.0
16.0 6.0 1.5 2.0
23.5
24.5
25.4
25.9
26.4
27.9
28.3
29.1
29.6
30.0
Earnings of unconsolidated affiliates
10.0
10.0
10.0
10.0
10.0
10.0
10.0
10.0
10.0
10.0
Income from operations
32.5
31.9
30.2
29.0
28.7
27.5
26.5
25.8
25.6
25.4
Other income (expense) Interest income Interest expense
4.0 (8.5)
4.0 (8.5)
4.0 (8.5)
4.0 (8.5)
4.0 (8.5)
4.0 (8.5)
4.0 (8.5)
4.0 (8.5)
4.0 (8.5)
4.0 (8.5)
(4.5)
(4.5)
(4.5)
(4.5)
(4.5)
(4.5)
(4.5)
(4.5)
(4.5)
(4.5)
Pretax income Income taxes—current
28.0 10.1
27.4 9.9
25.7 9.3
24.5 8.8
24.2 8.7
23.0 8.3
22.0 7.9
21.3 7.7
21.1 7.6
20.9 7.5
Net income
17.9
17.5
16.5
15.7
15.5
14.7
14.1
13.6
13.5
13.3
Total cost of goods sold (base case) Gross profit (base case)
Combined revenues Combined cost of goods sold
Total operating expenses
Total other income (expense)
SOURCE: Jackpot’s September 2003 long-term business plan, management estimates, and analyst calculations.
Based on IPFA analyst estimates, NewTech’s share of the combined intellectual property expenditures is approximately 40 percent, and Jackpot’s share of the combined intellectual property expenditures is approximately 60 percent. Therefore, IPFA analysts estimated the share or split of the projected pretax profit that Jackpot would be willing to pay to NewTech for the use of the slot machine patent at 40 percent. Exhibit 19.13 summarizes the calculation of the estimated slot machine royalty rate using the profit split method. Applying the profit split percentage of 40 percent to the low, median, and high projected pretax profit margins of 34.0, 34.5, and 36.0 percent, respectively, results in a royalty rate range from 13.6 to 14.4 percent, with a median of 13.8 percent. Therefore, based on the profit split method, IPFA analysts concluded that the appropriate arm’s-length royalty rate range for the slot machine patent is from 13.6 to 14.4 percent of revenues, with a median of 13.8 percent of revenues.
523
34.5% 40.0% 13.8%
40.0% 13.6%
Median
Low 34.0%
36.0%
21,600
— NM
60,000
1,187,540 332,511 28.0%
2005 ($000)
—
1,113,082 311,663 28.0%
2004 ($000)
40.0% 14.4%
36.0%
High
35.5%
31,950
90,000
1,267,002 335,756 26.5%
2006 ($000)
35.5%
47,925
135,000
1,343,022 342,471 25.5%
2007 ($000)
35.5%
67,095
189,000
1,423,604 363,019 25.5%
2008 ($000)
34.5%
84,766
245,700
1,509,020 369,710 24.5%
2009 ($000)
34.5%
101,720
294,840
1,594,934 374,809 23.5%
2010 ($000)
Fiscal Years Ended September 30
Jackpot, Inc., Profit Split Method
b
presented in Exhibit 19.9. Calculated as pretax profit (base case) divided by revenues (base case). c As presented in Exhibit 19.11. d Calculated as pretax profit (alternative case), per Exhibit 19.11, less pretax profit (base case), per Exhibit 19.9. e Calculated as pretax profit (new products, excluding estimated charge for royalty payments) divided by revenues (new products). f NewTech’s estimated share of the combined slot machine technology expenditures (as estimated by IPFA analysts).
a As
Projected pretax profit margin (new products) Profit split percentage f Indicated royalty rate
Revenues (base case)a Pretax profit (base case)a Pretax profit margin (base case)b Revenues (new products)c Pretax profit (new products, excluding estimated charge for royalty payments)d Pretax profit margin (new products)e
Exhibit 19.13
34.0%
120,295
353,808
1,674,681 385,177 23.0%
2011 ($000)
34.0%
144,354
424,570
1,758,415 404,435 23.0%
2012 ($000)
34.0%
173,224
509,484
1,840,979 423,425 23.0%
2013 ($000)
524
IV / Intellectual Property Valuation Issues
Summary of Royalty Rate Estimation Methods IPFA analysts developed a range of royalty rates based on the CUT method, the CPM, and the profit split method, as presented earlier in this case study. A summary of the estimated royalty rates from these methods is presented in the following table. Intellectual Property Royalty Rate Method Comparable uncontrolled transaction method Comparable profits method Profit split method
Range of Royalty Rates as a Percent of Revenues 13.8–16.0 12.9–19.3 13.6–14.4
Since competitors are also negotiating with NewTech management, knowing the maximum royalty rate that Jackpot can offer to NewTech will provide Jackpot management with the key information it needs to successfully outbid them. In addition, knowing the maximum royalty rate that it can reasonably offer will keep Jackpot management from overpaying for the patent license and, thereby, impairing the overall value of the company. Therefore, IPFA analysts also used the discounted cash flow method to estimate the maximum royalty rate that Jackpot should pay to NewTech without impairing the value of the company.
Discounted Cash Flow Method IPFA analysts used the DCF method3 to estimate the maximum royalty rate that Jackpot could pay to NewTech without impairing the value of the company. This DCF analysis is described as follows: •
•
•
First, IPFA analysts estimated the value of the Jackpot equity based on a DCF analysis. This analysis (the base case analysis) assumes that Jackpot does not enter into a license agreement with NewTech to develop the new line of slot machines. The value estimated by this income approach method represents the value of the Jackpot equity assuming that the company continues operating as it has historically. Second, IPFA analysts prepared an alternative DCF analysis (the alternative case analysis) based on the assumption that Jackpot does enter into a license agreement with NewTech to develop a new line of slot machines. The alternative case analysis was based on the projections reflected in the base case analysis, adjusted to include revenues, expenses, and an assumed royalty rate for the licensed technology. The alternative case analysis results in an estimate of the value of the Jackpot equity, based on a DCF analysis, assuming that the company does enter into the patent use license agreement with NewTech. Third, IPFA analysts adjusted the assumed royalty rate in the alternative case analysis, which changed the resulting value of the company’s equity. IPFA
3 This method is presented as an advanced royalty rate estimation method in Russell L. Parr and Patrick H. Sullivan, Technology Licensing: Corporate Strategies for Maximizing Value (New York: John Wiley & Sons, 1996), pp. 233–246.
19 / Licensing of Intellectual Property Case Study
525
analysts adjusted the assumed royalty rate until the value of the company equity in the alternative case analysis was equal to the value of the company equity in the base case analysis. This resulted in the maximum royalty rate that the company could pay to license the patent from NewTech without resulting in a decrease to the overall value of the company equity. Any royalty rate that Jackpot’s management could negotiate lower than this maximum rate would result in an increase in the value of the company equity. The next section of this case study presents a description of the DCF method.
Base Case Analysis Discounted Cash Flow Method Exhibits 19.9, 19.10, 19.14, and 19.15 present the DCF method for the base case analysis. The DCF method estimates the value of a company by (1) projecting the company’s expected future cash flows and (2) calculating the present value of those cash flows using a risk-adjusted present value discount rate. Projected Financial Statements. The first step in the DCF method is to develop reasonable projections of Jackpot’s financial statements. Based on projections prepared by management, Jackpot’s projected financial statements for fiscal years 2004 through 2013 are presented in Exhibit 19.9. These projected income statements are based on the projection variables presented in the exhibit. Common-size income statement projections are presented in Exhibit 19.10. As presented in Exhibits 19.9 and 19.10, the Jackpot revenues are projected to increase at a compounded annual rate of 5.8 percent over the fiscal 2004–2013 time frame in the base case analysis. In addition, the company’s net profit margins will decrease from 17.9 percent in fiscal 2004 to 14.7 percent in fiscal 2013. Calculation of Net Cash Flow to Invested Capital. The second step in the DCF method is to estimate the Jackpot projected net cash flow to invested capital. As an economic earnings measure, net cash flow to invested capital represents the maximum amount of cash that could be distributed to a company’s stakeholders (holders of both debt and equity securities) without depleting normal operational cash requirements. For purposes of this analysis, IPFA analysts define net cash flow to invested capital as follows: Net income + noncash charges (such as depreciation and amortization) − capital expenditures − additions to working capital + interest expense (net of tax deduction) = net cash flow to invested capital Exhibit 19.14 presents the calculation of Jackpot’s net cash flow to invested capital for fiscal years 2004 through 2013, based on the projection variables listed in the exhibit. Estimation of a Present Value Discount Rate. The third step in the DCF method is to estimate a present value discount rate (market required rate of return on investment) appropriate for discounting Jackpot’s net cash flow. The appropriate discount rate is the Jackpot weighted average cost of capital (WACC), which represents the weighted average of the cost of each of the components in the Jackpot capital structure (i.e., debt and equity capital). These capital costs, expressed as required rates of return, are then weighted according to estimates of the average capital structure for companies in Jackpot’s industry.
526
IV / Intellectual Property Valuation Issues
Exhibit 19.14
Jackpot, Inc., Base Case Analysis, Discounted Cash Flow Method, Value Summary 2004 ($000)
2005 ($000)
2006 ($000)
Fiscal Years Ended September 30 2007 2008 2009 2010 ($000) ($000) ($000) ($000)
2011 ($000)
2012 ($000)
2013 ($000)
Normalized 2013 ($000)
Present value of discrete net cash flow Net incomea Plus: Depreciation and amortizationb Less: Capital expendituresc
199,464 61,219 (33,392)
212,807 65,315 (35,626)
214,884 69,685 (38,010)
219,181 73,866 (40,291)
232,332 78,298 (42,708)
236,614 82,996 (45,271)
239,878 87,721 (47,848)
246,513 92,107 (50,240)
258,839 96,713 (52,752)
Less: Working capital requirementsd
(13,954)
(14,892)
(15,893)
(15,204)
(16,116)
(17,083)
(17,183)
(15,949)
(16,747)
(16,513)
(16,513)
Plus: Interest expense, net of taxese
60,552
64,602
68,925
73,060
77,444
82,091
86,764
91,103
95,658
100,149
100,149
228,241
292,206
299,591
310,613
329,250
339,347
349,333
363,533
381,710
400,653
354,629
0.417 0.960
1.333 0.877
2.333 0.796
3.333 0.721
4.333 0.654
5.333 0.593
6.333 0.537
7.333 0.487
8.333 0.442
9.333 0.401
219,106
256,402
238,334
224,028
215,294
201,175
187,756
177,143
168,631
160,471
5.50 3.00
5.50 3.00
5.50 3.00
5.50 3.00
5.50 3.00
5.50 3.00
5.50 3.00
5.50 3.00
5.50 3.00
5.50 3.00
20.00
20.00
20.00
20.00
20.00
20.00
20.00
20.00
20.00
20.00
36.00
36.00
36.00
36.00
36.00
36.00
36.00
36.00
36.00
36.00
Net cash flow before adjustment Months remaining in initial projected yearf
270,992 101,254 (55,229)
270,992 -
273,889 10.0
Net cash flow to invested capital Discounting periodsg Present value factor, 10.3h Present value of discrete net cash flows Total present value of discrete net cash flows
2,048,340
Present value of terminal net cash flow Fiscal 2014 net cash flow ($000)i Capitalization multiplej
368,814 15.9
Terminal value ($000) Present value factor, 10.3
5,854,185 0.401
Present value of terminal cash flow ($000)
2,344,742
($000) 2,048,340 2,344,742
Valuation summary Total present value of discrete net cash flows Present value of terminal cash flow Market value of invested capital Less: Interest-bearing debt
4,393,082 861,096
Indicated value before adjustments
3,531,986
Plus: Cash and equivalents and investments
328,268
Indicated equity value (rounded)
3,860,000
Base case projections % of Revenue Depreciation and amortization Capital expenditures Working capital requirements as a % of revenue increase % of Pretax Income Income tax rate
a As
presented in Exhibit 19.9. Total depreciation and amortization expense equal to 5.5% of revenues. c Total capital expenditures equal to 3.0% of revenues. d Based on estimated working capital requirement equal to 20% of revenue increase. e As presented on Exhibit 19.9, net of taxes based on an estimated effective corporate income tax rate of 36%. f As of the valuation date. g Based on mid-year convention. h Based on the weighted average cost of capital (WACC) estimated in Exhibit 19.15, and the indicated discounting periods. i Adjusted 2013 net cash flow increased by the expected long-term growth rate of 4%. j Based on the Gordon growth model, calculated as 1 divided by (WACC less the expected long-term growth rate). SOURCE: Exhibits 19.9 and 19.15 and analyst calculations. b
The basic formula for computing a company’s after-tax WACC is as follows: WACC = (ke × We) + (kd[1 − t] × Wd) where WACC = Weighted average cost of capital ke = Company’s cost of equity capital
19 / Licensing of Intellectual Property Case Study
kd We Wd t
= = = =
527
Company’s cost of debt capital Percentage of equity capital in the capital structure Percentage of debt capital in the capital structure Company’s effective income tax rate
Exhibit 19.15 presents the weighted average cost of capital analysis for Jackpot for the base case analysis. The IPFA analysts estimated the Jackpot cost of equity capital using the capital asset pricing model (CAPM), expanded to include a small stock equity risk premium and a company-specific equity risk premium. The formula to estimate the cost of equity capital using the expanded CAPM is presented as follows: Risk-free rate of return + (equity risk premium × beta) + small stock equity risk premium + company-specific equity risk premium = cost of equity capital The DCF method for Jackpot is based on a long-term investment horizon. Therefore, the appropriate risk-free rate is represented by a long-term government security. Exhibit 19.15
Jackpot, Inc., Base Case Analysis, Discounted Cash Flow Method, Weighted Average Cost of Capital Cost of Equity Capital
Source
Risk-free rate of return Plus Equity risk premium Multiplied by: Beta
4.1%
Stocks, Bonds, Bills & Inflation, 2002 Yearbook, Ibbotson Associates.
7.4% 0.90
Cost of Capital 2002 Yearbook, Ibbotson Associates. 6.7% 0.6% 0.0% 11.4%
Small stock equity risk premium Company-specific equity risk premium Total cost of equity capital
Cost of Debt Capital
Stocks, Bonds, Bills & Inflation, 2002 Yearbook, Ibbotson Associates. IPFA estimate.
Source
Average cost of debt Income tax rate After-tax total cost of debt capital
7.0% 36.0% 4.5%
Cost of equity capital Percent of capital structure Weighted rate
11.4% 85.0%
Cost of debt capital Percent of capital structure Weighted rate Weighted average cost of capital
4.5% 15.0%
Estimated based on Jackpot’s embedded cost of debt. Jackpot’s September 2003 long-term business plan.
Source
Weighted Average Cost of Capital (WACC)
SOURCE: As indicated above.
The Wall Street Journal, November 30, 2002.
Cost of Capital 2002 Yearbook, Ibbotson Associates. 9.7%
Cost of Capital 2002 Yearbook, Ibbotson Associates. 0.7% 10.3%
528
IV / Intellectual Property Valuation Issues
The promised yield to maturity of 20-year U.S. Treasury bonds is the most appropriate risk-free rate since it best matches the equity risk premium described below. The stated yield to maturity on 20-year Treasury bonds as of the analysis date was 4.1 percent. One leading authority on equity risk premiums is Ibbotson Associates. Ibbotson Associates annually publishes a calculation of the long-term equity risk premium.4 This premium is calculated by subtracting the risk-free rate (20-year Treasury bonds) from the total annual rates of return on common stocks (using the Standard & Poor’s 500 index as a proxy). According to Ibbotson Associates, the arithmetic mean equity risk premium for the period 1926–2002 was 7.4 percent. Typically, the equity risk premium is adjusted by an industry-derived beta. Beta is a measure of the systematic risk (risk relative to returns in a measure of the overall equity market, such as the S&P 500 index) inherent in a company’s investment returns. To select a beta for Jackpot, IPFA analysts reviewed Cost of Capital Quarterly 2002 Yearbook 5 statistics for the SIC code appropriate for Jackpot—SIC code 3999 (manufacturing industries, not elsewhere classified). Based on this information, IPFA analysts selected a beta of 0.90 as appropriate for Jackpot, equal to the median levered equity beta for companies in SIC code 3999. Multiplying this indicated beta by the equity risk premium results in a betaadjusted equity risk premium of 6.7 percent. Ibbotson Associates also calculates the difference between the total returns of all public companies (7.4 percent as mentioned above) and the returns earned by companies based on size. Historically, smaller company stocks have earned returns in excess of those implied by the betas of small stocks. According to the Ibbotson Associates study, companies in the third decile of the study, or stocks with an average common equity capitalization of approximately $3.0 billion, exhibited an arithmetic mean annual return of 0.59 percent above the overall equity risk premium exhibited by the S&P 500 common stock index. The Jackpot equity value is approximately this size. Therefore, the IPFA analysts incorporated a small stock equity risk premium of 0.60 percent (rounded from 0.59 percent) into its analysis. An additional unsystematic (i.e., company-specific) equity risk premium is often appropriate to reflect risks specific to an investment in a particular closely held company. However, in the opinion of the IPFA analysts, no further adjustment is necessary to reflect a company-specific equity risk premium. Based on the factors discussed above, the IPFA CAPM analysis results in an estimated cost of equity capital of 11.4 percent, as presented in Exhibit 19.15. This represents an estimate of the rate of return an informed investor would expect in return for an equity investment in Jackpot. IPFA analysts estimated the Jackpot cost of debt capital based on the cost of its current debt securities. Since corporate interest expense is tax deductible, the cost of debt is calculated on an after-tax basis. IPFA analysts calculated this figure to be 4.5 percent, based upon an estimated pretax cost of debt of approximately 7 percent and an estimated income tax rate of 36 percent, as presented in Exhibit 19.15. In this case, the appropriate weights to assign to these costs of capital are the respective percentages of debt and equity in the industry average capital structure
4 Stocks, 5 Cost
Bonds, Bills, and Inflation, 2002 Yearbook (Chicago: Ibbotson Associates, 2002). of Capital Quarterly 2002 Yearbook (Chicago: Ibbotson Associates, 2002).
19 / Licensing of Intellectual Property Case Study
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(calculated on a market value basis). To select the percentages of debt and equity in the industry average capital structure, the IPFA analysts reviewed Cost of Capital Quarterly 2002 Yearbook statistics for the SIC code 3999. The median debt to total capital ratio for companies in this SIC code was approximately 13.6 percent. Therefore, the IPFA analysts applied weightings for Jackpot of 15 percent for debt (rounded from 13.6 percent) and 85 percent for equity, resulting in a WACC of 10.3 percent, as presented in Exhibit 19.15. Present Value of Net Cash Flow to Invested Capital. The fourth and final step in the DCF method is to calculate the present value of the Jackpot estimated future net cash flow to invested capital. This amount is calculated by applying a present value discounting factor based on the previously calculated WACC, assuming that, on average, each year’s cash flow is received at mid-year. Jackpot is expected to continue to generate cash flow beyond 2013. In order to capture the value represented by cash flow received in 2013 and beyond, the IPFA DCF analysis incorporates a terminal value. This terminal value is based on the Gordon growth model, which incorporates the WACC and an expected long-term growth rate for Jackpot. The terminal value for Jackpot, based on the Gordon growth model, is calculated as follows: Calendar year 2013 net cash flow to invested capital WACC minus the expected long-term growth rate Based on Jackpot management projections, the Jackpot annual revenue growth for the years 2004 through 2013 is presented as follows: Fiscal Years
Projected Revenue Growth Rate (%)
2005–2006 2007–2009 2010 2011–2012 2013
6.7 6.0 5.7 5.0 4.7
In addition, projected annual growth in net income decreases to 4.7 percent in 2013, and projected annual growth in net cash flow to invested capital decreases to 5.0 percent in 2013. In the opinion of the IPFA analysts, a 4.0 percent expected long-term growth rate is appropriate for Jackpot. The terminal value calculation is based on normalized fiscal year 2013 net cash flow to invested capital, as presented in Exhibit 19.14. The only appropriate adjustment in the terminal year is to equate depreciation and amortization and capital expenditures. Over the interim period, depreciation and amortization exceeded capital expenditures due to amortization expenses associated with acquisitions the company has made historically. After 2013, depreciation and amortization and capital expenditures will be nearly equal. As presented in Exhibit 19.14, the terminal value for Jackpot, based on an expected long-term growth rate of 4.0 percent and a present value discount rate of 10.3 percent, is $2.345 billion. Base Case Analysis Discounted Cash Flow Method—Summary of Indicated Value. As presented in Exhibit 19.14, the total present value of interim cash flow for Jackpot is calculated as $2.048 billion. The present value of the terminal value for
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Jackpot is calculated as $2.345 billion. The sum of the discrete cash flow value and the terminal value represents the market value of invested capital (MVIC) for the company. As presented in Exhibit 19.14, this method results in an MVIC of $4.393 billion. Subtracting the company’s interest-bearing debt as of September 30, 2003, of $861 million results in a value of $3.532 billion. Adding the company’s cash and equivalents and investments of $328 million results in an equity value for Jackpot of $3.860 billion under the base case analysis.
Alternative Case Analysis Discounted Cash Flow Method Exhibits 19.11, 19.12, 19.16, and 19.17 present the DCF method for the alternative case analysis. Projected Financial Statements. Jackpot’s projected financial statements under the alternative case analysis for fiscal years 2004 through 2013 are presented in Exhibit 19.11. These projections include revenues and expenses from the sale of the new products based on the patent licensed from NewTech (new products). Common-size income statement projections are presented in Exhibit 19.12. The projected income statements are based on the projection variables presented in Exhibit 19.11. As presented in Exhibit 19.11, the Jackpot revenue from new products is projected to increase from $60 million in fiscal 2004 to $509 million in fiscal 2013. In addition, the company’s combined revenues from traditional gaming machines, progressive gaming operations, and new products are projected to increase from $1.11 billion in fiscal 2004 to $2.35 billion in fiscal 2013, or at a compounded annual growth rate of 8.7 percent. Cost of goods sold for new products is projected to be 46 percent of new products revenue over the fiscal 2004–2013 time period. Also presented in Exhibit 19.11 are the projected royalties paid to NewTech. As discussed in the following sections of this case study, 20.9 percent is the royalty rate that results in the same equity value for Jackpot under the alternative case analysis that was estimated under the base case analysis. Calculation of Net Cash Flow to Invested Capital. Exhibit 19.16 presents the calculation of the Jackpot net cash flow to invested capital for fiscal years 2004 through 2013 under the alternative case analysis, based on the projection variables listed in the exhibit. Estimation of a Present Value Discount Rate. Exhibit 19.17 presents the weighted average cost of capital estimate for Jackpot for the alternative case analysis. The weighted average cost of capital estimate for the alternative case analysis is the same as the estimate for the base case analysis, except for the estimate of the company-specific equity risk premium. To estimate the Jackpot cost of equity capital under the alternative case analysis, IPFA analysts included an additional company-specific equity risk premium of 0.9 percent to reflect the additional risks associated with achieving the new product projected revenues. Based upon this additional equity risk premium, the IPFA CAPM analysis results in an estimated cost of equity capital of 12.3 percent, as presented in Exhibit 19.17. Incorporating the after-tax cost of debt capital of 4.5 percent and
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Exhibit 19.16
Jackpot, Inc., Alternative Case Analysis, Discounted Cash Flow Analysis, Value Summary 2004 ($000)
2005 ($000)
2006 ($000)
Fiscal Years Ended September 30 2007 2008 2009 2010 ($000) ($000) ($000) ($000)
2011 ($000)
2012 ($000)
2013 ($000)
276,176 111,567 (50,240)
294,435 120,064 (52,752)
313,707 129,275 (55,229)
Normalized 2013 ($000)
Present value of discrete net cash flow Net incomea Plus: Depreciation and amortizationb Less: Capital expendituresc
199,464 61,219 (33,392)
218,606 68,615 (35,626)
223,293 74,635 (38,010)
231,796 81,291 (40,291)
249,992 88,693 (42,708)
258,000 96,510 (45,271)
Less: Working capital requirementsd
(13,954)
(26,892)
(21,893)
(24,204)
(26,916)
(28,423)
(27,011)
(27,743)
(30,899)
(33,496)
(33,496)
Plus: Interest expense, net of taxese
60,552
67,866
73,821
80,404
87,726
95,457
102,804
110,350
118,754
127,865
127,865
228,241
292,569
311,847
328,997
356,787
376,273
397,423
420,110
449,601
482,123
408,077
0.417 0.957
1.333 0.869
2.333 0.782
3.333 0.704
4.333 0.634
5.333 0.570
6.333 0.513
7.333 0.462
8.333 0.416
9.333 0.374
218,447
254,259
243,935
231,639
226,107
214,632
204,047
194,145
187,015
180,507
5.50 3.00
5.50 3.00
5.50 3.00
5.50 3.00
5.50 3.00
5.50 3.00
5.50 3.00
5.50 3.00
5.50 3.00
5.50 3.00
20.00
20.00
20.00
20.00
20.00
20.00
20.00
20.00
20.00
20.00
36.00
36.00
36.00
36.00
36.00
36.00
36.00
36.00
36.00
36.00
Net cash flow before adjustment Months remaining in initial projected yearf Net cash flow to invested capital Discounting periodsg Present value factor, 11.1%h Present value of discrete net cash flows Total present value of discrete net cash flows
Present value of terminal net cash flow Fiscal 2014 net cash flow ($000)i Capitalization multiplej
2,154,733
424,400 14.1 5,977,462 0.374
Present value of terminal cash flow ($000)
2,237,960
Valuation summary Total present value of discrete net cash flow Present value of terminal cash flow
($000) 2,154,733 2,237,960
Market value of invested capital Less: Interest-bearing debt
4,392,693 861,096
Indicated value before adjustments
3,531,597
Indicated equity value (rounded)
328,268 3,860,000
Alternative case projections % of Revenue Depreciation and amortization Capital expenditures Working capital requirements as % of revenue increase % of Pretax Income Income tax rate
a As
presented in Exhibit 19.11. Total depreciation and amortization expense equal to 5.5% of revenues. c Total capital expenditures equal to 3.0% of revenues. d Based on estimated working capital requirement equal to 20% of revenue increase. e As presented in Exhibit 19.11, net of taxes based on an estimated effective corporate income tax rate of 36%. f As of the valuation date. g Based on mid-year discounting convention. h Based on the weighted average cost of capital (WACC) estimated in Exhibit 19.17, and the indicated discounting periods. i Adjusted 2013 net cash flow increased by the expected long-term growth rate of 4%. j Based on the Gordon growth model, calculated as 1 divided by (WACC less the expected long-term growth rate). SOURCE: Exhibits 19.11 and 19.17 and analyst calculations. b
313,707 -
273,889 10.0
Terminal value ($000) Present value factor, 11.1%
Plus: Cash and equivalents and investments
265,541 103,938 (47,848)
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IV / Intellectual Property Valuation Issues
Exhibit 19.17
Jackpot, Inc., Alternative Case Analysis, Discounted Cash Flow Method, Weighted Average Cost of Capital Cost of Equity Capital
Source
Risk-free rate of return
4.1%
Plus Equity risk premium Multiplied by: Beta
The Wall Street Journal, November 30, 2002.
7.4%
Stocks, Bonds, Bills & Inflation, 2002 Yearbook, Ibbotson Associates.
0.90
Cost of Capital 2002 Yearbook, Ibbotson Associates. 6.7% 0.6% 0.9% 12.3%
Small stock equity risk premium Company-specific equity risk premium Total cost of equity capital
Cost of Debt Capital
Stocks, Bonds, Bills & Inflation, 2002 Yearbook, Ibbotson Associates. IPFA estimate.
Source
Average cost of debt Income tax rate After-tax total cost of debt capital
7.0% 36.0% 4.5%
Weighted Average Cost of Capital (WACC) Cost of equity capital Percent of capital structure Weighted rate
12.3% 85.0%
Cost of debt capital Percent of capital structure Weighted rate Weighted average cost of capital
4.5% 15.0%
Estimated based on Jackpot’s embedded cost of debt. Jackpot’s September 2003 long-term business plan.
Source
Cost of Capital 2002 Yearbook, Ibbotson Associates. 10.4%
Cost of Capital 2002 Yearbook, Ibbotson Associates. 0.7% 11.1%
SOURCE: As indicated above.
applying weightings for Jackpot of 15 percent for debt and 85 percent for equity results in a WACC of 11.1 percent, as presented in Exhibit 19.17. Present Value of Net Cash Flow to Invested Capital. As presented in Exhibit 19.16, the terminal value for Jackpot, based on an expected long-term growth rate of 4.0 percent and a present value discount rate of 11.1 percent, is $2.238 billion. Summary of Indicated Value from Discounted Cash Flow Method—Alternative Case Analysis. As presented in Exhibit 19.16, the total present value of interim cash flow for Jackpot is calculated as $2.154 billion. The present value of the terminal value for Jackpot is calculated as $2.238 billion. The sum of the discrete net cash flow value and the terminal value represents the MVIC for the company. As presented in Exhibit 19.16, this method results in an MVIC of $4.393 billion. Subtracting the company’s interest-bearing debt as of September 30, 2003, of $861 million results in a value of $3.532 billion. Adding the company’s cash and equivalents and investments of $328 million results in an equity value for Jackpot
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Exhibit 19.18
Jackpot, Inc., Impact on Equity Value of Various Alternative Royalty Rates
Royalty Rate Paid to NewTech (as a % of Revenues)
Base Case Equity Value ($000)
Alternative Case Equity Value ($000)
Increase (Decrease) in Equity Value ($000)
22.5 20.9 17.5 15.0 12.5 10.0 7.5
3,860,000 3,860,000 3,860,000 3,860,000 3,860,000 3,860,000 3,860,000
3,819,000 3,860,000 3,946,000 4,009,000 4,072,000 4,136,000 4,199,000
(41,000) — 86,000 149,000 212,000 276,000 339,000
Increase (Decrease) in Equity Value (%) −1 2 4 5 7 9
SOURCE: IPFA analyst calculations.
of $3.860 billion under the alternative case analysis, or equal to the conclusion under the base case analysis. Exhibit 19.18 presents various assumed royalty rates and the resulting impact on the equity value of Jackpot, based on the DCF method. As presented, negotiating a royalty rate of 22.5 percent would lower the value of the Jackpot equity by $41.0 million. Negotiating a royalty rate below 20.9 percent would have a significantly positive impact on the company’s equity. For example, negotiating a royalty rate of 15.0 percent would increase the value of Jackpot’s equity by $149.0 million, and negotiating a royalty rate of 10.0 percent would increase the value of the company’s equity by $276 million. Therefore, the maximum royalty rate Jackpot should pay to license the NewTech patent is 20.9 percent.
Synthesis and Conclusion IPFA analysts developed a range of royalty rates based on the CUT method, the CPM, and the profit split method. A summary of the estimated royalty rates from these methods is presented in the table as follows: Intellectual Property Royalty Rate Method Comparable uncontrolled transaction method Comparable profits method Profit split method
Range of Royalty Rates as a Percent of Revenues 13.8–16.0 12.9–19.3 13.6–14.4
As presented in the table, the range of royalty rates from the three methods was from a low of 12.9 percent of revenues to a high of 19.3 percent of revenues.
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IV / Intellectual Property Valuation Issues
IPFA analysts also used the discounted cash flow method to estimate the maximum royalty rate that Jackpot could pay to NewTech without impairing the value of the company. Based on this DCF analysis, the maximum royalty rate that Jackpot should pay to NewTech is 20.9 percent. Based on the IPFA analysis as presented in Exhibit 19.18, negotiating a royalty rate below 20.9 percent would have a significantly positive impact on the company’s equity value. Therefore, based on the conclusions from the CUT method, the CPM, the profit split method, and the DCF method, the IPFA analysts recommended that the royalty rate that Jackpot management should be willing to pay for the exclusive domestic use of the NewTech slot machine patent is in the range of 12.9 percent of revenues to 19.3 percent of revenues.
Part V
Intellectual Property Transfer Price Analysis Issues
Chapter 20 Transfer Pricing Considerations in Estimating Fair Market Value Kenneth R. Button and Jerrie V. Mirga
Introduction: When Are Transfer Prices Likely to Be a Valuation Issue? The Regulatory Framework Fair Market Value Financial Reporting and FASB Statement No. 57 Federal and State Tax Reporting OECD Guidelines How Do Non-Arm’s-Length Transactions Distort an Entity’s Financial Statements? The Identification of the Subject Company Related-Party Transfer Prices Methods of Determining Arm’s-Length Transaction Prices The Comparable Uncontrolled Price Method The Comparable Uncontrolled Transaction Method Resale Price Method Cost Plus Method The Comparable Profits Method Profit Split Methods Use of “Comparable” Companies in Determining the Arm’s-Length Price Adjusting the Financial Statements to Reflect Arm’s-Length Prices Sales of Product A and the CUP Method Sales of Product B and the RPM Sales of Product C and the CPM Administrative Overhead Charge and Cost Plus Method Intercompany Loan Use of Parent Manufacturing Technology with the CUT Method and the CPM Overall Impact on Financial Statements Conclusion
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Introduction: When Are Transfer Prices Likely to Be a Valuation Issue? Intercompany transfer pricing considerations can be important in the valuation of corporate entities such as subsidiaries and branches. This is because “fair market value” is a common standard of value that normally requires that such entities be valued on a stand-alone basis, as if they were operating at arm’s length with all other parties. However, some corporations carry out intercompany transactions among related corporate entities at transfer prices that may reflect specific corporate goals and objectives that may not be consistent with arm’s-length pricing.1 Transfer pricing issues can arise in various types of intercompany transactions. For example, a corporate entity may supply raw materials to a related party that uses the materials in the production of a finished product. The latter entity may transfer the finished product to a third entity that operates as a sales subsidiary handling marketing and sales operations. A corporate parent may provide administrative services to subsidiaries at little or no charge. A corporate entity may extend financing to another corporate entity at an interest rate that does not properly reflect the borrower’s stand-alone creditworthiness. The array of possible intercompany transactions is diverse. Transfer pricing issues can arise not only in transactions among domestic related parties, but also between domestic and foreign related parties. For example, a domestic entity may make an intangible asset, such as a trademark or patent, available to a foreign related party at a royalty rate that is greater than or less than what would result if the parties were negotiating on an arm’s-length basis. In conducting a valuation of a corporate entity on a fair market value standalone basis, the analyst should be aware of the possibility (1) that non-arm’s-length transfer prices exist and (2) that such prices that can impair the usefulness of the financial performance revealed in the entity’s financial statements. The analyst should examine documents and financial statements for indicators of possible non-arm’slength transactions. And, the analyst should adjust any such transactions to an arm’slength basis in the business valuation process.
The Regulatory Framework An analyst valuing an entity that engages in related-party transactions should be aware of the regulatory framework that may be relevant to that valuation. That framework would include regulations directly related to the valuation as well as regulations that govern the setting of transfer prices actually received and paid by the subject entity.
1 Two entities are related parties if (1) one entity can exercise effective control or influence over the business operations of the other
entity or (2) a third entity can exercise effective control or influence over both. Related-party relationships can take many forms, including (1) direct ownership, such as through the controlling equity ownership by one entity of another, or (2) indirect ownership, such as through a significant ownership interest in two entities held by a third entity.
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Fair Market Value Assuming that the appropriate standard of value is fair market value, the analyst would assess the company on a stand-alone basis from the perspective of an unrelated buyer and seller in a hypothetical arm’s-length negotiation. This perspective is most prominently expressed in Internal Revenue Service Revenue Ruling 59-60.2 During the course of such hypothetical negotiations, both the buyer and the seller are presumed to be able to refer to timely financial statements. And, each party would avoid relying on data that may be distorted against its own interests. For example, the buyer would be concerned that revenues were not overstated and that costs were not understated by the existence of non-arm’s-length transfer pricing arrangements. The seller would have the corresponding converse interest. Furthermore, the hypothetical buyer and seller are considered to be “well informed” with “both parties having reasonable knowledge of relevant facts” under the fair market value standard.3 Therefore, it is assumed that the buyer and seller are aware of relevant facts about (1) related-party relationships that the target entity may have and (2) how the related-party relationships may affect the value of the entity when operating on an independent basis. In the buyer’s valuation analysis, the buyer will analyze that target company as the buyer expects the target will actually operate as a stand-alone entity. Although commercial relationships with entities related to the target entity in the presale period may continue after the buyer acquires the target entity, the buyer will incorporate those commercial relationships into the expected financial results. These financial projections will be based on the actual transaction prices likely to occur following the acquisition. The buyer will assess whether long-term contracts and special commercial relationships will continue after the acquisition. Such special relationships could permit, for example, preacquisition access to materials at preferentially low prices or the ability to sell finished product at above-market prices. If such special relations will not continue after the acquisition, the buyer will project prices that would result from parties negotiating at arm’s length.4 Rev. Rul. 59-60 also highlights the importance of the analyst considering the predictive value of the target entity’s financial history and current financial condition with regard to gross and net income and dividends. The predictive value of historical financial data presumes that the subject financial data reflect transactions on an arm’s-length basis.5 Indeed, Rev. Rul. 59-60 notes that “Potential future income is a major factor in many valuations of closely held stocks, and all information concerning past income which will be helpful in predicting the future should be secured.”6 Such potential future income can be accurately estimated only if the historical transactions are consistent with the premise of stand-alone business operations. Therefore, the analyst should ensure that the valuation is based on financial statements that reflect the economic interplay of market forces rather than administratively determined transfer prices.
2 See
Estate Tax Regulation 20.2031-1(b) and Internal Revenue Service Revenue Ruling 59-60, 1959-1 C.B. 237, Section 2.02. Rul. 59-60, Section 2.02. 4 As a practical matter, unrelated companies can have complex and multifaceted commercial relationships in which the price agreed for transactions in one product may be influenced by mutual commercial interests in other areas and, therefore, not match what might be identified as the prevailing “arm’s-length” price for that product. 5 Rev. Rul. 59-60, Section 4.01(d). 6 Ibid. 3 Rev.
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Financial Reporting and FASB Statement No. 57 For financial reporting purposes under generally accepted accounting principles (GAAP), guidance regarding related-party transactions is provided by the Financial Accounting Standards Board (FASB) in its Statement No. 57 (SFAS 57). While SFAS 57 does not require that financial statements reflect arm’s-length pricing, it does require that financial statements “include disclosures of material related party transactions.”7 Such disclosures are considered necessary because: Without disclosure to the contrary, there is a general presumption that the transactions reflected in the financial statements have been consummated on an arm’s-length basis between independent parties. However, that presumption is not justified when related party transactions exist because the requisite conditions of competitive, free-market dealings may not exist. Because it is possible for related party transactions to be arranged to obtain certain results desired by the related parties, the resulting accounting measures may not represent what they usually would be expected to represent.8 The same rationale underlies the need for the analyst to assess the presence and impact of related-party relationships during a valuation.9
Federal and State Tax Reporting While intercompany transfer pricing arrangements may have relatively little impact on the consolidated U.S. federal income tax liability of an entirely domestic U.S. corporation, there could be a significant impact on the corporation’s state and local income tax liability. This impact would depend on how the domestic corporation operations are structured among two or more U.S. states. The income tax regulations vary among states as to how transfer prices are treated. However, in general, these state regulations require that tax liability be determined based on prices at arm’s length among related parties. A U.S. entity engaged in related-party transactions with an entity located in a foreign country must comply in its U.S. federal tax reporting with Internal Revenue Code (IRC) Section 482. Section 482 permits the Secretary of the Treasury to allocate gross income, deductions, credits, or allowances among related parties if such allocation is needed in order to “prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses…”10 The Section 482 regulations apply the arm’s-length standard to controlled transactions. The Section 482 regulations state that this standard is met “if the results of the [controlled] transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances….”11 7 Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 57: Related Party Disclosures, March 1982, para 2. Disclosure is not required for related-party transactions involving “compensation arrangements, expense allowances, and other similar items in the ordinary course of business.” Also, “disclosure of transactions that are eliminated in the preparation of consolidated or combined financial statements is not required in those statements,” para 2. 8 Ibid., para 15. 9 If the analyst is using guideline companies in either the market approach or the income approach, the wisdom of examining the presence and impact of related-party relationships is highlighted by the SFAS 57 observation: “Information about transactions with related parties is useful to users of financial statements in attempting to compare an enterprise’s results of operations and financial position with those of other enterprises.” Ibid., para 18. 10 IRC Section 482. 11 Treasury Regulation §1.482-1(b).
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U.S. companies operating in a foreign country must also comply with the foreign country’s tax regulations. In Canada, for example, the arm’s-length principle is the foundation of Canada’s transfer pricing law. The Canadian transfer pricing law “requires that, for tax purposes, the terms and conditions agreed to between nonarm’s-length parties in their commercial or financial relations be those that one would have expected had the parties been dealing with each other at arm’s length.”12
OECD Guidelines An effort to harmonize the transfer pricing regulations among various national tax authorities was undertaken by the Organization for Economic Cooperation and Development (OECD).13 The OECD originally issued transfer pricing guidelines in 1979; these guidelines were substantially updated in 1995. The guidelines support the arm’s-length principle as the international standard to be used in setting transfer prices within a multinational company. The OECD guidelines state that, in instances where tax revenues are distorted due to transfer prices that do not reflect market forces: … for tax purposes the profits of associated enterprises may be adjusted as necessary to correct any such distortions and thereby ensure that the arm’s length principle is satisfied. OECD member countries consider that an appropriate adjustment is achieved by establishing the conditions of the commercial and financial relations that they would expect to find between independent enterprises in similar transactions under similar circumstances.14 All of the OECD 30 member countries claim to rely upon these transfer pricing guidelines. Some non-OECD countries rely upon them as well.
How Do Non-Arm’s-Length Transactions Distort an Entity’s Financial Statements? The financial condition reflected in a corporate entity’s financial statements can vary significantly if the statements incorporate intercompany transactions based on transfer prices set to meet particular corporate goals rather than set on an arm’slength basis. Depending on the circumstances, the transfer price–based financial statements can indicate a financial condition that is stronger or weaker than the financial condition if prices are set on an arm’s-length basis. There can be a significant impact on corporate financial statements as a result of non-arm’s-length transactions for tangible property, services, and intangible property. To illustrate, a series of transactions are presented among the hypothetical entities presented in Exhibit 20.1. The entities include a parent company (Parent), its 12 Information
Circular 87-2R on International Transfer Pricing, released 9/27/99 by Revenue Canada, as published in Tax Management’s Transfer Pricing Report dated November 24, 1999, p. 34. 13 In 1961, the OECD became the successor to the Organization for European Economic Co-operation. The OECD mission “has been to build strong economies in its member countries, improve efficiency, hone market systems, expand free trade and contribute to development in industrialized as well as developing countries.” (Source: www.oecd.org, accessed April 16, 2003.) 14 Organization for Economic Cooperation and Development, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, July 1995, para 1.3.
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V / Intellectual Property Transfer Price Analysis Issues
Exhibit 20.1
Transactions among Related and Unrelated Parties Unrelated Third-Party Supplier Product A
Product A Product B Parent Administrative Services
Domestic Sales Sub
Unrelated Customers
Loan
Product C Manufacturing Technology
Foreign Manufacturing and Sales Sub
Unrelated Customers
domestic sales subsidiary (Domestic Sales Sub), and its foreign manufacturing and sales subsidiary (Foreign Sub). Parent engages in various transactions with these subsidiaries at prices that are not on an arm’s-length basis. Parent produces Product A and Product B which it sells at transfer prices to Domestic Sales Sub. Domestic Sales Sub performs the sales functions for all sales of these products. It is assumed that Domestic Sales Sub purchases some of its requirements for Product A from an unrelated third-party supplier.15 Domestic Sales Sub sells Product A and Product B to unrelated customers. If the transfer price for Product A from Parent to Domestic Sales Sub is lower than the arm’s-length, third-party price, the effect will be to understate the Domestic Sales Sub cost of goods sold (COGS).16 Assume that Domestic Sales Sub sells Product A to unrelated customers at the prevailing end-user market price. Because of the understated COGS, Domestic Sales Sub will earn higher profitability than if the Product A supplied by Parent is purchased at an arm’s-length price. Unless the transfer price effect is recognized and adjusted, the financial statements could lead an analyst to overvalue Domestic Sales Sub. Parent also produces Product C and sells it exclusively to Foreign Sub. Foreign Sub carries out typical sales functions, but Foreign Sub also performs significant additional functions and absorbs additional risks related to the sale to end-user purchasers of 15 Assume that, other than price, there are no significant differences in the terms and conditions of the Domestic Sales Sub purchase of Product A from Parent and from Unrelated Third-Party Supplier. 16 Conversely, the transfer price understates Parent’s sales revenues.
20 / Transfer Pricing Considerations in Estimating Fair Market Value
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Product C. Foreign Sub sells Product C to unrelated customers at the prevailing end-user market price. As with Domestic Sales Sub, if the Foreign Sub purchase cost is lower than the arm’s-length acquisition cost (1) the Foreign Sub COGS will be understated and (2) its profitability would be overstated. With respect to services, assume that Parent provides administrative services (e.g., payroll and accounting services) to Domestic Sales Sub. If Parent separately charged Domestic Sales Sub for administrative services based on a transfer price that is lower than what Domestic Sales Sub would pay on an arm’s-length or stand-alone basis, the Domestic Sales Sub selling, general, and administrative (SG&A) expense would be understated.17 The effect of understated SG&A expense would be to increase the Domestic Sales Sub profitability as reflected in its financial statements. This profitability overstatement could potentially lead an analyst to overvalue Domestic Sales Sub. Similarly, if Parent made a loan to Domestic Sales Sub at an interest rate below the interest rate that Domestic Sales Sub could secure as a stand-alone entity (1) the Domestic Sales Sub interest expense would be understated and (2) its net income would be overstated. It is not uncommon for a parent company to have financial resources superior to a subsidiary. Therefore, the parent company may be capable of borrowing at a lower interest rate than could the subsidiary if the subsidiary’s borrowing were based only on its own resources. Also assume that Parent has succeeded in developing substantial value in an intangible asset—in this case, certain manufacturing technology that Parent makes available to Foreign Sub at no cost. Use of the technology in the Foreign Sub manufactured products permits Foreign Sub to realize a higher price on these products, and hence a greater profit, than it could earn if it did not have use of this intangible asset. However, absent payment of a royalty to the Parent, the SG&A expense associated with the Foreign Sub manufacturing operations would be understated. The effect of this understatement of SG&A expense would be an overstatement of the Foreign Sub profitability as reflected on its financial statements.18
The Identification of the Subject Company Related-Party Transfer Prices At the beginning of a valuation assignment, the analyst should gather information as to whether the subject entity has ownership relationships with any other entities. If so, the analyst should determine whether the subject entity provides to, or receives from, these other entities any goods, services, or intangibles. A common procedure at the outset of a valuation assignment is for the analyst to prepare a comprehensive list of required information regarding the subject entity. The analyst typically submits the list of required information to the client management. The information list should include a request for a description of the subject entity’s corporate structure 17 The arm’s-length price and stand-alone cost for such services may not be the same. Depending on factors such as economy of scale, an entity’s cost to perform administrative services internally may be higher or lower than the price required to have those services performed by an unrelated third party. 18 Conversely, Parent’s revenues are understated by the absence of royalty compensation for Foreign Sub’s use of its intangible assets. It is assumed that, absent the related-party relationship, Parent would be unwilling to permit Foreign Sub the continued use of the technology at no cost.
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and ownership relationships. The information list should request a chart graphically illustrating all intercompany relationships. The list should also seek detailed information about all related-party transactions. If the parent company or subject entity prepares financial statements in compliance with GAAP, the statements should comply with the SFAS 57 requirement regarding the disclosure of material related-party transactions. Filings to the Securities and Exchange Commission (SEC), such as form 10-K, typically include (1) information about a corporation’s organizational structure and (2) a list of the domestic and foreign entities with which the corporation has ownership relationships. Once any related-party relationships have been identified, the analyst should determine whether there has been significant provision of goods, services, or intangibles between the subject entity and its related entities. Generally, this information becomes available only through interviewing management. This information should be the subject of questions in the analyst’s initial information request. The analyst should ask management specifically how transfer prices are set and whether they are intended to be at arm’s-length levels. In addition, as discussed below, it is very useful to know whether the subject entity makes purchases or sales involving unrelated third parties of the same or similar products, services, or intangibles as those involved in related-party transactions. If related-party transactions are identified, the analyst needs to determine whether there is a basis for suspecting that they were carried out at non-arm’s-length prices. While there are no simple tests for screening such transactions, the analyst’s attention should be heightened if (1) related-party purchases or sales are an important part of the subject entity operations or (2) the subject entity has consistently very high or very low levels of profitability. The actual determination of whether the related-party transactions are at arm’s-length prices will require the calculation of arm’s-length prices using the transfer price methods described below.
Methods of Determining Arm’s-Length Transaction Prices Although there are no specifically stipulated methods for determining arm’s-length prices for intercompany transactions under SFAS 57 or under the Uniform Standards for Professional Appraisal Practices (USPAP) promulgated by The Appraisal Foundation, the methods that are prescribed under Section 482 regulations are widely used for this purpose in the United States. The Section 482 regulations set forth several methods that can be used. Under Section 482, there is no strict hierarchy when choosing the method to be used. Rather, the guiding principle is that the “best method” should be used. The “best method” is defined as “the method that, under the facts and circumstances, provides the most reliable measure of an arm’s-length result.”19 The IRS states that the two key factors to consider in selecting the best transfer price method are (1) “the degree of comparability between the controlled transaction (or taxpayer) and any uncontrolled comparables,” and (2) “the quality of the data and assumptions used in the analysis.”20
19 Treasury 20 Treasury
Regulation §1.482-1(c)(1). Regulation §1.482-1(c)(2).
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When assessing the comparability of the controlled and uncontrolled transactions (or companies), the following factors should be considered: • • • • •
The functions performed and the resources employed by the controlled and uncontrolled taxpayers (e.g., do both taxpayers undertake R&D activities?) The contractual terms involved in the controlled and uncontrolled transactions (e.g., are there differences in payment terms?) The risks borne by the controlled and uncontrolled taxpayers (e.g., do both taxpayers bear the risks associated with failed R&D efforts?) The economic conditions in which the controlled and uncontrolled transactions occur (e.g., similar geographic markets and same level of trade) The similarity of the products or services being exchanged in the controlled and uncontrolled transactions, including the existence of any intangibles that may be imbedded in transfers of tangible property
The IRS regulations specify the array of methods that can be used to establish arm’s-length prices for intercompany transactions involving tangible property and intangible property. For transfers of tangible property among related parties, the following transfer price methods can be applied: • • • • • •
The comparable uncontrolled price (CUP) method The resale price method (RPM) The cost plus method The comparable profits method (CPM) The profit split method Other, unspecified methods21
With respect to intangible property, the regulations state that, “the arm’s-length consideration for the transfer of an intangible asset must be commensurate with the income attributable to the intangible.”22 The following transfer price methods can be applied for intercompany transactions involving intangibles: • • • •
The comparable uncontrolled transaction (CUT) method The CPM The profit split method Other, unspecified methods
Thus, there are six specified methods for determining arm’s-length prices, each of which is discussed in more detail in the sections that follow. The CUP, CUT, RPM, and cost plus methods are generally described as transaction-based methods. The CPM and profit split methods are generally described as profit-based methods. Transaction-based methods attempt to set or evaluate intercompany prices by reference to the prices charged or the gross margins (or markups) realized in transactions between unrelated parties, thereby setting the transfer price itself. In comparison, profit-based methods evaluate the operating profits that are earned as a result of the controlled transactions. And, if such profits are comparable to the profits earned in uncontrolled transactions, the underlying transfer prices are assumed to be consistent 21 In order for an unspecified method to be used, it must satisfy the principles of the “best method rule” (i.e., provide the most reli-
able measure of an arm’s-length result), and it “should take into account the general principle that uncontrolled taxpayers evaluate the terms of a transaction by considering the realistic alternatives to that transaction, and only enter into a particular transaction if none of the alternatives is preferable to it.” [Treas. Reg. §1.482-4(d)(1)] 22 Treasury Regulation §1.482-4(a).
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with arm’s-length expectations. The transaction-based methods are discussed first, followed by the profit-based methods.
The Comparable Uncontrolled Price Method The CUP method uses the price charged for the same product sold in a transaction between unrelated parties as the basis for setting intercompany prices. Thus, if reliable product CUPs are available, this is generally the most straightforward way to establish the prices to be charged in a controlled transaction. According to the IRS regulations, in order for the CUP approach to be used, “similarity of products generally will have the greatest effect on comparability…”23 In addition to product similarity, the circumstances of the two sales should also be sufficiently similar so that the two transactions can be viewed as comparable. Where the products or circumstances in the uncontrolled transaction are not identical to those in the controlled transaction, adjustments should be made to take into account all differences that would affect the price. The inability to quantify reliably all such differences can make it difficult to find product CUPs. Adjustments to account for the differences that can be quantified should be made to the price of the uncontrolled transaction. Examples of the areas where relevant differences can occur, and where adjustments may be needed, include the following:24 • • • • • • • •
Product quality Contractual terms (e.g., credit terms, transportation terms, sales volumes) Level of the market Geographic market Dates of the transactions Presence of intangibles Foreign currency risks Realistic alternatives available to the buyer and seller
The Comparable Uncontrolled Transaction Method The CUT method is generally considered to be the most accurate method for determining transfer prices for intangibles, such as trademarks and manufacturing technology. However, the CUT method can be difficult to apply because of the difficulty in locating sufficiently similar transactions among unrelated parties. The application of the CUT method is analogous to the application of the CUP method used for tangible property. Under the CUT method, transfer prices are derived from specific uncontrolled transactions among unrelated parties that deal with transfers of the same intangible property under the same, or substantially the same, circumstances. As with the CUP method, adjustments for differences in circumstances between the controlled and uncontrolled transaction should be made where reliable data are available to quantify such differences. Where uncontrolled transactions involving the same intangibles (i.e., exact comparables) are unavailable, uncontrolled transactions involving comparable intangibles (i.e., inexact comparables) can be used in applying the CUT 23 Treasury 24 Treasury
Regulation §1.482-3(b)(2)(ii)(A). Regulation §1.482-3(b)(2)(ii)(B).
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method. However, the use of inexact comparables reduces, to some degree, the reliability of the analysis. Therefore, in order for an uncontrolled transaction to be used as a comparable, it must involve either (1) the same intangible property or (2) comparable intangible property—as compared to the intangible involved in the controlled transaction. In order for intangible property to be considered comparable, it should (1) be used for similar products and be within the same general industry or market and (2) have similar profit potential. The contractual terms and economic conditions within which the controlled and uncontrolled transactions occur should also be similar (i.e., the circumstances should be similar). In order for the circumstances to be similar, the following elements should be considered: • The terms of the transfer, including the exclusive or nonexclusive nature of the rights granted • The stage of development of the intangible in the relevant market • The rights to receive updates to the intangible • The uniqueness of the property and the period for which it remains unique • The duration of the license • Any economic risks assumed by the transferee • The existence and extent of any ongoing business relationship between the transferor and the transferee • The functions to be performed by the transferor and the transferee
Resale Price Method The RPM is typically applied to distributors that purchase products from related parties and then resell them to unrelated customers without making substantial modifications to the products. The RPM uses the gross profit margins found in uncontrolled transactions to derive an arm’s-length price for controlled transactions. In a sense, the RPM is a “work-back” method. That is, the RPM begins with the end price charged to an unrelated customer, and then deducts the arm’s-length gross margin to derive the price for the controlled transaction. The IRS regulations state a preference for deriving arm’s-length gross margins from uncontrolled transactions involving the same reseller (i.e., internal comparables). However, in the event the reseller does not purchase the same (or similar) products from both related and unrelated suppliers (or if reliable adjustments cannot be made to account for differences between purchases from related and unrelated suppliers), then the arm’s-length gross margin can be derived from uncontrolled transactions involving other resellers (i.e., external comparables). Two potential sources for external arm’s-length gross margins are (1) observed transactions among unrelated parties and (2) use of the profit ratios realized by similar resellers. In order for transactions to be considered comparable under the RPM, it is important to consider whether the controlled and uncontrolled transactions are similar in terms of the functions performed, the risks borne, and the contractual terms.25 Product similarity is not as important for the RPM as it is for the CUP method. Typically, however, arm’s-length gross margins from within the same general industry should
25 Treasury
Regulation §1.482-3(c)(3)(ii)(A).
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be used. As with the other methods, adjustments for differences between the controlled and uncontrolled transactions should be made where reliable data are available to do so (e.g., differences in payment terms).
Cost Plus Method The cost plus method is typically applied to manufacturers that purchase their inputs from unrelated suppliers and then sell the finished products to related customers. It can also be applied to entities that provide services to related parties. Like the RPM, the cost plus method uses the gross margins found in uncontrolled transactions to derive an arm’s-length price for a controlled transaction. However, the cost plus method can be thought of as a “build-up” method. That is, the cost plus method begins with the cost of sales incurred by the controlled manufacturer, and then derives the price for the controlled transaction by adding an arm’s-length gross profit markup. As is the case for the RPM, there is a preference for deriving arm’s-length gross margins from uncontrolled transactions involving the same manufacturer or service provider. However, if such internal comparables are not available (or reliable adjustments cannot be made), arm’s-length gross margins can be derived from external comparables. The factors to consider in terms of comparability would be similar to those for the RPM. Specifically, comparability is more dependent upon the similarity of (1) functions performed, (2) risks assumed, and (3) contractual terms than upon product similarity.
The Comparable Profits Method The CPM first identifies one of the two parties engaged in the controlled transaction as the “tested party.” The tested party is typically the party that owns the fewest intangibles and faces the least risk. Transfer prices are then set at a level that gives the tested party operating profits that are consistent with those of uncontrolled comparable companies. The presumption of symmetry means that the arm’s-length price found for the tested party is also an arm’s-length price for the other party. In a business valuation, while the subject company may or may not be the tested party, the price determined as appropriate for the tested party becomes the price used in the valuation. There are two notable advantages to the CPM. First, the CPM method can be easier to implement than other transfer pricing methods, in that it does not require detailed transactional data for the selected uncontrolled comparable companies. Second, the CPM can be applied when the tested party provides significant functions beyond those of basic selling activities. Gross profit is the focus of the RPM and cost plus methods. However, operating profit is the focus of CPM. This is because the operating profit incorporates not only the cost of goods but also expenses related to all sales and other support functions performed. Use of an operating profit measure is also useful because there can be inconsistency among potential comparable companies as to their accounting treatment of various sales-related services. Some companies may incorporate into COGS the expenses associated with providing selling and other services while other companies may classify these expenses under
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SG&A. Uncertainty as to whether the expense for such services was captured in the profitability measure for the comparable companies can be avoided by use of the operating margin—rather than the gross margin. In the selection of comparable companies, the analyst should consider the resources employed, the risks assumed, and the functions performed as important factors in determining the degree of comparability between the tested party and the uncontrolled companies. Assume, for example, that a parent company sells goods to a subsidiary that performs not only typical sales functions but also (1) performs additional functions and (2) absorbs additional risks associated with selling the product. However, there is a significant mix among other otherwise comparable sales companies as to whether they perform only the basic sales functions or also perform additional functions and absorb additional risk. Examination of the profit indicator of the total pool of these sales companies could result in a profit margin indicator for the subject company which would be too low. This is because the profit margin indicator would incorporate both those companies whose profit margins had to be high enough to cover the additional functions and additional risk absorption and those companies that could accept lower profit margins sufficient to cover their more limited traditional selling activities. Nonetheless, the analyst would still need to assess whether an adjustment to the profit indicator for the more limited pool of comparable companies was needed. That adjustment would account for other differences between the tested party and the uncontrolled comparable companies (e.g., for differences in payment terms).
Profit Split Methods The profit split methods examine how the profits attributable to an intercompany transaction are divided, taking into consideration (1) the functions performed, (2) risks assumed, and (3) the resources employed by each party to the transaction. The basic premise is that one should expect the relative profits of the related parties to be consistent with how profits would be divided if the transaction had taken place at arm’s length. Two ways of implementing the profit split methods are the comparable profit split and the residual profit split. Profit splits can be used in situations where detailed transactional data are not available, but where both parties to the intercompany transaction have significant intangibles and/or incur significant risks. The comparable profit split method starts with the total operating profits that are generated from the subject intercompany transactions. The single most important requirement of the comparable profit split method is that operating profits are to be split in a manner consistent with splits observed at arm’s length. The comparable profit split method can be difficult to implement. This is because the data on the profit splits obtained by unrelated parties are generally not available. The residual profit split method is carried out in two steps. In the first step, each party to the intercompany transactions is provided with a return (i.e., operating profit) for its “routine” functions (e.g., a routine return for distribution functions). Such routine profits are typically determined through use of a CPM analysis. After deducting both parties’ routine profits from the total pool of operating profits, the remaining profits are considered the “residual” profits—or the profits attributable to intangibles. Thus, in step two, the residual profits are allocated to each party based upon the relative value of its contribution of intangible property.
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Use of “Comparable” Companies in Determining the Arm’s-Length Price The IRS acknowledges that in reality, the “arm’s-length price” for a good or service, in fact, constitutes a range of values, rather than simply a single point value. Therefore, in testing whether a transfer price is consistent with the prices that uncontrolled parties would set after negotiating at arm’s length, the IRS will accept a transfer price as being at arm’s length if it falls within an appropriate range of prices. This appropriate range of prices could be found among comparable transactions or companies. The IRS does not require that the selected transfer price be precisely at the mean or median point. If there are no material differences between the pool of comparable companies and the target entity (or if such differences can be removed through appropriate adjustments to the data), then the subject entity’s transfer price will be accepted as at arm’s length if it falls within the upper and lower boundaries of the pool’s range.26 If the transfer price falls outside the range, the IRS has the discretion to set the transfer price consistent with values anywhere within the range. For pools of comparables where adjustments cannot be made to remove all material differences, the IRS will typically narrow the acceptable arm’s-length range to be the interquartile range covering the 25th percentile to the 75th percentile of the pool values.27 If the transfer price falls outside the interquartile range, the IRS will ordinarily set the acceptable transfer price as the median of the range. The IRS will typically use that procedure rather than accept the range’s upper or lower boundary value that is closest to the subject transfer price. For a business valuation, purposes however, the analyst is free to exercise judgment as to whether to set the transfer price at any point within the absolute range or interquartile range (or possibly outside the range) that the analyst believes is justified by the particular facts or circumstances.
Adjusting the Financial Statements to Reflect Arm’s-Length Prices The various methods for determining arm’s-length prices in a Section 482 tax context provide useful tools for an analyst estimating fair market value. Once the arm’slength transaction prices have been determined, the analyst can make adjustments so that the financial statements reflect results consistent with arm’s-length pricing. Let’s use the example of the related-party transactions between Parent and Domestic Sales Sub and Foreign Sub. This example will illustrate that the adjustment of transactions from the original transfer prices to arm’s-length prices can have a significant impact on the financial condition indicated by the financial statements. Each of six types of related-party transactions involving Parent and its subsidiaries are described below and illustrated in Exhibits 20.2 through 20.6.
26 Treasury 27 Treasury
Regulation §1.482-1(e)(2)(iii)(A). Regulation §1.482-1(e)(2)(iii)(B).
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Exhibit 20.2
Acquisition Cost of Products A and B for Domestic Sales Subsidiary Before Adjustment of Transfer Prices
Unrelated Third-Party Supplier Product A $ 200 Product A $ 170 Parent Product B $ 210
Domestic Sales Sub
Unrelated Customers
After Adjustment of Transfer Prices
Unrelated Third-Party Supplier Product A $ 200 Product A $ 200 Parent Product B $ 244
Domestic Sales Sub
Unrelated Customers
Assume that Domestic Sales Sub and Foreign Sub are the entities that are the valuation subjects. The impact on Domestic Sales Sub of adjusting transfer prices to arm’s length is presented in Exhibits 20.7 and 20.8. These exhibits present income statements for Domestic Sales Sub before and after adjusting transfer prices to an arm’s-length basis. Exhibits 20.9 and 20.10 similarly present Foreign Sub’s income statements before and after adjustment of (1) its transfer price for Product C and (2) its royalty payment to an arm’s-length basis.28
28 While these examples illustrate the impact on the entity’s income statement of adjusting transfer prices to an arm’s-length basis,
the analyst should recognize that there can also be important effects on the entity’s balance sheet and statement of cash flows. The balance sheet effects can arise quite directly, for example, as a result of the flow-through of a change in profitability to the retained earnings entry and, thereby, have an impact on both profitability ratios, such as the return on equity, and on leverage ratios, such as the debt–equity ratio. Adjusted transfer prices relating to procurement and sales similarly can raise or lower the expected levels of accounts payable and accounts receivable. A balance sheet effect can also arise more indirectly by changing the available cash flow and, thereby, the amount of debt required to support working capital or capital expenditures. Cash flow effects should be assessed not only with regard to the statement of cash flows but also in performing any discounted cash flow analysis.
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Exhibit 20.3
Acquisition Cost of Product C for Foreign Subsidiary Before Adjustment of Transfer Prices
Parent
Product C $150
18.3% operating margin
Unrelated Customers
Foreign Sub
10.0% operating margin
Unrelated Customers
Comparable Companies
10.0% operating margin
Unrelated Customers
Foreign Sub
After Adjustment of Transfer Prices
Parent
Product C $169
Sales of Product A and the CUP Method Parent sold to Domestic Sales Sub 100 units of Product A at a transfer price of $170 per unit, as presented in Exhibits 20.2 and 20.7.29 This acquisition is reflected in the Domestic Sales Sub income statement as its COGS of $17,000 for Product A acquired from Parent. Domestic Sales Sub sells these units of Product A to unrelated customers at the prevailing market price of $225 per unit, with a resulting gross margin of 24.4 percent. Domestic Sales Sub acquired an additional 100 units of Product A from an unrelated third-party supplier at a price of $200 per unit. On the Domestic Sales Sub income statement, this purchase is recorded as a COGS of $20,000. Assuming that the product and the nonprice terms of sale related to the purchase by Domestic Sales Sub from the unrelated third-party supplier are substantially the same as those for the Domestic Sales Sub purchase from Parent, the unrelated third-party supplier price constitutes a good CUP indicator of the arm’s-length price of Product A. In the Domestic Sales Sub income statement, replacing the $170 unit price paid to Parent with the $200 unit price paid to the unrelated third-party supplier causes the
29 The
illustrative examples assume no freight charges.
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Exhibit 20.4
Administrative Services Charge Paid by Domestic Sales Subsidiary Before Adjustment of Transfer Prices
Parent Cost $1,425 Markup 0% $0 Total charge $1,425
Administrative Services $1,425
Domestic Sales Sub
After Adjustment of Transfer Prices
Parent Cost $1,425 Markup 5.0% $71 Total charge $1,496
Administrative Services $1,496
Domestic Sales Sub
External comparable gross margin on sales of administrative services 4.8%. Equivalent to Cost-Plus Markup of 5.0%
Domestic Sales Sub COGS to increase, as presented in Exhibit 20.8. The Domestic Sales Sub gross margin decreases to 11.1 percent, the same level as on the resale of its Product A purchases from the unrelated supplier.
Sales of Product B and the RPM The transactions in Exhibit 20.2 also indicate that Domestic Sales Sub acquires Product B exclusively from Parent at a unit price of $210. Domestic Sales Sub then (1) resells Product B to unrelated customers and (2) earns a gross margin of 23.6 percent. Under the RPM, the Domestic Sales Sub arm’s-length acquisition price for Product B can be estimated based on application of an estimated arm’slength gross margin to Domestic Sales Sub’s resale price to back out the implied arm’s-length purchase price from Parent. As described in an earlier section, the arm’s-length gross margin can come from either an internal comparable or an external comparable. Assume that the sales functions and risks that Domestic Sales Sub undertakes regarding Product A and Product B are reasonably similar. Then, the gross margin that Domestic Sales Sub earned
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V / Intellectual Property Transfer Price Analysis Issues
Exhibit 20.5
Loan from Parent to Domestic Sales Subsidiary Before Adjustment of Transfer Prices
Loan interest rate 5%
Parent
Domestic Sales Sub
Parent’s arm’s-length borrowing cost 5%
Unrelated Bank
After Adjustment of Transfer Prices
Parent
Loan interest rate 8%
Domestic Sales Sub
Parent’s arm’s-length borrowing cost 5%
Unrelated Bank
Borrowing rate of companies comparable to Sales Sub 8%
on its resale of Product A purchased from the unrelated third-party supplier can provide an appropriate internal comparable for use with Product B. As presented in Exhibit 20.8, the Domestic Sales Sub gross margin on resale of Product A purchased from the unrelated third-party supplier is 11.1 percent. When applied to the $275 resale price of Product B, the implied arm’s-length acquisition price for Product B is $244 per unit,30 which is higher than the transfer price. Adjusting the Domestic Sales Sub income statement by increasing its COGS to incorporate the higher estimated arm’s-length price for Product B results in a decline in the gross margin on Product B to 11.1 percent. 30 Calculated
as [$27,500 – ($27,500 × 11.1%)]/100 units = $244.
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Exhibit 20.6
Royalty Payment by Foreign Subsidiary for Use of Parent’s Manufacturing Technology Before Adjustment of Transfer Prices
Payment for Manufacturing Technology: 0% of Sales by Foreign Sub
Parent
Foreign Sub
After Adjustment of Transfer Prices
Payment for Manufacturing Technology: 5% of Sales by Foreign Sub
Parent
Foreign Sub
External CUT or CPM analysis: Comparable royalty rate of 5%
If Domestic Sales Sub did not have arm’s-length transactions that could serve as an internal comparable, it would be necessary to use an external comparable measure. The external comparable measure would be based on the resale gross margins of other companies whose products and sales and marketing functions were appropriately similar to those associated with the Domestic Sales Sub sales of Product B.
Sales of Product C and the CPM With respect to sales of Product C from Parent to Foreign Sub, there is no internal comparable. This is because Foreign Sub performs significant functions and absorbs risks that are significantly beyond those associated with Domestic Sales Sub with respect to Products A and B. Therefore, an external comparable measure should be determined with a CPM analysis based on uncontrolled comparable companies. Foreign Sub would be the appropriate “tested party” for the purposes of the CPM. Assume that an analysis of potential comparable companies was performed which confirmed that companies performing the extra functions and absorbing additional risks of the sort undertaken by Foreign Sub had significantly different operating income results than those companies in the pool which did not do so.
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Exhibit 20.7
Sales Subsidiary before Adjusting Transfer Prices to Arm’s Length ($ Values, Unless Otherwise Indicated)
Unit Values
Product A Related Unrelated
Product B Related
Sales price to unrelated customers Cost of goods paid to supplier Gross profit per unit Net income per unit
225 170 55 25
225 200 25 6
275 210 65 29
Units purchased and sold
100
100
100
Product A Related Unrelated
Product B Related
Income Statement Sales Cost of goods sold Gross profit Selling, general and administrative Selling Corporate overhead charge (at cost) Operating income Interest paid at 5% on $3000 intercompany loan Earnings before tax (EBT) Income taxes Net income Gross margin (gross profit/sales) Operating income margin (operating income/sales) Net income margin (net income/sales)
Total
22,500 17,000 5,500
22,500 20,000 2,500
27,500 21,000 6,500
72,500 58,000 14,500
1,125 442 3,933 47 3,886 1,360 2,526
1,125 442 933 47 886 310 576
1,375 541 4,584 57 4,528 1,585 2,943
3,625 1,425 9,450 150 9,300 3,255 6,045
24.4% 17.5% 11.2%
11.1% 4.1% 2.6%
23.6% 16.7% 10.7%
20.0% 13.0% 8.3%
Therefore, the analyst would need to focus attention on the group of comparable companies with function and risk characteristics more similar to Foreign Sub.31 As presented in Exhibits 20.3 and 20.9, Parent sells Product C to Foreign Sub at a unit price of $150. Foreign Sub marks up Product C to $225 per unit for sale to unrelated customers and earns an operating margin of 18.3 percent. The CPM analysis based on a pool of comparable companies (1) performing essentially the same functions and (2) absorbing the same risks as Foreign Sub. The CPM analysis determines that an operating income margin of 10.0 percent is the appropriate profitability indicator, a level lower than the 18.3 percent level based on the transfer price. As presented in Exhibit 20.10, with a 10.0 percent operating margin, the implied arm’s-length sales price for the Parent sales of Product C to Foreign Sub is increased to $169. 31 As operating income margin, rather than gross profit margin, is used as the profitability measure for the CPM analysis, distortions are reduced with respect to possible inconsistency among the comparable companies regarding the accounting classification of the expenses underlying these functions/risks.
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Exhibit 20.8
Sales Subsidiary after Adjusting Transfer Prices to Arm’s Length ($ Values, Unless Otherwise Indicated)
Unit Values
Product A Related Unrelated
Product B Related
Sales price to unrelated customers Cost of goods paid to supplier Gross profit per unit Net income per unit
225 200 25 5
225 200 25 5
275 244 31 7
Units purchased and sold
100
100
100
Product A Related Unrelated
Product B Related
Income Statement Sales Cost of goods sold* Gross profit Selling, general and administrative Selling Corporate overhead charge (cost plus 5%) Operating income Interest paid at 8% on $3000 intercompany loan Earnings before tax (EBT) Income taxes Net income Gross margin (gross profit/sales) Operating income margin (operating income/sales) Net income margin (net income/sales)
Total
22,500 20,000 2,500
22,500 20,000 2,500
27,500 24,444 3,056
72,500 64,444 8,056
1,125 464 911 74 836 293 544
1,125 464 911 74 836 293 544
1,375 568 1,113 91 1,022 358 664
3,625 1,496 2,934 240 2,694 943 1,751
11.1% 4.0% 2.4%
11.1% 4.0% 2.4%
11.1% 4.0% 2.4%
11.1% 4.0% 2.4%
*COGS Product B is based on unrounded arm’s–length price of $244.44.
Administrative Overhead Charge and Cost Plus Method With respect to services, Parent provides Domestic Sales Sub with administrative support services, such as payroll and accounting. But, as presented in Exhibit 20.4, Parent does so on a cost-reimbursable basis with no markup for profit. With the assumption of Domestic Sales Sub operating as an independent company, Domestic Sales Sub would either perform such services internally or acquire them from an outside supplier at an arm’s-length price.32 32 In a Section 482 context, the provision by Parent to Domestic Sales Sub of such routine administrative support services at cost with
no markup might not require any adjustment for tax purposes, but it would still require an adjustment for valuation purposes. The provision of services by Parent to Domestic Sales Sub which the IRS considers to be “integral” to the Domestic Sales Sub basic business activity would generally require a transfer price based on cost plus an arm’s-length markup. (Treasury Regulation § 1.482-2(b)(3).) However, for those routine administrative services which the IRS defines as not integral, the regulations permit a transfer price based on cost with no markup to be treated, in effect, as if it were an “arm’s-length” price for tax purposes. Nonetheless, for a business valuation, the cost to Domestic Sales Sub, as a stand-alone business entity, for obtaining these services would need to be recognized. The Domestic Sales Sub cost to perform the services internally or to procure them commercially may be greater or lesser than what it paid to Parent.
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V / Intellectual Property Transfer Price Analysis Issues
Exhibit 20.9
Foreign Subsidiary before Adjusting Transfer Prices to Arm’s Length ($ Values, Unless Otherwise Indicated)
Unit Values
Product C Related Imports
Sales price to unrelated customers Cost of goods paid to supplier Gross profit per unit Net income per unit
225 150 75 26
Units purchased and sold
100
Income Statement Sales Cost of goods sold Gross profit Selling, general and administrative Royalty Other SG&A Operating income Interest income (expense) Earnings before tax (EBT) Income taxes Net income Gross margin (gross profit/sales) Operating income margin (operating income/sales) Net income margin (net income/sales)
Product C Related Imports 22,500 15,000 7,500
Product Manufactured by Foreign Sub
Total
25,000 20,000 5,000
47,500 35,000 12,500
-3,375 4,125 (166) 3,959 1,386 2,573
1,500 3,500 (184) 3,316 1,161 2,155
4,875 7,625 (350) 7,275 2,546 4,729
33.3% 18.3% 11.4%
20.0% 14.0% 8.6%
26.3% 16.1% 10.0%
Product Manufactured by Foreign Sub Unit Values Sales price to unrelated customers Manufacturing COGS per unit Gross profit per unit Net income per unit
250 200 50 22
Units produced and sold
100
The cost plus method offers a means to estimate an arm’s-length price for such services. The cost plus method uses the gross margins found in uncontrolled transactions to derive an arm’s-length price. Although internal comparables tend to be viewed as most reliable, it is assumed that there is no comparable provision of services by Parent to any unrelated party. Therefore, an external comparable would need to be derived from the gross margins found with an appropriate sample of companies that sell similar services
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Exhibit 20.10
Foreign Subsidiary after Adjusting Transfer Prices to Arm’s Length ($ Values, Unless Otherwise Indicated)
Unit Values
Product C Related Imports
Sales price to unrelated customers Cost of goods paid to supplier Gross profit per unit Net income per unit
225 169 56 14
Units purchased and sold
100
Income Statement
Product C Related Imports
Sales Cost of goods sold* Gross profit Selling, general and administrative Royalty (at 5% of sales) Other SG&A Operating income Interest income (expense) Earnings before tax (EBT) Income taxes Net income
22,500 16,875 5,625
Product Manufactured by Foreign Sub 25,000 20,000 5,000
Total 47,500 36,875 10,625
3,375 2,250 (166) 2,084 729 1,355
1,250 1,500 2,250 (184) 2,066 723 1,343
1,250 4,875 4,500 (350) 4,150 1,453 2,698
Gross margin (gross profit/sales) Operating income margin (operating income/sales) Net income margin (net income/sales)
25.0% 10.0% 6.0%
20.0% 9.0% 5.4%
22.4% 9.5% 5.7%
Comparables: Operating income/sales
10.0%
Product Manufactured by Foreign Sub Unit Values Sales price to unrelated customers Manufacturing COGS per unit Gross profit per unit Net income per unit
250 200 50 13
Units produced and sold
100
*COGS product C is based on unrounded arm’s-length price of $148.75
to unrelated customers. This illustration assumes that the external comparable companies earned a gross margin of 4.8 percent, as presented in Exhibit 20.4. The comparable gross margin is used to estimate the percentage markup over cost that Parent would be expected to receive on the provision of its administrative services. This assumes that the administrative services were being provided to an
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unrelated customer. The comparable gross margin of 4.8 percent is equivalent to a 5.0 percent markup on cost. Thus, rather than paying Parent $1425 for administrative services, the Domestic Sales Sub estimated arm’s-length price for such services would increase to $1496. This transfer price would cause its net income to decline, as presented in Exhibit 20.8.
Intercompany Loan Parent also provides Domestic Sales Sub with a working capital loan. However, Parent charges Domestic Sales Sub interest based on Parent’s relatively low 5 percent borrowing rate, as presented in Exhibit 20.5. In order to estimate a related party’s likely borrowing interest rate as a stand-alone entity, the analyst should determine whether the subject entity has a history of borrowing under terms in which there was no recourse to any related-party entities. Additionally, the subject entity’s financial management might provide a useful estimate of the likely interest rate that would be faced if it were a stand-alone company. Furthermore, the borrowing cost faced by a sample of comparably situated companies could be used to derive an estimate of the target entity’s likely borrowing cost. Assuming that comparably situated companies face a borrowing interest rate of 8 percent, this figure would be applied to the Domestic Sales Sub debt to determine its interest expense. As a result, the Domestic Sales Sub arm’s-length interest expense would increase, and its net income would decline, as presented in Exhibit 20.8.
Use of Parent Manufacturing Technology with the CUT Method and the CPM Assume that Parent makes valuable manufacturing technology available to Foreign Sub. Also assume that Foreign Sub does not make a royalty payment to Parent, as presented in Exhibits 20.6 and 20.9. Foreign Sub uses the technology in connection with the product that it manufactures and sells to unrelated customers. If Foreign Sub was unrelated to Parent, it would normally have to pay a royalty to Parent for use of the technology. Commonly, such royalties take the form of a percentage royalty rate applied to the licensee’s sales of the product incorporating the technology. Two methods for determining the arm’s-length royalty rate include the CUT method and the CPM. Use of the CUT method to estimate an arm’s-length royalty rate that Foreign Sub should pay to Parent is similar to use of the CUP method described above. If Parent licensed the same technology to an unrelated party, that royalty rate would represent an ideal situation in providing an internal comparable CUT royalty rate. Absent an internal comparable, the analyst would need to conduct a search for inexact comparable royalty rates based on technology licensed by other companies (i.e., external comparables). As discussed earlier in this chapter, adjustments to the identified comparable rates may be necessary to reflect differences in the characteristics, use, and circumstances between the technology utilized by Foreign Sub and the technology involved in the external comparable transactions. Alternatively, absent reasonable external comparable royalty rates, a CPM analysis could be performed to determine the operating income profit margin that Foreign Sub would be expected to earn on sales of its manufactured product. Based on that level of profitability, an implied royalty rate would be determined.
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Assuming that a CUT or CPM analysis determined that a comparable royalty rate of 5 percent was the best estimate of the arm’s-length royalty rate, the 5 percent rate would be applied to Foreign Sub’s revenues to determine the royalty payment that would be made to Parent. This royalty payment would increase the Foreign Sub SG&A expense and, thereby, decrease its profitability, as presented in Exhibit 20.10.
Overall Impact on Financial Statements These illustrative transactions are intended to demonstrate that the restatement of transfer prices to an arm’s-length basis can have a significant impact on the reported financial condition of a company. In the example of Domestic Sales Sub, the various adjustments caused the net income margin to drop from 8.3 to 2.4 percent. For Foreign Sub, the net income margin decreased from 10.0 to 5.7 percent. Therefore, an analyst should take great care in assessing a target company’s possible relatedparty relationships and transactions and, where necessary, adjusting them to an arm’s-length basis.
Conclusion In a valuation assignment, the analyst should investigate whether the target entity engages in related-party transactions that may not be based on arm’s-length pricing. Such transactions can involve tangible assets, intangible assets, and services. The analyst should gather the requisite information to determine the presence and nature of any related-party transactions as well as to test whether they are conducted on an arm’s-length basis. Depending on the type of transaction, the analyst can estimate arm’s-length prices based on a variety of methods, including the CUP, CUT, RPM, cost plus, CPM, and profit split methods. Once the arm’s-length prices have been estimated, the subject company’s financial statements can be adjusted to reveal its financial condition on a stand-alone basis.
Chapter 21 Intangible Asset Intercompany Transfer Pricing Analyses Thomas J. Millon Jr.
Introduction The Nature of Intercompany Transfer Pricing Income Tax Consequences Key Features of Section 482 Regulations Reporting “Taxable Income” The Arm’s-Length Standard The Best Method Rule The Arm’s-Length Range Determining Comparable Circumstances Summary of the Section 482 Regulations Two Major Types of Intercompany Transfers Intangible Asset Transfer Pricing Methods Comparable Uncontrolled Transaction Method The Comparable Profits Method Other Methods Transfer Pricing for Domestic Taxation Purposes Transfer Pricing–Related Valuation Misstatement Penalties Valuation Misstatement Transfer Pricing Penalty Safe Harbor Provisions The Role of Transfer Pricing Analysts Exposure Analysis and Defense Planning and Compliance
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Introduction The social science of economics can be defined as the study of human behavior in producing, distributing, and consuming goods and services. Economics students are taught that there are three major aggregates within a mixed-capitalism economic system: businesses, households, and government. As these three groups comprise the entirety of a modern-day market system, their decisions determine which goods are produced in what quantities, which services are provided, and how these goods and services are distributed to their end users. Within this abstract trio of aggregates, the function of the private business is to utilize the economy’s scarce resources and accumulate assets in order to fabricate and distribute goods and services. From an accounting and financial analysis perspective, a company’s balance sheet summarizes, as of a given point in time, the nature and “value” of its owned assets as well as its obligations. For the most part, a company’s assets are tangible, perceptible, and possess form and some degree of physicality. Some business managers, certainly those who read this book, are familiar with the concept of intangible assets, intellectual properties, and commercial goodwill. These types of assets represent the unseen properties of a business enterprise. To the accountant, however, corporate goodwill has a precise meaning, especially when made with reference to a company that has recently acquired another business entity. In that context, goodwill is an asset recorded on the balance sheet that measures the portion of the buyer’s purchase price for the acquired company (or the target company) in excess of the net value of the acquired company’s identifiable assets. Many managers in the business community are not alert to the existence and contributing value of intangible assets and intellectual properties. For those business managers who do appreciate the significance of these intangible properties to the value of a business enterprise, the concept of goodwill takes on a meaning different from that of the accountant. The intangible assets and intellectual properties that form a business’ asset portfolio may be proactively developed, maintained, and nurtured in order to enhance the overall value of the business unit. Multinational companies routinely manage their business asset portfolios by transferring or licensing intangible assets and intellectual properties to related entities. Once transferred into the related, specialized unit, intangible property is more easily developed, maintained, and managed in order to enhance the generation of the enterprise’s consolidated income. There are a number of operational, strategic, and legal motivations for implementing an intangible asset transfer program. A corporate trademark or trade name is one type of intangible asset that is particularly well-suited to an asset transfer program. In the retail industry, for example, because of the practical necessity for the transferor to protect, manage, and control the use of trademarks and trade names, the transferee is usually only allowed to use the asset. However, corporations in just about every line of business—wholesale, distribution, manufacturing, service, and so forth—clearly have an advantage if they protect, manage, and optimize the contribution of all of their intangible assets. In assessing which intangible assets to include in an asset transfer program, company management should consider a number of factors. These factors include, but are not necessarily limited to, the following: • •
Which corporate intangible assets (intangibles) have legal existence? Which intangibles have economic substance?
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• • • •
• •
565
Which intangibles can be legally transferred to a foreign subsidiary? Which intangibles have a practical business reason for being transferred to a foreign subsidiary? Which intangibles are actually used, or consumed, in normal business operations in another country? Which intangibles can be associated with a determinable royalty rate or other type of transfer price, in order to effectively quantify the value of the intangible asset transfer program? Which intangibles have a reasonably long-term and determinable remaining useful life? Which intangibles will not have to be sold, abandoned, or otherwise transferred back out of the foreign domicile in the foreseeable future?
One potential benefit not mentioned above is the possible reduction in the worldwide federal income taxes paid by the consolidated corporation. Where the opportunity for income tax reduction exists, however, national taxing authorities are likely to scrutinize such activities. This extra scrutiny represents one negative aspect of intangible asset transfer programs. Such intangible asset transfers and intercompany transactions have drawn careful examination from the Internal Revenue Service (IRS), especially when the intangible asset transfer program is suspected of having been set up to improperly shift income from the U.S. corporation to the foreign subsidiary. Over time, the Treasury Department has argued that the U.S. tax code was not effectively protecting the U.S. taxing jurisdiction from such arbitrary shifting of income. Accordingly, various methods have been promulgated by the Treasury Department to assess whether or not related or controlled parties receive fair value, or a fair and reasonable price including a reasonable profit, in consideration for the use of the intangible property. In the following section, we will discuss the nature of intercompany transfer pricing as it relates to intangible assets.
The Nature of Intercompany Transfer Pricing In an organized market economy, prices reflect the nominal terms at which property, or the right to use property, is bought and sold. Under this form of economic system, the market-determined price represents, to some extent, one outcome of an implicit negotiating session between the transaction’s two primary participants: the buyer and the seller. For those transactions involving buyers and sellers with no overlapping interests, economic theory posits that each party attempts to negotiate terms that are more favorable to its self-interests. For example, a rational buyer prefers paying lower prices, whereas sellers favor selling at higher prices. When buyer and seller reach an agreement that results in a completed transaction, economic theory contends that each party is “better off” (or, at least, no worse off) by virtue of having agreed to transact at the accepted price.1 Under specific circumstances, market prices at which arm’s-length transactions take place simultaneously reflect the underlying value of the property to each transactor. The arm’s-length price is a proxy for 1 For the untold number of unconsummated transactions, the parties presumably cannot agree to a price that is both sufficiently high enough to induce the seller to deliver the property while simultaneously being low enough to induce the buyer to accept the property.
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both the property’s utility to the buyer as well as the seller’s cost (including a fair return for entrepreneurial effort) to bring the property to market. The existence of competing self-interests between buyers and sellers defines the arm’s-length setting. The arm’s-length standard uses market outcomes involving unrelated or uncontrolled parties as benchmarks to compare to the behavior and outcomes of transactions that are not exposed to similar countervailing market forces. The arm’s-length standard also relates to the fair market value concept, as cited in the U.S. tax code. Consider the case of a consolidated U.S. business enterprise engaged exclusively in arm’s-length transactions. All its economic activity—the sale of goods and services, the procurement of materials and resources, and the acquisition and disposition of business assets—occur in settings characterized as arm’s-length situations. The consolidated enterprise’s economic activity is measured at prices that reflect current market conditions. The market prices reflect the collective influences of market participants. Therefore, the income earned by this enterprise, measured at market prices, is trustworthy from the taxing authority point of view. In contrast, two parties under common economic control may bilaterally transact without confronting these same market forces. Negotiating in a sort of vacuum, two commonly controlled entities can transfer property at any “price” of their own choosing. This “internal” transfer price may vary from the arm’s-length outcome, or the market price, that two unrelated parties would agree to under identical circumstances. In effect, two commonly controlled parties have the opportunity to concertedly maximize the interests of the combined group, as opposed to individually and competitively maximizing their separate individual interests. This distinction between the internal transfer prices within commonly controlled parties and what would otherwise be the market prices observed within an arm’s-length transactions is the focus of a transfer pricing study.
Income Tax Consequences In the United States, Internal Revenue Code Section 482 (Section 482) authorizes the Department of the Treasury to allocate income, expenses, and other items related to corporate reporting of taxable income among related taxpayers so that their respective incomes reflect an outcome that would likely occur when an uncontrolled taxpayer deals at arm’s length with a separate, uncontrolled taxpayer. For a business enterprise exclusively engaged in arm’s-length transactions, operating income is measured at market prices. Since these market prices directly impact the enterprise’s taxable income as reported to the government, the company’s income taxes are also based upon independent market conditions. However, for commonly controlled enterprises, the federal income tax liability may be subject to manipulation, depending on the nature of the internal transfer pricing mechanism established by the related parties. Let’s consider the example of a U.S. corporation, which we will refer to as Alpha Systems, Inc. (Alpha). Alpha manufactures running shoes from a single West Coast facility located in Portland, Oregon. Over the years, Alpha has developed a proprietary technology, which allows it to fabricate a running shoe that protects the wearer from every imaginable foot injury. As a result of this internally developed technology, Alpha is able to sell its standard pair of running shoes to third-party
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distributors for a unit price of $50. The direct production costs associated with each pair of shoes are $15. Alpha decides to expand its operations by setting up a separate, wholly owned manufacturing subsidiary (Omega) on the East Coast. Alpha’s marketing department decides that the wholesale price of shoes manufactured by Omega will be identical to the wholesale prices charged for the same brand of shoes made in Portland. Production costs in both manufacturing facilities are expected to be identical. For internal accounting purposes, Alpha enters into a formal license agreement with Omega, whereby Alpha charges Omega a $10 royalty for use of the proprietary technology needed by Omega to manufacture each pair of shoes. This royalty is recognized as royalty revenue by Alpha and as royalty expense by Omega. On a consolidated basis, the existence and magnitude of this internal royalty charge has absolutely no impact on Alpha’s consolidated income (which includes the income of Omega) as reported to the IRS for federal income tax reporting purposes. Every dollar of royalty expense incurred by Omega is matched by a dollar of royalty revenue earned by Alpha. Accordingly, the mere existence of this relatedparty transaction is of no concern to the IRS. In this case, the internal transfer price does not impact the consolidated arm’s-length income earned and reported by Alpha on a consolidated basis. From a domestic perspective, however, the internal royalty rate does “shift” income from the East Coast to the Portland facility.2 However, if a similar transaction were to take place between two commonly controlled parties located in different countries, the IRS would be much more likely to examine the terms of the “internal” license arrangement. To the extent that related parties are located in separate national tax jurisdictions with different income tax rates, the opportunity exists for the consolidated entity to actually influence its overall tax liability by adjusting its internal transfer pricing policy. Continuing with this illustration, let’s assume that Alpha could alternatively expand its operations by setting up a foreign manufacturing operation. Alpha could then license its proprietary technology to the new foreign subsidiary, Omega, in return for a stream of royalties based upon production levels. Alpha and Omega, as two separate but related parties isolated from the marketplace of arm’s-length buyers and sellers, are able to establish any royalty charges they choose. If Alpha and Omega agree to an intercompany royalty charge that is less than what two uncontrolled parties would agree to as part of an otherwise identical arm’slength setting, income is being shifted from the United States toward the foreign jurisdiction in which Omega does business. In this case, Alpha receives less royalty income from Omega than it would have received had Alpha licensed the same intangible asset to a third party. Therefore, Alpha is “giving up” royalty income. On the other side of the transaction, however, Omega benefits from the controlled party licensing arrangement because the foreign subsidiary recognizes less royalty expense than it would in an uncontrolled transaction. This artificially inflates Omega’s income. Accordingly, when the royalty rate used in this type of controlled party transaction is less than the royalty rate to which arm’s-length participants would agree, the relative income of the entity using the transferred intangible asset increases. The relative income increases by an amount equal to the amount by which the licensor foregoes royalty income by virtue of discounting the royalty rate below the
2 The
implications of interstate intellectual property transfers are discussed below.
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market rate. In this case, the consolidated company is basically shifting income from the United States toward the foreign jurisdiction. The net impact of the internal royalty rate program on Alpha’s consolidated pretax income is zero. However, if the program successfully shifts income out of a country with a relatively high marginal income tax rate into a jurisdiction with a lower marginal income tax rate, the consolidated corporate income tax liability is reduced. The pace of international commerce is accelerating and more corporations are setting up foreign operations. Accordingly, the revenues (expenses) of a subsidiary located in a particular national taxing jurisdiction will represent the mirror image of the expenses (revenues) of its related or controlled corporation involved on the other side of an international transaction. Where two corporations are unrelated, there is every reason to believe that the impact of the international transaction on each party’s income reflects the return required by each party as compensation for engaging in the transaction. Indeed, one would not reasonably argue that the international aspects of the uncontrolled transaction involve improper circumstances with regard to the reporting of each party’s taxable income to its respective taxing authority. In order to attract “outside” capital, some foreign governments legislate favorable tax environments for multinational companies. For U.S. companies with multinational business interests, some portion of their economic activity, as reflected in the generation of sales revenue or the incidence of expenses, may be attributable to activities performed outside the United States. In this type of situation, questions may arise about the proper apportionment of income to be reported to each of the two nations. In such a situation, a U.S. corporation with operations in a tax-favored nation (or, favorable tax havens) would be motivated to shift income into the country with the lower tax rate so as to minimize the combined entity’s global tax liability.
Key Features of Section 482 Regulations Section 482 provides that the income from a transfer or license of intangible property must be “commensurate with the income” attributable to the intangible. Internal Revenue Code Section 6662 (Section 6662) regulations include penalty provisions for valuation misstatements. The following section briefly outlines the key features of the Section 482 regulations.
Reporting “Taxable Income” The regulations discuss issues that may arise when a company transacts with one affiliate at terms that are not at “arm’s length.” They provide that, “if necessary to reflect an arm’s length result, a controlled taxpayer may report … the results of its controlled transactions based upon prices different from those actually charged.”3 Previous regulations had imposed various preconditions to the revised reporting of transactions by taxpayers. Taxpayers wishing to depart from the form of transactions between affiliates and report “true taxable income” on their return were
3 Regs.
§ 1.482-1(a)(3).
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required to enter into formal written agreements and to make compensating adjustments on their books and in their records. This compensating adjustment mechanism has been removed and replaced with an obligation of contemporaneous reporting. Taxpayers wishing to use Section 482 must affirmatively report the results on a timely filed tax return and may not do so on an amended return.
The Arm’s-Length Standard The construction of “true taxable income” remains the fundamental remedy of Section 482. True taxable income is a condition that exists when a controlled taxpayer reports financial results that are consistent with the results that an uncontrolled taxpayer would have attained under comparable circumstances. This formulation contains two core components: (1) consistency (with uncontrolled results) and (2) comparable circumstances. Consistency tests a controlled taxpayer’s financial results against the arm’s-length results of a comparable uncontrolled taxpayer. The arm’s-length results are established by using methods that are determined under the “best method rule.”
The Best Method Rule The “best method” provides the “most reliable measure” of an arm’s-length result, rather than the “most accurate measure.” The series of factors to be considered in searching for the most reliable result under the arm’s-length standard of transfer pricing are (1) the particular facts and circumstances of the transaction; (2) the completeness and accuracy of available data; and (3) the degree of comparability between controlled and uncontrolled transactions.
The Arm’s-Length Range Consistency with an arm’s-length result is determined by creating an “arm’s-length range” based on comparable information. The arm’s-length range is established by a group of comparables. In order for a comparable to be useful in the transfer price analysis: (1) all the information of both the controlled transaction and the uncontrolled comparable must be sufficiently complete and (2) any material differences that have an ascertainable effect on the prices or profits of the comparable must be able to be adequately reconciled by adjustments. If the data on the comparables are not sufficiently complete, all comparables with a similar level of comparability and reliability are then considered with their reliability enhanced using appropriate “statistical techniques.”
Determining Comparable Circumstances The portions of the regulations that are most useful are the descriptions of the factors to be used to determine comparability. Rather than providing a checklist of specific factors that are required to be considered in determining comparability the regulations clarify that all factors that could affect a financial result are to be taken into account.
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Comparability Factors. Generally, the factors to be considered in determining comparability include the following: 1. Functional Analysis—an analysis of the economically significant activities of the controlled and uncontrolled taxpayers including research and development, manufacturing, marketing, distribution, and managerial functions. In order for the two transactions (i.e., the controlled and the uncontrolled) to be comparable, the entities should perform similar economic functions with respect to those transactions. 2. Contractual Terms—to be considered comparable, an uncontrolled transaction should have similar significant contractual terms that could affect the prices that would be earned. 3. Risk Analysis—the risks borne by each party in the controlled and uncontrolled transactions should be analyzed, including market risks, research and development, financial risks, product liability risks, and general business risks. The economic substance of transactions will be reviewed by the IRS to determine risks borne. Taxpayers should not mismatch the allocation of risks and potential rewards for bearing those risks. 4. Economic Conditions—the economic conditions surrounding the transactions should be similar and must consider factors such as (a) alternatives realistically available to the buyer and seller (e.g., make vs. buy); (b) the similarity of the geographic markets; (c) the relative size of each market and the extent of economic development; and (d) the level of the market, market share for items transferred, location-specific costs, and competition in the market. The final regulations also address the three special circumstances that may affect comparability: (1) market share strategies, (2) differences in geographic markets, and (3) extraordinary or tax-motivated transactions. Multiple Year Data. The regulations provide that the results of a controlled transaction ordinarily will be compared with the results of uncontrolled comparables occurring in the taxable year under review. It is “appropriate” to consider earlier or subsequent data to examine circumstances—such as the assumption of risk and market share strategies—which are perceived as involving longer time periods. The regulations continue to make available the use of multiple year averages to establish a range of results. However, if the taxpayer’s results for a particular year fall outside of the multiple year range, a new provision states that the requisite adjustment should ordinarily be based on the range of the uncontrolled comparable results for the single year—and not the multiple year average. This adjustment is unfavorable to taxpayers and undermines the more economically relevant use of the multiple year averages.
Summary of the Section 482 Regulations The principles and mechanics of Section 482 regulations set the stage for elaborate routines of investigation, analysis, comparison, and documentation. The regulations require careful analysis of the facts and circumstances surrounding each intercompany transaction—including comparable transactions. And, the regulations impose a substantial factual burden of proof on the taxpayer, including detailed documentation of its intercompany transfer pricing policy and analysis in support of its prices as arm’s length.
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As a result, multinational taxpayers are required to devote significant resources to complying with these regulations. Taxpayers rely increasingly on their advisors to assist in choosing and documenting the method or methods that best determine the most appropriate intercompany price—given the economic and business circumstances of a controlled transaction. The following section presents a number of situations that necessitate an intercompany transfer pricing analysis. The following section also describes the role that the transfer pricing analysts play in that process.
Two Major Types of Intercompany Transfers There are two primary types of intercompany asset transfers between a first party and a second party that create the intercompany transfer price or royalty rate relationships subject to analysis. These types of intercompany transfers are (1) import or export of tangible assets (typically product inventory) where the cost or revenues received is affected by the transfer price and (2) outbound or inbound conveyance of intangible assets in return for royalty income or royalty expenses.4
Intangible Asset Transfer Pricing Methods Intercompany royalty rate analysis opportunities arise in connection with the transfer of intangible assets between related parties. These transfers may result from the outright sale, licensing, or contribution of intangible personal property. Under these circumstances, the currently acceptable transfer pricing methods are applied. Section 482 defines an intangible asset as any commercially transferable interest in any item that has substantial economic value independent of the services of any individual included in the following six classes: 1. 2. 3. 4. 5.
Patents, innovations, formulae, processes, designs, patterns, or know-how Copyrights and literary, musical, or artistic compositions Trademarks, trade names, or brand names Franchises, licenses, or contracts Methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data 6. Other similar items This list of intangible assets subject to the transfer pricing regulations is very broad. Of particular interest is the clause that introduces this list of intangibles, that is, “any commercially transferable interest.” Historically, transfer pricing analysts conceptualize intangible assets from an economic perspective—that is, any item that contributes to the profitability of an enterprise—and not from a legal perspective—that is, whether the item constituted property that was commercially transferable. This wording limits the number and type of intangible assets that are subject to transfer pricing analysis to those that are legally transferable.
4 Intercompany
transfers of services is another category that is not discussed herein.
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For transfer pricing purposes, it is important to identify any and all nonroutine, valuable intangible assets. These assets are typically developed in the United States and then transferred to low-tax-rate jurisdictions. The Treasury Department developed the “commensurate with income” standard to ensure that domestic corporations refrain from shielding the income generated by these assets from U.S. taxes. Section 482 specifies four methods for estimating an arm’s-length transfer price in connection with a transfer of intangible property. In general, the estimated transfer price must be commensurate with the income attributable to the subject intangible asset(s). The four methods presented in the final regulations are as follows: 1. 2. 3. 4.
The comparable uncontrolled transaction (CUT) method The comparable profits method (CPM) The profit split method Other methods
Comparable Uncontrolled Transaction Method The CUT method requires that the controlled party consideration be equal to the consideration that would be paid in a comparable uncontrolled transaction. Despite the fact that the regulations suggest that the results of the CUT method are considered the most accurate measure of price, there are several ever-present considerations, including access to relevant data and the existence of an active market, that impede its routine application. The standards of comparability within the CUT method relate to the nature of the intangible property and the circumstances under which the transaction takes place. Comparable Intangible Property. In order to be considered comparable intangible property, an intangible asset or intellectual property should be in the same one of the six classes of assets listed above. Additionally, the subject asset should be involved in the same type of products, processes, or know-how. The subject and comparable assets should also be employed in the same general industry and market. And they should also have substantially the same profit potential. The profit potential of an intangible asset is measured as the net present value of the economic benefits associated with the use or transfer of the property. The present value of these benefits should consider any required capital outlays, start-up expenses, incremental risk factors, and so on. Although these data may be relatively ascertainable in regard to the subject intangible asset, comparable data to measure the profit potential of the third-party transaction data is likely to be unavailable to the analyst. Comparable Circumstances. Besides involving a comparable property, the third-party uncontrolled transfer should also have occurred under “comparable circumstances.” This assessment suggests consideration of the following factors: 1. Terms of the transfer (restrictions on the use of the asset, exclusive vs. nonexclusive rights of use, etc.) 2. Stage of development (such as any necessary government approvals, licenses, etc.) 3. Rights to receive and use periodic updates or improvements 4. Uniqueness of the property and the expected time period during which it will remain unique 5. Duration of the intangible asset transfer contract or agreement, with consideration of any cancellation or renegotiation rights
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6. Economic and product process liability risks to be assumed by the transferor versus the transferee 7. Collateral transactions or other ongoing business relationships between the transferor and the transferee 8. Companion functions to be performed by each party to the asset transfer agreement Several of these factors may prove to be difficult in conducting a transfer pricing analysis. For example, the stage of development of the intangible asset is an issue that the IRS often emphasizes. This is because transfer prices are sometimes based upon comparable license agreements that were executed early in the technological life of the comparable asset—that is, prior to the time at which the property was usable to manufacture a commercially viable product. In related-party transactions, the transferred intangible property has typically been employed in the manufacture of a commercially viable product for some time in advance of the transfer to the controlled entity. Beyond these two difficult hurdles—finding comparable transactions involving (1) similar enough intangible assets transferred under (2) similar enough circumstances—the transfer pricing analyst also faces a more daunting reality: detailed descriptions of the royalty rates are seldom disclosed in uncontrolled party transactions. Therefore, even though the CUT method theoretically represents the most reliable indication of value and royalty rates, there are often significant limitations to its use by the analyst.
The Comparable Profits Method The comparable profits method actually applies to the transfers of both tangible assets (e.g., product inventory) and intangible assets. Under the best method rule, the comparable profits method results are preferred, or will provide the most reliable indication of an arm’s-length transfer price, unless the “tested party” uses valuable, nonroutine intangible assets that are acquired from uncontrolled taxpayers or developed internally. Accordingly, in applying the CPM, the tested party usually does not employ these “super” intangibles. Of course, the tested party is usually the party to the controlled transaction that does employ valuable, nonroutine intangible assets or intellectual properties. The overall purpose of the CPM is to measure the total return on the business activities of the tested party. Section 482 only requires that the controlled and uncontrolled transactions be broadly similar. Accordingly, substantial product diversity and substantial functional diversity between the subject companies and the comparable is acceptable. In applying the comparable profit method, the analyst should first determine which of the two controlled parties is the “tested party.” The tested party is more often the participant that does not use valuable, nonroutine intangible assets. Conceptually, it may be relatively easy to identify the tested party. However, the transfer pricing analyst should consider whether the CPM could be applied to other members of the controlled group. Documentation of this consideration should help ensure that the IRS does not select a different tested party. Second, the analyst should identify and compile financial data of companies engaged in the appropriate industry segment. These financial data include the operating profit and the related assets and liabilities for both the tested party and the guideline companies. In selecting the guideline companies, the analyst should avoid
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assembling too diverse a group of companies. The more similar the guideline companies are to the tested party, the better. This latter point was strongly emphasized in the Westreco decision.5 In Westreco, one of the expert witnesses used companies reporting the same Standard Industrial Classification (SIC) code as Westreco and applied these data to what amounted to a CPM analysis. The U.S. Tax Court essentially rejected that analysis because of (1) the diversity of companies within the group of comparable companies listed under that SIC code and (2) their basic lack of similarity to Westreco (the subject company). Third, as guideline company data are analyzed, adjustments are typically made to the profit level indicators. These adjustments are made in order to improve consistency and to provide greater similarity between the guideline companies as a group and the tested party. The regulations require such adjustments to reflect those differences in accounting classifications, functions performed, and risks assumed that are both material and have a definite and ascertainable impact on profitability. Fourth, after the successful selection of guideline companies and adjustments to their data, the analyst is prepared to analyze and compute various profit level indicators. These profit level indicators are intended to show the profits actually earned by the guideline companies engaged in business activity similar to that of the tested party. These profit level indicators are then applied to the relevant fundamental data of the tested party in order to compute constructive operating profits (COP). To control for any vagaries of the marketplace, data covering several periods may be considered. The number of years selected should be sufficient to measure the returns that accrue to uncontrolled taxpayers with risk characteristics similar to those of the tested party. As a practical matter, database constraints may limit these types of data to 3–5 years. If the preceding analyses have been conducted and all of the required adjustments have been applied, then the arm’s-length transfer price range includes all the constructive cost operating profits derived from the guideline company group. However, if no adjustments were made, then the appropriate range consists of the interquartile range. The interquartile range includes the observations between the 25th and 75th percentile values of the COP derived from the profit level indicators of the guideline companies. The Section 482 regulations list several profit level measures that the IRS will accept as providing a reliable basis for comparing operating profits of similar controlled and uncontrolled taxpayers. These profit level measures include the rate of return on capital employed (ROCE) and various other financial ratios. Operating profit is defined for IRS purposes to be gross profit less operating expenses. Operating expenses are defined to include all expenses included in cost of sales except for interest expense, foreign and domestic income taxes, interest and dividend income, income from business activities not being tested by this method, as well as extraordinary gains or losses. The rate of ROCE is defined as operating profit divided by operating assets. The regulations suggest that ROCE is appropriate when the tested party has substantial fixed assets or working capital that play a significant role in generating an economic return. Therefore, ROCE can be applied to a manufacturing concern. When financial ratios that do not directly relate operating profit to the level of investment and risk in a trade or business are used for comparing similar controlled
5 Westreco,
Inc. v. Commissioner, 64 T.C.M. 849 (1992).
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and uncontrolled taxpayers, more stringent comparability is required than when a ROCE is used. Other acceptable financial ratios include operating profit as a percentage of sales, as well as the Berry Ratio (i.e., gross profit/operating expenses). Let’s consider the hypothetical case of a U.S. drug company that transfers its manufacturing technology to its wholly owned French subsidiary. The French subsidiary sells its manufactured product at arm’s-length prices back to the same U.S. parent for sale in the United States. The French subsidiary is selected as the tested party. Its financial data are presented below: Assets $35 Sales of product (to U.S. parent) $40 Cost of goods sold $28 Operating expenses $5 The COP interval is computed as between $4 and $6. These data support the conclusion that the arm’s-length royalty rate should be approximately 5 percent of sales revenue. Such a rate would increase the French subsidiary’s expenses by $2. This increase in expenses reduces the operating profit to $5, which is the midpoint of the COP interval.
Other Methods Since the CPM cannot be applied when both parties have valuable, nonroutine intangible assets, it is likely that taxpayers in such situations may have to resort to an “other method” when no appropriate guideline companies can be found. The profit split method is an example of an “other method” that can be applied in such a situation. To be permitted to employ an “other method,” a taxpayer must disclose the use of such a method by attaching a disclosure statement to its income tax return. It is worth noting that the taxpayer must also prepare contemporaneous supporting documentation regarding (1) the specific analysis adopted, (2) the rationale for using the method (that is, why it satisfies the best method rule), and (3) all supporting data. Profit Split Methods. There are at least three profit split methods that may be used to estimate the appropriate transfer price or royalty rate for intangible assets and intellectual properties: (1) the residual allocation rule, (2) the capital employed allocation rule, and (3) the comparable profit split rule. The profit split method may be applied if the following conditions are met: • • • •
Each controlled taxpayer owns a valuable, nonroutine intangible asset that it either acquired from uncontrolled taxpayers or developed itself. Such intangible asset contributes significantly to earning the combined profit. There are significant transactions between the controlled taxpayers, and the activities of each party contribute significantly to the combined profit or loss. The controlled taxpayer elects to apply the profit split method and complies with the procedural requirements contained in the regulations.
Profit split methods rely either wholly or in part on internal data rather than on data derived from unrelated-party transactions. From the perspective of the IRS, methods that rely upon comparable transactions generally provide the more reliable and accurate measure of the arm’s-length royalty rate. This is one reason that the regulations allow taxpayers to apply a profit split methodology if, and only if, each controlled party owns valuable, nonroutine intangible assets.
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Residual Allocation Rule. The application of the residual allocation rule version of the profit split method is a two-step process. First, the taxpayer should assign market returns to the various related parties’ routine functions. For example, if one of the related parties is a distributor, a market return for this function is estimated by reference to the returns earned by uncontrolled taxpayers engaged in similar distribution activities. A functional analysis may be required to identify the contribution made by each of the related taxpayers through their routine activities. Since the profit split method can only be used in cases where each taxpayer owns valuable, nonroutine intangible assets, in the second step, there will be residual profits left to be allocated after assigning each related party a return to its routine economic activities. The residual profit should typically be divided among the related parties based upon the relative value of the contributions of the valuable, nonroutine intangible assets to their relevant business activities. The method used to value each of the parties’ contributions should be adapted to the particular circumstances of the intercompany transactions. For example, in cases where technology development expenditures are relatively constant over time, the relative value of actual expenditures in recent years may be a reasonable estimate of the relative value of the technology-related intangible asset contributions. Alternatively, in cases where these expenditures vary over time or where the facts and circumstances indicate that comparison of such expenditures does not satisfactorily approximate the relative values of the controlled taxpayer’s contributions, other methods of approximating the relative values may be appropriate. Capital Employed Allocation Rule. Under this profit split method, the combined profit or loss from the relevant business activities of the two (or more) controlled parties is allocated to each party according to the ratio of the taxpayers’ average capital employed in the business activity. This rule applies only if each taxpayer involved in the controlled transaction assumes approximately equal levels of risk with respect to its investment in the business activity. Section 482 requires that risk be measured on the basis of the probability of success or failure—rather than on the basis of absolute measures of the maximum potential gain or loss. It suggests that approximately equal levels of risk exist when the activities of all parties involved in the transaction are so interdependent that the degree of risk or failure of any one participant is inexorably linked to the success or failure of all the other participants. As a practical matter, this argument can usually be made with reference to all intercompany relationships. The capital employed allocation rule requires that the operating assets of each controlled party be adjusted for the value of the intangible assets employed as part of the controlled transaction. The capital attributable to the subject intangible assets is measured by one or more valuation methods from either the cost, market, or income valuation approaches. The selected valuation method is important because the regulations require that the method used to estimate capital attributable to intangible assets and intellectual properties be used consistently from year to year. Furthermore, if fair market value is the standard of value selected to value either the tangible or intangible assets of the controlled parties, then all assets should be valued based on this standard. Comparable Profit Split Rule. This allocation rule under the profit split method divides the combined profits earned by unrelated taxpayers in transactions based upon (1) functions performed and risks assumed by each party, (2) products brought to market, and (3) intangible assets developed and owned. As with most
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comparable transaction methods, the profit split observed within the comparable transaction is applied to the combined profit earned in the related-party transaction in order to estimate the arm’s-length pricing policy. In order to properly apply this particular method, a thorough functional analysis is required (as is the case with all methods involving comparisons) to determine the degree of comparability between the related and unrelated parties. Beyond this qualitative analysis, business segment financial data should also be available. Accordingly, the method is rarely applicable due to both the difficulty of identifying acceptable comparable transactions and the lack of detailed financial data. The comparable profit split method may not be applicable if the combined return on capital earned by the uncontrolled taxpayer varies significantly from that of the subject taxpayer.
Transfer Pricing for Domestic Taxation Purposes In recent years, many multistate corporations have formed subsidiaries in the State of Delaware (or other states that exempt intangible property royalty income from state income taxation). These multistate corporations transfer legal title to various intellectual properties to the Delaware subsidiary. The structure for these types of interstate intellectual property transfer programs is identical to those set up across national boundaries, which were described above. This corporate intellectual property management strategy involves a holding company subsidiary, often chartered in Delaware, which has no state income tax on royalty income. The legal title to the intellectual property is transferred to the Delaware holding company (DHC). The DHC subsequently licenses the use of the intellectual property to related entities operating their businesses in other states. The related entities make royalty payments to the DHC, which represent deductible expenses for these operating companies for state income tax purposes. However, no state tax liability is realized by the DHC from the royalty income from the intellectual property. One result of this transaction is to reduce the combined state income tax obligation of the combined entities. In order to validate this interstate transfer pricing strategy, a DHC must have form and substance as well as a legitimate business purpose. One very obvious result of forming an active DHC is that it allows the business to more effectively manage its valuable intellectual property. The following valuation approaches are used to value intellectual property at the point of transfer to the DHC: cost approach, income approach, and market approach. The Section 482 transfer pricing methods are typically used to estimate a fair arm’s-length royalty rate for the intercompany license of the transferred intellectual property.
Transfer Pricing–Related Valuation Misstatement Penalties Over the years, the statutory pronouncements have codified certain valuation-related penalties—and safe harbor exceptions to these penalties—with regard to international intercompany transfer pricing. These pronouncements encompass not only quantifying an incorrect transfer price for goods and services, they also encompass
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(1) selecting the wrong transfer pricing method and (2) failing to document the method actually used and the related transfer price calculations. The following section focuses upon the current transfer pricing method and the documentation requirements to avoid intercompany transfer pricing–related valuation penalties. The transfer pricing rules under Section 482 allow the IRS to adjust, if necessary, transfer prices in order to prevent the evasion of taxes or to clearly reflect income of any of the related parties. If the adjustment is large enough, per Section 6662, the taxpayer may have either a “substantial valuation misstatement” or a “gross valuation misstatement.” A substantial valuation misstatement will subject the taxpayer to an accuracyrelated penalty of 20 percent of the underpayment of tax due to the misstatement. A gross valuation misstatement will subject the taxpayer to an accuracy-related penalty of 40 percent of the underpayment of tax due to the misstatement.
Valuation Misstatement The definition of a “substantial valuation misstatement” includes an intercompany transfer price adjustment that exceeds 10 percent of the taxpayer’s gross receipts. In addition, the amount of the transfer price adjustment that may cause a substantial valuation misstatement was lowered from $10 million to $5 million. The transfer price adjustment may also cause a “gross valuation misstatement.” A gross valuation misstatement includes transfer price adjustments exceeding 20 percent of the taxpayer’s gross receipts.
Transfer Pricing Penalty Safe Harbor Provisions A decade ago, taxpayers could reduce the accuracy-related penalties to the extent they could show (1) “reasonable cause” for the transfer price and (2) that they acted in good faith with respect to the setting of the transfer price. This subjective test for avoiding misstatement penalties has been replaced with two objective safe harbor tests. The first safe harbor provision excludes transfer price adjustments attributable to prices determined in accordance with one of the specified Section 482 methods. Exclusion is permitted if (1) the use of such an accepted and specified transfer price method is reasonable, (2) the taxpayer has contemporaneous documentation supporting the use of the specified method, and (3) the taxpayer provides such documentation to the Secretary of the Treasury within 30 days of a request for such documentation. The second safe harbor provision applies to those taxpayers that do not use one of the specified pricing methods listed in the Section 482 regulations. The transfer price adjustment is excluded if the taxpayer establishes that (1) none of those methods would likely result in a price “clearly reflecting income” and (2) the method selected would do so. The taxpayer also must have contemporaneous documentation supporting the pricing method used and be able to provide that documentation to the Treasury within 30 days of notice. For years, multinational companies have been conscious of the income taxation consequences of transferring tangible assets, intangible assets, or services between controlled related parties. Also, many multistate corporations have formed active corporate subsidiaries in the State of Delaware to hold, manage, and license their valuable intellectual properties.
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In both cases, some taxing authority will scrutinize the pricing terms embedded within the related-party transactions, since these terms ultimately impact the income taxes due to the authority. This discussion has presented a number of issues pertaining to (for the most part, international) intercompany transfer pricing. The reader should appreciate that this is a complex issue and taxpayers should seek appropriate professional advice with regard to the legal, valuation, and taxation issues at stake.
The Role of Transfer Pricing Analysts Taxpayers can draw on the expertise of analysts (1) to assess their exposure to potential IRS transfer pricing adjustments before the fact and (2) to develop a defense of existing pricing practices once the IRS has begun a transfer pricing examination. Analysts can also develop planning strategies that minimize tax burdens and audit-associated risks. Among their virtues, both defense and planning have the salutary effect of reducing the likelihood of double taxation. Equally important, a well-conceived and economically defensible transfer pricing policy significantly reduces the likelihood of valuation misstatement penalties.
Exposure Analysis and Defense Exposure analysis is similar to the compliance analysis that IRS economists conduct in evaluating taxpayers’ intercompany pricing practices. In fact, exposure analysis essentially duplicates this analysis before the fact, to determine whether a given transfer pricing policy is likely to be challenged. Analysts’ efforts to defend a multinational company’s status quo transfer pricing policies have been (and, under the current regulations, continue to be) directed toward identifying a sample of comparable uncontrolled transactions or companies and demonstrating that the tested party’s results are reasonable. The analyst can also challenge any controversial or questionable assumptions and methodologies used by the IRS economist in developing pricing adjustments, thereby casting doubt on proposed reallocations of income on conceptual grounds. Analysts have employed a variation of the arm’s-length range as part of their exposure and defense analysis long before the range was incorporated into the regulations. The IRS’s basis for a pricing adjustment is clearly undermined in the defense scenario if the analyst can construct a range of profits earned by reasonably comparable uncontrolled companies, and demonstrate that (1) the controlled company’s reported profits fall within this range (for either exposure analysis or defense purposes) or (2) the controlled company’s profits after the IRS adjustments fall outside this range (for defense only).
Planning and Compliance Planning analysis, another service of transfer pricing analysts, seeks to balance multinational companies’ objectives of minimizing global tax burdens, while conforming to the arm’s-length standard. The planning mode allows more flexibility and creativity than the defensive mode. Whereas the analyst should take into account the
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actual facts and circumstances characterizing a case as given for the purposes of defending a transfer pricing policy after the fact, the analyst may recommend restructuring intercompany dealings. The intercompany relationships may be restructured so as to create the facts and circumstances necessary to justify a desired pricing structure for planning purposes. An entity can restructure for tax purposes in a variety of ways to justify corresponding changes in pricing policies. However, the restructuring must be substantive—not simply a matter of form. For example, the ways in which related parties share risks is an important determinant of how combined income should be allocated among members of the controlled group. At the same time, it is fairly easy to shift risks (in a real sense) within the controlled group. Similarly, the ownership of intangible assets plays a very significant role in determining how global profits should be apportioned within a controlled group. This feature, too, can be modified in a variety of real ways to justify desired modifications in arm’s-length pricing policies. Allocation of Economic Risk. The Section 482 regulations enumerate different types of risk in some detail and expressly impose a number of requirements on the allocation of risk. Enumerated risks include (1) market risks from fluctuations in cost, demand, pricing, and inventory levels; (2) research and development risks associated with the success or failure of research activities; (3) financial risks associated with fluctuations in foreign currency exchange rates and interest rates; (4) credit and collection risks; (5) product liability risks; and (6) general business risks related to ownership of property, plant, and equipment. Some of these risks relate more to manufacturing operations. Other risks are more related to the distribution function. An entity is deemed to bear a given risk only if (1) it has a reasonable opportunity to realize an economic benefit that is commensurate with the risk(s) assumed that would induce a similarly situated uncontrolled taxpayer to bear the risk that the controlled taxpayer assumed; (2) it has the financial capacity to fund the losses that may result from assuming the indicated risk; and (3) it is engaged in the active conduct of a trade or business to which the risk relates and carries out substantial managerial and operational control thereover. Ownership of Intangible Assets. Ownership of intangible assets (both manufacturing and marketing intangibles) and, hence, the arm’s-length allocation of combined income, can likewise be varied within a controlled group. In this regard, multinational companies have several options. One entity can (1) develop the intangible asset (i.e., incur all of the associated development expenses and risks), (2) retain sole ownership rights thereto, and (3) sell products embodying the intangible assets to controlled entities. In this event, all income associated with the intangible asset should accrue to the developer. Although the product embodies intangible assets, the developer has not transferred any rights to the intangibles simply by selling the product itself. Alternatively, a sole developer may permit another group member to use its intangible assets in specified ways via licenses, while retaining sole ownership. For example, suppose the intangible at issue is a cost-reducing technology used in the production of a product with an established market. The developer is a U.S. entity (the parent), and the licensee is a foreign subsidiary that both manufactures the product and sells it directly to third parties. In this event, the licensee should pay an arm’s-length royalty in return for its rights to use the parent’s technology. And intangible income will be divided between licenser and related licensee via this payment, in accordance with arm’s-length practices.
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Finally, two or more members of a controlled group may enter into a qualified cost-sharing agreement, whereby the costs and risks are shared on some economic basis. The intangible assets ultimately developed are jointly owned. And the earned intangible income is allocated among cost-sharing participants. According to the cost-sharing provisions in the regulations, costs are shared in proportion to reasonably anticipated benefits, as variously measured by anticipated (1) units of production, (2) sales, (3) gross or net profit, or (4) some other defensible measure.
Chapter 22 Transfer Pricing Case Study Thomas J. Millon Jr.
Introduction Membership Leadership Division Publications Events Endorsed Vendors IGTMA Services Endorsed Vendor Royalty Income Purpose and Objective of the Analysis Premise of the Analysis Financial Statement Analysis Consolidated Balance Sheets Consolidated Income Statements Adjusted Financial Fundamentals Analytical Procedures Description of the Intellectual Property Subject to Analysis Definition of Trademarks Attributes to Consider in the Economic Assessment of Trademarks Trademark Analysis Company-Specific Analyses Industry-Specific and Guideline Company–Specific Royalty Rate Analysis Market-Derived Royalty Rate Analysis Economic Analysis Synthesis and Conclusion
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Introduction This chapter presents a case study that estimates an arm’s-length royalty rate and an arm’s-length allocation for certain trademarks for intercompany transfer pricing purposes. Founded in 1984, Independent Golf Tee Manufacturers Association (IGTMA or the Association) is the largest golf tee manufacturers trade association in the United States. IGTMA represents over 85 percent of golf tee manufacturers in the United States. IGTMA provides its members with a variety of services, publications, legal advice, vendor discounts, and regulatory compliance information. In general, the purpose of the Association is to present the views of golf tee manufacturers to the golf industry at large and to the public. In addition, the Association promotes and protects the interests of the golf tee manufacturing industry. IGTMA is a not-for-profit business, exempt from federal income taxes under Internal Revenue Code Section 501(c)(6). The Association includes approximately 150 golf tee manufacturers throughout the United States. Additionally, in 1994, IGTMA established an alliance with 90 golf tee manufacturers located outside the United States, which increased the Association’s total representation to 240 institutions.
Membership IGTMA membership is open to all golf tee manufacturers. The Association’s members have access to IGTMA attorneys, receive weekly and monthly IGTMA publications, and benefit from member pricing discounts on all endorsed products, services, events, and courses. Membership dues vary depending on the members’ size; membership dues range from $500 to $5,000 per year. IGTMA also offers associate memberships to non-golf-tee-manufacturing companies that provide products and services to golf tee manufacturers. IGTMA associate members receive, among other benefits, an annual copy of the Association’s membership list, advertising space in and subscriptions to certain IGTMA publications, and reduced member prices for selected training programs and IGTMA events. Associate membership dues are approximately $80 per year. For those product and service providers that do not require all of the services that are provided to associate members, IGTMA offers affiliate memberships. Affiliate members are entitled to reduced member prices for certain training programs and IGTMA events, as well as discounts on advertising space and subscriptions to certain IGTMA publications. Affiliate membership dues are approximately $50 per year.
Leadership Division Founded in 1988, the IGTMA Leadership Division is designed to enlist the support of young golf tee manufacturing executives in an effort to preserve the golf tee manufacturing philosophy. Membership is offered to employees and directors of IGTMA members. Leadership Division members participate in educational programs, serve on the IGTMA Manufacturing Task Force Committee, receive IGTMA publications, attend leadership training, and receive discounts for IGTMA events.
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Publications IGTMA publishes a variety of weekly and monthly periodicals, such as the following: • • •
•
The Alliance of Golf Tee Manufacturers is a monthly magazine of association news and issues affecting golf tee manufacturers. Regulatory Comments is a weekly “hot topics” summary of laws, regulations, and recent events of interest to golf tee manufacturers. IGTMA Assurance Report is sent via e-mail, either weekly or on an as-needed basis, and is designed to brief members on critical and timely events in the industry. The Golf Tee Series is a detailed, periodic research paper focusing on important golf tee manufacturing issues.
Events The Association hosts three large events each year: (1) the IGTMA EXPO, (2) the IGTMA Leadership Conference, and (3) the IGTMA Annual Convention. The IGTMA EXPO is one of the largest trade shows for the golf tee industry. The IGTMA Leadership Conference offers educational programs, presentations, and family activities. The Leadership Conference is attended by over 100 golf tee manufacturing executives from around the world, as well as by IGTMA Leadership Division members, IGTMA members, and associate members. The IGTMA Annual Convention is also educational in nature and provides an opportunity for social networking, board meetings, and keynote presentations. The Annual Convention is attended by golf industry representatives from over 300 different locations throughout the world. In addition to the three events discussed above, every year IGTMA organizes numerous training programs, seminars, and regional meetings.
Endorsed Vendors In addition to hosting events and authoring publications, the Association identifies and promotes products and services for the benefit of IGTMA members. Based on a thorough due diligence process, IGTMA endorses vendors of top-of-the-line golf industry products and services (endorsed vendors). By providing a comprehensive selection of prescreened, high quality vendors, the Association offers members significant time and cost savings associated with product and supplier research. In addition, members benefit from endorsed vendor pricing discounts and rebates, which are negotiated by IGTMA. The IGTMA endorsed vendor due diligence process involves an ongoing review of the subject vendor’s management capabilities, financial position, competitors, customer satisfaction, facilities, representation, employees, and marketing plan. IGTMA also performs a detailed review of the subject product’s quality and price. IGTMA also provides an analysis of the potential market for the particular product. The purpose of the due diligence process is to guarantee members’ satisfaction and to maintain the integrity of the IGTMA endorsement. That is, this rigorous screening process ensures that the IGTMA trademarks and trade names (the IGTMA trademarks) are associated with high quality products and services. Endorsed vendors have the right to use the IGTMA trademarks in product-specific marketing literature.
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IGTMA Services The Association’s wholly owned subsidiary, IGTMA Services, Inc. (IGTMA Services or the company), supports endorsed vendor products and services through certain marketing and promotional activities. These activities include, but are not limited to, the following: • • • • • • •
Announcing new product endorsements and coordinating regional meetings to launch new endorsements Identifying opportunities and providing the networking necessary to increase product awareness with members Assisting in the design of product-specific marketing strategies, such as identifying and creating market opportunities Resolving disputes between endorsed vendors and members and providing other essential quality control services Including a description of the product or service in a catalog—the Golf Tee Portfolio—which is distributed to all IGTMA members Providing up-to-date IGTMA membership lists to all endorsed vendors Hosting and sponsoring conferences, conventions, tradeshows, seminars, and regional meetings as well as supporting endorsed vendor participation
Due to its marketing-related activities, IGTMA Services does not qualify as a not-for-profit business under the Internal Revenue Code.
Endorsed Vendor Royalty Income For the services provided by IGTMA and IGTMA Services, endorsed vendors pay IGTMA a royalty based on total endorsed vendor sales to IGTMA members. Historically, total endorsed vendor royalty income has been allocated equally between IGTMA and IGTMA Services. Endorsed vendor royalty income compensates (1) IGTMA for endorsed vendor use of the IGTMA trademarks and (2) IGTMA Services for its marketing-related services. IGTMA avoids endorsing vendors that sell competing products or provide similar services. That is, IGTMA focuses on endorsing the “best” vendor of a particular type of product or service. In situations where a particular vendor’s product quality diminishes or a better vendor is identified, IGTMA may decide to terminate its endorsement. Currently, the three largest IGTMA endorsed vendors include Ludwig Lumber Mills, Perfect Paint Incorporated, and Perry’s Plastic Bag, Inc.
Purpose and Objective of the Analysis Our analysis was conducted for both management information and federal income tax compliance purposes. The objective of our analysis was to provide IGTMA with an independent opinion as to the arm’s-length allocation of IGTMA royalty income (referred to as “total endorsed vendor royalty income”) between IGTMA and IGTMA Services. The effective date of this analysis is December 31, 2002.
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For the purposes of this analysis, an “arm’s-length result” is defined as the result that would have been realized if independent parties had engaged in the same transaction under comparable circumstances.
Premise of the Analysis We analyzed the IGTMA trademarks based on a premise of continued use, assuming that the subject trademarks are used as part of a going-concern business enterprise. This premise assumes that the IGTMA trademarks will continue to be used as part of an income-producing business, that the trademark owner/operator will act rationally, and that the subject trademarks will benefit from the association with any other assets (tangible or intangible) of a going-concern business enterprise.
Financial Statement Analysis IGTMA consolidated financial statements for the fiscal years ended December 31, 1998 through 2002 (the observed period), are presented in Exhibits 22.1 through 22.3.
Consolidated Balance Sheets Exhibits 22.1A and 22.1B present the Association’s consolidated balance sheets for the observed period. Total assets have remained relatively consistent over the observed period, ranging from a high of $3.5 million in fiscal 1999 to a low of $3.2 million in fiscal 2002. As of December 31, 2002, net property and equipment represented 61.5 percent of total assets, with a balance of $1.9 million. Stockholders’ equity has remained relatively stable over the observed period, ranging from a high of $1.5 million in fiscal 2000 to a low of $1.1 million in fiscal 2002. Stockholders’ equity represented 35.8 percent of total liabilities and stockholders’ equity as of December 31, 2002.
Consolidated Income Statements The consolidated IGTMA income statements, as presented in Exhibit 22.2, include the accounts of both the Association and its subsidiaries (including IGTMA Services). Consolidated IGTMA revenue increased from $5.6 million for the fiscal year ended December 31, 1998, to $6.9 million for the fiscal year ended December 31, 2002. During this period, IGTMA generated its revenue from a variety of sources, such as membership dues, royalty and promotional fees, convention and seminar fees, and magazine and publication income. Royalty and promotional fees represent total
588 190,740 3,166,191
3,358,065
202,788
1,463,441 1,488,018 102,410 262,500 (1,373,607) 1,942,763
385,667 694,197 132,650 1,212,514
2001
SOURCE: IGTMA consolidated, audited financial statements.
TOTAL ASSETS
Other assets
1,512,824 1,506,740 107,077 262,500 (1,442,287) 1,946,854
243,310 703,864 81,424 1,028,598
2002
3,483,037
167,788
1,410,364 1,309,046 102,410 262,500 (1,145,391) 1,938,928
279,559 915,777 180,985 1,376,321
2000
3,543,106
89,222
1,395,657 1,288,254 96,215 262,500 (1,017,259) 2,025,366
840,063 486,689 101,766 1,428,518
1999
Fiscal Years Ended December 31
3,495,202
65,322
1,395,111 1,256,733 99,157 262,500 (868,712) 2,144,788
659,439 513,179 112,474 1,285,092
1998
100.0%
6.0%
47.8% 47.6% 3.4% 8.3% −45.6% 61.5%
7.7% 22.2% 2.6% 32.5%
2002
100.0%
6.0%
43.6% 44.3% 3.0% 7.8% −40.9% 57.9%
11.5% 20.7% 4.0% 36.1%
2001
100.0%
4.8%
40.5% 37.6% 2.9% 7.5% −32.9% 55.7%
8.0% 26.3% 5.2% 39.5%
2000
Common Size
Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Consolidated Historical Balance Sheets—Assets (in $)
Building Furniture and equipment Automobiles Land Less: Accumulated depreciation Total property and equipment, net
Property and equipment
Current assets Cash and cash equivalents Accounts receivable Other current assets Total current assets
ASSETS
Exhibit 22.1A
100.0%
2.5%
39.4% 36.4% 2.7% 7.4% −28.7% 57.2%
23.7% 13.7% 2.9% 40.3%
1999
100.0%
1.9%
39.9% 36.0% 2.8% 7.5% −24.9% 61.4%
18.9% 14.7% 3.2% 36.8%
1998
589
3,166,191
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY 3,358,065
455,375 98,455 846,403 364,662 108,617 1,873,512 186,489 2,060,000 1,298,064
2001
SOURCE: IGTMA consolidated, audited financial statements.
497,529 109,810 856,296 286,262 121,763 1,871,658 160,584 2,032,242 1,133,949
2002
3,483,037
317,011 88,982 861,767 325,334 121,511 1,714,605 295,290 2,009,894 1,473,143
2000
3,543,106
244,585 76,713 800,378 447,799 131,250 1,700,725 404,327 2,105,052 1,438,054
1999
Fiscal Years Ended December 31
3,495,202
235,288 52,070 691,103 411,110 818,346 2,207,916 119,950 2,327,866 1,167,336
1998
100.0%
15.7% 3.5% 27.0% 9.0% 3.8% 59.1% 5.1% 64.2% 35.8%
2002
100.0%
13.6% 2.9% 25.2% 10.9% 3.2% 55.8% 5.6% 61.3% 38.7%
2001
100.0%
9.1% 2.6% 24.7% 9.3% 3.5% 49.2% 8.5% 57.7% 42.3%
2000
Common Size
Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Consolidated Historical Balance Sheets—Liabilities & Stockholders’ Equity (in $)
Current liabilities Accounts payable and accrued expenses Employee benefit plan payable Deferred membership dues Other deferred revenue Current portion of notes payable Total current liabilities Notes payable, net of current portion Total liabilities Stockholders’ equity
LIABILITIES
Exhibit 22.1B
100.0%
6.9% 2.2% 22.6% 12.6% 3.7% 48.0% 11.4% 59.4% 40.6%
1999
100.0%
6.7% 1.5% 19.8% 11.8% 23.4% 63.2% 3.4% 66.6% 33.4%
1998
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V / Intellectual Property Transfer Price Analysis Issues
Exhibit 22.2
Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Consolidated Historical Income Statements (in $) 2002
Fiscal Years Ended December 31 2001 2000 1999
1998
2002
Common Size 2001 2000 1999
1998
Operating revenue Membership dues Royalty fees* Promotional fees† Convention fees Seminar fees Other income Magazine income Publications income Total revenue
1,757,397 1,172,086 1,169,086 1,115,739 852,271 466,281 212,951 157,365 6,903,175
1,760,680 1,255,469 1,245,722 1,092,105 794,309 398,990 206,243 106,967 6,860,485
1,658,640 1,062,768 1,073,216 910,081 1,184,895 358,010 215,415 59,196 6,522,219
1,556,161 1,025,495 1,018,789 912,198 736,953 151,849 181,669 102,338 5,685,453
1,401,020 819,471 809,338 1,060,451 711,356 501,254 165,158 144,611 5,612,660
25.5% 17.0% 16.9% 16.2% 12.3% 6.8% 3.1% 2.3% 100.0%
Operating expenses Membership services Seminars and conventions General and administrative Magazine and publications Other operating expenses Total operating expenses
4,664,259 808,644 655,193 306,759 49,553 6,484,408
4,641,931 787,999 751,630 283,241 47,136 6,511,937
4,391,086 757,152 616,109 254,634 45,343 6,064,322
3,570,205 641,095 752,596 264,521 54,770 5,283,187
3,175,545 759,091 1,076,338 247,791 104,529 5,363,293
67.6% 11.7% 9.5% 4.4% 0.7% 93.9%
Operating income
418,767
348,548
457,896
402,266
249,366
6.1%
Other income (expense) Interest income Interest expense Total other income (expense)
12,165 (26,823) (14,657)
19,283 (28,035) (8,752)
13,978 (39,596) (25,618)
42,003 (50,880) (8,877)
32,972 (89,138) (56,166)
Pretax income
404,110
339,796
432,278
393,389
193,200
5.9%
5.0%
6.6%
6.9%
3.4%
60,616
50,969
64,842
59,008
28,980
0.9%
0.7%
1.0%
1.0%
0.5%
343,493
288,826
367,436
334,381
164,220
5.0%
4.2%
5.6%
5.9%
2.9%
Income tax expense (benefit) Net income
25.7% 18.3% 18.2% 15.9% 11.6% 5.8% 3.0% 1.6% 100.0%
25.4% 16.3% 16.5% 14.0% 18.2% 5.5% 3.3% 0.9% 100.0%
27.4% 18.0% 17.9% 16.0% 13.0% 2.7% 3.2% 1.8% 100.0%
25.0% 14.6% 14.4% 18.9% 12.7% 8.9% 2.9% 2.6% 100.0%
67.7% 67.3% 62.8% 56.6% 11.5% 11.6% 11.3% 13.5% 11.0% 9.4% 13.2% 19.2% 4.1% 3.9% 4.7% 4.4% 0.7% 0.7% 1.0% 1.9% 94.9% 93.0% 92.9% 95.6% 5.1%
7.0%
7.1%
4.4%
0.2% 0.3% 0.2% 0.7% 0.6% −0.4% −0.4% −0.6% −0.9% −1.6% −0.2% −0.1% −0.4% −0.2% −1.0%
* Portion of total endorsed vendor royalty income allocated to IGTMA. † Portion of total endorsed vendor royalty income allocated to IGTMA Services. SOURCE: IGTMA consolidated, audited financial statements and internal management statements.
royalty income generated from endorsed vendor (or total endorsed vendor royalty income). Royalty fees reflect the return earned by IGTMA for endorsed vendor use of the IGTMA trademarks, and promotional fees reflect the revenue generated by IGTMA Services for its marketing-related activities. As presented in Exhibit 22.3, total endorsed vendor royalty income increased from $1.6 million to $2.3 million over the observed period. Total endorsed vendor royalty income represented 33.9 percent of total revenue for the fiscal year ended December 31, 2002. The weighted average royalty rate paid by endorsed vendors was approximately 4.3 percent during the observed period. Historically, total endorsed vendor royalty income was allocated equally between IGTMA and IGTMA Services.
591
2,501,191 2,135,984 17.1% 4.5%
4.5%
4.2%
430,933 769,188
26,823 338,256
404,110
367,831 697,134
28,035 329,303
339,796
471,874 804,507
39,596 332,633
432,278
6,903,175 6,860,485 6,522,219 418,767 348,548 457,896 404,110 339,796 432,278 -
4.2%
1998
4.3%
444,269 751,283
50,880 307,014
393,389
282,338 540,521
89,138 258,182
193,200
5,685,453 5,612,660 402,266 249,366 393,389 193,200 -
4.1%
819,471 50.3% 809,338 49.7%
2,044,284 1,628,809 25.5%
1,172,086 1,255,469 1,062,768 1,025,495 50.1% 50.2% 49.8% 50.2% 1,169,086 1,245,722 1,073,216 1,018,789 49.9% 49.8% 50.2% 49.8%
2,341,172 −6.4%
2002
Fiscal Years Ended December 31 2001 2000 1999
* Sum of royalty fees and promotional fees, as shown on Exhibit 22.2. SOURCE: IGTMA consolidated, audited financial statements and internal management statements.
EBIT EBITDA 399,449 712,527
46,894 313,078
Interest expense Depreciation and amortization expense
ADJUSTED FINANCIAL FUNDAMENTALS
352,555
6,316,798 375,369 352,555
4.3%
1,067,058 50.1% 1,063,230 49.9%
2,130,288
Adjusted pretax income
Total revenue Operating income Pretax income, unadjusted Total adjustment
ADJUSTMENTS
Total royalty rate charged to endorsed vendors
Historical allocation of total royalty income from endorsed vendor IGTMA % of total royalty income from endorsed vendor IGTMA Services % of total royalty income from endorsed vendor
Total royalty income from endorsed vendor* Percent annual growth
Average for the Period 1998–2002
6.3% 11.3%
0.7% 5.0%
5.6%
6.2% 11.1%
0.4% 4.9%
5.9%
100.0% 6.1% 5.9% 0.0%
16.9%
16.8%
100.0% 5.9% 5.6% 0.0%
17.0%
33.9%
2002
16.9%
33.7%
Average for the period 1998–2002
5.4% 10.2%
0.4% 4.8%
5.0%
100.0% 5.1% 5.0% 0.0%
18.2%
18.3%
36.5%
2001
7.2% 12.3%
0.6% 5.1%
6.6%
100.0% 7.0% 6.6% 0.0%
16.5%
16.3%
32.7%
Common Size 2000
Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Adjusted Financial Fundamentals (in $)
HISTORICAL ROYALTY ALLOCATION
Exhibit 22.3
7.8% 13.2%
0.9% 5.4%
6.9%
100.0% 7.1% 6.9% 0.0%
17.9%
18.0%
36.0%
1999
5.0% 9.6%
1.6% 4.6%
3.4%
100.0% 4.4% 3.4% 0.0%
14.4%
14.6%
29.0%
1998
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Adjusted Financial Fundamentals As presented in Exhibit 22.3, consolidated EBIT (earnings before interest and taxes) increased from $0.3 million in fiscal 1998 to $0.4 million in fiscal 2002. Similarly, consolidated EBITDA (earnings before interest, taxes, depreciation, and amortization) increased from $0.5 million to $0.8 million over the same period.
Analytical Procedures Description of the Intellectual Property Subject to Analysis As of December 31, 2002, the Association had 24 trademarks and trade names registered with the U.S. Patent and Trademark Office.
Definition of Trademarks For purposes of this economic analysis, we will use a broad definition of the term trademarks. The statutory source of federal trademark law is the Lanham Act of 1947, which is Title 15 of the United States Code. The Lanham Act provides for the registration of trademarks, which are broadly defined to include any “device” used to identify the origin of goods. The Lanham Act also provides for the registration of three other types of marks: 1. Service marks—that is, marks used in the sale or advertising of services 2. Collective marks—that is, marks used to identify the goods or services of members of a group 3. Certification marks—that is, marks used to certify the geographic origin or other characteristics of goods and services
Attributes to Consider in the Economic Assessment of Trademarks There are numerous attributes or factors to consider in the economic assessment of trademarks and their associated goodwill. These attributes or factors may be either quantitative or qualitative in nature. It is common for the analyst to perform an overall assessment of the quality and nature of the trademark before conducting the actual economic analysis. Of course, this assessment may be either implicit or explicit. This assessment will assist the analyst (1) in understanding the use and function of the subject trademark and (2) in identifying the factors (and, ultimately, the methods and procedures) that are important in the economic analysis of the subject trademark. Exhibit 22.4 presents a nonexhaustive list of several of the attributes that are often considered in the economic analysis and assessment of commercial trademarks. The general influences on trademark value are also indicated in this exhibit.
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Exhibit 22.4
Attributes That Affect the Economic Analysis of Trademarks and Trade Names Economic Attribute
Item
Positive Influence on Royalty Rate/Value
Negative Influence on Royalty Rate/Value
1
Age—absoulate
Long established trademark
Newly created trademark
2
Age—relative
Older than competing trademarks
Newer than competing trademarks
3
Use—consistency
Name used consistently on related products and services
Name used inconsistently on unrelated products and services
4
Use—specificity
Name is general and can be used on a broad range of products and services
Name is specific and can only be used on a narrow range of products and services
5
Use—geography
Name has wide appeal, e.g., can be used internationally
Name has narrow appeal, e.g., can only be used locally
6
Potential for expansion
Unrestricted ability to use name on new or different products and services
Restricted ability to use name on new or different products and services
7
Potential for exploitation
Unrestricted ability to license name into new industries and uses
Restricted ability to license name into new industries and uses
8
Associations
Name associated with positive person, event, location
Name associated with negative person, event, location
9
Connotations
Name has positive connotations and reputation among consumers
Name has negative connotations and reputation among consumers
10
Timeliness
Name is perceived as modern
Name is percived as old-fashioned
11
Quality
Name is perceived as respectable
Name is perceived as less respectable
12
Profitability—absolute
Profit margins or investment returns on products and services higher than industry average
Profit margins or investment returns on products and services lower than industry average
13
Profitability—relative
Profit margins or investment returns on products and services higher than competing names
Profit margins or investment returns on products and services lower than competing names
14
Expense of promoting
Low cost of advertising, promotion, deals, or other marketing of name
High cost of advertising, promotion, deals or other marketing name
15
Means of promoting
Numerous means available to promote name
Few means available to promote name
16
Market share—absolute
Products and services have high market share
Products and services have low market share
17
Market share—relative
Products and services have higher market share than competing names
Products and services have lower market share than competing names
18
Market potential—absolute
Products and services are in an expanding market
Products and services are in a contracting market
19
Market potential—relative
Market for products and services expanding faster than competing names
Market for products and services expanding slower than competing names
20
Name recognition
Name has high recognition, e.g., high aided or unaided recall among consumers
Name has low recognition, e.g., low aided or unaided recall among consumers
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V / Intellectual Property Transfer Price Analysis Issues
Clearly, not all of these attributes or factors will apply to every trademark. It is noteworthy that each of these attributes does not have an equal influence on the economic value of a trademark. Some of these attributes are more important in some industries than in others—and some are more important for certain products and services than others. Also, it is noteworthy that there is a substantial range (both qualitative and quantitative) of positive to negative influences for each individual attribute.
Trademark Analysis To estimate the arm’s-length allocation of total endorsed vendor royalty income between IGTMA and IGTMA Services, we relied on both quantitative and qualitative analyses. These analyses develop an arm’s-length royalty rate for the IGTMA trademarks. We then subtract the fair, arm’s-length royalty rate for the IGTMA trademarks from the total royalty rate charged to the endorsed vendors.1 The residual royalty income is then allocated to IGTMA Services as income related to its marketing-related services. Inasmuch as the primary objective of these analyses is to estimate a fair, arm’slength royalty rate for the IGTMA trademarks, the first step in this analysis is to estimate the fair economic income, or fair return, attributable to the IGTMA trademarks. There are several individual methods and procedures to estimate the fair economic income attributable to trademarks and trade names. For purposes of this intellectual property transfer price analysis, these individual methods can be grouped into the following categories of analyses: 1. Company-specific analyses a. Profit split method b. Excess earnings method—asset basis 2. Industry and guideline company analyses—excess earnings method (industryspecific and guideline company–specific) In addition to the company-specific analyses, industry analyses, and guideline company analyses, market-derived guideline trademark sale/license analyses provide particularly relevant data points with regard to the development of a range of royalty rates. As part of our consideration of the market-derived sale/license transaction analyses, we researched different sources of information regarding the contemporaneous arm’s-length licensing of trademarks and trade names. We also researched studies and other database compilations regarding royalty rates associated with trademark license agreements.
Company-Specific Analyses In this section, we will discuss the company-specific economic analyses. 1 For purposes of this illustrative analysis, we assume that the total royalty rate charged to the endorsed vendors represents an arm’slength royalty rate for (1) the trademarks and (2) the marketing services provided by IGTMA and IGTMA Services. That is, the total royalty rate charged to the endorsed vendors is negotiated between independent, third parties.
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Profit Split Method. The profit split method relates to the amount of profit that the subject trademarks and trade names generate. The profit split method is based on the share (or split) of the operating profit margin that a hypothetical licensee would be willing to pay to a hypothetical licensor for the use of the subject trademarks and trade names. Through the payment of a royalty rate percentage, the licensee is willing to pay a “split” of its profits to the licensor. This is because the use of the subject trademarks and trade names enhances the licensee’s operating profits. The quantification of the operating profit split percentages is based on subject-specific risk and return investment characteristics, including an analysis of (1) the products, (2) the markets, (3) financial profitability relative to other providers in the industry, and (4) the degree of consumer recognition. The profit allocated to the subject trademarks and trade names is compared to average annual revenues in order to estimate the appropriate, arm’s-length royalty rate. The actual royalty payments based on this royalty rate would then be a necessary cost of goods sold to the licensee in order to maintain that level of operating profits. In the profit split method, the first step is to estimate the average revenue over the observed period. For the observed period, the IGTMA average revenue was $6.3 million. The second step is to estimate the average pretax profit. For the same period, the average pretax profit was $0.3 million, or 5.6 percent of revenue (on an adjusted basis). The third step is to estimate the share, or split, of the adjusted pretax profit that the licensee would be willing to pay to the licensor for the use of the subject trademarks. The typical range of such splits is between 25 and 50 percent as evidenced by the preponderance of actual arm’s-length, third party intellectual property license agreements. In the case of IGTMA, we used an equal (i.e., 50/50 percent) split between the licensor and the licensee. The pretax income split attributable to the subject trademarks is then compared to the average historical revenues, and the resulting ratio is expressed as a percentage. Exhibit 22.5 presents the detailed calculation of the arm’s-length royalty rate for the IGTMA trademarks using the profit split method.
Exhibit 22.5
Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Profit Split Method Average for the Period
Consolidated IGTMA revenue Adjusted pretax income % of revenue Concluded profit-split percentage Profit attributable to IGTMA trademarks Indicated fair, arm’s-length royalty rate (rounded)
Fiscal Year Ended December 31
1998–2002
2002
2000
1999
1998
1997
6,316,798 352,555 5.6 50% 176,277
6,903,175 404,110 5.9
6,860,485 339,796 5.0
6,522,219 432,278 6.6
5,685,453 393,389 6.9
5,612,660 193,200 3.4
3%
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V / Intellectual Property Transfer Price Analysis Issues
Based on our analysis, the indicated fair, arm’s-length royalty rate for the IGTMA trademarks, as of December 31, 2002, using the profit split method, is 3 percent of revenue. Excess Earnings Method—Asset Basis. The excess earnings method is based on the excess economic earnings that will be generated by the business enterprise using the subject trademarks and trade names (i.e., the trademark licensee). To use this method, first a fair rate of return is determined for (1) all identified net tangible and intangible assets (e.g., property, plant, and equipment assets, and other identified intangible assets) and (2) all the net working capital assets (i.e., cash plus accounts receivables plus inventory less accounts payables and accrued liabilities) used in the trademark licensee business. This fair rate of return is applied against the total value of (1) the net tangible assets and (2) the net working capital assets in order to estimate a fair return on the trademark licensee business investment, or the required level of economic income to satisfy the trademark licensee. Second, the economic income earned by the trademark licensee company is quantified. This economic income can be defined in many different ways. For purposes of this analysis, we will define economic income as operating cash flow. Actual economic income is then compared to the required level of economic income for the trademark licensee business. If the actual economic income is greater than the required level of economic income, then excess economic income exists. Part of this excess economic income is attributable to the use of the (i.e., to the licensee of the) subject trademarks and trade names. The amount of excess economic income attributable to the subject trademarks and trade names is compared to average annual revenues, in order to estimate a royalty rate for license of the subject trademarks and trade names. Expected Rate of Return. Expected rates of return on the various assets of a business vary with the associated business risks—specifically market risk, financial risk, managerial risk, and other uncertainties. Generally, the expected rates of return on net working capital assets are lower than the expected rates of return on most of the other assets of the licensee business. These rates of return may be indirectly related to the effective cost of borrowing funds by the license company. On the other end of the spectrum, intellectual properties (on account of their comparatively risky nature) are expected to earn a higher rate of return than net working capital assets or tangible assets. These expected rates of return on intellectual properties may be indirectly related to either the weighted average cost of capital for the licensee company or the estimated cost of equity capital of the license company. The expected rates of return on the net tangible and the intangible assets (other than the subject intellectual property of IGTMA) are based on our analysis of the capital structures of companies within the membership organization industry. The capital components of the license business that are reported on the righthand (or liability/equity) side of the balance sheet include (1) various types of interestbearing, long-term debt, (2) preferred stock, and (3) common stock. Any net increase in the assets of the licensee business must be financed by either an increase in current liabilities or an increase in one or more of the capital components. Capital is a factor of production and, like any other factor of production, it has a cost. The cost of each capital component is defined as the component cost of that particular type of capital. For example, if the licensee company can borrow money at 8 percent, then
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the pretax component cost of debt (within a reasonable level of leverage) is defined as 8 percent. For consistency purposes in this discussion, we identified the capital component costs by the following symbols throughout this chapter: kd = component cost of debt capital ke = component cost of equity capital WACC = weighted average cost of capital According to the Association’s consolidated financial statements, the IGTMA weighted average borrowing rate is 9.5 percent. Thus, the effective pretax cost of debt (kd) for IGTMA is 9.5 percent. A company’s cost of equity capital (ke) is the expected rate of return on the company’s common stock. The company is expected to earn ke on the equity-financed portion of its investments in order to keep the price of its stock from falling. There are several generally accepted methods for calculating the cost of equity capital. We will use the capital asset pricing model (CAPM) in our trademark transfer pricing analysis. We will apply the capital asset pricing model to estimate the cost of equity capital of IGTMA as of December 31, 2002. Using the capital asset pricing model to estimate ke, we proceed as follows: Step 1. Estimate the risk-free rate of return (Rf), which is generally the long-term U.S. Treasury bond yield to maturity interest rate as of the analysis date. Step 2. Estimate the subject industry’s beta coefficient (B) and use this beta as an indicator of the subject investment level of systematic risk. Step 3. Estimate the appropriate market risk premium. This market risk premium is designated as (Rm – Rf) in the CAPM equation. Step 4. Estimate the investment size–related risk premium. Step 5. Estimate the investment-specific (nonsystematic) risk factor, alpha (A). Step 6. Calculate the expected rate of return on the subject investment as follows: ke = R f + B ( Rm − R f ) + A
In the basic capital asset pricing model, systematic (or capital market-related) risk is the only type of risk that is relevant in (1) the pricing of capital market securities and (2) the estimation of expected rates of return. Systematic risk is measured by beta. Beta provides a measure of the tendency of a capital market security’s return to move with the overall capital market’s return (e.g., the return on the S&P 500 index). For example, the price of a common stock with beta of 1.0 tends to rise and fall by the same percentage as the “price” of the market (i.e., the S&P 500 index). Thus, when B = 1.0, this indicates an average level of systematic risk for the subject investment. The prices of common stocks with a beta greater than 1.0 tend, on average, to increase and decrease by a greater percentage than the increase or decrease of the “price” of the market. Likewise, common stocks with a beta less than 1.0 have a low level of systematic risk. And they are, therefore, less sensitive to changes in the “price” of the general stock market index. In the case of IGTMA, the appropriate risk-free rate of return (Rf) is the current yield to maturity on 20-year U.S. Treasury securities. This yield was 4.8 percent (rounded) as of December 31, 2002.2
2 Per
The Wall Street Journal, January 2, 2003.
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V / Intellectual Property Transfer Price Analysis Issues
We reviewed the published betas for publicly traded companies that are engaged in the same industry as IGTMA. Based on these data, we selected the industry average beta of 0.75 for use in calculating the cost of equity capital component of the CAPM. To estimate the market risk premium (Rm – Rf), we used the average historical spread between the rates of return earned on an investment in large company stocks and the rates of return earned on an investment in long-term government bonds. These market risk premium data are published in the Ibbotson 2003 Yearbook (SBBI 2003). According to SBBI 2003, this market risk premium was 7.0 percent.3 This market risk premium is the third component of the CAPM. We applied a small capitalization equity stock equity risk premium of 3.5 percent, as the fourth component of the CAPM. We obtained this small capitalization stock equity risk premium data from SBBI 2003. We also applied a company-specific equity risk premium (i.e., the alpha or A factor in the CAPM) of 1.0 percent. This fifth investment-specific component of the CAPM is intended to compensate investors for company-specific or investmentspecific (nonsystematic) risk. The capital asset pricing model yields a cost of equity capital (or, alternatively, an expected rate of return on an equity investment) on an after-tax basis. For purposes of our specific trademark transfer price analysis, however, we will apply the weighted average cost of capital to a pretax measure of intellectual property economic income. Therefore, we will estimate a pretax cost of equity capital. We will make this adjustment from an after-tax cost of capital to a pretax cost of capital by dividing the after-tax expected rate of return by one minus an estimated effective income tax rate of 40 percent. Based on our IGTMA-specific analyses and our golf tee manufacturer industry analyses, we will weight the cost of debt capital and cost of equity capital components 70 and 30 percent, respectively, to calculate the weighted average cost of capital. As a result, we estimated a weighted average cost of capital of 20 percent for use in our trademark transfer price analysis, as shown in Exhibit 22.6. Excess Economic Income. As mentioned above, first we calculate a fair return on the net tangible assets and the net working capital of IGTMA. In this example, we use the IGTMA weighted average cost of capital as the appropriate fair rate of return on the various IGTMA assets. Analysts commonly use the WACC as the fair rate of return in the excess income method when the subject intellectual property is being analyzed as part of a going-concern business enterprise. For our analysis, we used the 20 percent WACC as the fair rate of return on both the IGTMA net tangible assets and the IGTMA net working capital. Since the WACC was computed on a pretax basis, this procedure indicates the pretax rate of return for the net tangible assets and net working capital. Exhibit 22.7 summarizes the IGTMA excess earnings analysis. The result of this analysis is an indication of the total intangible asset value associated with the IGTMA business enterprise. However, the objective of our analysis is the IGTMA trademark intellectual property only. Accordingly, we have to allocate the IGTMA total intangible asset value between the subject trademark and any other commercial intangible assets. Such an allocation is typically made based on a functional analysis—that
3 Stocks,
Bonds, Bills, and Inflation, 2003 Yearbook (Chicago: Ibbotson Associates, 2003).
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Exhibit 22.6
Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Weighted Average Cost of Capital Cost of Equity Capital
Source
Risk-free rate of return 4.78% Long-term equity risk premium 7.00% Industry beta 0.75 Beta-adjusted equity risk premium 5.25% Small company equity risk premium 3.50% Unsystematic investment-specific risk premium 1.00% After-tax expected rate of return 14.53% Pretax adjustment 60% Pretax expected rate of return 24.22%
The Wall Street Journal, January 2, 2003 Stocks, Bonds, Bills, and Inflation—2003 Yearbook,Ibbotson Associates Standard & Poor’s Compustat Stocks, Bonds, Bills, and Inflation—2003 Yearbook,Ibbotson Associates Analyst estimate 100% minus the effective income tax rate of 40%
Cost of Debt Capital Pretax average cost of debt Pretax debt rate of return
9.50% 9.50%
IGTMA audited financial statements
Weighted Average Cost of Capital (WACC) Capital Component Equity Debt
Cost of Capital 24.2% 9.5%
Capital Structure 70% 30%
Pretax weighted average cost of capital Pretax weighted average cost of capital (rounded)
WACC 17.0% 2.9% 19.8% 20%
SOURCE: As indicated.
is, an analysis of the relative economic contribution of each intangible asset to the total intangible asset value of the subject business enterprise. Separately, we performed such a functional analysis of the relative economic contribution of each intangible asset to the IGTMA overall intangible value. Based on that functional analysis, we concluded that 50 percent of the excess economic income is attributable to the IGTMA trademarks. Next, the excess economic income associated with the IGTMA trademarks is divided by the IGTMA average annual revenues. The result is an indication of the appropriate royalty rate for the subject intellectual property. Based on the excess earnings method analysis summarized in Exhibit 22.7, the indicated fair, arm’s-length royalty rate for the IGTMA trademarks, as of December 31, 2002, is 2 percent of revenue.
Industry-Specific and Guideline Company–Specific Royalty Rate Analysis A common procedure in the analysis of trademark royalty rates is to seek guidance from the profitability of comparative companies—that is, companies with and without established trademarks and trade names—in order to estimate the arm’s-length
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V / Intellectual Property Transfer Price Analysis Issues
Exhibit 22.7
Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Excess Earnings Method—Asset Basis (in $) Average for the Period 1998–2002 Consolidated IGTMA revenue
2002
6,316,798 6,903,175
Fiscal Year Ended December 31 2001 2000 1999
1998
6,860,485
6,522,219
5,685,453
5,612,660
Adjusted operating income % of revenue
375,369 5.9%
418,767 6.1%
348,548 5.1%
457,896 7.0%
402,266 7.1%
249,366 4.4%
Plus: Depreciation and amortization expense
313,078
338,256
329,303
332,633
307,014
258,182
EBITDA % of revenue
688,446 10.9%
757,023 11.0%
677,851 9.9%
790,529 12.1%
709,280 12.5%
507,549 9.0%
Book Value as of 12/31/02
Current IGMTA Asset Structure
1,946,854 449,645 Total required economic return to asset structure 2,396,499
Less: Return on net property and equipment Less: Return on working capital*
Excess economic income after return to asset structure Percent of excess economic income allocated to IGTMA trademark Excess economic income attributable to IGTMA trademarks Indicated fair, arm's-length royalty rate (rounded)
Required Rate of Return 20.0% 20.0%
389,370 89,929 479,299 209,147 50% 104,574 2.0%
* Cash and cash equivalents, plus accounts receivable, less accounts payable and accrued expenses. SOURCE: Exhibits 22.1A, 22.1B, 22.3, and 22.6 and analyst calculations.
royalty rate for the subject trademarks. In this section, we discuss the extraction of a trademark royalty rate from industry and guideline company data. Excess Earnings Method—Industry-Specific and Guideline Company– Specific. A typical first step in selecting guideline companies is to identify the Standard Industrial Classification (SIC) code that is most appropriate to the owner/operator of the subject intellectual property. We concluded that SIC code 8611 (i.e., business associations) is most appropriate for the IGTMA business. In addition, we concluded that the following SIC codes would provide meaningful guidance with regard to the identification and extraction of market-derived royalty rates: 8621 (i.e., professional membership organizations) and 8631 (i.e., labor unions and similar labor organizations). Based on our review of publicly available financial and operational information, we concluded that the following publicly traded companies (the selected guideline companies) are sufficiently comparative to IGTMA for purposes of extracting trademark royalty rate data: 1. Automotive Manufacturers of America 2. Door & Window Manufacturers Association
22 / Transfer Pricing Case Study
601
3. Housing Association of America 4. Marketing & Advertising Trade Association 5. U.S. Paper Manufacturers In order to compare the financial performance of IGTMA with that of the five selected guideline companies, we calculated the following three financial fundamentals: (1) EBIT, (2) EBITDA, and (3) revenues. Exhibit 22.8A through Exhibit 22.8F present the historical data related to the development of these three financial fundamentals. Using this market-derived evidence, we compared the IGTMA, EBIT, and EBITDA margins, calculated as a percentage of revenue, to the median EBIT and EBITDA margins calculated for the five selected guideline companies. As presented on Exhibit 22.8E, the median EBIT margin calculated earned by the selected guideline companies over the indicated 5-year period is 4.8 percent. Industry Data Sources. In order to estimate an industry average EBIT margin for the IGTMA analysis, we also considered such publicly available information as RMA Annual Statement Studies, Almanac for Business and Industrial Ratios, and IRS Corporate Financial Ratios. These particular industry financial data resources are updated annually. From these published resources, we analyzed the EBIT margin data with regard to the industry groups associated with the selected SIC codes. In particular, we analyzed the EBIT margins earned by the average companies within the membership organization industry—companies both with and without trademarks and trade names. Excess Economic Income. Next, we compared the average earning capability of companies within the membership organization industry to the earning capability of IGTMA (both measured on the basis of EBIT margins). As presented in Exhibit 22.9, the earning capability of IGTMA exceeds that of the average companies within the membership organization industry. The superior EBIT margins earned by IGTMA (as compared to industry average EBIT margin data) indicated excess economic returns. These excess economic returns earned by IGTMA are attributable to all of the IGTMA intangible assets (including the IGTMA trademarks). In the above analysis of the IGTMA trademark royalty rate, we used EBIT as the relevant measure of economic income. In this analysis, we will use EBITDA as the relevant measure of economic income. In order to calculate IGTMA excess economic income based on an EBITDA margin, we added the average depreciation and amortization expense ratio (as a percent of revenue) to the IGTMA excess EBIT margin. Exhibit 22.9 summarizes this excess earnings analysis using EBITDA as the measure of excess economic income. As with the EBIT excess earnings analysis, this EBITDA excess earnings analysis indicates the total excess economic income earned by IGTMA. This total excess economic income is generated by all of the IGTMA intangible assets—including the subject trademark intellectual property. Also as with the EBIT excess earnings analysis, we would normally allocate the total excess economic income among all of the IGTMA based on a functional analysis of the relative economic contribution of each intangible asset. Our functional analysis indicated that 50 percent of the total IGTMA excess economic income is attributable to the subject trademarks. Next, we divide the excess economic income allocated to the subject trademark by the IGTMA average annual revenues. The result of this division procedure
602 Dec 02 Dec 02 Dec 02
HOME SELL USPM Dec 02
Dec 02
DWMA
NM
Dec 02
CAR
FYE
1,416
121,174
350,583 11,855
479,827
679,805
NOTE: Definitions, sources, and footnotes are found on Exhibit 22.8F.
Independent Golf Tee Manufacturers Association
Automotive Manufacturers of America Door & Window Manufacturers Association Housing Association of America Marketing & Advertising Trade Association U.S. Paper Manufacturers
Company
Ticker Symbol
282
4,708
133,348 —
246,871
383,000
Latest Quarter TBVIC MVIBD* $000 $000
Dec 02
Dec 02
Dec 02 Dec 02
Dec 02
Dec 02
As of or for Period Ending
NA
5.25
7.25 3.15
12.50
1.25
Bid/Close Price Per Common Share 12/31/02 $
NA
14,718
13,098 3,529
92,418
50,514
Common Shares Outstg.† 000s
NM
77,270
94,961 11,116
1,155,225
63,143
NM
—
— —
—
—
NM
81,978
228,309 11,116
1,402,096
446,143
Market Value of Equity Common Preferred MVIC $000 $000 $000
Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Guideline Company Analysis, Market Value of Invested Capital
Exhibit 22.8A
603
21,637 474 5,972
21,637 474 5,972
431
86,150
86,150
431
15,272
15,272
368
7,733
422
22,386
88,019
23,906
472
6,190
508
7,380
79,664
17,520
444
5,190
576
6,138
71,412
11,746
282
4,141
255
6,025
60,185
5,547
Earnings before Interest and Taxes (EBIT) 2002 2001 2000 1999 1998 $000 $000 $000 $000 $000
NOTE: Definitions, sources, and footnotes are found on Exhibit 22.8F.
Independent Golf Tee Manufacturers Association
LOW HIGH MEAN MEDIAN
Automotive Manufacturers of America Door & Window Manufacturers Assoication Housing Association of America Marketing &Advertising Trade Association U.S. Paper Manufacturers
Company
LTM EBIT $000
399
5,845
447
12,713
77,086
14,798
11.2
9.4 37.7 20.4 16.8
9.6
16.8
37.7
9.4
28.8
5-Year Compound Average‡ Annual EBIT Growth§ $000 %
NM
81,978
11,116
228,309
1,402,096
446,143
MVIC $000
NM
10.6 29.2 18.6 16.3
13.7
23.5
10.6
16.3
29.2
NM
14.0 30.1 21.0 18.2
14.0
24.9
18.0
18.2
30.1
MVIC/EBIT 5-Year LTM Average
Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Guideline Company Analysis, Earnings before Interest and Taxes
Exhibit 22.8B
604 42,988 2,054 8,080
42,988 2,054 8,080
769
111,613
111,613
769
29,590
29,590
697
9,942
1,721
40,536
113,434
38,094
805
8,253
1,322
20,251
103,174
30,660
751
7,066
1,344
13,503
93,960
24,331
541
5,713
983
11,970
81,895
13,471
Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA) 2002 2001 2000 1999 1998 $000 $000 $000 $000 $000
NOTE: Definitions, sources, and footnotes are found on Exhibit 22.8F.
Independent Golf Tee Manufacturers Association
LOW HIGH MEAN MEDIAN
Automotive Manufacturers of America Door & Window Manufacturers Assoication Housing Association of America Marketing &Advertising Trade Association U.S. Paper Manufacturers
Company
LTM EBITDA $000
713
7,811
1,484
25,850
100,815
27,229
9.2
8.0 37.7 19.3 20.2
9.1
20.2
37.7
8.0
21.7
5-Year Compound Average‡ Annual EBITDA Growth§ $000 %
NM
81,978
11,116
228,309
1,402,096
446,143
MVIC $000
NM
5.3 15.1 9.7 10.1
10.1
5.4
5.3
12.6
15.1
NM
7.5 16.4 11.4 10.5
10.5
7.5
8.8
13.9
16.4
MVIC/EBITDA 5-Year LTM Average
Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Guideline Company Analysis, Earnings before Interest, Taxes, Depreciation, and Amortization
Exhibit 22.8C
605
6,903
363,010 32,463 73,648
427,038 39,492 70,263
6,860
1,006,981
1,045,964
6,903
472,920
2001 $000
477,256
2002 $000
NOTE: Definitions, sources, and footnotes are found on Exhibit 22.8F.
Independent Golf Tee Manufacturers Association
LOW HIGH MEAN MEDIAN
Automotive Manufacturers 477,256 of America Door & Window 1,045,964 Manufacturers Assoication Housing Association 427,038 of America Marketing &Advertising 39,492 Trade Association U.S. Paper Manufacturers 70,263
Company
LTM Revenues $000
6,522
68,776
20,331
257,427
926,984
438,001
Revenues 2000 $000
5,685
62,530
19,196
147,300
813,627
419,500
1999 $000
5,613
52,415
18,202
118,907
792,703
264,137
1998 $000
6,317
65,526
25,937
262,736
917,252
414,363
5.3
7.2 37.7 17.9 15.9
7.6
21.4
37.7
7.2
15.9
5-Year Compound Average‡ Annual Revenues Growth§ $000 %
NM
11,116 1,402,096 433,928 228,309
81,978
11,116
228,309
1,402,096
446,143
MVIC $000
NM
0.28 1.34 0.85 0.93
1.17
0.28
03.5
1.34
0.93
NM
0.43 1.53 1.03 10.8
1.25
0.43
0.87
1.53
1.08
MVIC/ Revenues 5-Year LTM Average
Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Guideline Company Analysis, Revenues
Exhibit 22.8D
606
V / Intellectual Property Transfer Price Analysis Issues
Exhibit 22.8E
Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Guideline Company Analysis, Revenue Performance Ratios LTM Return on Revenues Company Automotive Manufacturers of America Door & Window Manufacturers Association Housing Association of America Marketing & Advertising Trade Association U.S. Paper Manufacturers LOW HIGH MEAN MEDIAN Independent Golf Tee Manufacturers Association
5-Year Average Return on Revenues
EBIT (%)
EBITDA (%)
EBIT (%)
EBITDA (%)
3.2 8.2 5.1 1.2 8.5
6.2 10.7 10.1 5.2 11.5
3.6 8.4 4.8 1.7 8.9
6.6 11.0 9.8 5.7 11.9
1.2 8.5 5.2 5.1
5.2 11.5 8.7 10.1
1.7 8.9 5.5 4.8
5.7 11.9 9.0 9.8
6.2
11.1
6.3
11.3
NOTE: Definitions, sources, and footnotes are found on Exhibit 22.8F.
Exhibit 22.8F
Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Guideline Company Analysis, Definitions, Footnotes, and Sources to Exhibits Definitions BV = Book value* EBIT = Earnings before interest and taxes DF = Deficit EBITDA = Earnings before interest, taxes, depreciation, and amortization FYE = Fiscal year-end† IBD = Interest-bearing debt IC = Invested capital LTM = Latest 12 months‡ MV = Market value§ MVIC = Long-term debt + short-term IBD + MV of preferred + MV of common equity NA = Not available NM = Not meaningful T = Tangible TBVIC = Stockholders’ equity − goodwill + long-term debt + short-term IBD * Book value if not publicly traded. † Per most recently available data prior to the valuation date. ‡ Includes latest 12 months if at least 6 months beyond latest fiscal year-end. § From earliest year on the table to the latest 12-month period. SOURCE: SEC forms 10-K and 10-Q, annual reports to shareholders, Standard & Poor’s Compustat and Corporations, and Disclosure’s Compact D SEC.
22 / Transfer Pricing Case Study
607
Exhibit 22.9
Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Excess Earnings Method—Industry-Specific and Guideline Company–Specific (in $) Average for the period 1998–2002 Consolidated IGTMA revenue Adjusted EBIT Adjusted EBIT margin Median 5-year average EBIT for the guideline companies Other Sources RMA Annual Statement Studies, 5-year average (1998–2002) Almanac of Business and Industrial Financial Ratios, 5-year average (1996–2000) (most recent years available) IRS Corporate Financial Ratios, 5-year average (1996–2000) (most recent years available)
2002
6,316,798 399,449 6.3%
6,903,175 430,933 6.2%
a
4.8%
b
2.6%
c
6.9%
d
7.8%
Average EBIT for membership organizations (average of a, b, c, and d)
5.5%
IGTMA excess EBIT above “industry” Plus: Average depreciation and amortization expense ratio (as a % of revenue)
0.8% 5.0%
Total excess EBITDA margin
5.8%
Indicated excess economic income (EBITDA) Percent of excess economic income allocated to IGTMA trademarks
365,676 50%
Excess economic income allocated to IGTMA trademarks
182,838
Indicated fair, arm’s-length royalty rate (rounded)
Fiscal Year Ended December 31 2001 2000 1999 6,860,485 367,831 5.4%
6,522,219 471,874 7.2%
5,685,453 444,269 7.8%
1998 5,612,660 282,338 5.0%
3.0%
SOURCE: Exhibits 22.3 and 22.8A through 22.8F, analyst calculations, and other sources as indicated above.
provides an indication of the appropriate royalty rate for the subject intellectual property. Based on this excess earnings analysis, the indicated fair, arm’s-length royalty rate for the IGTMA trademarks, as of December 31, 2002, is 3 percent of revenue.
Market-Derived Royalty Rate Analysis Continuing with the IGTMA trademark royalty rate example, next we examine marketderived evidence with respect to comparable uncontrolled transactions (i.e., arm’slength trademark license agreements). Such an analysis of market-derived evidence
608
V / Intellectual Property Transfer Price Analysis Issues
of royalty rates is particularly appropriate when there are sufficient market data to both extract units of comparison and support market adjustments for elements of comparability between the subject intellectual property and the comparable uncontrolled transactions. However, the effectiveness of this analysis is reduced when the comparable uncontrolled transactions involve intellectual properties that are not sufficiently comparable to the subject. For example, this method becomes less applicable when there are more than minor differences in contractual terms or economic conditions between the subject intellectual property and the comparable uncontrolled transactions. Market-derived transactional evidence is best used to estimate an appropriate range of royalty rates by reference to transfers or licenses of similar intellectual properties under similar contractual terms and economic conditions. Each year, numerous commercial trademarks are bought, sold, or licensed under various contractual terms and economic conditions. When commercial trademarks are licensed, the principal economic parameters in the license agreement are the royalty rate, the license term, any guaranteed minimum license payments, the product line or industry use restrictions, and the geographic—or territory— use restrictions. We researched trademark license activity information through a comprehensive literature search, including library research and a review of electronic databases. In this industry, the confidential and proprietary nature of the trademark license arrangements caused a dearth of useable comparable uncontrolled transaction data. However, the limited available market-derived transactional data provided sufficient evidence to conclude a reasonable range of arm’s-length royalty rates. Exhibit 22.10 summarizes the market-derived evidence with regard to the membership organization industry trademark license transactions. Based on these market-derived data, we extracted a range of trademark royalty rates of between 2 and 5 percent of revenue, with a median royalty rate of 3 percent of revenue. Based on this analysis of comparable uncontrolled license transactions, the indicated fair, arm’s-length royalty rate for the IGTMA trademark, as of December 31, 2002, is 3 percent of revenue.
Economic Analysis Synthesis and Conclusion Based on our assessment of their relative strengths and weaknesses, each of the analyses discussed above provides an equally relevant indication of the fair, arm’s-length royalty rate for the IGTMA trademark. Accordingly, as summarized in Exhibit 22.11, we conclude that an arm’s-length royalty rate for the IGTMA trademark is the average of the four royalty rate indications, or 3 percent of revenue. The 3 percent royalty rate for the IGTMA trademark is equal to 70 percent of the total royalty rate that IGTMA charges for all of its services to the endorsed vendors. To estimate an arm’s-length royalty rate related to IGTMA Services, we subtract the concluded 3 percent royalty rate for IGTMA trademark from the total 4.3 percent royalty rate actually charged to the endorsed vendors. The residual royalty rate of 1.3 percent of revenue is equal to 30 percent of the total royalty rate charged to endorsed vendors. Based on the above-presented illustrative analyses, this
609
Financial Advisory Council
Sky Sales, Inc.
4
5
Drummond Knife Company
Profit Research Corp.
Sunshine Food Company
March 7, 1998
January 31, 2001
April 26, 2000
August 1, 1997
Used in connection with the marketing and sale of products; licensee’s products are also recommended and exclusively marketed to licensor’s membership through licensor publications and conventions
“FAC” trademark and trade name
Worldwide
3.0
2.0
United States Industry analyses and company financial reviews
Cutlery and other housewares
3.0
United States and Western Europe
5.0
2.5
Royalty Rate (%)
“Approved” food products are those products deemed by Licensor to be produced using environmentally friendly practices
Not available
United States
Appliances and small consumer electronics
Inventory management software
Territory
Products/Services
SOURCE: Text of third-party license agreements, as contained within the corporate exhibits of various SEC documents.
Right to market and sell products through licensor’s publication, which is furnished on a variety of passenger airlines
Right to use the trademark and trade name for the marketing and sale of “approved” food products
Right to use the “Logic” trademark in connection with the marketing and sale of licensor-inspected products
Right to implement, transmit, display, copy, and use the licensed trademarks in connection with the marketing and sale of products and services
Terms/Uses
“Green Earth Seal of Approval” trademark and trade name
“Logic” trademark and trade name
Renolds Quality (RQ) trademarks and trade names
Trademark
3 years, with the Sky Sales Magazine option to renew for an additional 2-year period
2 years with automatic, annual renewal thereafter
7 years
5 years
Perpetual unless breached
3%
Green Earth Company
3
American Software, Inc.
September 28, 1994
Expiration Date
Indicated fair, arm’s-length royalty rate (rounded)
Logic Assurance Company
2
Albright Appliance Corporation
Effective Date
2.0% 5.0% 3.1% 3.0%
Renolds & Associates
1
Licensee
Royalty Rate Analysis Low High Mean Median
Licensor
No.
Licensee incurs all customer distribution costs
Licensee must reimburse licensor for certain costs incurred to inspect food products and production process
Replaces previous agreement
Additional up-front payment of $2000 per product launch
Comments
Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Third-Party License Agreements
Exhibit 22.10
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V / Intellectual Property Transfer Price Analysis Issues
Exhibit 22.11
Independent Golf Tee Manufacturers Association, Royalty Rate Allocation Analysis, Summary Source
Indicated Royalty Rate (%)
Exhibit 22.5 Exhibit 22.7 Exhibit 22.9
3 2 3
Exhibit 22.10
3
Indicated Arm’s-Length Royalty Rate for IGTMA Trademarks a b c d e = (a + b + c + d)/4
Profit split method Excess earnings method—asset basis Excess earnings method—industry-specific and guideline company-specific Third-party license agreements Indicated arm’s-length royalty rate for IGTMA trademarks (rounded)
3
Indicated Arm’s-Length Royalty Rate Allocation f g=e h=f−g
Total royalty rate charged to endorsed vendors Indicated arm’s-length royalty rate for IGTMA Indicated arm’s-length royalty rate for IGTMA Services
Exhibit 22.3
Indicated arm’s-length royalty income allocation (rounded) i = g/f (rounded) IGTMA j=1−i IGTMA Services
4.3 3.0 1.3 70 30
SOURCE: As indicated.
1.3 percent royalty rate provides IGTMA Services with a fair, arm’s-length return on its marketing-related services. Based on this illustrative synthesis of the above royalty rate analyses, an arm’slength allocation between IGTMA and IGTMA Services of total royalty income earned from the endorsed vendors follows: Entity IGTMA IGTMA Services
Allocation (%) 70 30
Part VI
Intellectual Property Economic Damages Issues
Chapter 23 Research Techniques for an Intellectual Property Economic Analysis Victoria A. Platt
Introduction Data Categories Owner/Operator Financial Statements Comparative Companies, Transactions, and Empirical Market Data Industry Statistics and Economic Indicators Securities Analyst Research Reports Remaining Useful Life Data Prospectuses and Other SEC Documents Trade Association Publications and Materials Guideline/Subject Company Public Relations Information Information Requirements by Purpose
614
VI / Intellectual Property Economic Damages Issues
Introduction The appropriate research related to an intellectual property valuation, damages, or transfer price engagement will depend on many factors, including the particular approaches, methods, and procedures selected by the analyst. The identification of the necessary types of data required for each analytical approach is an important component of the intellectual property analysis. Although we live in an age of everincreasing availability of information, locating data relevant to an intellectual property valuation, damages, or transfer price analysis can be a challenging task. Conducting a research investigation as part of an intellectual property engagement involves two principal information types: quantitative data and qualitative data. Data may be gathered from sources that are internal or external to the intellectual property owner/operator. In this discussion, we will focus on the external sources of quantitative and qualitative data commonly used in an intellectual property economic analysis.
Data Categories The research needs of most intellectual property economic analyses can be aggregated into the following eight categories of data: 1. 2. 3. 4. 5. 6.
Owner/operator financial statements Guideline companies, transactions, and market size Industry statistics and economic indicators Securities analyst research reports Economic remaining useful life data Prospectuses and other U.S. Securities and Exchange Commission (SEC) documents 7. Trade association publications and materials 8. Guideline/subject company public relations information Each of these categories of data is helpful in understanding the industry structure and economic environment in which the subject intellectual property operates.
Owner/Operator Financial Statements If the intellectual property owner/operator is a company with publicly traded securities, one of the first tasks of the researcher is to obtain financial statements filed with the SEC. SEC Forms 10-K and 10-Q provide a starting point for (1) identifying all assets (including intellectual property) and (2) determining the financial condition of the company. The ease in retrieving SEC filings has increased since 1996, when the SEC required that most major filings be submitted electronically. The financial statements of public companies that are comparative to the intellectual property owner/operator should also be obtained during the data gathering process. Numerous sites on the Internet provide access to the filings through
23 / Research Techniques for an Intellectual Property Economic Analysis
615
EDGAR—the Electronic Data Gathering, Analysis, and Retrieval system. These sites include the following: 1. EDGAR, www.sec.gov/edgar.shtml1 2. Global Securities Information, Inc., www.gsionline.com
Comparative Companies, Transactions, and Empirical Market Data Comparative Company Data. The purpose of gathering data on comparative publicly traded companies is to derive benchmarks for the analysis of the subject intellectual property. The search for comparative companies should use the appropriate industry SIC or NAICS code and be exhaustive in scope. Several print, electronic, and Internet-based databases provide detailed financial information regarding publicly traded companies. Print sources include examples such as Mergent’s Manuals and Standard & Poor’s Register. CD-ROM products include Compustat produced by Standard & Poor’s, and Compact D/SEC produced by Thomson Financial. Numerous Internet-based sources are available and include the following: 1. 2. 3. 4. 5.
Mergent Manuals, www.mergent.com Standard & Poor’s Register, www.standardandpoors.com Compact D/SEC, www.thomsonfinancial.com EDGAR, www.sec.gov/edgar.shtml Hoovers Online, www.hoovers.com
Comparative Intellectual Property Sale/License Transactions. The identification of comparative sale/license transactions should reflect the industry and economic environment in which the subject intellectual property operates. Locating such sale/license transactions can be difficult. However, there are a handful of sources available that report reliable intellectual property sale/license transaction data. These sources are described below. The Financial Valuation Group maintains a proprietary database of intellectual property sale/license transactions searchable by SIC or NAICS code. The database may be useful to quantify intellectual property economic damages, reasonable royalty percentage rates, market value estimates, and transfer pricing estimates. The Licensing Economics Review is a bimonthly newsletter published by AUS Consultants that reports on sale/license transactions in all types of intellectual property. In each issue, current royalty rate information is discussed, tips for negotiating better licensing transactions and joint ventures are covered, and the latest intellectual property infringement damage awards are reported. Using data from the last 15 years, AUS Consultants also created a searchable database of technology and trademark sale and licensing transactions called RoyaltySource. This transaction database includes the following: • • • •
Intellectual property licensee and licensor, including industry description or code Description of the intellectual property licensed or sold Royalty rate details Other license/use compensation, such as up-front payments or equity positions
1 This Internet address and all subsequent Internet addresses were current as of this writing, but may change or be removed over time.
616
VI / Intellectual Property Economic Damages Issues
• •
Transaction terms, such as exclusivity, geographical restrictions or grant-backs Source of the information
Intellectual Property Research Associates has also assembled an impressive amount of information on intellectually property values. Data from the above sources can be obtained from several different publications and/or Web sites, including the following: 1. 2. 3. 4. 5.
The Financial Valuation Group, www.fvgi.com Licensing Economics Review, www.ausvaluation.com RoyaltySource, www.royaltysource.com Intellectual Property Research Associates, www.ipresearch.com RoyaltyStat, LLC, www.royaltystat.com
Empirical Market Data. Most intellectual property analyses use market-derived empirical data for various purposes. Credible sources of market data can easily be found on the Internet. However, this area of research can be expensive. The following list presents some commonly used intellectual property market data Internet sources: 1. 2. 3. 4. 5.
ECNext’s Knowledge Ctr., www.ecnext.com/commercial First Research, www.1stresearch.com Market Research.com, www.marketresearch.com MindBranch, www.mindbranch.com Thomson Research, research.thomsonib.com
Industry Statistics and Economic Indicators The rapid development of the Internet has simplified the retrieval of (1) industry statistics and (2) national or regional economic data. The U.S. government collects, analyzes, and disseminates more industrial and economic data than any other country. To gather relevant industry data, some of the following sources can be consulted: trade associations and trade magazines, government agencies and publications, the business press, brokerage houses, and standard industry sources. Industry sources include, for example, U.S. Industry & Trade Outlook (pre 2000) and Standard & Poor’s Industry Surveys. A researcher should also consider that the use of qualitative industry sources places total reliance on the ability of others to correctly consider and interpret the many factors affecting the industry. The Federal Reserve and U.S. Department of Commerce provide access to leading economic indicators that report on the status of the U.S. economy. Major commercial banks produce letters and white papers that are also excellent sources of statistics on a regional, national, and international level.2
Securities Analyst Research Reports Most major investment banks publish proprietary research reports on publicly traded companies. Such analyst reports can be an important source of information for 2 For a more detailed discussion on how to conduct general industry and economic research, refer to Chap. 6, “Researching Economic and Industry Information,” in Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 4th ed., by Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs (New York: McGraw-Hill, 2000).
23 / Research Techniques for an Intellectual Property Economic Analysis
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gaining insight into the functioning of an industry. In addition to providing information on publicly traded companies, securities analyst research reports often provide stock prices, financial data, estimated earnings, revenue projections, interest rates, and historical graphs. Using analyst report clearing houses—such as Thomson Research (Investext), FirstCall, MarketResearch.com, Multex, Northern Lights, and Profound’s Brokerline—is often more efficient and economical than individually contacting each investment bank.
Remaining Useful Life Data Remaining useful life (RUL) data are a function of the general economic climate in which the intellectual property is used. Some of the relevant factors in RUL analysis include demand for the subject service or product, pricing pressure, the property’s ability to contribute to sustainable profits, competition, capital requirements, and the term of expected cash flow. Risk analysis is another component of an RUL analysis. Some of the factors analysts use to evaluate risk and expected rate of return are the consumer price index (CPI); interest rates of corporate bonds, municipal debt, or treasury securities; the risk-free rate of return; the expected rate of inflation; and investment risk premiums. With the exception of investment risk premiums, expected rate of return data can be obtained from the Federal Reserve Statistical Release. Current and historical Federal Reserve data releases can be found at www.federalreserve.gov/ releases. Ibbotson Associates of Chicago, Illinois, publishes the Stocks, Bonds, Bills, and Inflation Yearbook. The yearbook contains domestic and international historical cost of capital data, Treasury bill/note/bond yield curve statistics, cost of capital data by industry, and risk-free rates of return. Beta values are calculated for specific securities by many investment advisory services and investment banks such as Ibbotson Associates, Merrill Lynch, Value Line, Standard & Poor’s, and the Media General Financial Weekly. The issue of RUL is an important component of most intellectual property economic analyses. The analyst can assess the economic factors in the intellectual property sale/license marketplace by reviewing analyst reports and association publications. However, estimating the RUL of an intellectual property is ultimately a matter of informed analyst judgment.
Prospectuses and Other SEC Documents A prospectus is a document prepared by a public company and filed with the SEC. A prospectus presents background information about the company and discloses company financial information with respect to a particular securities offering. Even though the prospectus is similar to the Form 10-K, it typically provides additional information regarding management objectives. It is possible to retrieve quantitative and qualitative information from a prospectus at the following Web sites, for example: 1. EDGAR, www.sec.gov/edgar.shtml 2. Global Securities Information, Inc., www.gsionline.com
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Trade Association Publications and Materials An industry’s trade association often provides a valuable source of authoritative information on a particular industry. Trade associations often collect financial statements from their members and compile composite financial data. Trade associations often publish general industry information, and they may include annual industry reports or articles in their trade magazines. The American Society of Association Executives, www.asaenet.org, is an excellent Internet source to help locate an association by industry. The association directory acts as a gateway to many of the associations currently operating on the World Wide Web.
Guideline/Subject Company Public Relations Information Visiting the Web site of an intellectual property owner/operator is often a costeffective method of retrieving qualitative information about the company. If the site doesn’t contain all of the needed information, a phone call to the company can also be helpful. Often, companies promote their latest research and development advances in press releases. Such information may be useful in the process of estimating the future economic benefit of their intellectual property. Many companies disclose their quarterly or annual profits and future revenue estimates in press releases. The quantity and quality of information provided in corporate press releases varies and should typically be verified by a second source.
Information Requirements by Purpose An intellectual property economic analysis may be performed for purposes of a sale/license transaction, resolution of a legal dispute, or for taxation or other regulatory conflict. The following list of intellectual property resources contains references to royalty rates, trademark sites, associations, academic information sources, books and publishers, legal associations, journals and magazines, and intellectual property search services. 1. Royalty rates Intellectual Property Research Associates Database, www.ipresearch.com. Intellectual Property Research Associates produces a proprietary database of royalty rates for patents, trademarks, and copyrights. This research is available in three publications, Royalty Rates for Trademarks & Copyrights; Royalty Rates for Technology; and Royalty Rates for Pharmaceuticals & Biotechnology. Intellectual Property Transaction Database, www.fvginternational.com/ipdatabase/ ipdatabase.html. The Financial Valuation Group produces a proprietary database of empirical research on intellectual property sale/license transactions. The database is searchable by SIC code or NAICS code. Licensing Royalty Rates, Gregory J. Battersby and Charles W. Grimes, Aspen Publishers, Inc., www.aspenpublishers.com. A one-volume reference tool provides
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royalty rates for 1500 products and services in 10 different licensed product categories: art, celebrity, character/entertainment, collegiate, corporate, designer event, music, nonprofit, and sports. RoyaltyStat, LLC, www.royaltystat.com. RoyaltyStat is a subscription-based database of royalty rates and license agreements, compiled from SEC documents. It is searchable by SIC code or by full text. Results can be viewed online or archived. The full text of each license agreement is available. RoyaltySource, www.royaltysource.com. AUS Consultants provides a database of royalty rates and license agreements. The database can be searched by industry, technology, and/or key word. Results are sent via fax or e-mail. 2. Patent, trademark, and copyright resources American Incorporators (provides assistance with incorporating companies in the United States), www.ailcorp.com. Corporate Intelligence (trademark searches, patent services, and intellectual property news), www.corporateintelligence.com. Electronic Frontier Foundation (defends digital privacy, civil liberties, and free expression on the Internet), www.eff.org. IP Network (trademark, copyright and patent marketplace, news, and services), www.ipnetwork.com. Primer on Trademark Law & Internet Addresses (background information on the legal status of domain names), www.loundy.com/JMLS-Trademark.html. U.S. Copyright Office (copyright law, regulations, searchable records, and current developments), http://lcweb.loc.gov/copyright. U.S. Patent & Trademark Office (information on U.S. patents and trademarks with searchable databases and inventor resources), www.uspto.gov. 3. Intellectual property associations American Association of Law Libraries (AALL), www.aallnet.org. American Society of Composers, Authors and Publishers (ASCAP), www. ascap.com. Author’s Registry (royalty collecting service), www.authorsregistry.org/ welcome.html. Broadcast Music Inc. (BMI) (songwriters’ licensing agency), www.bmi.com. Chartered Institute of Patent Agents, www.cipa.org.uk. Copyright Clearance Center, www.copyright.com. Institute of Trademark Attorneys, www.itma.org.uk/intro/index.htm. Intellectual Property Management Institute, www.ipinstitute.com. Intellectual Property Owners Association, www.ipo.org. International Intellectual Property Alliance (IIPA), www.iipa.com. International Intellectual Property Institute, www.iipi.org.
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International Trademark Association, www.inta.org. National Inventor’s Hall of Fame, www.invent.org. Licensing Executive Society (Australia & New Zealand), Inc., www.lesanz. org.au. Licensing Executive Society (Europe), Inc., www.les-europe.org. Licensing Executive Society (USA & Canada), Inc., www.usa-canada.les.org. Patent & Trademark Office Society (PTOS), www.ptos.org. Patent Information User’s Group, www.piug.org. Patent Office Professional Association (POPA), www.popa.org. Software & Information Industry Association, www.siia.net. Software Patent Institute (SPI), www.spi.org. World Intellectual Property Organization, www.wipo.org. 4. Academic information sources Association of University Technology Managers (AUTM), www.autm.net. Boston College Law School, Intellectual Property and Technology Forum, www.bc.edu/bc_org/avp/law/st_org/iptf. Cornell Law School, Introduction to Basic Legal Citation, www.law.cornell.edu/ citation. Franklin Pierce Law Center, Intellectual Property Mall, www.ipmall.fplc.edu. George Mason University School of Law, Intellectual Property Law Society (IPLS), www.law.gmu.edu/ipls. Harvard University, Overview of Trademark Law, http://cyber.law.harvard.edu/ metaschool/fisher/domain/tm.htm. Indiana University, WWW Virtual Library, www.law.indiana.edu/v-lib/index.html. Institute of Patent Studies, Inc. (IPS), U.S. Patent Bar Information, www.ipsinc.org. Iran University of Science & Technology (IUST), www.iust.ac.ir. Oxford Intellectual Property Research Centre, www.oiprc.ox.ac.uk. University of British Columbia, PATSCAN, www.library.ubc.ca/patscan. University of California at Los Angeles (UCLA) Office of Intellectual Property Administration, www.research.ucla.edu/oipa/. University of California Patent Resources, www.library.ucsb.edu/subj/ patents.html. University of California, Berkeley, http://otl.berkeley.edu. University of California, San Diego Science & Engineering Library, Patent Information, http://libnet.ucsd.edu/se/list.html?type=3. University of Hong Kong, Patent Information, http://library.ust.hk/guides/ patent/patweb.htm.
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University of Houston, Patent Information, http://info.lib.uh.edu/patents.htm. University of Illinois, Intellectual Property Legal Society, www.law.uiuc.edu/ipls. University of Michigan Media Union Library, Patent Information, www.lib. umich.edu/ummu. University of Nevada, Patent, Trademark & Copyright Information, www. library.unr.edu/depts/bgic/guides/government/fed/patent.html. University of Washington, Center for Advanced Study and Research on Intellectual Property (CASRIP), www.law.washington.edu/casrip/. University of Washington, Engineering Library Patent & Trademark Information, www.lib.washington.edu/Engineering/ptdl. University Technologies International, Inc., University of Calgary, www.uti.ca. Vinnytsia State Technical University (Ukraine), www.vstu.vinnica.ua. 5. Publishers and Booksellers. The following are sources for books related to various aspects of intellectual property: Aspen Publishers, Inc., www.aspenpublishers.com. Butterworths Services, www.butterworths.com. John Wiley & Sons, Inc., www.wiley.com. LexisNexis Bookstore, http://bookstore.lexis.com/bookstore/catalog. LexisNexis Matthew Bender, www.bender.lexisnexis.com. Nolo, www.nolo.com/lawcenter/ency/index.cfm. Oxford University Press, www.oup-usa.org. Practising Law Institute, www.pli.edu. The British Library, www.bl.uk. The Law Bookstore, www.lawbooks.com. West Group, www.westgroup.com/store. 6. Legal associations American Bar Association (ABA), Section of Intellectual Property Law, www.abanet.org/intelprop. American Intellectual Property Law Association (AIPLA), www.aipla.org. American Patent & Trademark Law Center, www.patentpending.com/index1. html. Association of Corporate Patent Counsel (ACPC), www.jurisdiction.com/ acpc.htm. Association of Patent Law Firms (APLF), www.aplf.org. Austin Intellectual Property Law Association, www.austin-ipla.org. Boston Patent Law Association (BPLA), www.bpla.org.
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Canadian Bar Association (CBA)—Intellectual Property Section, www.cba.org/ CBA/Sections/IP. Intellectual Property Law Foundation, http://home.planet.nl/~intprop. National Association of Patent Practitioners (NAPP), www.napp.org. Philadelphia Intellectual Property Law Association (PIPLA), www.pipla.org. 7. Periodicals Berkeley Technology Law Journal, www.law.berkeley.edu/journals/btlj. BNA International (several intellectual property publications), www.bnai.com. Global Technoscan, www.globaltechnoscan.com. Harvard Journal of Law & Technology, http://jolt.law.harvard.edu. Intellectual Property Magazine, www.ipmag.com. Intellectual Property Worldwide, www.ipww.com. Internet Patent News Service, www.ibiblio.org/patents/ipnsinfo.html. Intellectual Property Today, www.iptoday.com. IP Asia, www.asialaw.com. IP World (includes Copyright World, Patent World, and Trademark World) http://64.84.13.71/IPW. Journal of Information Law and Technology (JILT), http://elj.warwick.ac.uk/jilt. Journal of Technology Law & Policy, http://grove.ufl.edu/~techlaw. JurisDiction, www.jurisdiction.com. Intellectual Property Notes, www.jurisnotes.com. Les Nouvelles, www.lesi.org. Licensing Economics Review, www.royaltysource.com/ler.html. The Licensing Journal, published by Aspen Publishers, www.aspenpublishers.com. The Monthly Patent News, www.patnewsinc.com. Patent Cafe (webzine), www.cafezine.com. Richmond Journal of Law & Technology, http://law.richmond.edu/jolt. The Texas Intellectual Property Law Journal, www.utexas.edu/law/journals/ tiplj/members/members.html. World Patent Information, www.elsevier.nl/inca/publications/store/6/5/4. 8. Search services • Patent searching – Community of Science, U.S. Patent Citation Database, http://patents. cos.com. – Computer Patent Annuities Limited Partnership (patent and trademark searching and intellectual property portfolio management), www. cpajersey.com.
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Delphion Intellectual Property Network, www.delphion.com. Derwent Information (subscription based, online global patent and scientific information service), www.derwent.co.uk. DOE Patent Databases (U.S. electricity and energy-related patents), www.osti.gov/waisgate/gchome2.html. Espacenet (British Patent Office and worldwide patent searches), http://gb.espacenet.com. Express Search (U.S. patent and trademark search service), www. expresssearch.com. Faxpat, Inc. (Patent documents, file histories, and translations by fax or email), www.faxpat.com. IFI Claims Patent Services (U.S. patent database), www.ificlaims.com. Intellectual Property Office of New Zealand (patent and trademark searching and registration), www.iponz.govt.nz/search/cad/dbssiten.main. International Patent Classification, 7th edition (Geneva: World Intellectual Property Organization, 2000), www.wipo.int/classifications/en/ipc. International Patent Research Office (IPRO) (international patent searches and other related services), www.ipro.nl. IPAustralia (Australian patent database), www.ipaustralia.gov.au/patents. Landon & Stark Associates (U.S. patent and trademark research), www.landonstark.com. Legal and Patent Search, Inc., www.1800inventor.com. LexisNexis (U.S. full-text patents, as well as a wealth of other legal and business information), www.lexis-nexis.com. MicroPatent USA, www.patent.com. Mogee Research & Analysis, LLC (patent analysis and consulting services, patent searching and technology reports), www.mogee.com. Patent Cafe (patent, trademark, and copyright searching), www.patentcafe.com. PatentExplorer, www.patentexplorer.com. PatentQuest (patent searching service), www.patentq.com. Patmark Research (New Zealand patent, trademark, and design searches), www.patmark.co.nz. PATON—Patentinformationszentrum und Online-Dienste (international patent database), www.patent-inf.tu-ilmenau.de/welcome-eng.html. Questel Orbit Intellectual Property Group (various intellectual property databases and services), www.questel.orbit.com/index.htm. R.E. Kemp & Co. Pty. Limited (Australian patent, trademark, and design searches), www.kemp.com.au. SurfIP (intellectual property database portal and integrated search tool— Singapore), www.surfip.gov.sg/sip_home.htm. Swiss Federal Institute of Intellectual Property (patent and trademark searching and registration), www.ige.ch. The Canadian Intellectual Property Office (official Canadian patent records), http://patents1.ic.gc.ca/intro-e.html. USDA Ag Biotechnology Patents and New Technologies (U.S. biotechnology patents), www.nal.usda.gov/bic. USPAT [full U.S. patent copies (from 1790) by fax or email], www. uspat.com/uspat.
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Chemical-related searching – Chemical Abstracts Service, American Chemical Society (international journal articles and searching services regarding chemical patents), http://info.cas.org. – ChemIndustry.com (chemical industry search engine), www. chemindustry.com. – ChemSpy.com (chemical industry databases and search engine), www.chemspy.com. – ChemWeb.com (chemical industry databases and resources), www. chemweb.com. – Current Patents Ltd. (pharmaceutical-related resources), www. current-patents.com. – RXlist.com (Internet drug index), www.rxlist.com. Trademark searching – 1-800-4-TRADEMARK, Inc. (trademark searching), www. trademark-search.com. – CDNameSearch (Canadian and U.S. trademark search), www. cdnamesearch.com. – Computer Patent Annuities Limited Partnership (patent and trademark searching and intellectual property portfolio management), www. cpajersey.com. – InfoMarks Australia (trademark search firm), www.infomarks.com. – Intellectual Property Office of New Zealand (patent and trademark searching and registration), www.iponz.govt.nz/search/cad/dbssiten. main. – IPAustralia (Australian trademark databases), www.ipaustralia.gov.au/ trademarks. – Landon & Stark Associates (U.S. patent and trademark research), www.landonstark.com. – NameProtect (trademark searching and protection services), www. idresearch.com. – NetMark (trademark and domain name searching and brokerage), www.internetmarken.de/netme.htm. – Office for Harmonization in the Internal Market (European trademark database), http://oami.eu.int/en/default.htm. – Patent Cafe (patent, trademark, and copyright searching), www. patentcafe.com. – Patmark Research (New Zealand patent, trademark, and design searches), www.patmark.co.nz. – R.E. Kemp & Co. Pty. Limited (Australian patent, trademark, and design searches), www.kemp.com.au. – Rospatent (Russian patent searches), www.fips.ru/ensite. – Saegis, Thomson & Thomson (trademark and copyright research service), www.thomson-thomson.com. – Swiss Federal Institute of Intellectual Property (patent and trademark searching and registration), www.ige.ch/E/gisi.htm. – The American Trademark Company (trademark searching and trademark portfolio management services), www.trademrk.com. – Waterlow Signature (British trademark searches), www.waterlow.com.
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International design searching – Indigo, Hungarian Patent Office (design database), www.hpo.hu/English/ db/indigo. – IP Australia (Australian design database), www.ipaustralia.gov.au/ designs/index.shtml. – Patmark Research (New Zealand patent, trademark, and design searches), www.patmark.co.nz. – R.E. Kemp & Co. Pty. Limited (Australian patent, trademark, and design searches), www.kemp.com.au. Copies of documents – Direct Patent Ltd. (copies of patents from 53 countries), www. direct-patent.nl/flash_index.html. – epoline (online document inspection service), www.epoline.org. – FaxPat, MicroPatent (faxed copies of patents and trademarks), www.faxpat.com. – GetthePatent.com (online patent document service), www.getthepatent. com. – Landon & Stark Associates (U.S. patent and trademark research), www.landonstark.com. – Patent Gopher (U.S. patent retrieval service), www.patentgopher.com. – Patentec (paper and electronic patent documents), www.patentec. com. – ReedFax, Reed Technology and Information Services, Inc. (online or fax delivery of U.S. and international patents), www.reedfax.com. – The Patent Office (online viewing of international patents, trademarks, and copyrights), http://www.patent.gov.uk/patent/dbase/espace.htm. Online scientific journals – Academic Press, an imprint of Elsevier Science, www.apnet.com/journals. – American Association for the Advancement of Science, Science Online, www.scienceonline.org. – American Chemical Society (ACS) publications, http://pubs.acs.org/ about.html. – American Institute of Physics (AIP) Journal Service, www.aip.org/ojs/ service.html. – Harvard University, Department of Molecular and Cellular Biology publications, http://mcb.harvard.edu/BioLinks.html. – Nature Publishing Group, www.nature.com. – New Scientist, www.newscientist.com. – Science Direct, a service of Elsevier Science, www.sciencedirect.com. – Scientific American, www.sciam.com. – University of California at Santa Cruz, Electronic Journals in the Sciences, http://library.ucsc.edu/ref/howto/jrnl.html. – University of Houston, Index of Scholarly Electronic Journals, http://info.lib.uh.edu/wj/webjour.html. – Wiley Interscience, www.interscience.wiley.com.
Chapter 24 Intellectual Property Economic Damages Case Study Terry G. Whitehead and Dennis M. Mandell
Introduction Background The Case Problem Purpose and Objective of the Analysis Description of the Subject Intellectual Property Data and Data Sources Alternative Analytical Methods Considered Analyses and Conclusions Comparison of Operating Results “with” and “without” Infringement Historical Lost Profits Method Discounted Cash Flow Method Reasonable Royalty Method Synthesis and Conclusion Analysis Work Product
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Introduction The law firm of Perry & Perry retained Grant Farleigh (Farleigh or the analyst) to provide an opinion of economic damages in the matter of Dead Dried Meats, Inc. v. Meats R Treats. The economic damages are the result of the court-determined trade secret recipe infringement related to the Barbecue Bovine recipe developed by Dead Dried Meats, Inc. (DDM or the company). Specifically, Farleigh was requested to provide (1) an estimate of the prospective economic damages (lost profits) to DDM; (2) an estimate of a fair, arm’s-length royalty rate (reasonable royalty rate) that Meats R Treats (MRT) will pay DDM related to future sales of MRT products using the DDM secret recipe; and (3) as an alternative to no. 2, an estimate of a lump sum compensation for future damages to DDM.
Background DDM is a smoked meat snack food processor. DDM is recognized throughout the West as a top quality, flavored meat snack producer with innovative recipes and an extensive product line. DDM products are sold in grocery and convenience stores throughout the western United States. The company is a C corporation for federal income tax reporting purposes. The company’s original and most successful product, “Barbeque Bovine,” was developed by the company’s founder Elvan Madera. Elvan and his wife Vera developed the product in the 1940s from a family recipe. According to Elvan: “Then, times were tough and the good meats weren’t always available.” The story goes that the family had an amazing recipe that was used on the most readily available meat for the family’s budget, the central valley ground squirrel. The Maderas started the company based on the old family saying, “If it can make squirrel taste good, think what it can do for real meats.” In 1950, Barbeque Bovine hit the grocery store shelves as DDM’s initial product. It was immediately a jerky sensation. Since the introduction of Barbeque Bovine, the company expanded its product line to more than 100 meat snack products, including a number of flavors of beef, chicken, and turkey. The DDM products include jerky strips and sticks, as well as other jerky products in a variety of shapes, sizes, and flavors. Additional popular jerky snack products include Peppersteak Poultry and Red Hot Rooster. The company primarily operates from a 100,000-square-foot meat processing plant and administration office located in Fresno, California. The DDM snack food recipes are carefully guarded trade secrets. There are significant procedures in place and steps taken in the production process to ensure that no single employee knows all of the proprietary recipe ingredients. There are two key food-processing rooms that require the highest level of security clearance to enter. The only two categories of employee in the history of the company that have attained this clearance are (1) the Maderas and (2) the company’s production managers. In addition to Elvan, DDM has had only three production managers: William Lynn (current), Timothy Jayne (former-deceased), and Bob Newridge (former). It would be virtually impossible for an employee or a competitor to accurately determine the complete secret recipe process without the knowledge of the processes conducted in the high-level rooms.
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Bob “Brownie” Newridge is a former production manager of DDM. He was fired from DDM in 1999, and his departure from DDM was not a friendly one. At DDM, Newridge gained complete knowledge of certain product recipes over the years. In late 1999, Newridge was hired by one of the company’s main competitors, MRT. During 2000, MRT added a new beef jerky product to its product line. This new product tasted and looked very similar to the famous DDM Barbeque Bovine product. DDM filed suit against MRT for infringement of trade secrets involving the Barbeque Bovine recipe. The DDM attorney retained the analyst to estimate the economic damages suffered by DDM as a result of the trade secret infringement. At the trade secret infringement trial, the DDM attorney presented photographs of Mr. Newridge and the owners of MRT on a fishing trip during 1996. It was also established during the trial that Newridge had been contemplating a move to MRT for a number of years. During that period, Newridge compiled recipe data regarding the DDM trade secrets. At the trial, DDM presented the facts surrounding Newridge’s departure and a number of scientific tests that proved that MRT was, in fact, using DDM proprietary recipes. In addition, the trial judge agreed to perform a blind taste comparison of the MRT and DDM products. Based on that evidence, the court determined that MRT was liable to DDM for economic damages related to the infringement on the DDM recipe trade secrets. The objective of the analysis is to estimate the economic damages suffered by DDM as a result of the recipe trade secret infringement. The New Role of Intellectual Property in Commercial Transactions describes the legal attributes of trade secrets as follows: Trade secrets are not registered by any government office, but are maintained through their owners’ precautions to preserve secrecy. The Uniform Trade Secrets Act greatly standardized the law of trade secrets by defining trade secrets and the protection accorded them. Matters of public knowledge or of general knowledge within an industry cannot be appropriated as trade secrets. Elements to be considered in determining what constitutes a trade secret include (1) the extent to which the information is known outside the business, (2) the extent to which information is known by employees involved in the business, (3) the extent to which the information is guarded, (4) the value of the information to the business and to its competitors, and (5) the ease with which the information can be duplicated.1 In the DDM trade secret infringement case, the following facts were stipulated by both parties in the liability phase of the litigation: 1. The unique aspects of the Barbecue Bovine recipe are not known outside of the DDM business. 2. The complete food recipe is not available to DDM employees, and only five people in the company’s history have gained security clearance to the two secret processes. 3. DDM uses numerous safeguards to ensure the secrecy of the many procedures and ingredients in the manufacturing process, including the use of two secure food-processing rooms.
1 Melvin
Simensky and Lanning G. Bryer, The New Role of Intellectual Property in Commercial Transactions (New York: John Wiley & Sons, Inc., 1994) p. 293.
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4. The Barbecue Bovine secret recipe is the foundation of the DDM business success, and it is commercially valuable both to the company and to the DDM competitors. 5. The process is difficult to duplicate. It is based on a recipe that was tested and modified over a 50-year period.
The Case Problem The facts outlined above present an interesting problem for the analyst. First, the analyst must identify both the type of economic damages involved and the type of intellectual property involved. In this case, the intellectual property is the trade secret related to the recipe of “world famous” Barbeque Bovine beef jerky. A food recipe (or the corresponding chemical formulation) is a trade secret (1) if it is used by the owner in its business operation and (2) if it is protected by the owner with the appropriate security measures. A processed food product recipe trade secret is an intellectual property. As such, the trade secret is afforded a certain level of legal protection. In this case study, we will not attempt to determine a jurisdiction-specific or precedent-specific interpretation of the case facts. Instead, the goal of this case study is to illustrate a process for estimating the economic damages incurred by the intellectual property owner/operator. This case study assumes that the liability phase of the infringement litigation is complete. Let’s assume that MRT was found guilty of trade secret infringement in the liability trial. Next, the damages phase of the litigation will take place. At the damages trial, DDM will claim damages based on the analyst’s intellectual property economic analysis. The trial judge in the infringement litigation recognized the importance of the trade secret recipe to the DDM business. Let’s assume that MRT’s use of the family secret recipe has already affected the profitability of DDM. Over the last 3 years, let’s assume that the company was forced to reduce prices in order to compete with the infringing MRT beef jerky product. Based on the court’s decision during the liability phase of the litigation, MRT will be allowed to continue using the DDM trade secret recipe to make its competing product. However, MRT was ordered by the court to pay DDM a license fee based on the analyst’s royalty rate conclusion. The analyst was asked (1) to quantify the lost profits to DDM as a result of the trade secret infringement and (2) to estimate the future impact of the MRT competition on the operating results of DDM. The company’s counsel asked Farleigh to estimate the economic damages sustained by DDM recognizing (1) the actual damages incurred through the date of the court ruling and (2) the expected damages to the DDM business. Farleigh is expected to prepare a written opinion including all exhibits and schedules necessary to support his data sources, analyses, and conclusions. Farleigh’s opinion and exhibits will be presented during the damages trial as evidence of the economic damages suffered by DDM.
Purpose and Objective of the Analysis The objective of the analysis is to estimate the economic damages suffered by DDM as a result of the infringement of its food recipe trade secret by MRT. DDM has requested
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that the court award damages adequate to compensate DDM for the historical lost profits suffered as a result of the infringement. In addition, DDM has requested that the court order MRT to pay DDM a reasonable royalty for the continued use of the DDM trade secrets. Therefore, the economic damages resulting from the trade secret infringement will be based on the historical lost profits of DDM’s trade secret plus (1) DDM’s future lost income related to MRT’s continued use of the DDM trade secret or (2) a reasonable royalty on MRT’s infringing future sales. The economic damages associated with MRT’s continued use of the DDM secret recipe could be quantified in two ways. First, the analyst could estimate the present value of the expected future lost income to DDM as a result of MRT’s competition. Or, second, the analyst could estimate a reasonable royalty rate that MRT would have to periodically pay to DDM for the continued use of the secret recipe. In order to quantify historical lost profits, Farleigh has decided to estimate the amount of income the intellectual property owner would have earned “but for” the trade secret infringement. This analysis encompasses the time period from the date of the first act of infringement through the date of the infringement trial. Practically, the end point of the historical lost profits analysis may be the date of Farleigh’s report. This is because Farleigh may have to conclude the analysis and issue the economic damages report some weeks or months prior to the trial date. This analysis assumes that if the infringement had not occurred, the intellectual property owner/operator would have earned the revenue that was earned by the infringer during the historical infringement period. As a result, the historical lost profits to DDM would consider (1) reduced unit sales volume, (2) reduced sales price per unit, (3) increased cost of sales, (4) increased selling and administration expenses, (5) increased investments in receivables and inventory, or (6) some combination of these factors. The trial court concluded that MRT began to infringe on the DDM trade secret recipe on January 1, 2000. Therefore, January 1, 2000, is the court-determined date that the economic damages began. The trial date for the damages portion of this litigation is set for January 2003. Therefore, the analyst will estimate the amount of lost profits suffered by DDM through December 31, 2002. Accordingly, the historical lost profits period for this case is the 3-year period from January 1, 2000, through December 31, 2002. In estimating the prospective economic damages to DDM as of January 1, 2003, the analyst will quantify and present to the court two alternative prospective damages claims. In the first claim, the analyst will estimate the present value of the expected lost profits to DDM as a result of MRT’s continued production of products that use the DDM secret recipe. In the alternative claim, the analyst will estimate a fair, arm’slength royalty rate that MRT will have to pay to DDM related to the future sales of MRT products using the DDM secret recipe. DDM legal counsel will ask the judge to order either a lump sum payment for future damages to DDM or the periodic payment of a royalty fee by MRT to DDM based on MRT’s continued use of the secret recipe.
Description of the Subject Intellectual Property A “secret recipe” trade secret is an intellectual property owned by its creator. The laws that protect intellectual property were enacted to motivate developers to spend the necessary amount of time and effort to create such intangible assets.
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VI / Intellectual Property Economic Damages Issues
For DDM, the Barbecue Bovine recipe is an integral part of the company’s historical success and future earnings potential. The company incurred a significant amount of time and expense in order to perfect and protect the Barbecue Bovine secret recipe. The ability of a competitor to produce a duplicate product would have a direct impact on the earnings potential of DDM. The value of the secret recipe to the company is evidenced by the extensive security procedures DDM takes to keep the Barbecue Bovine recipe confidential. The Barbecue Bovine recipe was created to produce a superb flavor when lower quality meat sources are cooked. The current recipe is still based on the DDM founders’ 1940s home recipe used to make dried meat products. The secret recipe is not merely a blend of spices added to the selected meats. Rather, it is a food process involving the blending of meats and spices—as well as the curing, drying, and cooking of the meats. Both the selected spices and the timing and method of the production process are based on the process developed by Elvan and Vera Madera. The process is not only used for the Barbecue Bovine recipe, it is also the foundation of all of the company’s snack food recipes. The subject intellectual property is used consistently by DDM in all of its food product formulations.
Data and Data Sources DDM management provided the analyst with relevant financial data including the company’s historical results of operations and projections of future results of operations. The company provided the analyst with audited financial statements for the fiscal years ended December 31, 1997 through 2002. Historically, company management has prepared a 1-year budget prior to each fiscal year, for management planning purposes. The analyst received the annual budgets for the last 5 years. The analyst noted that the company exceeded its budgeted results (both in terms of revenues and net income) in each of the past 5 years. According to company management, budgets are prepared based on (1) historical company experience and (2) current industry and economic growth expectations. However, according to DDM management, the company budgets typically include conservative growth assumptions. This assertion is consistent with the company’s historical trend of exceeding its budgeted projections. Based on the same procedures used to prepare the annual budget, company management prepared two sets of income statement projections beginning in 2003. The first set of projections was based on the results of operations DDM management would have expected had they not suffered the MRT infringement. The second set of projections reflects management’s best expectation of future results of operations including the effects of the MRT infringement. Both sets of projections encompass the period from January 2003 (i.e., the damages trial date) through December 2007—that is, a 5-year discrete projection period. The analyst performed due diligence to assess both the reasonableness and the development process of the company projections. In particular, the analyst interviewed all members of DDM management who participated in the preparation of the projections. Based on this due diligence investigation, the analyst is comfortable with the reasonableness and the objectivity of the projection assumptions and the projection model.
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DDM management also provided the analyst with historical annual sales volume reports by product line. These reports provide an indication of historical growth by product line and indicate which DDM products used the subject secret recipe. Company management also provided historical sales price reports by product line. The company provided the analyst with product cost reports. These product cost reports indicate the cost components and profit margins for each product line. These cost components reports should prove useful to the analyst in understanding the significant factors affecting income. For a food-processing company like DDM, there are usually a few specific ingredients that ultimately determine the product’s total cost and, consequently, its profitability. In addition to reviewing the historical and prospective data provided by DDM management, the analyst researched a number of additional sources. These additional sources included capital market financial information, security analyst reports, industry research sources, trade association surveys and databases, and regional and national economic surveys. The analyst obtained the following data, in addition to the information provided by company management: • • • • •
Royalty rate publications and databases (including Licensing Royalty Rates, 2001 Edition2). Data related to equity risk premium rates (including SBBI 2002 Yearbook3). Industry forecasts (including Standard & Poor’s Industry Surveys4). List of MRT’s infringing products from MRT. Historical sales for MRT’s infringing products from MRT.
Alternative Analytical Methods Considered There are a number of analytical approaches and methods available for the analyst to perform the three objectives of this case study. To review, the three objectives (or analysis problems) are: 1. What are the historical lost profits suffered by DDM during the period from the first infringement activity until the damages trial—that is, from January 1, 2000 through December 31, 2002? 2. What is the amount of lump sum award the court should order to compensate DDM for expected future damages related to MRT’s continued use of the DDM trade secret recipe? 3. What is the amount of the fair, arm’s-length royalty rate that the court should order MRT to pay DDM related to MRT’s continued use of the DDM trade secret recipe? The first objective relates to DDM’s historical lost profits claim. Objectives 2 and 3 are mutually exclusive, alternative remedies related to DDM’s prospective economic damages claim. All three of these analyses should be prepared as of January 2003—that is, the economic damages trial date. 2 Gregory
J. Battersby and Charles W. Grimes, Licensing Royalty Rates, 2001 Edition (New York: Aspen Law & Business, 2001). Bonds, Bills, and Inflation, 2002 Yearbook (Chicago: Ibbotson Associates, 2002). 4 Industry Surveys: Foods and Nonalcoholic Beverages (New York: Standard & Poor’s, December 5, 2002). 3 Stocks,
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In developing the historical lost profits analysis for this case, the analyst should consider the following questions: • • • • • •
What amount would the trade secret recipe owner have earned but for the infringement? Is it likely that the trade secret recipe owner would have made the sales that the infringer made? Did the infringement cause a reduction in the sales volume related to the trade secret products? Did the infringement cause a reduction in the unit sale prices related to the trade secret products? Were the recipe owner’s production costs or selling expenses affected by the infringement? What other investments did the trade secret owner make during the infringement period?
Alternative economic damages analyses are typically based on income approach methods. A historical lost profits analysis is based on the actual lost income of the intellectual property owner/operator. In addition, an economic damages analysis will typically incorporate an estimate of future damages expected to be incurred by the property owner/operator. One common economic damages analysis is based on a comparison of the owner/operator business enterprise value under two alternative scenarios: (1) including the effect of the infringement event and (2) excluding the effect of the infringement event. Depending on the facts and circumstances of each particular case, various income approach methods may be appropriate to the analysis. For this particular case, the analyst estimated the value of the DDM total business enterprise “with” and “without” the economic damage caused by the subject infringement. In this case, the analyst performed a business valuation analysis in order to estimate the DDM total business enterprise value under two scenarios: (1) the subject infringement did not occur and DDM continued to have exclusive use of its trade secret recipe and (2) as a result of the actual infringement and MRT continued to use the trade secret recipe in competition with DDM. One indication of the economic damages would be measured by the difference in the two alternative DDM business enterprise values. In this case, let’s assume that the analyst prepared two discounted cash flow method analyses in order to estimate the DDM business enterprise value under the two scenarios. The difference in the two business enterprise values is one estimate of the economic damages to DDM as a result of MRT’s expected continued use of the trade secret recipes.
Analyses and Conclusions Comparison of Operating Results “with” and “without” Infringement Exhibit 24.1 presents unit sales and prices for the infringed product and other products of the company for the years ended December 31, 1997 through 2002. Exhibit 24.1 also presents projected unit sales and prices through 2007. The actual and
635
8.6% 6.4%
Change in infringed product dollar sales Change in other product dollar sales
SOURCE: Management projections.
1,741 $8.44 3.5% 2.8% 14,692 27,984
1,351 $9.84 4.4% 4.0% 13,293 47.5%
2007 $000
11.5% 7.1%
1,682 $8.21 4.0% 3.0% 13,808 26,053
1,294 $9.46 6.2% 5.0% 12,245 47.0%
15.6% 6.6%
1,617 $7.97 3.5% 3.0% 12,891 23,871
1,219 $9.01 10.1% 5.0% 10,981 46.0%
2005 $000
11.7% 5.6%
1,563 $7.74 3.0% 2.5% 12,092 21,593
1,107 $8.58 7.4% 4.0% 9,501 44.0%
2004 $000
6.2% 5.4%
1,517 $7.55 3.3% 2.0% 11,453 19,960
1,031 $8.25 3.1% 3.0% 8,507 42.6%
2003 $000
1,429 $7.27 4.6% 2.7% 10,389 20,336 −33.6% −7.4%
−19.5% −4.6%
1,134 $8.77 −13.0% −23.7% 9,947 48.9%
2001 $000
1,468 $7.40 2.8% 1.8% 10,867 18,877
1,000 $8.01 −11.8% −8.7% 8,010 42.4%
2002 $000
−12.3% −7.7%
1,366 $7.08 4.7% 2.9% 9,671 24,651
1,303 $11.50 −7.7% −5.0% 14,980 60.8%
2000 $000
21.0% 8.7%
1,305 $6.88 5.4% 3.1% 8,976 26,057
1,412 $12.10 14.1% 6.0% 17,081 65.6%
1999 $000
1998 $000
17.3% 9.6%
1,238 $6.67 6.1% 3.3% 8,259 22,376
1,237 $11.41 12.1% 4.5% 14,117 63.1%
Fiscal Years Ended December 31
Fiscal Years Ending December 31 2006 $000
Actual
Projected
Dead Dried Meats, Inc., Product Sales Volume and Pricing
Unit sales (000s lbs.) Average sale price/lb Change in unit sales Change in average sale price Other product dollar sales Total sales
Other Products
Unit sales (000s lbs.) Average sale price/lb Change in unit sales Change in average sale price Infringed product dollar sales Percent of total sales
Infringed Products
Exhibit 24.1
17.9% 7.7%
1,167 $6.46 4.7% 2.9% 7,538 19,578
1,103 $10.92 8.8% 8.4% 12,040 61.5%
1997 $000
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VI / Intellectual Property Economic Damages Issues
projected data presented on Exhibit 24.1 are based on the “with continued infringement” scenario. •
•
•
Infringed product unit sales increased from 1.1 million pounds in 1997 to more than 1.4 million pounds in 1999 and then decreased to 1.0 million pounds for 2002. The projections indicate resumption of growth in unit sales during the projection period. However, projected unit sales of 1.35 million pounds in 2007 are less than the 1999 level of 1.4 million pounds. The average sale price for infringed products increased from $10.92 in 1997 to $12.10 in 1999 before decreasing to a low of $8.01 for 2002. The trade secret infringement appears to have affected unit sales as well as unit selling prices. Unit selling prices are projected to increase above current levels; however, unit selling prices are projected to remain well below the unit prices prior to the trade secret infringement. Revenues associated with the trade secret infringed products represented a high of 65.6 percent of total revenues in 1999 then decreased to 42.4 percent of total revenues for 2002. According to the projections, the infringed products are not expected to recover to the portion of revenues that they once historically represented. In addition to volume reductions, the reduced unit selling price of the infringed products, which is below historical levels, significantly contributes to the decrease in the percent of total sales. Historically, DDM charged a significant price premium on its Barbecue Bovine products. This price premium decreased as a result of the MRT products in the marketplace.
Exhibit 24.1 indicates a pattern of (1) consistent historical growth in unit volume and unit selling price prior to the trade secret infringement and (2) consistent decrease in unit volume and unit selling price after the trade secret infringement. In this case, the historical lost profits experienced by DDM are a result of decreased unit volume as well as decreased unit selling price. Exhibit 24.2 presents historical and projected income statements for the company under two scenarios (1) “without” infringement and (2) “with” continued infringement. The analyst worked closely with company management to understand the projections of what the results of operations would have been “but for” the effects of the MRT infringement. The projected results of operations “without” the expected effects of the trade secret infringement encompass the following variables: •
• •
•
•
Actual results of operations through fiscal 1999 and estimated results for 2000 through 2002. The estimated results are the analyst’s calculation of the DDM results “but for” the effects of the infringement. In other words, these are the results that DDM management would have expected had the infringement not occurred. Unit sales volume will increase from 2003 through 2007, based on management estimates and historical unit sales volume increases. Average unit selling sales price for the infringed products will increase through 2007, based on the historical rate of unit selling price increases and management estimates. The infringed trade secret products are expected to continue to represent an increased percentage of total company revenues (approximately 73 percent by 2007), based on the historical percentage of trade secret products to total company revenues. The net income profit margin is 6.0 percent, based on the company historical average net income profit margins and management estimates.
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Exhibit 24.2
Dead Dried Meats, Inc., Projected Income Statements Projected
Estimated
Fiscal Years Ending December 31 “WITHOUT’’ INFRINGEMENT
2007 ($000)
2006 ($000)
Infringed Products Unit sales (000s lbs) Average sale price/lb
2,500 $16.00
2,400 $15.50
2005 ($000)
2,275 $15.00
Actual
Fiscal Years Ended December 31
2004 ($000)
2003 ($000)
2002 ($000)
2001 ($000)
2000 ($000)
1999 ($000)
1998 ($000)
1997 ($000)
2,150 $14.50
2,000 $14.00
1,850 $13.50
1,725 $13.00
1,575 $12.50
1,412 $12.10
1,237 $11.41
1,103 $10.92
Change in unit sales Change in average sale price
4.2% 3.2%
5.5% 3.3%
5.8% 3.4%
7.5% 3.6%
8.1% 3.7%
7.2% 3.8%
9.5% 4.0%
11.5% 3.3%
14.1% 6.0%
12.1% 4.5%
8.8% 8.4%
Infringed product dollar sales Percent of total sales
40,000 73.1%
37,200 72.9%
34,125 72.6%
31,175 72.1%
28,000 71.0%
24,975 69.7%
22,425 68.3%
19,688 67.1%
17,081 65.6%
14,117 63.1%
12,040 61.5%
Other product dollar sales
14,692
13,808
12,891
12,092
11,453
10,867
10,389
9,671
8,976
8,259
7,538
Total sales
54,692
51,008
47,016
43,267
39,453
35,842
32,814
29,359
26,057
22,376
19,578
Cost of goods sold
36,644
34,176
31,500
28,989
26,434
24,014
21,985
19,670
17,288
15,175
13,033
Gross profit
18,048
16,833
15,515
14,278
13,020
11,828
10,829
9,688
8,769
7,200
6,545
Pretax Income Income Taxes
5,469 2,188
5,101 2,040
4,702 1,881
4,327 1,731
3,945 1,578
3,943 1,577
3,774 1,509
3,523 1,409
3,297 1,401
2,275 981
2,318 558
Net income
3,282
3,061
2,821
2,596
2,367
2,366
2,264
2,114
1,896
1,294
1,759
6.0%
6.0%
6.0%
6.0%
6.0%
6.6%
6.9%
7.2%
7.3%
5.8%
9.0%
Percent of total sales
“WITH” CONTINUED INFRINGEMENT Infringed Products Unit sales (000s lbs)* Average sale price/lb*
Projected
Actual
Fiscal Years Ending December 31
Fiscal Years Ended December 31
2007 ($000)
2006 ($000)
2005 ($000)
2004 ($000)
2003 ($000)
2002 ($000)
2001 ($000)
2000 ($000)
1999 ($000)
1998 ($000)
1997 ($000)
1,412 $12.10
1,237 $11.41
1,103 $10.92
1,351 $ 9.84
1,294 $ 9.46
1,219 $ 9.01
1,107 $ 8.58
1,031 $ 8.25
1,000 $ 8.01
1,134 $ 8.77
1,303 $11.50
4.4% 4.0%
6.2% 5.0%
10.1% 5.0%
7.4% 4.0%
3.1% 3.0%
−11.8% −8.7%
−13.0% −23.7%
−7.7% −5.0%
14.1% 6.0%
12.1% 4.5%
8.8% 8.4%
Infringed product dollar sales* Percent of total sales*
13,293 47.5%
12,245 47.0%
10,981 46.0%
9,501 44.0%
8,507 42.6%
8,010 42.4%
9,947 48.9%
14,980 60.8%
17,081 65.6%
14,117 63.1%
12,040 61.5%
Other product dollar sales*
14,692
13,808
12,891
12,092
11,453
10,867
10,389
9,671
8,976
8,259
7,538
Total sales* Cost of goods sold Gross profit
27,984 19,589 8,395
26,053 18,498 7,556
23,871 17,426 6,445
21,593 16,194 5,398
19,960 15,769 4,192
18,877 15,396 3,480
20,336 16,168 4,169
24,651 18,537 6,114
26,057 17,288 8,769
22,376 15,175 7,200
19,578 13,033 6,545
1,343 4.8%
1,094 4.2%
573 2.4%
130 0.6%
672 2.7%
1,896 7.3%
1,294 5.8%
1,759 9.0%
Change in unit sales* Change in average sale price*
Net income (loss) Percent of total sales
(599) −3.0%
(901) −4.8%
(468) −2.3%
* Actual historical results per Exhibit 24.1. SOURCE: Management projections.
In addition, the analyst worked closely with company management to understand the projections of the most likely results of operation for DDM. These projections are based on the expected effects of the actual MRT infringement of the DDM trade secret recipe under the “with” continued infringement scenario. The projected results of operations “with” the continued trade secret infringement encompass the following variables:
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VI / Intellectual Property Economic Damages Issues
• •
• •
•
Actual results of operations for fiscal 1997 through 2002. Unit sales volumes of infringed products will begin to increase in 2003 and will continue to show improvement, eventually leveling off by 2007 near the long-term growth rate estimate. Average unit selling prices also will begin to increase in 2003 after the first 3 years of decreases from the infringement. Trade secret products will rebound slightly as a percentage of total company revenues (approximately 48 percent in 2002), but will still be well below the levels recognized prior to the infringement. A net loss is expected again in 2003 with profitability improving through 2007; however, the profit projections will still be below the profit expectations “without” infringement.
Historical Lost Profits Method Exhibit 24.3 presents a summary of the historical lost profits resulting from the trade secret recipe infringement. As indicated previously, the court-determined historical lost profits period is the 3-year period from January 1, 2000, through December 31, 2002. The analyst utilized the income statements “with” and “without” infringement presented in Exhibit 24.2 as the basis for the historical lost profits determination. In order to estimate the DDM lost profits as a result of the infringement, the analyst calculated what the results of the company would have been “but for” the trade secret recipe infringement. A comparison of the estimated results with the actual company results is then necessary to determine the “lost profits.” As presented on Exhibit 24.3, the analyst used the estimated unit sales and sales price per unit under the “without” infringement scenario presented on Exhibit 24.2 Exhibit 24.3
Dead Dried Meats, Inc., Historical Lost Profits Method Summary Years Ended December 31
“But-for” unit sales (lbs.)* “But-for” price per unit* “But-for” sales*
Total $
2002 $
2001 $
2000 $
1,725,000 13.00 22,425,000
1,575,000 12.50 19,687,500
67,087,500
1,850,000 13.50 24,975,000
“Actual” unit sales (lbs.)* “Actual” price per unit* “Actual” sales*
32,937,739
1,000,000 8.01 8,009,758
1,134,000 8.77 9,947,490
1,303,000 11.50 14,980,491
Lost unit sales Incremental cost of goods sold† Lost gross profit Incremental selling, general, & administrative‡
34,149,761 22,880,340 11,269,421 6,277,456
16,965,242 11,366,712 5,598,530 2,964,887
12,477,510 8,359,932 4,117,578 2,119,681
4,707,009 3,153,696 1,553,313 1,192,888
2,633,643
1,997,897
360,425
Total historical lost profit damages
4,991,965
67.0%
* As presented on Exhibit 24.2. † Based on the historical profit margin. ‡ Based on the difference between “with” and “without” infringement selling, general, and administrative expenses.
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as a proxy for unit sales and sales prices “but for” the infringement. As a result, “but-for” sales totaled $19.69 million, $22.43 million, and $24.97 million for the years ended 2000 through 2002, respectively. Therefore, if the infringement had not occurred, the analyst estimated that DDM would have recognized a total of $67.1 million in sales on infringed products, as presented on Exhibit 24.3. Exhibit 24.2 presents the actual sales of DDM for the years ended 2000 through 2002. These results are presented on Exhibit 24.3 and total $32.9 million for the historical lost profits period. Lost unit sales to be used as a basis for the infringement lost profits therefore equal the difference in “but-for” and “actual” sales, or $34.1 million. The next step for the analyst is to estimate the incremental costs associated with the lost unit sales. Incremental costs are defined as the additional costs the company would have incurred if the “but-for” sales had been achieved. In every business, there are certain costs that will be incurred regardless of the level of sales achieved. Simply stated, companies have both fixed and variable expenses. For purposes of this analysis, it is the variable costs that would have been incurred, had the lost unit sales been achieved, that determine the incremental costs to the company. Historically, the cost of goods sold on infringed products was approximately 67 percent. According to management, the cost of goods sold for DDM products are directly attributable to the volume of products produced. As a result, the analyst selected the historical cost of goods sold percentage as an appropriate estimate of the incremental cost of goods sold for lost unit sales. This amount equaled $22.9 million for the 3-year historical lost profits period. The final step in the determination of historical lost profits is an estimate of incremental selling, general, and administrative costs (SG&A). Based on a review of the historical income statements and discussions with management, the analyst determined that SG&A include both fixed and variable components. Unlike the direct correlation between sales and cost of goods sold above, there is not a “standard” percent of revenues attributable to SG&A. Ultimately, the analyst determined that the most reasonable estimate of incremental SG&A was equal to the difference between SG&A under the “with” infringement and “without” infringement scenarios. As a result, for the historical lost profits period, incremental SG&A totaled $6.3 million. As presented on Exhibit 24.3, the analyst began the historical lost profits analysis with an estimate of “but-for” sales totaling $67.1 million. Subtracting “actual” sales of $32.9 million results in lost unit sales of $34.1 million. Reducing lost unit sales by the incremental cost of goods sold ($22.9 million) and the incremental SG&A ($6.3 million) results in total lost profits of approximately $5.0 million. DDM suffered the lost profits during the period of January 1, 2000, to December 31, 2002. This amount is presented on the damages summary on the final exhibit of this chapter (Exhibit 24.8).
Discounted Cash Flow Method The analyst decided to use a DCF analysis to provide one estimate of the economic damages to the company, as presented in Exhibits 24.1 and 24.2. As previously indicated, the analyst prepared two DCF analyses: (1) the “without” infringement scenario presented in Exhibit 24.4 and (2) the “with” continued infringement scenario presented in Exhibit 24.5. Following is a summary of information included on these exhibits. The DCF method estimates a company’s business enterprise value by (1) projecting the company’s expected net cash flows and (2) calculating the present value of
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Exhibit 24.4
Dead Dried Meats, Inc., Business Enterprise Value Method “without” Infringement Scenario Summary Years Ending December 31 Terminalg ($000)
2007 ($000)
2006 ($000)
2005 ($000)
2004 ($000)
2003 ($000)
Net income after taxesa
3,282
3,282
3,061
2,821
2,596
2,367
Depreciationb Gross cash flow Working capital requirementsb Capital expendituresb Changes in debt principalb Equity net cash flow (NCF)
500 3,782 (729) (500) 2,552
878 4,159 (1,228) (500) 2,432
854 3,914 (1,331) (500) 2,083
829 3,650 (1,250) (500) 1,900
805 3,401 (1,271) (500) 1,630
785 3,152 (1,204) (964) 985
Discounting periodsc Discount factord
4.500 0.577
3.500 0.652
2.500 0.737
1.500 0.832
0.500 0.941
Present value interim NCF
1,403
1,358
1,400
1,357
926
Present value sum interim NCF
6,444
Cost of Equity
Terminal Value
Risk-free rate Plus Equity risk premium Multiplied by beta
5.00% 8.00% 0.50
Small stock and company-specific equity risk premium Required rate of return on equity
Fundamentals 4.00% 4.00% 13.00%
Projected NCFe Present value factor Present value of terminal value
($000) 2,654
Multiple f 11.1
Terminal Value ($000) 29,493 0.577 17,016
Market Value of Equity ($000) Present value of interim NCF Present value of terminal value
6,444 17,016
Total market value of equity
23,461
a As
derived in Exhibit 24.2. provided in company projections. c Using a mid-year discounting convention as of January 1, 2003. d Based on the cost of equity using the discounting periods. e Based on terminal net cash flow increased by the estimated long-term growth rate of 4%. f Based on the cost of equity less an expected long-term growth rate of 4%. g Depreciation and capital expenditures expected to offset on a normalized long-term basis. SOURCE: Exhibit 24.2, industry data, and appraiser calculations. b As
the projected net cash flows using a risk-adjusted present value discount rate. This method uses a company’s projected financial statements in conjunction with the analyst’s risk assessment of an ownership interest in the company and the company’s capital structure. Exhibits 24.1 and 24.2 present the projected income statements under both scenarios. As indicated in the projected income statements, total company revenues in 2007 are projected to be $54.7 million (“without” infringement) versus $28.0 million (“with” the most likely expected effect of the continued MRT infringement).
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Exhibit 24.5
Dead Dried Meats, Inc., Business Enterprise Value Method “with” Continued Infringement Scenario Summary Years Ending December 31 Terminalg ($000) Net income after taxesa
1343
Depreciationb
2007 ($000)
2006 ($000)
2005 ($000)
2004 ($000)
2003 ($000)
1343
1094
573
130
(599)
500
878
854
829
805
785
1843 (373) (500) -
2221 (344) (500) -
1948 (458) (500) -
1402 (528) (500) -
934 (320) (500) -
186 (767) (964) -
970
1377
990
374
114
(1545)
4.500 0.577
3.500 0.652
2.500 0.737
1.500 0.832
0.500 0.941
Present value interim NCF
794
645
275
95
(1453)
Present value sum interim NCF
357
Gross cash flow Working capital (requirements) decreasesb Capital expendituresb Changes in debt principalb Equity net cash flow (NCF) Discounting periodsc Discount factord
Cost of Equity
Terminal Value
Risk-free rate Plus Equity risk premium Multiplied by beta
5.00% 8.00% 0.50
Small stock and company-specific equity risk premium Required rate of return on equity
Fundamentals 4.00% 4.00% 13.00%
Projected NCFe Present value factor
($000)
Multiplef
1,009
11.1
Present value of terminal value
Terminal Value ($000) 11,210 0.577 6468
Market Value of Equity ($000) Present value of interim NCF Present value of terminal value
357 6468
Total market value of equity
6825
a As
derived in Exhibit 24.2. provided in company projections. c Using a mid-year discounting convention as of January 1, 2003. d Based on the cost of equity using the discounting periods. e Based on terminal net cash flow increased by the estimated long-term growth rate of 4%. f Based on the cost of equity less an expected long-term growth rate of 4%. g Depreciation and capital expenditures expected to offset on a normalized long-term basis. SOURCE: Exhibit 24.2, industry data, and appraiser calculations. b As
The projected results of operations are incorporated into the DCF business enterprise value analyses presented in Exhibits 24.4 and 24.5. Exhibit 24.4 presents the DDM business enterprise value estimate based on the “without” the expected effect of the continued infringement projections. Exhibit 24.4 summarizes the projections presented on Exhibit 24.2. Exhibit 24.4 then adjusts the projected net income to a net cash flow level of economic income.
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VI / Intellectual Property Economic Damages Issues
For purposes of this economic damages analysis, the analyst defined net cash flow as follows: Net income after taxes + Noncash expenses (e.g., depreciation expense) = Operating cash flow − Net working capital investments − Capital expenditure investments − Payments of outstanding long-term debt principal = Net cash flow For purposes of estimating the terminal period net cash flow, the analyst assumed that depreciation expense and capital expenditures would be equal on a long-term, normalized basis. Also, the analyst estimated that net working capital investments would increase at the expected long-term growth rate. Next, the analyst calculated the present value of the projected cash flow and the present value of the terminal period cash flow. In the selection of the present value discount rate, the analyst considered the required rate of return for the company’s equity capital. In developing this required rate of return, the analyst used the capital asset pricing model (CAPM). Based on the CAPM analysis summarized in Exhibit 24.4, the required rate of return for an investment in the DDM equity is 13 percent. The analyst calculated the present value of the company’s expected cash flow by applying a present value discount factor. This factor is based on the present value discount rate of 13 percent. In this case, the analyst projected that each year’s cash flow will be received by the company at midyear. Of course, the company will continue to generate cash flow beyond the end of the discrete projection period. Therefore, in order to encompass the value associated with the cash flow expected beyond the discrete projection period, the analyst estimated the company’s “terminal value.” The “terminal value” is the company’s expected business enterprise value at the conclusion of the discrete projection period. The analyst elected to estimate the company’s terminal value by using the Gordon growth model. The Gordon growth model applies a direct capitalization rate to the expected cash flow for the next period after the discrete projection period. This direct capitalization rate is typically estimated as the present value discount rate less the expected long-term growth rate. The analyst estimated the expected long-term growth rate in this case to be 4 percent. Based on the analysis summarized in Exhibit 24.4, the DDM business enterprise value “without” the expected effects of MRT trade secret infringement is $23.5 million. Exhibit 24.5 presents a summary of the DDM business enterprise value analysis “with” the expected effects of the MRT continued use of the trade secret recipes. In this business enterprise value analysis “with” the expected effects of continued infringement, the analyst again selected 13 percent as the appropriate present value discount rate. Also, the analyst again concluded that the appropriate long-term expected growth rate in net cash flow was 4 percent. Based on the analysis summarized in Exhibit 24.5, the terminal value calculation is based on a 9 percent direct capitalization rate, calculated as the 13 percent discount rate less the 4 percent expected long-term growth rate. Accordingly, the DDM business enterprise value “with” the expected effects of MRT’s continued use of the DDM trade secret recipe is $6.8 million. As previously discussed, the above business enterprise value estimates are made as of January 1, 2003. This date was selected to correspond with the penalty phase (i.e., the award of the economic damages) of the subject litigation. The analyst understands that the economic damages phase of the infringement trial will take place in early January 2003. The analyst performed the DCF analysis incorporating two scenarios for DDM’s operating results in order to estimate a present value lump sum of the future damages
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sustained by DDM as a result of the trade secret recipe infringement. Under the first scenario, the analyst estimated the business enterprise value of DDM “without” infringement. This scenario estimates what the operating results of DDM could reasonably have been “but for” the infringement by MRT. The second scenario considers the business enterprise value of DDM “with” continued infringement by MRT of the trade secret recipes. The difference in these two conclusions, therefore, is an estimate of the impact of the continued infringement on the value of DDM. As described herein, the analyst’s conclusions of business enterprise value are approximately $23.5 million “without” infringement and approximately $6.8 million “with” continued infringement. The difference of approximately $16.6 million represents the present value lump sum estimate of economic damages for the period January 1, 2003 and beyond. These calculations are set forth in the final exhibit of this chapter (Exhibit 24.8).
Reasonable Royalty Method An alternative to a determination of lump sum damages is an estimate of an appropriate royalty rate to be paid to DDM as an award for future damages resulting from continued future use of the trade secret recipe by MRT. The question to be answered under this method is, “What would a fair, arm’s-length royalty rate be if both parties negotiated the right for MRT to use the trade secret recipe under a licensing arrangement?” An appropriate royalty rate determination should consider benefits afforded both parties in the transaction. There are a number of available methods to estimate an appropriate royalty rate. In this instance, the analyst selected the profit split method (under the income approach) and the guideline license transaction method (under the market approach). The profit split method incorporates a profit estimate for the trade secret recipe and a profit split estimate between the licensor (DDM) and the licensee (MRT). Exhibit 24.6 presents the analyst’s projections used in the profit split method.
Exhibit 24.6
Dead Dried Meats, Inc., Reasonable Royalty Rate Analysis Summary Profit Split Method Projected 2003 net sales* Pretax net income, EBITDA/sales† Profit split percentage Profit attributable to subject trade secret recipe Indicated royalty rate
Profit Split Level
Low
Average
High
12.0%
28,000,000 3,360,000 25.0%
28,000,000 3,360,000 37.5%
28,000,000 3,360,000 50.0%
840,000 3.0%
1,260,000 4.5%
1,680,000 6.0%
Low
Average
3.5%
6.0%
Guideline License Royalty Rates Median snack food royalty rates‡ Selected royalty rate
1.0% 4.0%
* As presented on Exhibit 24.2. † Based on the EBITDA/sales ratio for infringed products per company management. ‡ As presented on Exhibit 24.7.
High
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VI / Intellectual Property Economic Damages Issues
Similar to the DCF method above, the analyst relied on projected company operations beginning January 1, 2003. As presented in Exhibit 24.2, under the “without” infringement scenario, the projected sales of infringed products for 2003 is $28.0 million. Therefore, these are the estimated dollars that DDM could generate for itself “without” infringement of its trade secret recipe. The profit split method is based on an allocation of the profit attributable to the referenced product sales that a licensee would be willing to pay the licensor in order to use the trade secret recipe. As a result, the first step in this method is to identify the appropriate level of product sales ($28.0 million in this case). The second step in this method is to identify the pretax profit margin associated with the product sales to be licensed. A 12 percent EBITDA/sales ratio is appropriate on these products based on conversations with the company management and historical financial statements. As a result, the projected pretax profit for the trade secret recipe sales is $3.36 million as presented in Exhibit 24.6. The third step in this method is to select the appropriate profit split that a licensee would be willing to pay the licensor for a license of the trade secret recipe. The analyst determined that the typical range of split is between 25 and 50 percent. As a result, the analyst calculated profit attributable to the trade secret recipe of $840,000 (25 percent split), $1.26 million (37.5 percent split or the average of the typical range), and $1.68 million (50 percent split). Based on these profit levels, the indicated royalty rates are 3.0, 4.5, and 6.0 percent, respectively. In addition to the profit split method, the analyst reviewed available transaction data for published royalty rates for specialty food products manufacturers. These data are presented in Exhibit 24.7. The analyst used these data as a reasonableness test for the conclusion reached in the profit split method. As presented on Exhibit 24.7, the median corporate royalty rates for the snack food categories identified by the analyst were 1.0 percent (low), 3.5 percent (average), and 6.0 percent (high). The analyst then considered the specific facts and circumstances of the DDM trade secret recipe in order to determine an appropriate royalty rate for the subject interest. An appropriate royalty rate should consider the quantitative data presented above in addition to certain qualitative factors. The following are some of the factors the licensor and licensee should consider in negotiating an appropriate royalty rate: • • • • •
The licensed product and degree of consumer recognition Sales and profit potential of the licensed product Industry competition Current and potential alternative products Economic conditions in the industry and in general
These factors are some of the considerations the two parties would take into account during negotiations. Based on the qualitative factors above and the history of the trade secret recipe’s consistent profitability, growth, and success, the analyst determined that an appropriate royalty rate should be near the average indication from the data presented. As presented in Exhibit 24.6, the analyst selected a royalty rate of 4.0 percent. If the royalty rate is determined to be the appropriate damages on future sales of MRT infringing sales, an agreement needs to clearly state how the rate is to be applied. For example, is the rate applied to gross sales or net sales less returns? The analyst can use the historical sales information that MRT provided to estimate future royalties that DDM may receive from MRT as a comparison to the lump sum estimate.
Exhibit 24.7
Dead Dried Meats, Inc., Reasonable Royalty Rate Analysis, Royalty Rate Transaction Data Corporate Royalty Rate Licensed Product
Low
Average*
High
1.0% 1.0% 3.0% 2.5% 2.0% 1.0% 1.0% 1.0% 1.0% 4.0% 5.0% 5.0% 3.0% 4.0% 3.0% 3.0% 1.0% 1.0% 1.0% 1.0% 1.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 1.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 1.0% 1.0% 3.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0%
3.0% 3.0% 4.5% 4.3% 3.5% 3.5% 3.5% 4.5% 3.5% 6.0% 7.0% 7.0% 4.5% 8.0% 6.5% 6.5% 3.5% 3.5% 3.5% 3.0% 3.0% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 3.5% 5.0% 5.0% 4.5% 4.5% 4.5% 5.0% 3.0% 3.5% 6.5% 3.0% 3.5% 3.5% 3.5% 3.5% 3.5% 3.5%
5.0% 5.0% 6.0% 6.0% 5.0% 6.0% 6.0% 8.0% 6.0% 8.0% 9.0% 9.0% 6.0% 12.0% 10.0% 10.0% 6.0% 6.0% 6.0% 5.0% 5.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 7.0% 7.0% 6.0% 6.0% 6.0% 7.0% 5.0% 6.0% 10.0% 5.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0%
3.0% 1.0% 1.0%
6.5% 3.5% 3.0%
10.0% 6.0% 5.0%
Analysis of Royalty Rates for Specialty Food Products Cheese and cracker combinations Cheese (in general or name-specific types) Chocolate milk Peanut butter Potato chips Snack food (fruit-based) Yogurt Bakery products Breakfast cereals Bubble gum Cake decorations (edible) Cakes Candied nuts and/or popped popcorn Candy Candy-coated popcorn Caramel popcorn Cereal-based snack food Cereals (breakfast) Cereals (processed) Cheese flavored puffed corn snacks Cheesecake Chewing gum Chocolate Chocolate (hot) Coffee Cookies Corn chips Crackers Decorations for cakes Fruit snacks (candied) Ice cream Ices (flavored) Licorice Mints (candy) Oatmeal Popcorn (popped) Pretzels Puddings Sherbet Snack food (cereal-based) Snacks (candied fruit) Tea-based beverages with fruit flavoring Yogurt (frozen) Yogurt (slightly melted) Snack Foods† High Median Low
* Calculated average of the low and high royalty rate indication for each product. † Analyst calculation based on selected categories of “snack foods.” SOURCE: Gregory J. Battersby and Charles W. Grimes, Licensing Royalty Rates, 2001 Edition (New York: Aspen Law & Business, 2001).
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VI / Intellectual Property Economic Damages Issues
Synthesis and Conclusion Exhibit 24.8 presents the conclusions of three component analyses in this economic damages case study: (1) the historical lost profits suffered by DDM for the period from the inception of the MRT infringement up to the date of the award in the subject litigation; (2) the claim for a lump sum award for the total expected economic damages suffered by DDM due to the continued use of MRT of the trade secret recipe; and (3) as an alternative damage analysis to the lump sum claim, the claim for a periodic fair, arm’s-length royalty rate that the court should order MRT to pay to DDM. This arm’s-length royalty rate relates to MRT’s continued use of the trade secret recipe. In this case, the analyst used the DCF method to quantify the economic damages to DDM associated with MRT’s continued use of the subject trade secret. Using this method, the analyst compared the expected results of operations of the company “with” and “without” consideration of the intellectual property infringement. Since the principal difference in the expected results of operations for DDM is the expected effect of the trade secret infringement, the difference in the two business enterprise value estimates is one measure of the lump sum economic damages suffered by DDM. Using the DCF method, the analyst estimated the DDM business enterprise value with and without MRT’s continued use of the trade secret Barbecue Bovine recipe. As presented in Exhibit 24.4, the business enterprise value of the company without the MRT continued use of the trade secret is $23.5 million. As presented in Exhibit 24.5, the business enterprise value of the company with the MRT continued use of the trade secret is $6.8 million. The two business value estimates represent the expected decrease in the company business value due to the expected effect of MRT’s continued use of the subject trade secret. Accordingly, the difference of $16.6 million represents one measure of the lump sum award that would compensate DDM for economic damages. This measure of economic damages to DDM relates to the expected effects of MRT’s continued competitive use of the trade secret Barbeque Bovine recipe. As an alternative to making a lump sum economic damages claim, DDM’s legal counsel could request that the judge order MRT to pay DDM a fair, arm’s-length Exhibit 24.8
Dead Dried Meats, Inc., Economic Damages Summary Period 1/1/00 - 12/31/02 Historical lost profits*
$4,991,965
Period 1/1/03 and Beyond Lump sum economic damages claim†
23,460,571 (6,824,874) $16,635,697
OR Royalty rate claim‡
4.0%
* As derived on Exhibit 24.3. † Based on the change in equity value “with” and “without” continued infringement per Exhibits 24.4 and 24.5. ‡ Based on indicated royalty rate per Exhibit 24.6.
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royalty rate for its continued use of the trade secret recipe. It is noteworthy that the judge ruled that MRT could continue using the trade secret Barbecue Bovine recipe at the end of the liability phase of the subject litigation. Accordingly, it is likely that the judge will issue an order for a royalty rate payment from MRT to DDM, if the analyst can support the royalty rate estimate. In this case, the analyst used the profit split method and reviewed transaction data for guideline license agreement royalty rates in order to estimate an appropriate range for a reasonably royalty of the trade secret Barbecue Bovine recipe. The analyst then considered the specific facts and circumstances of DDM’s business in order to conclude a royalty rate of 4.0 percent.
Analysis Work Product As indicated earlier in this chapter, the judge in this matter has found that MRT did, in fact, violate the legally protected DDM trade secret recipe. Accordingly, in the damages phase of the litigation, the analyst must prepare an expert report that (1) quantifies the historical lost profits suffered by DDM as a result of MRT’s actions and (2) quantifies a claim for compensation to DDM for the economic damages associated with MRT’s future use of the subject intellectual property. Now that liability has been established, the judge will issue an order specifying the amount and structure of an award to DDM. To assist the judge in determining the amount and structure (e.g., lump sum payment vs. royalty payment) of the award, the analyst’s economic damages expert report should be clear, convincing, and cogent. Accordingly, the analyst’s expert report (which is not included in this chapter) will include the following sections: 1. 2. 3. 4.
Introduction (purpose) Summary description of the sources of information Summary of analysis (methods used) Conclusion (damages summary)
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Norton, George M. III, Valuation: Maximizing Corporate Value. New York: Wiley, 2003. Pratt, Shannon P., Business Valuation Body of Knowledge, 2nd ed. New York: Wiley, 2003. ______, Business Valuation Discounts and Premiums, New York: Wiley, 2001. ______, Cost of Capital: Estimation and Applications, 2nd ed. New York: Wiley, 2002. ______, The Lawyer’s Business Valuation Handbook. Chicago: American Bar Association, 2000. ______, The Market Approach to Valuing Businesses. New York: Wiley, 2001. Pratt, Shannon P., Robert F. Reilly, Robert P. Schweihs, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 4th ed. New York: McGraw-Hill, 2000. ______, Valuing Small Businesses and Professional Practices, 3rd ed. New York: McGraw-Hill, 1998. Rappaport, Alfred, Creating Shareholder Value: A Guide for Managers and Investors. New York: The Free Press, 1998. Razgaitis, Richard, Dealmaking Using Real Options and Monte Carlo Analysis. New York: Wiley, 2003. Reilly, Robert F., Robert P. Schweihs, eds., The Handbook of Advanced Business Valuation. New York: McGraw-Hill, 1999. Solomon, Lewis D., Lewis J. Saret, Valuation of Closely Held Businesses: Legal and Tax Aspects. New York: Panel Publishers, 1998. Trugman, Gary R., A CPA’s Guide to Valuing a Closely Held Business. Harborside, NJ: American Institute of Certified Public Accountants, 2001. Weil, Roman L., Michael J. Wagner, Peter B. Frank, Litigation Services Handbook: The Role of the Financial Expert, 3rd ed. New York: Wiley, 2001 (supplemented through 2003). West, Thomas L., Jeffrey D. Jones, Handbook of Business Valuation, 2nd ed. New York: Wiley, 1999.
Intangible Asset and Intellectual Property Valuation Books Andriessen, Daniel, Making Sense of Intellectual Capital: Designing a Method for the Valuation of Intangible Assets. Burlington, MA: Butterworth-Heinemann, 2004. Askew, Anthony B., Elizabeth C. Jacobs, 2002 Intellectual Property Law Update. New York: Aspen Law & Business, 2002. Battersby, Gregory J., Charles W. Grimes, eds., Licensing Desk Book: Legal & Business Guide. New York: Aspen Law & Business, 1999 (supplemented through 2002). ______, Licensing Royalty Rates. New York: Aspen Law & Business, 2004. Boer, F. Peter, The Valuation of Technology: Business and Financial Issues in R&D. New York: Wiley, 1999. Bryer, Lanning, Melvin Simensky, Intellectual Property Assets in Mergers and Acquisitions. New York: Wiley, 2002. Cole, Robert T., Practical Guide to U.S. Transfer Pricing. New York: Aspen Publishers, 1999. Contractor, Farok J., ed., Valuation of Intangible Assets in Global Operations. Westport, CT: Quorum Books, 2001. Daum, Juergen H., Intangible Assets and Value Creation. New York: Wiley, 2002. Feinschreiber, Robert, Transfer Pricing International: A Country-by-Country Guide. New York: Wiley, 2000. Gardner, Christopher, The Valuation of Information Technology: A Guide for Strategy Development, Valuation, and Financial Planning. New York: Wiley, 2000.
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Index A Accounting Oversight Board, 36 accumulated earnings tax, 142 ad valorem taxation, 471–501 summation valuation concept, 472 unit valuation concept 472–74 Adams v. Commissioner, 72, 90, 95, 100, 102–03 aggregate market value, 210–13. See also market value of invested capital capitalized lease obligations, 211 diluted shares, 211 maximum dilutive effect, 211 treasury stock method, 211 long-term debt, 211–12 short-term debt, 211–12 zero coupon debt, 211 Almanac for Business and Industrial Ratios, 601 alternative minimum tax, 141 American General Corp. v. Camp, 245 American Institute of Certified Public Accountants (AICPA), 349 American Partnership Board, 43 American Society of Appraisers, 40, 349 American Society of Association Executives, 618 annuity in perpetuity, 405, 407 antikickback statutes, 301 Appraisal Foundation, The, 331, 349, 544 arbitrage pricing theory. See income approach, discount rate, arbitrage pricing theory arithmetic mean, 216–18. See also income approach, equity risk premium, arithmetic vs. geometric average Arnott, Robert, 10 asset-based approach, 46, 76–77, 85, 282–84 adjusted net asset method, 76 asset accumulation method, 76 excess earnings method, 76 (see also intellectual property, valuation methods) net asset value, 40–42, 46, 69 See also cost approach asset value, 224–25 assignee interest, 180, 197, 207 AUS Consultants, 615, 619
B bankruptcy, 468–69 debtor-in-possession (DIP), 469 reorganization plan, 469 Barney, Jay B., 313, 316
Bates stamp, 348 before and after method. See economic damages analysis, approaches and methods Bernstein, Peter, 10 beta. See income approach, equity risk premium Black-Scholes options pricing model, 60, 68 Bolotsky, Michael, 40 Bonbright, James, 244–45 book value, 299 breach of fiduciary duty, 231 built-in gains tax, 45–69, 98, 114, 148, 152, 155 buy-sell agreements, 135
C call option, 263 Canadian business laws, 233–52 Canada Business Corporations Act (CBCA), 241–46 corporate dissolution, 245 oppression remedies, 242–45 shareholder rights, 243–46 take-over bids, 245–46 Canada-U.S. Income Tax Treaty, 238, 441 Canadian-controlled private corporation (CCPC), 238 Canadian Income Tax Act environmental laws, 250–51 Canadian Environmental Assessment Act (CEAA), 251 Canadian Environment Protection Act (CEPA), 250–51 Fisheries Act, 251 Transportation of Dangerous Goods Act, 251 exchangeable share transaction, 242 Federal Competition Bureau, 236 foreign ownership restrictions, 234–37 income tax, 237–42 Industry Canada, 234–36 Investment Canada Act, 234–36 Nova Scotia Companies Act, 240n, 241 Nova Scotia Unlimited Liability Co. (NSULC), 240–42 Ontario Securities Act, 246 Ontario Securities Commission, 246–50 formal valuation, 246–50 going-private transactions, 247–48 insider bid, 246–48 issuer bid, 246–48 related-party transactions, 247–48 retractable shares, 242 safe income rules, 238 transaction structure, 238 transfer pricing law, 541
654
Canadian companies, 233–52 capital asset pricing model (CAPM). See income approach, discount rate capital expenditures, 223–24, 285, 460, 464–66, 481 capital gains, 262 on C corporations vs. S corporations, 78 deferral of, 131–32, 146, 156, 161–65 with pass-through entities, 92, 103, 108, 151 in the S corporation economic adjustment, 79–82 unrealized, 86–87, 181 capital structure, 294, 596, 640 analysis of, 285 value of (see market value of invested capital) See also income approach, equity risk premium, weighted average cost of capital capitalization rate. See income approach cash flow. See economic income cash method of accounting, 142 Center for Research in Security Prices database, 6, 20, 23–27 Center for Software Engineering, 482 Chandler, Alfred D., 306 check-the-box regulations, 240n Chen, Peng, 10, 16 Church v. United States, 205–06 Clausewitz, Carl Von, 312, 327 closed-end investment companies. See closed-end funds Community Board and Conflicts of Interest Policy, 296 Compact D/SEC, 290 comparable companies. See market approach, guideline companies compensation, 295–96 competitive analysis, 311–12, 326–27 Compustat database, 19 control, corporate, 236 control, lack of. See discounts, lack of control discount control premium. See premiums, for ownership control controlling ownership interests, 11–12 in S corporations, 76, 96–98, 103–10, 115–20, 124, 160–62 convertible debentures, 142 convertible preferred stock, 142 Copyright Act of 1976, 427 copyrights. See intellectual property, types of Cornell, Bradford, 16 cost approach, 269, 272, 283, 422, 479–80, 482. See also asset-based approach cost avoidance, 284 principle of substitution, 282–83 replacement cost, 283, 479–83, 486–88, 492 functionality, 283 utility, 283 reproduction cost, 283, 479–80 software engineering model method (see intellectual property, software) trended historical costs, 284, 479, 480, 482 cost/benefit analysis, 464–66 cost of capital, 12, 218, 221–22, 338–41, 407, 617. See also income approach, equity risk premium, weighted average cost of capital Creating Shareholder Value, 18
Index
D damages analysis. See economic damages analysis Daubert v. Merrill Dow Pharmaceuticals, Inc., 351–52 debt interest rate, 49–50, 62–63 Delaware holding company, 577 depreciation, 223-24, 284, 466 Dimensional Fund Advisors Small Company 9–10 Fund (DFA), 26–27 discount rate. See income approach discounted cash flow (DCF) method. See income approach discounts, 31–43, 178–79, 351 discount for built-in gains, 45–69 investment company discount, 181, 184 lack of control discount, 31–38 for Canadian companies, 249 in fairness opinions, 225 for family limited partnerships, 178–79, 181, 184–87, 191, 200–01, 206 for investment companies, 40–43 for S corporations, 76 for sports teams, 265 lack of marketability discount for Canadian companies, 249 in fairness opinions, 225 for family limited partnerships, 178–79, 184–85, 190–94, 200–02, 206, for S corporation ESOPs, 158–59 for S corporations, 62, 65, 87, 99, 116 pre-IPO studies, 201–02 Willamette Management Associates study, 195 Quantitative Marketability Discount Model (QMDM), 191 restricted stock studies, 191–94, 201–02 Columbia Financial Advisors study, 193 SEC Institutional Investor study, 192 Silber study, 193 from net asset value, 41–43, 184–89, 195, 200–01, 206 portfolio discount, 206 diverted cash flow, 35 dividend deduction tax relief, 93 dividend discount model, 13 dividend history, 86–87 dividend payout ratio, 78–82, 87, 92 dividends, 60, 78–82, 174 in rate of return formula, 75 in S corporations, 131–32, 139, 142, 151 Domglas, Inc., Re, 244 domestic international sales corporations (DISCs), 138 double taxation, 124 avoidance of, 92–94, 138–39, 142, 151 on C corporations, 128, 164, 174
E economic damages analysis, 329–52 approaches and methods before and after, 335 but-for estimate, 331, 631, 634, 636, 639, 643 economic modeling, 334 ex ante, 342–45, 347
Index
ex post, 342–47 historical lost profits, 638–39 hybrid analysis, 346–47 reasonable royalty method, 643–44 (see also intellectual property, valuation methods, profit split method and guideline transaction method) yardstick case study, 627–47 damage event date, 331 discount rates for, 394–97, 407–08 future damages, 634, 642–44, 646 income projections for, 383 income tax effect, 331 mitigation, 331–32, 345 remaining useful life estimation for, 425–26, 430 reporting requirements 348–50 risk parity, 347 Sherman Act, 333 tax-affect procedure, 335–41 types of damages breach of contract, 333 lost profits, 330, 335, 338–41 case study, 630–31, 638–39, 646 for patent infringement, 383–84 lost sales, 332 Economic Growth and Tax Relief Reconciliation Act of 2001, 129, 133 economic income, 74, 150 definitions of, 463–67, 448 earnings before interest and taxes (EBIT), 150, 217–18, 339–40, 601, 603 earnings before interest, taxes, depreciation, and amortization (EBITDA), 150, 217–18, 601, 604 earnings before interest, taxes, depreciation, amortization, and rent expense (EBITDAR), 218 fair economic income, 594 free cash flow, 105, 124 net cash flow, 74, 218, 220 after-tax, 285, 335–36, 339–41 in damages estimates, 639, 641–42 in discount and capitalization rates, 387, 399, 409 to invested capital, 525, 529–30, 532 model, 286 projections of, 356 net income, 74–75, 150, 356, 399, 405, 466, 641 operating cash flow, 596 operating income, 466, 560, 566, 573–75, 595 (see also earnings before interest and taxes) projection of (see income projections) revenues, 217, 601, 605–06 true taxable income, 568 excess economic income, 598–99, 601, 607 in discount and capitalization rates, 386–89, 392, 396–99, 401–10 in remaining useful life analysis, 425, 428 in transfer pricing, 596 remainder income (see residual income) residuum income (see residual income) residual income, 448, 451–58, 576
655
royalty income, 453–58, 461–67, 567, 577, 586–91, 594 (see also royalties) terminal income (see residual income) economic value added (EVA), 306 Electronic Data Gathering and Retrieval (EDGAR), 615, 617 Employee Retirement Income Security Act (ERISA), 159 employee stock ownership plans (ESOPs). See S corporation employee stock ownership plans employment agreements, 114–15, 477 Endicott Johnson Corp. v. Bade, 245 enterprise value, 634, 639–43, 646. See also market value of invested capital environmental issues, 250–251. See also Canadian laws, environmental laws equity risk premium. See income approach Equity Risk Premium, The, 17 excess earnings method. See asset-based approach and intellectual property, valuation methods
F fair market value. See standards of value, fair market value fair value. See standards of value, fair value fairness opinions, 209–32 Fama, Eugene, 10 family attribution, 178 family limited partnerships (FLPs). See pass-through entities Federal Employer’s Liability Act (FELA), 338 Federal Health Care Program Civil Monetary Penalties Law (CMP Law), 299–300 Federal Reserve Statistical Release, 617 Federal Rules of Civil Procedure (FRCP), 331, 348–49 fee simple ownership basis, 282 fiduciary-out provision, 231 Financial Accounting Standards Board (FASB), 540 Statement No. 57, 540, 544 Statement No. 141, 115n financial distress, 162–64 financial reporting, 540 Financial Valuation Group database, 615, 618 First Call, 15 Fishman v. Estate of Wirtz and Illinois Basketball, Inc. v. Estate of Wirtz, 333 Five-Forces Framework, 306–07, 309–311 fixed income portfolios, 184 fractional ownership interests. See noncontrolling ownership interests French, Kenneth, 10 fresh start, 67
G generally accepted accounting principles (GAAP), 540 generic competitive strategy, 322–23 cost leadership, 322 differentiation, 322–23 geometric mean, 216. See also income approach, equity risk premium, arithmetic vs. geometric average gift tax, 206 Global Securities Information, 615, 617 going-concern premise of value, 268, 412, 467–68, 587 going-private transaction, 227, 243
656
Index
Goodwill Registry, The, 292 Grant, Robert M., 315 Gross v. Commissioner, 72, 90, 92, 99–100, 102–03 guideline merged and acquired company method. See market approach guideline publicly traded company method. See market approach
H Hall v. Chicago & N.W. Railway Company, 336 Hamel, Gary, 313 harmonic mean, 216–18 Harper, Estate of Morton B., v. Commissioner, 203–04 health care entities, 279–301 fee-for-service delivery system, 280 gainsharing, 299–301 integrated delivery systems, 280–81, 297, 299, 301 managed care, 280, 295 patient relationships, 282 physician compensation, 295–96 physician practice management (PPM), 299 physician practices, 281, 293–99 regulatory constraints, 297–98 tax-exempt status, 281, 295, 297–98 trained and assembled workforce, 283, 299 valuation of, 281–99 asset-based approach, 282–84 cost approach, 283–84 income approach, 284–90 market approach 290–93 Health Care M&A Report, The, 291, 298–99 Heck v. Commissioner, 72, 90, 99–100, 102–03 highest and best use, 96, 372, 467–68 hurdle rate, 12
I Ibbotson Associates, 6–8, 14–15, 18–21, 25–28, 402, 528 Cost of Capital, 14, 528–29 Stocks, Bonds, Bills & Inflation, 8, 28, 288–89, 407, 598, 617 Ibbotson, Roger, 10, 16 income approach, 73–76, 84, 89–125, 150, 355–419 in ad valorem cases, 480–81 capitalization method (see direct capitalization method) capitalization rate, 74–75, 88, 91, 150, 385–419 in damages analysis, 335, 642 in fairness opinions, 220 direct capitalization method, 74–75, 150, 389, 393, 405–09, 472 discount rate, 4, 21, 60 arbitrage pricing theory, 4, 410–413 build-up model, 4, 288, 405–08, 413 capital asset pricing model (CAPM), 4, 5n, 19–22, 288, 642 in estimating a discount rate for intellectual property, 399–405, 413, 527–28 in fairness opinions, 220–222 in transfer pricing, 597–98 in damages analysis, 331, 335, 344, 346, 425
in fairness opinions, 218–24 Fama-French three-factor model, 4 for intellectual property, 379, 385–419, 452–57, 525–26, 529–32 in damages analysis, 640–42 for S corporations, 74, 90–92, 99–109, 124, 150 in valuation of health care entities, 285–89, 294 discounted cash flow analysis, 73–74, 90–91, 99–102, 150 in ad valorem cases, 480–81 in damages analysis, 330, 332, 634, 639–43, 646 in fairness opinions, 216, 218–24 for intellectual property, 380–81, 444–45, 524–33 for estimating a discount rate, 387–95 in valuation of health care entities, 283–89, 294 equity risk premium, 3–29, 53–55, 527–28 arithmetic vs. geometric average, 9, 24, 27 beta, 19–20, 24, 366, 528, 617 for estimating a discount rate on intellectual property, 400–05, 411 in damages analysis, 346–47 in fairness opinions, 221 in transfer pricing, 598 in valuation of health care entities, 288 bottom-up method, 13–15 company-specific risk premium, 308, 312, 315, 323, 527, 530, 598 for estimating a discount rate on intellectual property, 400, 402–08 ex ante approach, 4 ex post approach (see realized return approach) in fairness opinions, 221 investment-specific risk, 308–25, 403, 407, 411, 415, 597 negative serial correlation, 9 realized return approach, 4–6 risk-free rate, 5, 54–55, 288, 527 for estimating a discount rate on intellectual property, 400, 405, 415 in fairness opinions, 221 in transfer pricing, 597 size effect, 18–29, 527 criticisms of, 23–29 bid/ask bounce bias, 23 delisting bias, 24–26 January effect, 23 transaction costs, 26 for estimating a discount rate on intellectual property, 403, 406, 411 in fairness opinions, 221 in transfer pricing, 597–98 in transfer pricing, 597 small stock premium (see size effect) sum beta method, 19 systematic risk, 399–401, 410, 528, 597 unsystematic risk, 399–400, 403, 528 Gordon growth model, 107, 220, 222–23, 285, 529, 642 growth rate, 107, 115–23, 529–32 for valuation of intellectual property, 380, 387–93, 407 in damages analysis, 642
Index
in fairness opinions, 220, 222–23 in residual value analysis, 456–58 net present value analysis, 460–67, 572 present value annuity, 454–57 remainder value (see residual value) remaining value (see residual value) residual value, 285, 359, 387, 449–70 (see also terminal value) salvage value, 449 terminal value, 62, 101, 103, 108–14, 529–32 (see also residual value) in damages analysis, 642 for estimating a discount rate for intellectual property, 387–89 in fairness opinions, 218, 220–23 weighted average cost of capital, 74, 99n, 525–27, 529–32 asset weightings, 416 cost of debt, 527–28, 530, 597–99 in estimating a discount rate for intellectual property, 413 for health care entities, 286–88 in lost profits calculations, 338–39 cost of equity, 527–28, 530, 596–99 in estimating a discount rate for intellectual property, 404–06, 413 for health care entities, 286–89 in lost profits calculations, 338–39 in damages analysis, 339–41 in fairness opinions, 220 for estimating a discount rate for intellectual property, 399, 412–18 formula for, 415 in transfer pricing, 596–99 return on debt (see cost of debt) return on equity (see cost of equity) in valuation of health care entities, 284–90, 299 in valuation of sports teams, 262, 270–71 yield capitalization rate (see discount rate) income projections, 355–84, 449–54, 461–67, 480, 525, 637 extrapolation methods, 361–71 curvilinear extrapolation, 366–68 polynomial function, 367 quadratic function, 367 disturbance factor, 364 linear extrapolation, 361–65 multicollinearity, 365–66 multiple regression, 369–71 parametric regression coefficients, 369 probability assessment, 359 probability distribution, 365 judgmental methods, 382–84 life cycle analysis, 373–78 market growth stage, 375–76, 378 market maturity stage, 375–77 product development stage, 375, 377–78 revenue decline curve, 376 sales decline stage, 375–78 Monte Carlo analysis, 372, 379–82 regression analysis, 365–67, 369–71
657
sensitivity analysis, 359, 378–80 simulation methods, 372, 380–82 tabula rasa methods, 371–73 individual retirement account (IRA), 130 Indu Craft, Inc. v. Bank of Baroda, 333 Institutional Broker’s Estimate System (I/B/E/S) Consensus Estimates, 14–15 intangible asset value, 281, 598 intangible assets, 269–273, 281–83, 545. See also intellectual property assembled workforce, 272, 283, 299 going-concern value, 225, 283 goodwill, 271, 417–18, 564, 592 patient relationships, 282 intellectual property, 251–52, 355–647 associations, 619–20 copyrights, 382, 404–05, 425, 427, 445–46, 477 engineering drawings, 425, 439–41 infringement, 629, 647 patents, 455, 461–63, 504–34 Canadian, 251 infringement examples, 363, 383, 395–96, 407–08, 439–41 purchase price allocation example, 417–18 statutory life, 427 technological life, 428 researching, 613–25 software, 397–98, 445–46, 472–501 cost per person-month, 483, 487–88 software engineering model methods, 480, 482–92 Constructive Cost Model (COCOMO), 482–85, 487–93, 498 KnowledgePLAN, 482–85, 491–92, 494–98 Software Lifecycle Management (SLIM) model, 482 technology, 543, 560–61, 566 trade name, 406–07, 585–610 trade secret, 472–77, 498 damages analysis example, 628–47 discounted cash flow example, 393–94 food recipe, 630–47 Monte Carlo analysis example, 380–82 statutory life, 427 valuation example, 441–44 trademark, 356–57, 377 certification marks, 592 collective marks, 592 declaration of use, 427 discounted cash flow analysis example, 388–93, 409–10 economic life, 428 licensing example, 444–45 service marks, 592 statutory life, 427 transfer pricing example, 585–610 valuation methods comparable profits method Berry ratio, 575 constructive operating profit (COP), 574–75 in licensing 512–17, 524 rate of return on capital employed (ROCE), 574–75
658
Index
intellectual property (Cont.) in transfer pricing, 426, 545, 548–49, 560–61, 573–75 comparable uncontrolled transaction (CUT) method in licensing 510–12, 524 in transfer pricing, 426, 545–47, 560–61, 572–73, 607–08 discounted cash flow (see income approach, discounted cash flow) excess earnings method, 426, 512, 596–601, 607 (see also asset-based approach, excess earnings method) guideline transactions, 509, 575, 577, 615–16, 643, 645 (see also market approach, guideline transactions) market-derived replacement cost method, 481–83 market-derived royalty rate analysis, 607–08 profit split method, 382–26 capital employed allocation rule, 575–76 comparable profit split rule, 575–77 in damages analysis, 643–44 in licensing 517–24 residual allocation rule, 575–76 in transfer pricing, 545, 549, 575–77, 595–96, relief from royalty method, 377, 481 Intellectual Property Research Associates, 616, 618 Internal Revenue Code, 62, 242, 267 Chapter 14, 172, 174–75 Section 197, 104, 267 Section 338, 140 Section 404, 157–58 Section 415, 147, 166 Section 482, 510n, 540, 544, 550, 557n, 566, 568–80 Section 501, 298, 584 Section 754, 196, 198, 267 Section 1042, 132–32, 146, 161, 164–65 Section 1056, 269 Section 2703, 175, 195, 199, 205–06 Section 2704, 175, 206–08 Section 2036, 174, 177–78, 199–200, 203–05 Section 4958, 297 Section 4975, 156–57 Section 6662, 568, 578 Internal Revenue Service, 38, 90, 136 sports team acquisitions, 268–69 transfer pricing matters, 544–45, 550, 565 valuation of family limited partnerships, 178–79, 190–208 valuation of health care entities, 285–86, 296–97 Internal Revenue Service Restructuring and Reform Act of 1998, 176 investment companies, 40–43, 76 investment holding period, 60, 87, 115, 262 Investment Valuation, 17 investment value. See standards of value, investment value Iowa State University, 428 IRS Corporate Financial Ratios, 610 Irving Levin Associates, Inc., 291
J Jobs and Growth Tax Reconciliation Act of 2003, 78n, 88, 117, 122, 124 Jones & Laughlin Steel Corp. v. Pfeifer, 338
K Kerr v. Commissioner, 200, 206–08 Kimbell, Estate of, v. United States, 204–05 Knight v. Commissioner, 206–07
L Lanham Act of 1947, 592 levels of value, 40–214 license agreements patent example, 504, 518–19, 524 remaining useful life analysis, 426–27, 430, 444 transfer pricing, 567, 573, 594–95, 607–09 license fee, 372, 397, 445, 507, 630 licensing, 358, 388, 426, 444–45, 503–34, 594 Licensing Economics Review, 615 Licensing Royalty Rates, 618, 633, 645 lifing. See remaining useful life analysis liquidation value, 225, 467–69 auction liquidation, 468 forced liquidation (see auction liquidation) orderly disposition, 467 voluntary liquidation, 467–69
M macroenvironmental analysis, 309–10 maintenance expenditures, 459–67 management buyout, 227 Maple Leaf Foods, Inc. v. Schneider Corporation, 245 market approach, 74–76, 84, 95, 149, 422, 425 in ad valorem cases, 481–482 comparable companies (see guideline companies) in fairness opinions, 217 guideline companies, 41, 512 in fairness opinions, 213–14, 222 in transfer pricing cases, 549–50, 573–75, 599–607 sources for, 615 in valuation of health care entities, 288, 290 in valuation of sports franchises, 263 guideline merged and acquired company method, 75–76, 149, 213–14, 291–93 guideline publicly traded company method, 75, 149, 213–14, 290–91 guideline transactions, 292, 350, 397, 409–10, 509, 615–16 (see also intellectual property, valuation methods, guideline transactions) market-derived pricing multiples, 74–76, 95, 149 in ad valorem cases, 483 in damages analysis, 350 in fairness opinions, 210, 213–18, 222–23 in valuation of health care entities, 290–95, 299 in valuation of sports franchises, 263–264 price/earnings multiple, 73 relief from royalty method (see intellectual property, valuation methods) stock and debt method, 472 in valuation of health care entities, 283, 290–93 in valuation of sports franchises, 262, 269 market capitalization. See market value of invested capital
Index
market risk premium. See income approach, equity risk premium market value, 21 market value-added (MVA), 306 market value of invested capital (MVIC), 210–13 in damages analysis, 341, 634 in licensing, 530–32 in transfer pricing cases, 602 in valuation of health care entities, 286, 289–90 in valuation of sports franchises, 265 marketability, lack of. See discounts, lack of marketability discount Marshall, Alfred, 309 McCord, Charles T. Jr. and Mary S., v. Commissioner, 200–02 McGrattan, Ellen R., 11 Medicaid/Medicare Fraud and Abuse Statutes. See Stark legislation Mergerstat Review, 291 Merrill Lynch, 13–15 mid-year compounding convention, 453–58, 461 minority interest. See noncontrolling ownership interests Monte Carlo analysis. See income projections Montgomery v. Shell Canada, 245
N Nath, Eric, 38 National Association of Certified Valuation Analysts (NACVA), 349 negative cash flow, 151, 261 Neonex International Ltd. v. Kolasa, 244 net asset value, 174, 176, 180–81, 185–89 net capital appreciation, 80 net economic benefit, 77–83, 270–71. See also economic income net operating loss carryforwards, 162–63, 237 New Role of Intellectual Property in Commercial Transactions, 629 noncompetition agreements, 114–15 noncontrolling ownership interests, 11–12, 72, 76, 85 in Canadian companies, 242–46 in damages analysis, 332 in fairness opinions, 212 in family limited partnerships, 172–208 in S corporations, 96–100, 110–16, 121–24, 160–62 in sports teams, 263–65 Norfolk & Western Railway Co. v. Liepelt, 338 North American Free Trade Agreement (NAFTA), 234
O obsolescence, 284, 422, 425, 478, 486–87 economic, 486 functional, 429, 486 technological, 486 option agreements, 135 Organization for Economic Cooperation and Development (OECD), 541 Oster, Sharon, 327
659
P Panduit Corp. v. Stahlin Bros. Fibre Works, 383 Partnership Profiles, 42–43, 185–86 Partnership Spectrum, 42–43, 185, 187–90 pass-through entities, 72–208, 241 pass-through basis adjustment, 95, 108 types of: closed-end funds, 41–42, 92, 181–84, 201 limited liability companies (LLCs), 92–93, 172, 267 family limited partnerships, 171–208 adequate consideration, 205 adequate disclosure, 176–78 valuation parameters, 179–95 degree of leverage, 186 distribution yield, 186 percentage of cash flow paid out, 186 price to cash flow, 186 price to net asset value, 186 voting rights, 173, 197 limited partnerships, 172–208 master limited partnerships (MLPs), 93 real estate investment trusts (REITs), 92–93, 95, 201 partnerships, 92–93, 267 partnership agreement, 34, 173–75, 180, 200, 205–08 business purpose, 195–96, 204–05 dissolution, 198 distributions, 197 provisions of, 191 transferability, 197 partnership structure, 172–73 S corporations, 62–66, 71–168 benefits of, 94–95, 138–42 eligibility, 138 restrictions of, 94–95, 142–44 S corporation economic adjustment (SEA), 79–82 S corporation equity adjustment multiple (SEAM), 82–88 seasoned S corporations, 98 tax-affecting net income, 72, 90–91 See also S corporation employee stock ownership plans valuation of, 95–117 C corporation equivalent method, 105–106, 112, 119, 122 conventional method, 99–102, 116, 149–50 discounted cash flow method, 99–102, 116 Gross method, 99–100, 102, 117 modified Gross method, 99–100, 103–05, 111, 118, 121 pretax discount rate method, 100, 105–09, 113, 120, 123 traditional method (see conventional method) passive equity holders, 34–43 patents. See intellectual property, types of Penrose, Edith, 307 phantom income, 94 Polaroid Corporation v. Eastman Kodak Company, 337 Porter, Michael, 306–07, 318–30, 322, 327
660
Index
possession corporations, 138 Prahalad, C.K., 313 preferred stock, 142, 212 call value, 212 economic market value, 212 liquidation value, 212 repurchase value, 212 premiums, 31–43, 351 acquisition premium, 33, 39, 76–77, 214–16 for ownership control, 31–43, 214–216, 225 for voting control, 39 Prescott, Edward C., 11 present value discount rate. See income approach, discount rate Principles of Corporate Finance, 17 private inurement, 297–98, 301 private placement approach. See discounts, lack of marketability, restricted stock studies prohibited transaction rules, 130–31 purchase price allocation, 264, 267–68, 416 put options, 57–60, 62, 68, 159
Q qualified replacement properties (QRPs), 132 Quantitative Profiles, 13 Quantitative Software Management, Inc., 482 Quest for Value, The, 18
R rate of return: formula, 75 on intellectual property, 366, 386–90, 394, 399–418 in damages analysis, 642 in excess earnings method, 596–98 on investment, 49–51, 53–57, 63 in damages analysis, 337–39 for valuation of an S corporation, 73–75, 85 for valuation of Canadian companies, 237 for valuation of sports teams, 262 ratio analysis, 312–14 real estate, 184–90, 201 real estate investment trusts (REITs). See pass-through entities related-party transactions, 230. See also transfer pricing, related-party transactions remaining useful life analysis, 446, 450–52, 463 actuarial tables, 423 in ad valorem taxation cases, 478, 480, 486 approaches and methods, 421–46 Iowa-type curves, 428–29, 435–36, 441 probable life curve, 433 regression analysis, 428, 437 S-curves, 429 sum-of-least-squares (SLS) curve fitting method, 428, 435, 441 survivor curves, 425, 428–29, 433, 437–41 technology forecasting methods, 437, 439 Fisher-Pry model, 437, 444 Gompertz model, 437
Pearl-Reed model, 437 tf.Innovate, 439 turnover rate analysis, 429 Weibull-type curve, 428–29, 436–38 Rayleigh curve, 437 survivor function equation, 437 composite decay, 441, 443–44 data sources, 617 decay patterns, 423 decay rate, 425, 434–36 experience band, 439 life cycle analysis, 373–78 life determinants, 423 life measurements and definitions, 426–29 analytical life, 428 average life, 432–33, 435–37, 441 average remaining useful life, 432–33 contract life, 427 economic life, 422, 428–29, 446 functional life, 429 judicial life, 427 legal life, 422, 460 perpetual life, 423 physical life, 429 probable life, 432–33, 441 statutory life, 427, 429 technological life, 428, 573 total life, 432–33 weighted average remaining useful life, 441–42 of player contracts, 269–71 retirement rate, 433–35 turnover rate (see retirement rate) vintage age groups, 432, 444 residual value analysis, 447–70 resource-based view (RBV), 308, 313–16, 320 financial capital, 313 human capital, 313–14 organizational capital, 313–14 physical capital, 313–14 return on investment. See rate of return, on investment Revenue Ruling 59–60, 311, 539 Revenue Ruling 93–12, 178 reverse cash conversion cycle, 322 risk. See income approach, equity risk premium, systematic risk and unsystematic risk RMA Annual Statement Studies, 601 royalties, 271, 382, 434, 439, 530. See also economic income, royalty income royalty rates, 359, 369, 372, 377, 397 allocation analysis, 587–91, 595, 600, 602–10 data sources, 616, 618–19 for licensing, 504–07, 510–12, 516, 518, 522–25, 530, 533 in damages analysis, 425–26, 630–31, 643–47 in transfer pricing, 560–61, 573, 575, 577 case study, 584, 594–95, 608–10 market-derived, 600, 607–08 weighted average royalty rate, 590 RoyaltySource, 615–16, 619 RoyaltyStat, 616, 619
Index
S S corporations. See pass-through entities, S corporations S corporation employee stock ownership plans (ESOPs), 127–68 advantages of, 144–46 antiabuse rules for, 133–37, 148 attribution-of-ownership rules, 134–35 deemed-owned shares, 133–37 disqualified persons, 133–34 nonallocation year, 134–37 synthetic equity, 134–36 deferred issuance stock right, 134 phantom stock units, 134 restricted stock, 134 stock appreciation rights, 134 stock options, 134 warrants, 134 back-to-back loan structure, 154 disadvantages of, 146–48 excess net passive income, 155 excise tax on premature distributions, 158 LIFO recapture tax, 155 prohibited transactions, 157 repurchase obligation, 159, 165–67 corporate-owned life insurance (COLI), 165 sinking fund, 165–67 step transactions, 161–62 tax-deductible contributions, limit on, 154 tax-deferred sales, 153–54 tax-qualified plan, 157 tax shield, 159–60 valuation issues, 148–53 conventional method (see pass-through entities, S corps, valuation of, C corporation equivalent method) enhanced cash flow (see enhanced economic benefit) enhanced economic benefit, 149–50, 153, 160–63, 165 range of value, 150–52 sale/leaseback transaction, 469 Schumpeter, Joseph, 320 SDC Platinum, 291 Search for Value, The, 18 Security Analysis, 18, 245 Securities and Exchange Commission (SEC), 36, 184, 214, 544 shareholder agreements, 34 Sharpe, William, 399 Shaw v. United States, 338 Sherman Act. See economic damages analysis Shumway, Tyler, 24–25 Siegel, Jeremy, 16, 18 SLIM-Estimate, 482 Small Business Job Protection Act of 1996, 129 Software. See intellectual property, types of Software Cost Estimation with COCOMO II, 485 Software Productivity Research, LLC (SPR), 482 Sonny Bono Copyright Term Extension Act, 427n sports teams, 253–78 acquisition of, 263–73 asset acquisition, 267–73 like kind exchange, 264
661
attrition rates, 271 broadcasting agreements, 271 collective bargaining agreements (CBAs), 255, 260, 265, 269 draft picks, 272 franchise value, 267, 268n, 270–71, 275 gate receipts, 258 local broadcasting revenue, 257 naming rights (see sports venues, naming rights) national broadcasting revenue, 257 other contracts, 272 personal seat licenses (PSLs), 270 player contracts, 267–70 premium seat agreements, 270 professional sports leagues, 254–60 Arena Football League, 255 Major League Baseball, 254–58, 260, 264–65, 274–77 Major League Soccer, 255 National Basketball Association (NBA), 255–58, 260, 265–66 National Football League, 254–60, 263 National Hockey League, 255–58, 260, 265–66 Women’s National Basketball Association, 255 renewal option provisions, 270 season ticket holders, 271 sponsorships, 259, 271–72 sports franchise agreement, 267–68 stadium leases, 258, 265, 270 (see also sports venues) ticket revenue (see gate receipts) valuation of, 261–66 value drivers, 262–63 sports venues, 258, 270, 273–78 feasibility analysis, 273–78 financing, 276–78 naming rights, 258–59, 274 squeeze-out transaction, 243 Standard & Poor’s (S&P) Corporate Value Consulting, 19, 21–23 Standard & Poor’s Corporations, 290 Standard & Poor’s Industry Surveys, 633 standard of value, 179, 225, 496, 538 fair market value, 96–97, 148–49, 152–53, 156, 160–65, 286 in damages analysis, 333, 343 defined, 179 of family limited partnerships, 176–79, 191, 200 in fairness opinions, 212, 225 in formal valuations of Canadian companies, 249 with gainsharing, 300 of trademark, 410 in transfer pricing, 537–61, 566, 576 with tax-exempt entities, 295, 298 fair value, 243–44, 246, 565 intrinsic value, 57 investment value, 149, 153, 159–60, 162 star framework, 323–25 Stark legislation, 298, 301 Statistical Analyses of Industrial Property Retirements, 435 statutory appraisal, 225, 231
662
Index
Stewart, G. Bennett, 18 Stigler, George, 306 stock options, 133–34, 142 stock-for-stock transactions, 226 stockholder agreement. See shareholder agreement Stocks for the Long Run, 18 straight-line amortization, 103, 398 straight-line depreciation, 223 Strangi, Estate of Albert, v. Commissioner, 198–200 strategic analysis, 313 strategic management, 306–08 structural fairness, 228–29 supermajority, 98, 197 super common stock, 142 survivor curves. See remaining useful life analysis, approaches and methods swing blocks, 97 SWOT analysis, 312, 320 synergistic value, 96, 216, 249, 261
T tangible assets, 283–84, 545 Tax Reform Act of 1993, 267 Tax Reform Act of 1997, 176 tax-deductible compensation, 138 tax-deferred rollover, 131–32 tax holiday, 133 Taxpayer Relief Act of 1997, 129 Texas Revised Limited Partnership Act (TRLPA), 207 Thomson Financial, 291 Thompson, Estate of v. Commissioner, 202–03 total asset structure, 416 total asset value, 85 total invested capital, 85. See also market value of invested capital total value of invested capital. See market value of invested capital trade names. See intellectual property, types of trade secrets. See intellectual property, types of trademarks. See intellectual property, types of transfer pricing, 261, 373, 397–98, 426–27, 535–610 arm’s-length allocation, 580, 586–87, 594–95 arm’s-length range, 569, 579, 608 arm’s-length standard, 540, 566, 569, 579 arm’s-length transactions, 565–66 case study, 583–611 commensurate with income, 568, 572 controlled parties (see controlled transactions) controlled transactions, 540, 545–48, 566, 569–73, 576, 579–80 cost sharing agreement, 581 exposure analysis, 579 financial statement adjustments, 550–61, 587–92 cost of goods sold (COGS), 542, 552–54 gross margin, 552–55, 558–59 selling, general, and administrative (SG&A) expense, 543 methodology, 544–50, 571–77 best method rule, 544–45, 569, 573
for intangible asset valuation (see intellectual property, valuation methods) penalties, 577–79 safe harbor provisions, 577–79 valuation misstatement, 577–79 related-party transactions, 538, 543–44, 550, 561, 579 for tangible asset valuation, 545–49 comparable profits method (CPM), 545, 548–49, 555–56 comparable uncontrolled price (CUP) method, 545–46, 552 cost plus method, 545, 548, 557–60 profit split method, 545, 549 resale price method (RPM), 545, 547–48 transfer price agreements, 427, 430, 448 uncontrolled parties (see uncontrolled transactions) uncontrolled transactions, 545–48, 558, 566–73, 576–80, 607 Treasury Department, 565, 572 Trevino v. United States, 338 Tzu, Sun, 326
U undivided interests, 205 Uniform Standards of Professional Appraisal Practice (USPAP), 331, 349–50, 544 Uniform Trade Secrets Act, 629 unit valuation concept. See ad valorem taxation United States Department of Labor, 149 University of Southern California, 482 unrelated business income tax (UBIT), 129
V Valuation: Measuring and Managing the Value of Companies, 17 Valuation of Intellectual Property and Intangible Assets, 356 valuation opinion report, 176–78, 495–01 valuation synthesis, 499, 646–47 value chain, 306, 308, 315–19 value creation, 308, 316, 319 ValueLine, 14–15 Valuing Intangible Assets, 437 voting rights, 227. See also, premiums, for voting control VRIO framework, 308, 319–21
W Wall and Redekop Corp., Re, 245 Wall v. Commissioner, 90 warrants, 134, 142 weighted average cost of capital (WACC). See income approach, equity risk premium Weibull, Waloddi, 436. See also remaining useful life analysis, approaches and methods, Weibull-type curve Westreco Inc. v. Commissioner, 574
Y yardstick approach. See economic damages analysis, approaches and methods, yardstick year-end compounding convention, 452
