Wealthy couple - divorce valuation issues

This articles addresses valuations issues in large complex divorce. As such cases typically involve private business assets the article is equally applicable to any form of private business valuation. (The author is 

Robert E. Kleenan of On Pointe Financial Valuation in Colorado.)

...The large asset marital dissolution case presents a number of important valuation issues that may or may not exist in the smaller case. Because of these issues, the attorney needs to have a better understanding of these valuation issues, and must be comfortable that the valuation professional has the experience and expertise to fully develop the issues and to communicate these complex issues to the Court.

I am defining the large asset case as one that includes closely held business interests in excess of $2,000,000 in fair market value. The problem with this definition is that rarely is the closely held business interests shown in the personal financial statement with “fair market value”, but rather have some sort of historic valuation number. Simply put, this is true because individuals that have asset values of this magnitude do not need to provide a “fair market value” for any purposes. These individuals are wealthy!

Where the parties’ wealth is in publicly traded securities, or other similar assets, the valuation issues may be limited. However, the attorney should never lose sight of the fact that even thought the entity is publicly traded; the ownership interests (including options, etc.) of the parties may have a different value that the value shown in the daily trading information of the underlying stock.

In this article, we will focus on several of the key issues that tend to be found in large asset cases. These issues include:

• The complexity of the financial structure of the entities.
• Valuation methodologies to be used.
• Appropriate application of discounts and/or premiums.
• Key person issues.
• Is there a standard of value issue?

Do More Commas in the Value Equate to More Problems in the Valuation?

On the surface, the short answer is NO! Larger cases usually involve a more sophisticated operating entity. Financial information is usually more complete, and the company may have executives that are not part of the family dispute. Industry data, and guideline company information is usually better, and more easily compared to the subject company’s data. However, that being said, there are many issues in the larger valuation that can lead to problems for both the valuation professional as well as the attorney managing the case.From a practical view, the larger case needs a more sophisticated valuation expert. Rarely are the so called “formula approaches” appropriate to the larger valuation. Although we have better financial information that information is usually much more sophisticated and needs greater analysis to fully understand the operations of the entity. There may be more “perks” or other benefits available to the business owner that are not available in the smaller company. Larger business interests are more subject to the future growth and operations of the entity. The need for capital to grow these entities must be identified and taken into consideration in determining the current “fair market value” to the holder of the security.

The larger marital dissolution also requires greater involvement in the valuation process by the attorney. Because the issues are more complex, there will be issues relating to discovery that are out or the norm. Additionally, because the valuation will be more complex, it will be necessary for the attorney to become much more familiar with the valuation experts methodologies.

The following are some of the issues that must be addressed when dealing with the larger valuation matter.

The Complexity of the Financial Structure of the Business may require different approaches to the valuation. – It is not uncommon in larger businesses to find multiple classes of stock (common and preferred) and in some cases, so called phantom stock” issues for non-family, key executives in the organization. The business may not be solely owned by the parties to the divorce, other non-parties may own substantial blocks of stock. Where multiple classes of stock exist, not only must the business be valued, but also each of the classes of stock must be separately valued.

The divorcing parties might not own controlling interest in the entity, with non-family owners involved, and detailed financial information may not be readily available. –This is not an uncommon issue in large asset dissolutions. Where financial data is not available for the operating entity, the valuation professional may have to use a valuation methodology that values the minority shares without performing a valuation of the operating entity. Where the operating entity is distributing economic benefits to the shareholder, this is easier than when the operating entity is not distributing, or is retaining significant economic benefits at the corporate level.

The entity may be closely held by a family unit, but the divorcing party may be a minority owner – This can raise interesting discovery issues. Can the divorcing party gain access to the financial information? Has the divorcing party in the past received this same or similar information? The valuation professional operating under this scenario will need to provide some addition investigative services to be certain that the information being used in the valuation is appropriate regarding historical data.

The valuation methodology will usually be fairly sophisticated and require greater analysis. – It should be obvious, but the Excess Earnings Method is not normally an appropriate method for valuing a larger company. As described by the IRS, the excess earnings method is a method of last resort, used only when no better methodology is available. On large cases, I cannot imagine a matter where no better methodology would be available, and hence Excess Earnings would be appropriate.

Valuation Methodologies in the Large Case

Normally, large case valuations are driven by one or more of the following methodologies.  Each one of these methods will be discussed briefly.

Discounted Future Cash Flow – This is the theoretically best method of valuing an entity. The difficulty of this method is having the company prepare operating projections that truly reflect the expected future economic benefits available to the appropriate shareholder. If the entity being valued is expected to have high growth, or inconsistent earnings, this method is one of the better indicators of the actual value of the entity. However, where reasonable projections are available, the valuation professional should consider using this method. Where the entity is a sophisticated company, the valuation professional needs to measure prior projections with the actual operating results of the entity to determine the ability of management to accurately project future benefits. This is a key part ofthe DCF methodology. It is imperative that the valuation professional take into consideration the degree of accuracy and precision which management has displayed relative to providing information regarding future expected cash flows. The DCF method is only as good as the underlying inputs. It is critical that the forecast be believable and reflects both the historical as well as the future of the business.

Caveat – Many jurisdictions do not allow for the DCF method to be used because they feel that the future efforts of the divorcing party are no part of the current value.

Capitalization of Earnings – This method should be considered on most valuations. The only caveat regarding this methodology is that “the historical benefits must be a proxy for the expected future benefits.” Where historical benefits are not a proxy for the expected future benefits, this method will not provide a reliable indicator of the value of the holdings. If the company being valued is not mature and providing stable earnings, the Cap of Earnings method may not capture the real value of the entity.

Guideline Company Method – Where the company being valued is large and in an industry that has meaningful information available, the valuation professional certainly should consider the use of this methodology. However, when using the guideline methodology, the valuation professional must determine the impact of the “beta” and other company specific factors as they relate to the company being valued.

Discounts and/or Premiums: Real or Imaginary?

One of my pet peeves when it comes to the application of discounts or premiums to a valuation conclusion is that after 20 pages of analysis of the financial issues surrounding the entity, discussions of the economy and the future, the valuation professional reduces the value of the business from 30% - 50% by applying a single paragraph that states that the valuator believes a discount for marketability and minority should be applied.

Before we can begin a meaningful dialogue regarding whether discounts or premiums are or not appropriate when valuing a business, we need to first discuss and understand the concept of “levels of value”. Generally, there are four recognized “levels of value”. These are: 
Synergistic or Strategic Value – this is a value that is not normally part of a “fair market value analysis, because by definition, this value is specific to a buyer, and therefore is outside the accepted definition of fair market value. This is usually considered to be the highest value of an entity.

Control Value – as the name implies, this is the value of a 100% ownership block of stock in the entity. The block does not have to be held by one individual, but the assumption is that the block can and will be traded as a single unit.

Minority / Marketable Value – this is the value of a minority (less than 50.1%) block of stock. This level of value assumes that the block of stock is freely traded as if it were publicly traded stock.

Minority / Non-Marketable – this is the value of a minority block of stock that cannot readily be traded. In most large asset valuations, this is the type of stock that we are valuing.

The “level of value” concept, simply put, is that certain valuation methodologies provide an indication of value at a stated entry level. Since certain methods assume a stated level of value, our application of discounts and/or premiums will always be driven by the entry level of value indicated by the methodology. (i.e. if we use a methodology that results in a minority / marketable level of value, it would be inappropriate to take a minority discount from that level of value).

One of the most common mistakes found in any valuation is the use of a valuation methodology that assumes a certain “level of value”, and then misapplying a  discount or premium because the “level of value” already implicitly contains that assumption. 

For most situations, there are two potential discounts/premiums that are expected.

Minority / Control Issues – It is a well established business valuation principal that a minority interest in an entity is worth less than a controlling interest in that same entity. Control can offer the interest holder greater access to the success of the entity. The question really becomes, what is minority and what is control? Clearly a 100% ownership interest in the equity of an entity is absolute control. However, there are many levels of effective control. An individual that owns a large enough block of stock to effectuate liquidation or other corporate actions based on state law may have a large element of control. In some instances, 50% + 1 share might be enough to have effective control of the organization.

In larger matters, it is not uncommon to have multiple classes of stock. These various classes of stock may have significantly different voting rights, and the “control” of the entity might not have any relationship to the number of shares owned, but rather by the number of votes that are controlled by the stock interest being reviewed.

Finally, the valuator must look at the effective control of the entity. There may be indications of control of voting blocks less than 50%. Situations could include a large minority block, with the remaining shares held in very small blocks by a large number of individuals. In that case, it may only be necessary for the large block holder to get one or two individuals to vote with the large block in order to obtain control.

The Minority Discount is NOT normally 35%. This has become a self-fulfilling prophecy. Every time 35% is used, it just supports the erroneous thought that 35% is the average. The Minority discount should be carefully reviewed by the valuation expert to reflect the reality of the marketplace. The size of the block being valued will impact the application of the minority discount. In short, a 1% block normally has a greater minority discount than a 40% block. The valuation report should clearly discuss the factors that support the discount taken in the valuation.

The Swing Vote Issue

In some instances, there may be a minority block that has greater value than the same percentage ownership in another entity. For instance, let us assume that there are three shareholders in an entity. 2 of the shareholders  each own 49%, and the 3rd shareholder owns the remaining 2%. If the two 49% holders are friendly and in agreement as to how the company is to be run, and how the benefits of the company are distributed, the 2% ownership interest would probably carry a very large minority discount. However, if the two 49% holders are largely in disagreement, the value of the 2% block increases significantly because  the addition of that 2% block by either of the 49% owners gives that owner control.  These issues need to be reviewed where we are valuing a small minority interest.

Marketability Discounts

Some commentators have opined that a 100% interest in  an entity would not be subject to any marketability discount, however most of the  business valuation community does not agree with that position. The Marketability  discount is nothing more than recognition of the present value of money. It is based  on the premise that if we own shares in a publicly traded entity, we can offer the  shares for sale today, and have our cash within 5 business days. As anyone who has  ever worked with a client to sell an interest in a closely held business, there clearly is  a time period between the time the business owner puts the ownership interest up  for sale, and the time that the business owner receives the cash proceeds from that  sale. The Marketablity discount needs to identify and quantify this time value of the  proceeds. Clearly, the smaller the block of stock being offered for sale, the longer  that the potential period of finding a buyer, consummating the sale, and receiving  the proceeds may be.

The issue of buy-sell agreements and other agreements needs to be addressed at  the same time that the Marketability discount is determined. Buy / Sell agreements  do not necessarily negate a marketability discount. Unless the holder of the security  has a “put” right (and the company has the where with all to purchase), the Buy /Sell agreement has little value relative to the marketability discount. Rights of first refusal to purchase the stock also have an impact on the marketability  of the security. Most commentators will tell you that a right of first refusal has a chilling impact on the marketability of the security. As we deal with larger entities,  potential buyers do not want to become involved in the due diligence process where  the entity has a right of first refusal.

Key Person Issues

We have all heard the statement “I am the business, without me, there would be no business”. While this may be true in very small, service based businesses, as the business  gets larger, this issue becomes less important. Yet at the same time, even in very large  businesses, an owner may have a very material impact on the business. This is a fact and  circumstances based decision. It is incumbent on the valuation professional to completely  explore the impact of the business owner on the business, and the ability of the business to  replace that owner / executive.

Most business valuation professionals believe that the impact of a key person should not be  addressed through the use of a separate discount, but should be addressed in the  capitalization rate through the specific company risk factors. It is important that you as the  attorney understand how the impact of a key person is addressed in the valuation, and that  you are comfortable with the analysis of that impact.

Compensation Issues

This issue goes hand in hand with key person issues. We all have seen the valuation report  where the compensation of the owner/spouse has been adjusted for purposes of  determining the “fair market value” of the entity. Then subsequently, for purposes of  determining maintenance and/or child support, the actual salary of the individual is used.  This clearly is a case of double dipping. In the large case, this can be a significant issue. At  the same time, we look at what corporate executives in large publicly traded entities are  earning today, and we need to ask if the compensation of the equity owner is appropriate in  light of compensation of that same person in another entity. This is not a simple issue.

In the larger case, compensation is usually a major part of the business valuation, and the  inappropriate analysis of this issue can result in millions of dollars of value being created or  destroyed. We have all seen cases where the compensation of the equity holders is  reasonable in light of the duties performed relative to other individuals holding similar  positions in publicly traded entities. Yet at the same time, there are equity holders that take large amounts of compensation in lieu of dividends in the entity. The equity holder  may not be providing any meaningful services to the entity.

Compensation issues are a significant item in the large case. These issues need to be  carefully reviewed not only by the business valuation professional, but also need to be  addressed with the attorney and the client.

Source Robert E. Kleenan

OnPointe Financial Valuation

Group, LLC.

FAQs about valuations of ESOPs

Some FAQ's for Employee Stock Option Plans (ESOP)
...Why do we need to engage an outside party to value our ESOP shares?
From a strictly regulatory standpoint, a valuation of ESOP shares by an independent third party is required by the Department of Labor (DOL) and the Internal Revenue Service (IRS).  The regulatory requirement stems from the practical need to insure that the value is determined by a party who does not have a personal or financial interest in the valuation result.  The valuation, moreover, should be performed on behalf of the ESOP trustee since it is the duty of the trustee to insure that transactions with the ESOP are consummated at “fair market value.”

What is meant by “fair market value”?
Fair Market Value (FMV) is a concept and not a price that emerges from application of some standard formula.  In simple terms, FMV is the price for which property would sell under the existing market conditions for such property as established in arms-length negotiations between knowledgeable and independent parties.  The “market” implied in definitions of FMV encompasses all potential buyers and sellers of the property involved. 

How is “fair market value” determined?
There are many method used in the determination of FMV.  The nature of the property being evaluated determines what methods are appropriate.  For example, the FMV of a single family home is determined by the price for which similar property is selling in the area in which such property is located.  The FMV of business interests that is generating earnings, however, is determined to a large degree on the basis of what a knowledgeable buyer would be willing to pay for the earnings stream considering available rates of return on relatively risk-free investments and the risks associated with the investment being appraised.  Although not the only method that might be considered, the present value of future earnings using a risk adjusted market rate is one of the most common approaches, referred to in business valuations as Discounted Future Earnings (DFE).

Reference to the results of mathematical formulas is not the sole determinant of FMV.  The judgment and experience of the valuation analyst is also a critical element since there can be many factors that can not be quantified by reference to the underlying financial information alone.

What is meant by a “control premium”?
A control premium is that amount which a buyer may be willing to pay to acquire a controlling interest in a business over and above the value of the interest based solely on the underlying financial factors.  The element of control, in this case, has a value which is added to the value that can otherwise be ascribed to the assets and earnings of the business.  The payment of a control premium in the purchase of a business does not necessarily add any value to the business.  Synergy value, unlike control, is susceptible to being measured in more concrete terms of increased financial benefits to the buyer over and above those being enjoyed by the selling parties.  Examples are the prospects of increased sales of the buyer’s products to the seller’s customer base or lower overall materials costs due to volume purchase discounts, etc.  Whether or not a control premium is appropriate in the purchase of shares by an ESOP must be determined on the facts in the individual case.  Moreover, since the ESOP generally doesn’t control a company itself, there is much debate as to whether or not an ESOP can pay a control premium for shares purchased, even if purchasing a controlling percentage.

How do ESOP valuations differ from valuations for other purposes?
Because of the regulatory requirement established in the Employee Retirement & Income Security Act of 1974 (ERISA) that an ESOP pay no more than “adequate consideration” in the purchase of employer securities, ESOP valuations must support the decisions of the trustees and must also withstand review by DOL and the IRS.  Valuations that are subject to being reviewed by third parties, whether for ESOP or other purposes, must include considerable discussions on the methods and factors employed as well as explanatory information on the sponsoring company’s financial and operating history and the industry in which it competes.  For similar reasons, valuations supporting tax related values for gift and estate or charitable deduction purposes must also include considerable background detail so that potential third party reviewers will have a clear understanding of the process leading up to the value conclusion.  In addition, ESOP regulations place various obligations on the sponsoring employer and allow for limitation of the voting rights of ESOP shares.  These, and other features specific to the ESOP require special consideration in the determination of the fair market value of ESOP owned securities of privately held companies...

Source is this firm GROCO CPA 

Seven not-so-obvious factors which influence private business valuations

Most businesses are complicated. As a result, assessing the financial value of a business is also complicated, which is why the services of an experienced valuation expert are often needed. There are countless factors that a valuator considers when valuing a business. Some of these are self-evident, whether or not you’ve ever seen a valuation report. Of course, a valuator will assess certain characteristics of the business, including products and services offered, industries served, key management, etc. The valuator will analyze the subject company’s financial statements (to get a grasp of historical performance and the current state of the business). The expert will also formulate, often with the help of management, financial projections for the company, under the premise that the value of a business is directly related to its future performance capabilities. Lastly, the expert will also evaluate the size of the ownership interest to be valued, mostly as it relates to a control or minority position in the subject company.

While these factors may be fairly obvious to financially-savvy businesspersons, there are other not-so-obvious factors that valuators consider as well. The factors discussed below, while they may be overlooked by managers or others, will be given proper attention by a quality valuator:

1 Company-Specific Risks:

Business risks can impact a company’s cash flows as well as its general health. Aside from normal business risks, such as the risk of an economic recession, there are company-specific risks. These risks are called non-systematic business risks in the financial world, and one of the most common risks for mid-market private companies is key management risk - when a company is dependent on a few key individuals or suffers from a general lack of management depth. Other company-specific risks include key customer risk (if the business has only a few major clients), key supplier risk, pending litigation, unnecessary debt burden, etc.

2 Working Capital Management:

Cash flow is the primary driver of a company’s value. Cash that is tied up in current assets such as accounts receivable or inventory is cash that cannot be distributed to shareholders, and may result in the need for additional debt financing (which would also impact value).

3 Upcoming Capital Purchases:

 In a similar vein, cash that will be needed for a large capital purchase (such as a building addition or a major piece of equipment) is cash that cannot be distributed. It will be important for management to determine whether the rate of return for such an expenditure justifies its purchase.

4 Other Classes of Equity:

 Stock options, warrants, phantom stock, and  other equity-based incentive compensation, can dilute the value of a company’s common stock. Stock options can cause dilution even when currently out-of-the-money (a popular misconception).

5 Shareholder Policies:

A discount for lack of marketability is typically applied to an ownership interest in a private company (particularly noncontrolling interests). There are certain shareholder policies that can often enhance or detract from a stock’s marketability. The existence of a buy-sell agreement (or another vehicle by which

a shareholder can achieve liquidity) enhances a stock’s marketability and generally leads to a lower marketability discount. Similarly, a distribution policy that provides shareholders with a meaningful, consistent return on their investment also enhances a stock’s marketability.

6 Existence of Potential Buyers:

Similar to buy-sell agreements and a shareholder-friendly distribution policy, the existence of potential buyers of the subject company is beneficial to shareholders, particularly minority interest shareholders. The availability of potential buyers shortens the expected holding period for an investor and increases the likelihood of a liquidity event. Which companies have the most potential buyers? Often those in industries that are targeted by private equity investors or subject to consolidation trends.

7 Public Stock Performance/Interest Rates:

A tried and tested economic principle states that the price of a good is influenced by the availability of substitutes. If a potential investor in a private company has more attractive options available

(such as a high interest rate on a bond or booming public stock prices), the investor is willing to pay less for private company stock.

Source BCQ Consulting

IRS Declines to Adopt the Wandry Decision

Earlier this year I blogged about good news for tax payers as a result of a court ruling known as the Wandry decision. Seems like the IRS is not about to go down without a fight.

Source Forbes
The IRS has thrown a significant road block into planning for large 2012 gifts. Our transfer tax system , gift and estate taxes, is unified. There is a credit against gift tax that if not used during a person’s lifetime is available to the estate. For the rest of 2012 the credit covers $5,120,000 in taxable transfers. Based on law in place now, that amount goes to $1,000,000 on January 1. For people who have not dipped into the $5,120,000 credit equivalent, the case for a large gift in 2012 can be compelling. There are of course problems and complications. Among them are deciding what to give and making sure that you leave yourself enough assets to live on.  The IRS announcement of non-acquiesence in the Wandry decision has made things difficult.

I wrote about the Wandry decision several months ago.  I indicated that setting up a gifting vehicle using the decision was even better than having Dr. Who, the Time Lord, helping you with your estate plan

Imagine someone with “legacy assets”.  Legacy assets are things like illiquid real estate, rare artwork or family business interests that may not provide current earnings.  Often there is a  hope that legacy assets will never be sold.  The legacy assets are owned by a family limited partnership.  In addition to the family limited partnership interest, the person, let’s call him Joe, has three million dollars in liquid investments.  Joe anticipates living on the three million dollars, perhaps depleting the principal as he gets older.  The thing for Joe to give away would be units in the family limited partnership.  How many units ?  $5,120,000 worth of course.  This is where knowing a Time Lord would be really handy.

Suppose the units are valued at $1,000.  Joe gives away 5,120 units.  The IRS challenges the valuation.  Ultimately it is agreed that the units are worth $2,000.  The gift tax, penalty and interest is going to take a pretty large chunk out of the three million dollars that Joe was counting on.  This is where time travel would be really handy.  After the case settles you ask Dr. Who to go back in time and instruct the attorney to make the gift 2,060 units rather than 5,120.  There is a possible looping problem here.  The valuation was the result of compromise and negotiation.  Maybe, if you started at $2,000 you would have ended up at $2,200 requiring another trip back in time.  The Wandry decision provided a much neater solution:

Although the number of Units gifted is fixed on the date of the gift, that number is based on the fair market value of the gifted Units, which cannot be known on the date of the gift but must be determined after such date based on all relevant information as of that date.

Furthermore, the value determined is subject to challenge by the Internal Revenue Service (”IRS”). I intend to have a good-faith determination of such value made by an independent third-party professional experienced in such matters and appropriately qualified to make such a determination. Nevertheless, if, after the number of gifted Units is determined based on such valuation, the IRS challenges such valuation and a final determination of a different value is made by the IRS or a court of law, the number of gifted Units shall be adjusted accordingly so that the value of the number of Units gifted to each person equals the amount set forth above …….

This elegant gift tax solution seems like it could create an income tax nightmare particularly if the units were gifted to multiple persons.  You could never be sure everybody’s income tax return was right until the number of units finally transferred was determined.  There is a solution to that problem.  If the gift is made to one or more intentionally defective grantor trusts, the flow through from all gifted units ends up on Joe’s return regardless of whether the gifts are considered completed or pulled back.

What To Do Now ?

Getting Doctor Who to help would be great, but it may not be possible. There are many unperceived threats to human existence that Doctor Who is protecting us against

So he may not be able to help you with your gift tax planning.  A case can be made for actually paying gift taxes.  The top rate is scheduled to go up to 55% from 35%.  Even without a rate increase, gift taxes can be a better deal than estate taxes.  The rates are the same, but there is a big difference.  Estate taxes are computed on the gross, while gift taxes are computed on the net.  Someone who has run through the unified credit who then leaves his heirs $1,000,000 will be leaving them a net of $650,000.  With sufficient prescience, the $1,000,000 could have been used to make a gift of roughly $740,000 with the associated gift tax paid with the balance.

There are several reasons why the case for paying gift tax remains unpersuasive.  One is the general rule that you should pay no tax before its time.  Then there is the prospect of the Tea Party Triumphant amending the Constitution to ban the death tax forever.  Given all the smart people dedicating their lives to coming up with clever estate planning ideas, it is only a matter of time before one of them comes up with a way that will make it possible for you to take it with you. Then wouldn’t you be sorry that you squandered it funding an Alaska dynasty and paying gift taxes ?  The main problem, of course, is having to come up with cash.

The Wandry decision has not been overturned.  In principle, it still works, but the IRS has thrown down the gauntlet on it.  It would seem that relying on it for a mega-gift would be risky.  If there is plenty of liquidity to pay the resulting gift tax if it does not work, it might be worth trying, but not otherwise.  For those who are charitably inclined the Petter case, which was upheld by the Ninth Circuit is worth considering.  Under the Petter formula  units would be transferred to charity rather than coming back to the donor.  Barring that, 2012 mega-gifts should be made with property that is not open to significant valuation adjustment.

Author: Peter Reilly CPA

Special Purpose Valuations and Alternative Valuation Dates

The AICPA's Tax Letter in October 2012 summarizes two key changes impacting valuations for Estate Tax. The first addresses Alternative Valuation dates, and the second deals with Special Use Valuations.

...Generally the value of property includible in a decedent’s gross estate is its fair market value (FMV) on the date of the decedent’s death. Two special valuation provisions may be elected—under Sec. 2032, to value the property on the alternate valuation date (AVD), and under Sec. 2032A, to value real estate used in farming or another business based on its special use, rather than its highest and best use. Reproposed regulations were issued to limit the availability of the alternate valuation date provision, and a district court declared invalid a provision of the special use valuation regulations.

Alternate Valuation Date

A decedent’s estate may elect to use the AVD if that date results in a valuation of the decedent’s estate that is lower than its date-of-death valuation and results in a combined estate and generation-skipping transfer (GST) tax liability that would have been less than such liability on the decedent’s date of death. For property that is distributed, sold, or otherwise exchanged within six months of a decedent’s date of death, the AVD is the date of the distribution, sale, or exchange (the transaction date). For all other property includible in a decedent’s gross estate, the AVD is the date that is six months after the decedent’s date of death (the six-month date).

In 2008, the IRS issued proposed regulations3 under Sec. 2032 in an attempt to change the result in situations similar to Kohler,4 in which the Tax Court held that valuation discounts attributable to restrictions imposed on closely held stock pursuant to a post-death reorganization of the closely held company should be taken into consideration in valuing the stock on the AVD. On Nov. 18, 2011, these regulations were withdrawn and reproposed.5

The reproposed regulations would amend Regs. Sec. 2032-1(c) to identify transactions that require the use of the transaction date for purposes of Sec. 2032 (nine types of transactions are listed). If an estate’s property is subject to such a transaction during the alternate valuation period, the estate must value that property on the transaction date. The value included in the gross estate is the FMV of the property on the date of and immediately before the transaction.

Two exceptions to this general rule would allow the estate to use the six-month rule. One exception is for exchanges of interests in the same or different entities provided the FMVs of the interests before and after the exchange are deemed to be equal. The other exception is for distributions from a business entity, bank account, or retirement account in which the decedent held an interest at death provided the FMV of the interest immediately before the distribution equals its FMV immediately after plus the amount of the distribution.

Special Use Valuation

One of the statutory requirements to qualify for the special use valuation is contained in Sec. 2032A(b)(1)(B), which provides that 25% of the estate must consist of real property used in farming or another trade or business. Regs. Sec. 20.2032A-8(a)(2) provides that while a Sec. 2032A election need not be made for all property that qualifies for the election, the property for which the election is made must meet the 25% threshold requirement in Sec. 2032A(b)(1)(B). In Finfrock,6 more than 25% of the total value of the gross estate consisted of real estate used in a farming business, but the estate chose to make the special use valuation election for only one piece of farmland that, by itself, represented 15% of the total value of the gross estate. The issue before the district court was whether the regulation is a valid interpretation of the statute.

The district court applied the Chevron test to determine whether Congress has directly spoken to the precise question at issue. If the intent of Congress is clear, both the court and the agency must give effect to the expressed intent of Congress. If the statute is silent or ambiguous about the particular issue, a court must then determine whether the agency’s interpretation is based on a permissible construction of the statute.

The district court noted that Sec. 2032A does not require that the election be made for real property constituting 25% or more of the value of the gross estate. The 25%-or-more requirement is only a threshold requirement in order to be able to make the election. Once the threshold is met, the only other requirement to qualify the property for the election is to designate the property in a tax recapture agreement. The court concluded that Congress did not require that the designation be of all or a certain percentage of the real property that otherwise meets the requirements of Sec. 2032A, so the statute unambiguously provides that an estate can elect the special use valuation for any portion of the property that qualifies. Noting that Regs. Sec. 20.2032A-8(a)(2) imposes an additional requirement to make an election under Sec. 2032A that is not included in the statute, the court ruled that the regulation was invalid...

Source Tax Letter

Written by Justin Ransome is a partner and Frances Schafer is a retired managing director in the National Tax Office of Grant Thornton LLP in Washington, D.C

How to value your start-up

"What is the appropriate valuation of my business?" It's one of the questions I get the most often from aspiring entrepreneurs. And what usually sparks it is an upcoming financing or pending takeover offer.
The answer is quite simple: Just as with anything, your business is worth what somebody is willing to pay for it. And the methodologies applied by one buyer in one industry may be different from the methodologies applied by another buyer in another industry. Here are some ways to value your business in a way that will make sense to you and line up with investor expectations.

To start, let's not forget about the obvious: The natural economic principles of supply and demand apply to valuing your business as well. The more scarce a supply (e.g., your equity in a hot new patented technology business), the higher the demand (e.g., multiple interested investors competing for the deal, and taking up valuation in the process). And, if you cannot create "real demand" from multiple investors, "perceived demand" can often work the same when dealing with one investor.
So, never have an investor think they are the only investor pursuing your business. That will hurt your valuation. And, before you start soliciting investment, make sure your business will be perceived as new and unique to maximize your valuation. A competitive commodity business or "me too" story, will be less demanded, and hence require a lower valuation to close your financing.

Another important factor: the industry in which you operate. Each industry typically has its unique valuation methodologies. A next-generation biotech or clean energy business would get priced at a higher valuation than yet another family diner or widget manufacturer. As an example, a new restaurant may get valued at three to four times earnings before interest, taxes and other items, and a hot dot-com business with meteoric traffic growth could get valued at five to ten times revenues. So, before you approach investors with valuation expectations, make sure you have studied the valuations achieved in recent financing or M&A transactions in your industry. If you feel you do not have access to relevant valuation statistics for your industry, engage a financial adviser who can assist you.

Investors will study things like: (i) revenue, cash flow or net income multiples from recent financings in your industry; (ii) revenue, cash flow or net income multiples from recent M&A transactions in your industry; and (iii) a discounted cash flow analysis of forecasted cash flows from your business. These multiple ranges can be very wide, and vary substantially, within and between industries. As a rough ballpark, assume earnings multiples can range from three times to ten times, depending on your "story." And forecasted earnings growth is typically the No. 1 driver of your valuation (e.g., a 25 percent annual net income grower may see a 25 times net income multiple, and a 10 percent annual net income grower may see a 10 times multiple).
If there are no earnings yet, with your business plowing profits into long-term growth, then revenue multiples or some other metric would be used. Revenue multiples for established businesses are typically in the 0.5 to 1 times range, but in extreme scenarios, can get as high as 10 times for high-flying dot-commers with explosive growth. But that is by far the exception to the rule. And, if there are no revenues for your business -- unless you are a bio tech business waiting for FDA approval or some new mobile app grabbing immediate market share before others, as examples -- raising funds for your business at any valuation will be very difficult. Investors need some initial proof of concept to get their attention.
Also note: Private company valuations typically get a 25 percent to 35 percent discount to public company valuations. While at the same time, M&A transactions can come at a 25 percent to 35 percent premium to financing valuations, as the founders are taking all their upside off the table.

And, remember, at the end of the day, the investor will have a very good sense to what a business is worth and what they are willing to pay for it. As they see deals all the time and typically have their finger on the market pulse. So, collect a few term sheets from multiple investors, and compare and contrast valuations and other terms, and play them off each other to get the best deal. As a rule of thumb, expect to give up 25 percent to 50 percent of your equity, in your first financing round, depending on the size of the investment and the type of investor (e.g., angel vs. venture capitalist).

Most important, you need to put on the hat of your investor in setting valuation. To get them excited about your startup vs. the hundreds of other startups they see each year, they are looking for that next 10-times return opportunity. So, make sure your three- to five-year forecasted earnings will grow large enough in that time frame to afford them a 10-times return. So, as an example, if you are worth $5 million today, post financing, and the new investor owns 25 percent of the company (a $1.25 million stake), they are going to need a financial plan that will get their stake up to $12.5 million (and the company up to $50 million) within three to five years. Which could mean driving earnings up to $5 million to $10 million within that period. So, do not show them a forecast that grows less than that and make sure you have built a credible financial plan to achieve these levels before approaching investors

By George Deeb
Source Crain Chicago Business

How to Achieve Safe Harbor for Stock Options Under S 409a

Trent Dykes on March 09, 2012
dlapiper.com

As a general rule, all stock option grants need to have an exercise price at or above the fair market value of the company’s common stock on the date such grant is made. This requirement, and its many related complexities, generally comes from Section 409A of the Internal Revenue Code and the related Internal Revenue Service (“IRS”) regulations (collectively, “Section 409A”). Section 409A was enacted several years ago in response to perceived abuse of deferred compensation arrangements brought to light during various high-profile corporate scandals.

The two main penalties imposed by Section 409A for granting a stock option with an exercise price below fair market value are (i) immediate tax upon vesting of the option (as opposed to at exercise or sale) and (ii) an additional 20% federal tax penalty (on top of the regularly applicable federal and state taxes). In addition, some states, such as California, may impose their own Section-409A-equivalent penalty tax. In order to avoid these penalties, the IRS requires that a stock option must be granted with an exercise price no less than the underlying shares’ fair market value determined as of the grant date and that such fair market value must be “determined by the reasonable application of a reasonable valuation method.”

The good news is that Section 409A provides three “safe-harbor” methods for determining fair market value, two of which are most commonly relied upon by startups and venture-backed companies (discussed below). If one of these safe harbor methods is used, then the resulting fair market value is presumed to be “reasonable” unless the IRS can establish that the company’s determination was “grossly unreasonable.”

Most Common Safe Harbor Valuation Methods for Startups

In addition to prescribing general valuation guidelines (discussed below), Section 409A creates a presumption that certain safe harbor valuation methods will result in a reasonable valuation. However, a method will not be considered reasonable if it does not take into consideration all available information material to the valuation of the company’s common stock. Further, a company may not rely on any valuation for more than 12 months. In other words, a company’s valuation must be updated after the earlier of (i) the occurrence of a development that impacts the company’s value (e.g., the resolution of material litigation, the issuance of a material patent, a financing, an acquisition, a new material customer or other significant corporate event) or (ii) 12 months after the date of the prior valuation. The following two safe harbors are most commonly used by startups and venture-backed companies:

1. Independent Valuation.  A valuation will be presumed to meet the requirements of Section 409A if it was performed by a qualified independent appraiser. These qualified independent appraisers range from valuation groups within very large accounting firms to small boutique shops and individuals that focus only on valuation work. In my experience, the cost of an initial independent valuation report ranges from $5,000 to $35,000, depending on the name brand of the firm conducting the valuation and the complexity of the company being valued (i.e., its financials, operations and capitalization). Subsequent “bring-down” updates to the initial valuation are often less expensive than the initial report. That said, given the cost associated with obtaining an independent appraisal (and its subsequent bring-downs), later-stage venture-backed companies often grant stock options less frequently (and instead batch them for board approval in bulk), in order to minimize the need for potentially costly and time consuming bring-down updates.

2. Illiquid Startup Inside Valuation.  A valuation will also be presumed to meet the requirements of Section 409A if it was prepared by someone that the company reasonably determines is qualified to perform such a valuation based on “significant knowledge, experience, education or training.”  Section 409A defines “significant experience” to mean at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending or comparable experience in the company’s industry. This person does not need to be independent from the company. However, in order to rely on the illiquid startup insider valuation safe harbor:

• the company must have been conducting business for less than 10 years;
• the company may not have a class of securities that are traded on an established securities market;
• neither the company, nor the recipient of the option, “may reasonably anticipate” that the company will be acquired within 90 days or go public within 180 days; and the common stock must not be subject to put or call rights or other obligations to purchase such stock (other than a right of first refusal or a “lapse restriction,” such as the right of the company to repurchase unvested stock held by the employee at its original cost).

A word of caution, though, given the potential liability involved with performing a valuation in-house:  a startup will want to make sure that they have appropriate D&O insurance coverage and indemnification agreements in place if relying on such safe harbor in order to protect directors and officers from potential future claims related to such valuation.

General Valuation Guidelines

As noted above, in addition to the foregoing safe harbors, Section 409A also contains general guidelines that apply to all valuation methodologies (safe harbor or otherwise) – and a valuation method will not be considered reasonable if it does not take into consideration all available information. Under the general guidelines, all valuation methods must consider the following factors, as applicable:

• the value of tangible and intangible assets of the company;
• the present value of anticipated future cash-flows of the company;
• the market value of stock or equity interests in similar companies and other entities engaged in trades or businesses substantially similar to those engaged in by the company, the value of which can be readily determined through nondiscretionary, objective means (such as through trading prices on an established securities market or an amount paid in an arm's length private transaction);
• recent arm's length transactions involving the sale or transfer of such stock or equity interests;
• and other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes that have a material economic effect on the service recipient, its stockholders or its creditors.

Which Safe Harbor is Right for My Company?

While understanding these formal legal requirements and the available valuation options is important for any startup granting stock options, in my experience, the safe harbor method a company selects is usually determined largely by its stage of development and available resources (both cash and appropriate personnel).

At Formation.  At formation, before a startup has begun operations or has tangible assets, any valuation method will be difficult to apply. As such, companies often elect to sell or grant restricted stock (rather than stock options) at formation, since restricted stock is generally outside the scope of Section 409A and an error in valuation would not raise the same concerns as with stock options.

Post-Seed Funding.  After a startup has obtained its initial round of seed funding (typically from angels, friends and family), the company will often rely on the illiquid startup insider valuation safe harbor. At such point in a startup’s life, the company will often have an officer who is running the startup’s financial operations and who would qualify to perform such a valuation – where such an officer does not exist, the company may elect to rely on an advisor or board member who possesses the appropriate set of skills.

Post-Venture Capital Funding or Pre-Liquidation Event.  After a startup either has (i) accepted an investment from a venture capital fund (and a VC designated director has joined the board) or (ii) “may reasonably anticipate” that the company will be acquired or go public in the foreseeable future, the company will typically rely on the independent valuation safe harbor. That said, if a venture-backed company is not yet earning revenue and/or a liquidity event in not on the near-term horizon (and the company is very focused on cash conservation), it is not usual for such a company to continue relying on the illiquid startup insider valuation safe harbor (assuming they can get their VC director(s) comfortable with that approach).

As indicated above, an alternative to dealing with Section 409A’s fair market value exercise price requirement is to grant restricted stock, which is not subject to Section 409A. However, it is important to also note that restricted stock grants pose a different challenge – the receipt of restricted stock for services is considered taxable income as the stock vests. See our prior post here regarding restricted stock and making a Section 83(b) election in connection with receipt of such grant.

While not within the scope of this post, it is important to note that the requirements of Section 409A are independent of accounting considerations associated with granting options below fair market value, such as the SEC’s concern with the proper accounting for “cheap stock.”  Such “cheap stock” accounting assessments are performed by the SEC (typically in connection with a company’s IPO registration process) and may result in one-time, non-cash earnings charges on the company’s financial statements

Fair market value of art that can not legally be sold

The IRS's Art Appraisal Unit values a unique piece of art at $65,000,000 by looking at "comparables" even though selling the piece which includes a stuffed eagle is forbidden by Federal Law. Accordingly the beneficiaries had valued the piece at zero for estate tax purposes.


Source New York Times
Art’s Sale Value? Zero. The Tax Bill? $29 Million.
By PATRICIA COHEN

What is the fair market value of an object that cannot be sold?

The question may sound like a Zen koan, but it is one that lawyers for the heirs of the New York art dealer Ileana Sonnabend and the Internal Revenue Service are set to debate when they meet in Washington next month.           The object under discussion is “Canyon,” a masterwork of 20th-century art created by Robert   Rauschenberg that Mrs. Sonnabend’s children inherited when she died in 2007.

Because the work, a sculptural combine, includes a stuffed bald eagle, a bird under federal protection, the heirs would be committing a felony if they ever tried to sell it. So their appraisers have valued the work at zero.

But the Internal Revenue Service takes a different view. It has appraised “Canyon” at $65 million and is demanding that the owners pay $29.2 million in taxes.

“It’s hard for me to see how this could be valued this way because it’s illegal to sell it,” said Patti S. Spencer, a lawyer who specializes in trusts and estates but has no role in the case.

The family is now challenging the judgment in tax court and its lawyers are negotiating with the I.R.S. in the hope of finding a resolution.

Heirs to important art collections are often subject to large tax bills. In this case, the beneficiaries, Nina Sundell and Antonio Homem, have paid $471 million in federal and state estate taxes related to Mrs. Sonnabend’s roughly $1 billion art collection, which included works by Modern masters from Jasper Johns to Andy Warhol. The children have already sold off a large part of it, approximately $600 million worth, to pay the taxes they owed, according to their lawyer, Ralph E. Lerner.

But they drew the line at “Canyon,” a landmark of postwar Modernism made in 1959 that three appraisers they hired, including the auction house Christie’s, had valued at zero. Should they lose their fight, the heirs, who were unavailable for comment, will owe the taxes plus $11.7 million in penalties.

Inheritances are generally taxed at graduated rates depending on their value. In this case, the $29.2 million assessment for “Canyon” was based on a special penalty rate because the I.R.S. contends the heirs inaccurately stated its value.

While art lovers may appreciate the I.R.S.’s aesthetic sensibilities, some estate planners, tax lawyers and collectors are alarmed at the agency’s position, arguing that the case could upend the standard practice of valuing assets according to their sale in a normal market. I.R.S. guidelines say that in figuring an item’s fair market value, taxpayers should “include any restrictions, understandings, or covenants limiting the use or disposition of the property.”

In this instance, the 1940 Bald and Golden Eagle Protection Act and the 1918 Migratory Bird Treaty Act make it a crime to possess, sell, purchase, barter, transport, import or export any bald eagle — alive or dead. Indeed, the only reason Mrs. Sonnabend was able to hold onto “Canyon,” Mr. Lerner said, was due to an informal nod from the United States Fish and Wildlife Service in 1981.

Even then, the government revisited the issue in 1998. Rauschenberg himself had to send a notarized statement attesting that the eagle had been killed and stuffed by one of Teddy Roosevelt’s Rough Riders long before the 1940 law went into effect. Mrs. Sonnabend was then able to retain ownership as long as the work continued to be exhibited at a public museum. The piece is on a long-term loan to the Metropolitan Museum of Art in New York, which Mr. Lerner said insures it, but the policy details are confidential.

Mr. Lerner said that the I.R.S.’s handling of the work has been confusing. Last fall, the agency sent the family an unsigned draft report that it was valuing “Canyon” at $15 million. After Mr. Lerner replied that the children were refusing to pay, the I.R.S. then sent a formal Notice of Deficiency in October saying it had increased the valuation to $65 million.

That figure came from the agency’s Art Advisory Panel, which is made up of experts and dealers and meets a few times a year to advise the I.R.S.’s Art Appraisal Services unit. One of its members is Stephanie Barron, the senior curator of 20th-century art at the Los Angeles County Museum of Art, where “Canyon” was exhibited for two years. She said that the group evaluated “Canyon” solely on its artistic value, without reference to any accompanying restrictions or laws.

“The ruling about the eagle is not something the Art Advisory Panel considered,” Ms. Barron said, adding that the work’s value is defined by its artistic worth. “It’s a stunning work of art and we all just cringed at the idea of saying that this had zero value. It just didn’t make any sense.”

Rauschenberg’s combines, which inventively slapped together everyday objects he found on the street, helped propel American art in a new direction.

Though the I.R.S. usually accepts the advisory panel’s recommendations, it is not required to; last year it did not follow the group’s opinion in 7 percent of the cases, according to panel’s annual 2011 report.

So how did the panel arrive at the $65 million figure? Ms. Barron said, “When you come up with a valuation you look at comparable works and what they have sold for at public or private sales.”

The I.R.S. declined to comment.

Mr. Lerner told Forbes magazine, which reported the dispute in February, that Joseph Bothwell, a former director of the agency’s Art Appraisal Services unit, had told him “there could be a market for the work, for example, a recluse billionaire in China might want to buy it and hide it.” Mr. Bothwell has since retired from the I.R.S. Ms. Barron said she did not consider any hypothetical black-market buyer.

Still, the notion that the I.R.S. might use the black market in this way to determine a fair market value has surprised some tax experts. James Joseph, a tax lawyer with Arnold & Porter in Washington, noted that the I.R.S. has taxed illegal contraband at its market value, but added: “I don’t know of any instance where the I.R.S. has assumed taxpayers will engage in an illegal activity in order to value their assets at a higher amount. Al Capone went to jail for not paying income taxes on his illegal income, but this is very different than that.”

At the moment, tax experts note that the I.R.S.’s stance puts the heirs in a bind: If they don’t pay, they would be guilty of violating federal tax laws, but if they try to sell “Canyon” to zero-out their bill, they could go to jail for violating eagle protection laws.

Mr. Lerner said that since the children assert the Rauschenberg has no dollar value for estate purposes, they could not claim a charitable deduction by donating “Canyon” to a museum. If the I.R.S. were to prevail in its $65 million valuation, he said the heirs would still have to pay the $40.9 million in taxes and penalties regardless of a donation.

Then, given their income and the limits on deductions, he said, they would be able to deduct only a small part of the work’s value each year. Mr. Lerner estimated that it would take about 75 years for them to absorb the deduction.

“So my clients would have to live to 140 or so,” he said.

Is Black-Scholes reliable for valuing options for s409a?

The most popular option pricing model -- Black-Scholes -- is outdated and unreliable, for several reasons:
1. First, it was first published in 1973, when the public trading of options was in its primitive stages. Calls were available on only a handful of listed companies, and puts were not traded publicly at all. With this in mind, the model was a theory only and not based on any market statistics.

2. The model assumes European style expiration (positions can be exercised only on the last trading day). However, options on listed stocks are traded American style, meaning they can be exercised at any time. This changes the assumptions underlying the Black-Scholes model.

3. The model assumes no dividend yield. Options traders know that dividends play a major role in total return and cannot be ignored.

4. The model further assumes that valuation and income have to be compared to an assumed rate of risk-free interest. Under today's odd money market, is this even valid any more?

5. With online trading and Internet access to information, the world of 1973 is practically prehistoric in terms of information flow, transaction speed, and costs.

Although subsequent papers have tried to modify Black-Scholes to make it more in line with market realities,the basic theory has little to do with modern options pricing. An alternative method may split premium into three parts, two of which are specific and easily identified in advance. First is intrinsic value, the in-the-money point spread between current price and strike. This is an exact dollar value. Second is time value, which is also predictable and precise. It can be modeled and isolated so that the rat of time decay is known well in advance -- and it should be unaffected by proximity between strike and current value.

The final leg of value is implied volatility, also called extrinsic value. This is where all of the variables are found. These include the complex interaction between proximity of strike to value, and time to expiration. The calculation of implied volatility is further complicated by historic volatility of the underlined as well as current fundamental and technical volatility of the stock. This may be based on company-specific news or events, or on market-wide perceptions, right or wrong. To get a handle on the complexities of implied volatility in a quick and easy way, check
volatility edge

In other words, it is time for a different and more realistic pricing model.

Source Options expert and author Thomsett

Over-valued Commerical Real Estate Appraisals are rampant

An article in today's New York Times confirms what many have suspected for many years...that the residential real estate appraisal profession needs an overhaul...

...In the recent economic crisis, commercial landlords and lenders discovered myriad ways to find themselves on the brink of financial disaster. Excessive purchase prices — many based on faulty property appraisals — were a major factor, specialists say.

Now, a new study has found just how inaccurate these appraisals can be. Using data from thousands of securitized real estate bonds in which the properties were foreclosed on and liquidated, the study, by KC Conway, an executive managing director at the brokerage firm Colliers International, and Brian F. Olasov, a managing director at the law firm McKenna Long & Aldridge, found a wide discrepancy between the appraisal values and the eventual sales prices of the properties.

“This study confirms what many of us have thought but heretofore have only known anecdotally: That appraisals are not very accurate,” Mr. Conway said. It was published in the winter edition of CRE Finance World, the publication of the CRE Finance Council, and is based on data from the research company Trepp L.L.C. for March 2007 through September 2011.

In general, appraisals overvalued the properties, the study found. Of the 2,076 properties it examined, 64 percent were appraised at values that exceeded the sale price, by a total of $1.4 billion, while 35.5 percent were appraised at less than the sale price, by a total of $661 million.

At the extremes, in 121 instances, the appraised value was more than double the sale price, and in 132 examples, the appraisal was less than 70 percent of the sale price. It is like “a game of horseshoes and throwing grenades,” the authors wrote of the results. “Close is good enough.”

Jay A. Neveloff, a partner at the law firm Kramer Levin Naftalis & Frankel, said, “Appraisals are important in nearly every aspect of a real estate deal, whether it is originating a loan, working out a loan, the decision to buy or sell a property and even bankruptcy.”

Marion T. Jones, a director of the brokerage firm Eastern Consolidated, said a recent appraisal of a development site in Brooklyn overstated the buildable area of the 100,000-square-foot site by as much as 40 percent. “As a result, the entire capitalization of the deal — including the acquisition price and the bank loan — was wrong,” Ms. Jones said.

When the developer realized the mistake, he stopped paying the debt, forcing the bank to foreclose. “The entire deal was derailed by this one bad appraisal, and now the lender is stuck with a site that they never intended to own,” said Ms. Jones, who is showing the site to several potential buyers but declined to name its location because the bank is not officially marketing it.

John Cicero, a managing principal of the appraisal firm Miller Cicero, said: “It is a broken profession in a lot of ways. The appraisal industry has become commoditized, where lenders see appraisals as simply a commodity to be purchased by a vendor and where more emphasis is placed on the price of an appraisal than the expertise of the appraiser.”

For example, Mr. Cicero said, in the past lenders would often have long discussions about the project and the appraiser’s qualifications before hiring. Now, it is more common for lenders to use an online bidding system, where they issue a request for proposals from appraisers and often choose the least expensive. “They actually refer to us as vendors submitting a bid, not educated professionals who are providing an important service,” he said.

Appraisers can serve multiple functions, used by lenders to help determine the size of a loan or by lawyers in litigation or sometimes buyers or sellers looking for market clarity. To conduct an appraisal, they visit sites, speak to brokers in the area, review financial statements like income and expense histories, and examine individual leases. The fee for an appraisal on a small commercial building in Manhattan can be less than $10,000.

“We are supposed to verify the information as much as is reasonably possible,” Mr. Cicero said, “but, unfortunately, so many appraisers rush through the process and don’t do all their homework.”

Bill Garber, the director of government and external relations for the Appraisal Institute, a group that represents about 23,000 appraisers nationally, questioned how the study had been conducted. “The sale price isn’t a good way to evaluate the accuracy of an appraisal,” Mr. Garber said.

“The motivation for why the loans were sold are unclear — maybe they were liquidated under duress and the market price didn’t even play a role,” he said. The only way to judge the accuracy of an appraisal, he argued, is to look at them individually and examine the factors that were used to reach the results.

Still, even a whiff of inaccuracy in appraisals could have broader implications for the commercial real estate market, the authors of the study say. The impact on banks, in particular, could be enormous. While the study tracked only securitized real estate bonds, for which much information is publicly available, they said, details of real estate loans made directly by banks, which are generally not available, would most likely show similar discrepancies.

In the next four years, $1.7 trillion in real estate debt will come due, and banks own roughly half of it, or some $867.5 billion, according to Trepp. So, if appraisals are as inaccurate as this study indicates, it could be assumed that the values of the real estate loans that banks are holding are also far off the mark.

“When you take a look at the 400-plus bank failures that have taken place going back to 2009, the precipitating cost was declining appraisal values” on real estate portfolios, Mr. Olasov. He said that appraisals that indicate a property’s value has declined often force banks to take write-downs, charge-offs and increase loan loss reserves, all of which drain bank capital and, in extreme cases, can lead to bank failures. Mr. Olasov is working with some federal banking regulators to see how the data from this study can be broadly applied to the value of bank real estate loans, although the lack of data on individual loans is slowing the research, he said....


Source New York Times May 8 2012 By Julie Satow