business valuation upon divorce: how theory and practice can lead to problems in court

Business Valuation Upon Divorce: How Theoryand Practice Can Lead to Problems In Court

(Endnotes are clickable. URLs contained in endnotes are web-enabled)

Richard R. [email protected]

http://www.orsinger.com

Orsinger, Nelson, Downing & Anderson, LLP

San Antonio Office:1717 Tower Life BuildingSan Antonio, Texas 78205

(210) 225-5567http://www.orsinger.com

and

Dallas Office:5950 Sherry Lane, Suite 800

Dallas, Texas 75225(214) 273-2400

http://www.ondafamilylaw.com

AICPA/AAML Conference on DivorceMay 10-12, 2012

Aria Resort & CasinoLas Vegas, NV

2012Richard R. OrsingerAll Rights Reserved

CURRICULUM VITAE OF RICHARD R. ORSINGER

Education: Washington & Lee University, Lexington, Virginia (1968-70)University of Texas (B.A., with Honors, 1972)University of Texas School of Law (J.D., 1975)

Licensed: Texas Supreme Court (1975); U.S. District Court, Western District of Texas (1977-1992; 2000-present); U.S.District Court, Southern District of Texas (1979); U.S. Court of Appeals, Fifth Circuit (1979); U.S. SupremeCourt (1981)

Certified: Board Certified by the Texas Board of Legal Specialization Family Law (1980), Civil Appellate Law (1987)

Organizations and Committees:

Chair, Family Law Section, State Bar of Texas (1999-2000)Chair, Appellate Practice & Advocacy Section, State Bar of Texas (1996-97)Chair, Continuing Legal Education Committee, State Bar of Texas (2000-02)Vice-Chair, Continuing Legal Education Committee, State Bar of Texas (2002-03)Member, Supreme Court Advisory Committee on Rules of Civil Procedure (1994-present);

Chair, Subcommittee on Rules 16-165aMember, Pattern Jury Charge Committee (Family Law), State Bar of Texas (1987-2000)Supreme Court Liaison, Texas Judicial Committee on Information Technology (2001-present)Tx. Bd. of Legal Specialization, Civil Appellate Law Advisory Commission (Member and Civil Appellate Law

Exam Committee (1990-2006; Chair 1991-1995); Family Law Advisory Commission (1987-1993)Member, Supreme Court Task Force on Jury Charges (1992-93)Member, Supreme Court Advisory Committee on Child Support and Visitation Guidelines

(1989, 1991; Co-Chair 1992-93; Chair 1994-98)Member, Board of Directors, Texas Legal Resource Center on Child Abuse & Neglect, Inc. (1991-93)President, Texas Academy of Family Law Specialists (1990-91)President, San Antonio Family Lawyers Association (1989-90)Associate, American Board of Trial AdvocatesFellow, American Academy of Matrimonial LawyersDirector, San Antonio Bar Association (1997-1998)Member, San Antonio, Dallas and Houston Bar Associations

Professional Activities and Honors:

One of Texas Top Ten Lawyers in all fields, Texas Monthly Super Lawyers Survey (2010 - 3rd Top Point Getter)Listed as one of Texas Top Ten Lawyers in all fields, Texas Monthly Super Lawyers Survey (2009)Recipient of the Franklin Jones, Jr. CLE Article Award for Outstanding Achievement in CLE (2009)Listed as Texas Top Family Lawyer, Texas Lawyers Go-To-Guide (2007)Listed as one of Texas Top 100 Lawyers, and Top 50 Lawyers in South Texas, Texas Monthly Super Lawyers Survey(2003-2010)Texas Academy of Family Law Specialists Sam Emison Award (2003)State Bar of Texas Presidential Citation for innovative leadership and relentless pursuit of excellence for continuing legal

education (June, 2001)State Bar of Texas Family Law Sections Dan R. Price Award for outstanding contributions to family law (2001)State Bar of Texas Gene Cavin Award for Excellence in Continuing Legal Education (1996)State Bar of Texas Certificate of Merit, June 1995, June 1996, June 1997 & June 2004Listed in the BEST LAWYERS IN AMERICA: Family Law (1987-2011); Appellate Law (2007-2011)

Continuing Legal Education and Administration:

Course Director, State Bar of Texas: Practice Before the Supreme Court of Texas Course (2002 - 2005, 2007, 2009 & 2011) Enron, The Legal Issues (Co-director, March, 2002) [Won national ACLEA Award] Advanced Expert Witness Course (2001, 2002, 2003, 2004) 1999 Impact of the New Rules of Discovery 1998 Advanced Civil Appellate Practice Course 1991 Advanced Evidence and Discovery

Computer Workshop at Advanced Family Law (1990-94) and Advanced Civil Trial (1990-91) courses 1987 Advanced Family Law Course. Course Director, Texas Academy of Family Law Specialists First Annual Trial Institute,

Las Vegas, Nevada (1987)

Books and Journal Articles:

Editor-in-Chief of the State Bar of Texas TEXAS SUPREME COURT PRACTICE MANUAL (2005)Chief Editor of the State Bar of Texas Family Law Section's EXPERT WITNESS MANUAL (Vols. II & III) (1999) Author of Vol. 6 of McDonald Texas Civil Practice, on Texas Civil Appellate Practice, published by Bancroft-Whitney Co.(1992) (900 + pages)A Guide to Proceedings Under the Texas Parent Notification Statute and Rules, SOUTH TEXAS LAW REVIEW (2000) (co-authored)Obligations of the Trial Lawyer Under Texas Law Toward the Client Relating to an Appeal, 41 SOUTH TEXAS LAW REVIEW111 (1999)Asserting Claims for Intentionally or Recklessly Causing Severe Emotional Distress, in Connection With a Divorce, 25 ST.MARY'S L.J. 1253 (1994), republished in the AMERICAN JOURNAL OF FAMILY LAW (Fall 1994) and Texas Family Law ServiceNewsAlert (Oct. & Dec., 1994 and Feb., 1995)Chapter 21 on Business Interests in Bancroft-Whitney's TEXAS FAMILY LAW SERVICE (Speer's 6th ed.)Characterization of Marital Property, 39 BAY. L. REV. 909 (1988) (co-authored)Fitting a Round Peg Into A Square Hole: Section 3.63, Texas Family Code, and the Marriage That Crosses States Lines, 13ST. MARY'S L.J. 477 (1982)

SELECTED CLE SPEECHES AND ARTICLES

State Bar of Texas' [SBOT] Advanced Family Law Course: Intra and Inter FamilyTransactions (1983); Handling the Appeal: Procedures and Pitfalls (1984); Methods andTools of Discovery (1985); Characterization and Reimbursement (1986); Trusts andFamily Law (1986); The Family Law Case in the Appellate Court (1987); Post-DivorceDivision of Property (1988); Marital Agreements: Enforcement and Defense (1989);Marital Liabilities (1990); Rules of Procedure (1991); Valuation Overview (1992);Deposition Use in Trial: Cassette Tapes, Video, Audio, Reading and Editing (1993); TheGreat Debate: Dividing Goodwill on Divorce (1994); Characterization (1995); OrdinaryReimbursement and Creative Theories of Reimbursement (1996); Qualifying andRejecting Expert Witnesses (1997); New Developments in Civil Procedure and Evidence(1998); The Expert Witness Manual (1999); Reimbursement in the 21st Century (2000);Personal Goodwill vs. Commercial Goodwill: A Case Study (2000); What Representingthe Judge or Contributing to Her Campaign Can Mean to Your Client: Proposed NewDisqualification and Recusal Rules (2001); Tax Workshop: The Fundamentals (2001);Blue Sky or Book Value? Complex Issues in Business Valuation (2001); Private Justice:Arbitration as an Alternative to the Courthouse (2002); International & Cross BorderIssues (2002); Premarital and Marital Agreements: Representing the Non-Monied Spouse(2003); Those Other Texas Codes: Things the Family Lawyer Needs to Know AboutCodifications Outside the Family Code (2004); Pearls of Wisdom From Thirty Years ofPracticing Family Law (2005); The Road Ahead: Long-Term Financial Planning inConnection With Divorce (2006); A New Approach to Distinguishing EnterpriseGoodwill From Personal Goodwill (2007); The Law of Interpreting Contracts: How toDraft Contracts to Avoid or Win Litigation (2008); Effect of Choice of Entities: HowOrganizational Law, Accounting, and Tax Law for Entities Affect Marital Property Law(2008); Practicing Family Law in a Depressed Economy, Parts I & II (2009); PropertyPuzzles: 30 Characterization Rules, Explanations & Examples (2009); Troubling Issuesof Characterization, Reimbursement, Valuation, and Division Upon Divorce (2010);Separate & Community Property: 30 Rules With Explanations & Examples (2010); TheRole of Reasoning in Constructing a Persuasive Argument (2011)

UT School of Law: Trusts in Texas Law: What Are the Community Rights inSeparately Created Trusts? (1985); Partnerships and Family Law (1986); Proving UpSeparate and Community Property Claims Through Tracing (1987); Appealing Non-JuryCases in State Court (1991); The New (Proposed) Texas Rules of Appellate Procedure(1995); The Effective Motion for Rehearing (1996); Intellectual Property (1997);Preservation of Error Update (1997); TRAPs Under the New T.R.A.P. (1998); JudicialPerspectives on Appellate Practice (2000)

SBOT's Advanced Evidence & Discovery Course: Successful Mandamus Approachesin Discovery (1988); Mandamus (1989); Preservation of Privileges, Exemptions andObjections (1990); Business and Public Records (1993); Grab Bag: Evidence &Discovery (1993); Common Evidence Problems (1994); Managing Documents--TheTechnology (1996); Evidence Grab Bag (1997); Evidence Grab Bag (1998); Making andMeeting Objections (1998-99); Evidentiary Issues Surrounding Expert Witnesses (1999);Predicates and Objections (2000); Predicates and Objections (2001); Building Blocks ofEvidence (2002); Strategies in Making a Daubert Attack (2002); Predicates andObjections (2002); Building Blocks of Evidence (2003); Predicates & Objections (HighTech Emphasis) (2003)

SBOT's Advanced Civil Appellate Practice Course: Handling the Appeal from aBench Trial in a Civil Case (1989); Appeal of Non-Jury Trials (1990); Successful

Challenges to Legal/Factual Sufficiency (1991); In the Sup. Ct.: Reversing the Court ofAppeals (1992); Brief Writing: Creatively Crafting for the Reader (1993); Interlocutoryand Accelerated Appeals (1994); Non-Jury Appeals (1995); Technology and theCourtroom of the Future (1996); Are Non-Jury Trials Ever "Appealing"? (1998);Enforcing the Judgment, Including While on Appeal (1998); Judges vs. Juries: A Debate(2000); Appellate Squares (2000); Texas Supreme Court Trends (2002); New AppellateRules and New Trial Rules (2003); Supreme Court Trends (2004); Recent Develop-ments in the Daubert Swamp (2005); Hot Topics in Litigation: Restitution/UnjustEnrichment (2006); The Law of Interpreting Contracts (2007); Judicial Review ofArbitration Rulings: Problems and Possible Alternatives (2008); The Role of Reasoningand Persuasion in the Legal Process (2010)

Various CLE Providers: SBOT Advanced Civil Trial Course: Judgment Enforcement,Turnover and Contempt (1990-1991), Offering and Excluding Evidence (1995), NewAppellate Rules (1997), The Communications Revolution: Portability, The Internet andthe Practice of Law (1998), Daubert With Emphasis on Commercial Litigation,Damages, and the NonScientific Expert (2000), Rules/Legislation Preview (StatePerspective) (2002); College of Advanced Judicial Studies: Evidentiary Issues (2001);El Paso Family Law Bar Assn: Foreign Law and Foreign Evidence (2001); AmericanInstitute of Certified Public Accounts: Admissibility of Lay and Expert Testimony;General Acceptance Versus Daubert (2002); Texas and Louisiana Associations ofDefense Counsel: Use of Fact Witnesses, Lay Opinion, and Expert Testimony; When andHow to Raise a Daubert Challenge (2002); SBOT In-House Counsel Course: Marital Property Rights in Corporate Benefits for High-Level Employees (2002); SBOT 19thAnnual Litigation Update Institute: Distinguishing Fact Testimony, Lay Opinion &Expert Testimony; Raising a Daubert Challenge (2003); State Bar College SpringTraining: Current Events in Family Law (2003); SBOT Practice Before the SupremeCourt: Texas Supreme Court Trends (2003); SBOT 26th Annual Advanced Civil Trial:Distinguishing Fact Testimony, Lay Opinion & Expert Testimony; ChallengingQualifications, Reliability, and Underlying Data (2003); SBOT New Frontiers in MaritalProperty: Busting Trusts Upon Divorce (2003); American Academy of Psychiatry and theLaw: Daubert, Kumho Tire and the Forensic Child Expert (2003); AICPA-AAMLNational Conference on Divorce: Cutting Edge IssuesNew Alimony Theories;Measuring Personal Goodwill (2006); New Frontiers` - Distinguishing EnterpriseGoodwill from Personal Goodwill; Judicial Conference (2006); SBOT New Frontiers inMarital Property Law: Tracing, Reimbursement and Economic Contribution Claims InBrokerage Accounts (2007); SBOT In-House Counsel Course: When an OfficerDivorces: How a Company can be Affected by an Officers Divorce (2009); SBOTHandling Your First Civil Appeal The Role of Reasoning and Persuasion in Appeals(2011); New Frontiers in Marital Property Law: A New Approach to DeterminingEnterprise and Personal Goodwill Upon Divorce (2011)

TABLE OF CONTENTS

I. INTRODUCTION.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

II. STANDARDS OF VALUE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1A. FAIR MARKET VALUE... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

1. Definitions of Fair Market Value.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. Inputs in Determining Fair Market Value.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23. Rev. Ruling 59-60's Fair Market Value of a Privately-Owned Business.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

B. FAIR VALUE (ACCOUNTING)... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41. Definition of Fair Value (Accounting).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42. Inputs for Determining Fair Value (Accounting).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

C. FAIR VALUE (DISSENTERS RIGHTS)... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71. Colorado.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82. California.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83. Colorado.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94. Delaware.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95. Illinois.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106. Iowa.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107. Kansas.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108. Kentucky.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109. Maine.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1110. New Jersey.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1111. New York.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1112. Texas... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1113. Vermont.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1114. Wyoming... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1215. Whats Fair?.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

D. ANALOGY TO DIVORCE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12E. INTRINSIC VALUE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

1. What is Intrinsic Value?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13F. INVESTMENT VALUE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13G. LIQUIDATION VALUE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14H. BOOK VALUE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14I. GOING CONCERN VALUE... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14J. SENTIMENTAL VALUE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15K. STANDARD OF VALUE FOR DIVORCE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Alabama... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15Arizona.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15Arkansas.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16California... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16Colorado.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16Connecticut.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16Delaware.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16Florida.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16Hawaii.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16Idaho.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16Illinois.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16Indiana.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17Iowa.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17Kansas.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17Mississippi... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

i

Missouri... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17New York.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17New Jersey... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17New Mexico.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17North Carolina.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17North Dakota.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17Ohio.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17Oklahoma.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17Pennsylvania.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17South Carolina.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17Tennessee.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18Texas.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18Vermont... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18Virginia.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18West Virginia... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19Wisconsin.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

III. STANDARDS OF LEGAL ADMISSIBILITY... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19A. GENERAL ACCEPTANCE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19B. DAUBERT RELIABILITY.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19C. WHERE THE STATES FALL... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20D. HOW MIGHT THESE STANDARDS APPLY TO BUSINESS VALUATION?. . . . . . . . . . . . . . . . . . . . . . . 22

IV. THE INCOME APPROACH (EARNINGS AND CASH FLOW)... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23A. PROJECTING FUTURE CASH FLOWS.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24B. NORMALIZING HISTORICAL EARNINGS OR CASH FLOW.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

1. Adjustments to the Income Statement.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25a. Normalizing Adjustments.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25b. Control Adjustments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26c. Fundamental Adjustments... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26d. Determining Reasonable Compensation.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

2. Applicable to the Market Approach as Well.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26C. DETERMINING AN EXPECTED GROWTH RATE... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26D. DETERMINING TERMINAL VALUE... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

V. THE INCOME APPROACH (DEVELOPING A CAP RATE/DISCOUNT RATE).. . . . . . . . . . . . . . . . . . . . 27A. MODERN PORTFOLIO THEORY... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27B. CAPM... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27C. THE RISK FREE RATE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28D. THE EQUITY RISK PREMIUM.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

1. Surveys.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302. Ex Post Analysis.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313. Ex Ante Analysis.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

E. MODERN APPLICATIONS OF MPT AND THE CAPM.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 331. Beta.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332. The CAPM Formula.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333. Size Premium... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 344. What Constitutes Diversification.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345. Using the CAPM to Value Private Businesses... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 356. Alternative Asset Pricing Models.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

F. BUILD UP METHOD.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351. The Risk Free Rate.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362. The Equity Risk Premium.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

ii

3. The Size Premium.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364. The Industry Risk Premium.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365. The Specific Company Risk Premium.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376. The Build-Up Method as an Extension of the CAPM.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

G. PROBLEMS WITH THE RISK FREE RATE... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381. Nominal vs. Real Yields.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382. Risk Free You Say?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383. Negative Yields.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 384. The Flip Side of Fear.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385. Government Manipulation.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 386. Selecting the Right Security... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397. Matching Horizons.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398. Compounding.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409. Historical vs. Current.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

H. PROBLEMS WITH THE EQUITY RISK PREMIUM.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 401. The Equity Premium Puzzle.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 402. Different Windows Into the Data.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413. Is Older Data Relevant?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 424. Geometric Versus Arithmetic Mean.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 435. Matching Maturities... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 446. Mismatched Time Frames.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 447. Survivor Bias.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 448. The ERP is Cyclical.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 449. Ex Post Is Not Ex Ante.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4510. Increased Systemic Risk.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4511. Other Problems.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4512. Recap of Problems with Estimating the ERP.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4513. What Would Warren Buffett Do?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4614. Is the Game Worth the Candle?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46

I. PROBLEMS WITH BETA.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 471. Differing Market Indexes... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 472. Estimation Period... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473. Return Interval.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474. Adjustments to Beta... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 475. Unrelated Market Pricing... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 476. High Betas Can Be Good... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 487. Conservatism.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 488. Comparability to Privately-Owned Businesses.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489. Admissibility in Court.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48

J. PROBLEMS WITH THE CAPM... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 481. Statistical.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 482. The Need to Adjust Inputs.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503. The CAPM Assumes Stable Inputs.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504. What Market Proxy to Use... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505. Admissibility in Court.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516. Uncharacteristic Market Behavior.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

K. PROBLEMS WITH THE SIZE PREMIUM.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 531. Using Market Cap to Measure Size.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 532. The Smallest Public Companies are not Comparable.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533. Beta Reversal.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 534. Small Caps in Financial Trouble.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 536. Excess Returns are Cyclical.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537. The January Effect.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

iii

8. Circularity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 539. The Breakpoints Between Deciles.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5410. Size Premia are Historical.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5411. Size Versus Liquidity Premium?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5412. Are There Better Measures of Risk Than Size?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

L. PROBLEMS WITH THE INDUSTRY RISK PREMIUM.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54M. SHOULD THERE BE A LIQUIDITY PREMIUM?.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54N. PROBLEMS WITH THE SPECIFIC COMPANY RISK PREMIUM... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

VI. THE MARKET APPROACH... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56A. THE GUIDELINE PUBLIC COMPANY METHOD.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56B. THE MERGED-AND-ACQUIRED COMPANY METHOD.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57C. COMPARABLE PRIVATELY-OWNED COMPANIES.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58D. PRIOR TRANSACTIONS INVOLVING THE SUBJECT COMPANY.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58E. CHALLENGES IN USING THE MARKET APPROACH.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58F. PROBLEMS WITH THE MARKET APPROACH.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

VII. NET ASSET APPROACH.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 591. Adjustments to the Balance Sheet.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

VIII. DISCOUNT FOR LACK OF MARKETABILITY, ADJUSTMENT FOR CONTROL, AND CONTROLPREMIUM/MINORITY DISCOUNT.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

A. DISCOUNT FOR LACK OF MARKETABILITY.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 601. Benchmark Studies.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

a. Restricted Stock Studies.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61b. Pre-IPO Pricing.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62c. Comparing Acquisitions.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

2. Survey-Based Approaches.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 623. Does the Marketability Discount Apply to a Controlling Interest?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 624. Double-Counting With Size Premium.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 635. Is Cost of Later Sale Properly Considered?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63

B. DISCOUNT FOR LACK OF CONTROL (MINORITY DISCOUNT).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 631. Comparability to a Marketable Minority Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 642. What Constitutes Control?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 643. Is a 50% Interest a Minority Interest?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 644. What if There is No Controlling Interest?.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 645. Where Should Lack of Control be ReflectedIn Projected Revenues, the Discount Rate, or an Ending Adjustment?

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65C. CONTROL PREMIUM.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65D. IMPLIED MINORITY DISCOUNT; CONTROL ADJUSTMENT.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66E. APPLICABILITY OF DISCOUNTS TO DIVORCE VALUATIONS.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

IX. BUY-SELL AGREEMENTS AND TRANSFER RESTRICTIONS.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72Arizona.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72Arkansas.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72California... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72Florida.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73Georgia.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73Indiana.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73Iowa.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73Minnesota.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73Missouri... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74Montana... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

iv

New Hampshire.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74New Mexico.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74New Jersey... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74New York.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75Oklahoma.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75Oregon.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75Pennsylvania.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75South Dakota.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75Tennessee.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75Texas.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75Utah.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76Virginia.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76Washington.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76West Virginia... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76

X. ENTERPRISE VS. PERSONAL GOODWILL.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77

XI. COVENANTS NOT TO COMPETE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77

XII. TAX-EFFECTING THE VALUE OF THE BUSINESS... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77A. TAX-EFFECTING DIVORCE VALUATIONS.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78B. TAX-EFFECTING S-CORPORATIONS.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78C. CONSIDERING TAX ON THE LIFO RESERVE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80D. CONSIDERING CAPITAL GAINS.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

1. Future Capital Gains on Sale of Ownership Interest.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 802. Embedded Capital Gains.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

v

Business Valuation Upon Divorce: How Theory and Practice Can Lead to Problems In Court


by

Richard R. OrsingerBoard Certified in Family Law& Civil Appellate Law by the

Texas Board of Legal Specialization

I. INTRODUCTION. There is no objectively valid wayto value a business interest that is not freely traded in amarketplace. There are theories, models, and methods,developed in connection with publicly-traded stocks andbonds, that have been adapted for use in valuingprivately-owned business interests. Even in their origi-nal field, however, these theories, and models, andmethods, are attended by controversy. Using thesetheories, models and methods to value privately-ownedbusinesses further compounds the problems.

Business valuators apply indicators of value derivedfrom stock sales in liquid markets to the task of valuingilliquid privately-owned business interests. Theseindicators of value have poor predictive ability whenapplied to the future stock prices of the very companiesfrom whom the measures are taken. There is reason tosuspect that these indicators of value work no better indetermining the value of a privately-owned businessinterest.

When a business valuation is done incident to divorce,ascertaining the value is complicated by the fact thatstandards of value vary from state to state. Thesecomplications are further compounded by differing rulesregarding the use of marketability and minority dis-counts, and how enterprise goodwill and personalgoodwill are treated in the divorce.

Under the Frye case, the test for admissibility of anexpert opinion was whether the experts methodologyhad been generally accepted. Since the U.S. SupremeCourt decided the Daubert case in 1993, trial judges andlawyers have become more inclined to question thereliability of the methods and data used by experts,including those who testify to business values. However,approximately one-fourth of the states still use a gen-eral acceptance standard for admissibility of experttestimony, further confounding business valuationpractice.

NOTE: In the pdf version of this article, you can clickon the superscripted endnote numbers and jump to theendnote. The URLs in the endnotes are web enabled andlink to the underlying cited material. You can downloadthe pdf file from this URL:

II. STANDARDS OF VALUE. The standard of valueis the type of value being used in a specific valuationengagement. In Shannon P. Pratt, VALUING A BUSINESS:THE ANALYSIS AND APPRAISAL OF CLOSELY HELDCOMPANIES 22-30 (3d ed. 2008), Pratt recognizes sevenstandards of value: (i) fair market value, (ii) fair value,(iii) investment value, (vi) intrinsic or fundamentalvalue, (iv) going-concern value, (vi) liquidation value, (vii) book value. See also James R. Hitchner, FINANCIALVALUATION: APPLICATIONS AND MODELS (2d ed. Wiley2006) pp. 3-6. To these can be added one more stan-dard, (viii) sentimental value.

A. FAIR MARKET VALUE. In the business valua-tion field, the idea of value is dominated by the defini-tion that the U.S. Government requires for tax purposes:fair market value.

1. Definitions of Fair Market Value. TreasuryRegulation 20.2031-1(b) defines "fair market value" inthis way:

The fair market value is the price at which theproperty would change hands between a willingbuyer and a willing seller, neither being under anycompulsion to buy or to sell and both havingreasonable knowledge of relevant facts.

See Treasury Reg. 25-2512-1 (fair market value definedfor gift tax purposes). Treasury Reg. 20.2031-1(b) goeson to say:

1


The fair market value of a particular item of prop-erty includible in the decedent's gross estate is notto be determined by a forced sale price. Nor is thefair market value of an item of property to bedetermined by the sale price of the item in a mar-ket other than that in which such item is mostcommonly sold to the public, taking into accountthe location of the item wherever appropriate.

Id.

In United States v. Cartwright, 411 U.S. 546, 550-51(1973), the U.S. Supreme Court said:

In implementing 26 U.S.C. 2031, the generalprinciple of the Treasury Regulations is that thevalue of property is to be determined by its fairmarket value at the time of the decedent's death.The fair market value is the price at which theproperty would change hands between a willingbuyer and a willing seller, neither being under anycompulsion to buy or to sell and both havingreasonable knowledge of relevant facts. Treas.Reg. 20.2031-1(b). The willing buyer-willingseller test of fair market value is nearly as old asthe federal income, estate, and gifts taxes them-selves, and is not challenged here.FN7 Under thistest, it is clear that if the decedent had ownedordinary corporate stock listed on an exchange, itsvalue' for estate tax purposes would be the pricethe estate could have obtained if it had sold thestock on the valuation date, that price being, underTreas. Reg. 20.2031-2(b), the mean between thehighest and lowest quoted selling prices on thatday.

2. Inputs in Determining Fair Market Value. TheIRS Regulations set out a hierarchy of information to beconsidered in estimating fair market value for estate andgift tax purposes. The more reliable indicators of valuemust be used if they are available; if none are available,then the next highest level of indicator should be used,and so on, in descending order. Subdivision (f) coversclosely-held business interests that has had no recentarms length sales.

IRS Regulation 20.2031-2 Valuation of stocksand bonds.

(a) In general. The value of stocks andbonds is the fair market value per share or bond on

the applicable valuation date.

(b) Based on selling prices. (1) In general, ifthere is a market for stocks or bonds, on a stockexchange, in an over-the-counter market, or other-wise, the mean between the highest and lowestquoted selling prices on the valuation date is thefair market value per share or bond. [Note: theclosing price is not used to fix value for tax pur-poses.] If there were no sales on the valuation datebut there were sales on dates within a reasonableperiod both before and after the valuation date, thefair market value is determined by taking aweighted average of the means between the high-est and lowest sales on the nearest date before andthe nearest date after the valuation date. Theaverage is to be weighted inversely by the respec-tive numbers of trading days between the sellingdates and the valuation date. If the stocks or bondsare listed on more than one exchange, the recordsof the exchange where the stocks or bonds areprincipally dealt in should be employed if suchrecords are available in a generally availablelisting or publication of general circulation. In theevent that such records are not so available andsuch stocks or bonds are listed on a compositelisting of combined exchanges available in agenerally available listing or publication of generalcirculation, the records of such combined ex-changes should be employed. In valuing listedsecurities, the executor should be careful to consultaccurate records to obtain values as of the applica-ble valuation date. If quotations of unlisted securi-ties are obtained from brokers, or evidence as totheir sale is obtained from officers of the issuingcompanies, copies of the letters furnishing suchquotations or evidence of sale should be attachedto the return.

* * *(c) Based on bid and asked prices. If the

provisions of paragraph (b) of this section areinapplicable because actual sales are not availableduring a reasonable period beginning before andending after the valuation date, the fair marketvalue may be determined by taking the meanbetween the bona fide bid and asked prices on thevaluation date, or if none, by taking a weightedaverage of the means between the bona fide bidand asked prices on the nearest trading date beforeand the nearest trading date after the valuationdate, if both such nearest dates are within a reason-

2


able period. The average is to be determined in themanner described in paragraph (b) of this section.

(d) Based on incomplete selling prices orbid and asked prices. If the provisions of para-graphs (b) and (c) of this section are inapplicablebecause no actual sale prices or bona fide bid andasked prices are available on a date within areasonable period before the valuation date, butsuch prices are available on a date within a reason-able period after the valuation date, or vice versa,then the mean between the highest and lowestavailable sale prices or bid and asked prices maybe taken as the value.

(e) Where selling prices or bid and askedprices do not reflect fair market value. If it isestablished that the value of any bond or share ofstock determined on the basis of selling or bid andasked prices as provided under paragraphs (b), (c),and (d) of this section does not reflect the fairmarket value thereof, then some reasonable modi-fication of that basis or other relevant facts andelements of value are considered in determiningthe fair market value. Where sales at or near thedate of death are few or of a sporadic nature, suchsales alone may not indicate fair market value. Incertain exceptional cases, the size of the block ofstock to be valued in relation to the number ofshares changing hands in sales may be relevant indetermining whether selling prices reflect the fairmarket value of the block of stock to be valued. Ifthe executor can show that the block of stock to bevalued is so large in relation to the actual sales onthe existing market that it could not be liquidatedin a reasonable time without depressing the mar-ket, the price at which the block could be sold assuch outside the usual market, as through anunderwriter, may be a more accurate indication ofvalue than market quotations. Complete data insupport of any allowance claimed due to the sizeof the block of stock being valued shall be submit-ted with the return. On the other hand, if the blockof stock to be valued represents a controllinginterest, either actual or effective, in a goingbusiness, the price at which other lots changehands may have little relation to its true value.

(f) Where selling prices or bid and askedprices are unavailable. If the provisions of para-graphs (b), (c), and (d) of this section are inappli-

cable because actual sale prices and bona fide bidand asked prices are lacking, then the fair marketvalue is to be determined by taking the followingfactors into consideration:

(1) In the case of corporate or otherbonds, the soundness of the security, the interestyield, the date of maturity, and other relevantfactors; and

(2) In the case of shares of stock, thecompany's net worth, prospective earning powerand dividend-paying capacity, and other relevantfactors.

Some of the "other relevant factors" referredto in subparagraphs (1) and (2) of this paragraphare: The good will of the business; the economicoutlook in the particular industry; the company'sposition in the industry and its management; thedegree of control of the business represented bythe block of stock to be valued; and the values ofsecurities of corporations engaged in the same orsimilar lines of business which are listed on a stockexchange. However, the weight to be accordedsuch comparisons or any other evidentiary factorsconsidered in the determination of a value dependsupon the facts of each case. In addition to therelevant factors described above, considerationshall also be given to nonoperating assets, includ-ing proceeds of life insurance policies payable toor for the benefit of the company, to the extentsuch nonoperating assets have not been taken intoaccount in the determination of net worth, prospec-tive earning power and dividend-earning capacity.Complete financial and other data upon which thevaluation is based should be submitted with thereturn, including copies of reports of any examina-tions of the company made by accountants, engi-neers, or any technical experts as of or near theapplicable valuation date.

(g) Pledged securities. . . .

(h) Securities subject to an option orcontract to purchase. Another person may holdan option or a contract to purchase securitiesowned by a decedent at the time of his death. Theeffect, if any, that is given to the option or contractprice in determining the value of the securities forestate tax purposes depends upon the circum-

3


stances of the particular case. Little weight will beaccorded a price contained in an option or contractunder which the decedent is free to dispose of theunderlying securities at any price he choosesduring his lifetime. Such is the effect, for example,of an agreement on the part of a shareholder topurchase whatever shares of stock the decedentmay own at the time of his death. Even if thedecedent is not free to dispose of the underlyingsecurities at other than the option or contract price,such price will be disregarded in determining thevalue of the securities unless it is determined underthe circumstances of the particular case that theagreement represents a bona fide business arrange-ment and not a device to pass the decedent's sharesto the natural objects of his bounty for less than anadequate and full consideration in money ormoney's worth. See section 2703 and the regula-tions at 25.2703 of this chapter for special rulesinvolving options and agreements (includingcontracts to purchase) entered into (or substantiallymodified after) October 8, 1990.

It is interesting to note that the Treasury Regs descrip-tion of factors to consider, when there is no market datafrom which to draw value inferences, is very much likeIntrinsic Value. See Section II.D.

3. Rev. Ruling 59-60's Fair Market Value of aPrivately-Owned Business. Modern business valuationtheory found an early expression in Revenue Ruling59-60,1 where the IRS grappled with the difficulty ofdetermining the fair market value of stock in a corpora-tion where there is no ready market price reflectinginvestors consensus on what the stock is worth. Reve-nue Ruling 59-60 uses the familiar definition of fairmarket value required by federal law for tax reporting.The IRS eschewed any specific instructions on how tovalue such a business: "No formula can be devised thatwill be generally applicable to the multitude of differentvaluation issues arising in estate and gift tax cases."Rev. Rul. 59-60 3.01.

Revenue Ruling 59-60 3.03 asserts that the bestindicator of value is the price at which stock in a com-pany trades in a free and active market. But where thestock is closely held, or traded infrequently, or traded inan erratic market, some other measure must be used. Id. 3.03. Revenue Ruling 59-60 suggests that the next bestmeasure may be the price of stock in comparablecompanies that are trading in a "free and open market."

Id. If comparable companies whose shares are traded onan exchange cannot be found, then sales of comparablecompanies whose stock is sold "over the counter" shouldbe used. Id. 4.02 (g).

Although Revenue Ruling 59-60 gives the marketapproach to business valuation first priority, it ulti-mately settles on an income approach using market-derived multipliers. Earning capacity and dividendpaying capacity are both listed as factors to consider invaluing a company. Id. 4.01. In Section 5, Rev. Rule59-60 says: "Earnings may be the most importantcriterion of value in some cases . . . . In general, theappraiser will accord primary consideration to earningswhen valuing stocks of companies which sell productsor services to the public. . . ." Id. 5(a). Section 6discusses capitalization rates, saying that "[a] determina-tion of the proper capitalization rate presents one of themost difficult problems in valuation." Id. 6.

The United States Tax Court said: [W]e note that eachfactor listed in Rev.Rul. 5960 does not necessarilyhave a bearing on value and need not be given weight inevery case. Estate of Ford v. C.I.R., T.C. Memo.1993-580, 1993 WL 501917, *11 (U.S. Tax Court1993).

Revenue Ruling 59-60 has endured remarkably well,considering the level of understanding of businessvaluation principles in 1959. Its durability is largelyattributable to the generality of the principles put forthin the Ruling, and the enduring nature of its insights thatpredate and really transcend the quantitative revolutionthat has come to dominate business valuation in recentyears. Nowadays business valuators primarily use someversion of the Capital Asset Pricing Model (CAPM) andthe Build Up Method to arrive at a defensible capitaliza-tion or discount rate to reply to projected earnings orcash flows. Both methods are examined in detail later inthis Article.

B. FAIR VALUE (ACCOUNTING).

1. Definition of Fair Value (Accounting). Theaccounting profession has adopted the term "fair value"as the equivalent to the legal "fair market value." Thecurrent definition and description of "fair value" is setout by the Financial Accounting Standards Board, inAccounting Standards Codification, Glossary:

Fair value is the price that would be received

4


to sell an asset or paid to transfer a liability in anorderly transaction between market participants atthe measurement date.

See FASB ASC Topic 820 Glossary.

Additional considerations have been established by theFASB regarding determining fair value:

A fair value measurement assumes that theasset or liability is exchanged in an orderly trans-action between market participants to sell the assetor transfer the liability at the measurement date.The transaction to sell the asset or transfer theliability is a hypothetical transaction at the mea-surement date, considered from the perspective ofa market participant that holds the asset or owesthe liability (FASB ASC 820-10-35). The exitprice objective applies for all assets and liabilitiesmeasured at fair value.

Fair value measurements of assets assumesthe highest and best use by market participants,considering the use of the asset that is physicallypossible, legally permissible, and financiallyfeasible at the measurement date. FASB ASCTopic 820 Implementation Guidance, p. 5(10-20-2009).

Fair value is a market-based measurement,not an entity-specific measurement. For someassets and liabilities, observable market transac-tions or market information might be available.For other assets and liabilities, observable markettransactions and market information might not beavailable. However, the objective of a fair valuemeasurement in both cases is the same--to estimatethe price at which an orderly transaction to sell theasset or to transfer the liability would take placebetween market participants at the measurementdate under current market conditions (that is, anexit price at the measurement date from the per-spective of a market participant that holds the assetor owes the liability).

FASB ASC 820-20-05-1B (as amended May 2011).2

Fair value measures should consider theutility of the asset or liability being measured andspecific attributes to the asset or liability.

FASB ASC Topic 820 Implementation Guidance, p. 5(10-20-2009).

Transaction costs should be excluded fromall fair value measurements.

FASB ASC Topic 820 Implementation Guidance, p. 5(10-20-2009).

2. Inputs for Determining Fair Value (Account-ing). The accounting profession has developed its ownhierarchy of indicators of fair market value to be used byaccountants when they are valuing assets (and liabilities)to be listed on a financial statement (like a balance sheetor statement of assets and liabilities). Take care to notethat the accounting profession uses the term "fair value"to mean what lawyers mean when lawyers say "fairmarket value."

In the USA, the ultimate authority on Generally Ac-cepted Accounting Principles (GAAP) is the FinancialAccounting Standards Board (FASB). In September2006, FASB promulgated Financial Accounting Stan-dard 157 ("FAS 157"). The document can be found at. FAS 157 estab-lished a hierarchy of information to use in determiningthe "fair value" of assets or liabilities under GenerallyAccepted Accounting Practices (GAAP).

Here is the Federal Reserve Bank of New York's sum-mary of FAS 157:

FASB Statement No. 157, Fair Value Mea-surements (FAS 157), issued in September 2006,defines fair value, establishes a framework formeasuring the fair value of assets and liabilitiesbased on a three level hierarchy, and expandsdisclosures about fair value measurements. TheFASB's three-level fair value hierarchy gives thehighest priority to quoted prices in active marketsfor identical assets or liabilities (Level 1) and thelowest priority to unobservable inputs (Level 3).Level 1 inputs are quoted prices in active marketsfor identical assets or liabilities that the reportingbranch or agency has the ability to access at themeasurement date (e.g., the FFIEC 002 reportingdate). Level 2 inputs are inputs other than quotedprices included within Level 1 that are observablefor the asset or liability, either directly or indi-rectly. Level 3 inputs are unobservable inputs forthe asset or liability.3

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Here is what FAS 157 itself says about the hierarchy ofinputs for estimating fair value:

Fair Value Hierarchy

22. To increase consistency and comparabil-ity in fair value measurements and related disclo-sures, the fair value hierarchy prioritizes the inputsto valuation techniques used to measure fair valueinto three broad levels. The fair value hierarchygives the highest priority to quoted prices (unad-justed) in active markets for identical assets orliabilities (Level 1) and the lowest priority tounobservable inputs (Level 3). In some cases, theinputs used to measure fair value might fall indifferent levels of the fair value hierarchy. Thelevel in the fair value hierarchy within which thefair value measurement in its entirety falls shall bedetermined based on the lowest level input that issignificant to the fair value measurement in itsentirety. Assessing the significance of a particularinput to the fair value measurement in its entiretyrequires judgment, considering factors specific tothe asset or liability.

23. The availability of inputs relevant to theasset or liability and the relative reliability of theinputs might affect the selection of appropriatevaluation techniques. However, the fair valuehierarchy prioritizes the inputs to valuation tech-niques, not the valuation techniques. For example,a fair value measurement using a present valuetechnique might fall within Level 2 or Level 3,depending on the inputs that are significant to themeasurement in its entirety and the level in the fairvalue hierarchy within which those inputs fall.

Level 1 inputs

24. Level 1 inputs are quoted prices (unad-justed) in active markets for identical assets orliabilities that the reporting entity has the ability toaccess at the measurement date. An active marketfor the asset or liability is a market in whichtransactions for the asset or liability occur withsufficient frequency and volume to provide pricinginformation on an ongoing basis. A quoted price inan active market provides the most reliable evi-dence of fair value and shall be used to measurefair value whenever available, except as discussedin paragraphs 25 and 26.

25. If the reporting entity holds a largenumber of similar assets or liabilities (for example,debt securities) that are required to be measured atfair value, a quoted price in an active market mightbe available but not readily accessible for each ofthose assets or liabilities individually. In that case,fair value may be measured using an alternativepricing method that does not rely exclusively onquoted prices (for example, matrix pricing) as apractical expedient. However, the use of an alter-native pricing method renders the fair value mea-surement a lower level measurement.

26. In some situations, a quoted price in anactive market might not represent fair value at themeasurement date. That might be the case if, forexample, significant events (principal-to-principaltransactions, brokered trades, or announcements)occur after the close of a market but before themeasurement date. The reporting entity shouldestablish and consistently apply a policy for identi-fying those events that might affect fair valuemeasurements. However, if the quoted price isadjusted for new information, the adjustmentrenders the fair value measurement a lower levelmeasurement.

27. If the reporting entity holds a position ina single financial instrument (including a block)and the instrument is traded in an active market,the fair value of the position shall be measuredwithin Level 1 as the product of the quoted pricefor the individual instrument times the quantityheld. The quoted price shall not be adjusted be-cause of the size of the position relative to tradingvolume (blockage factor). The use of a blockagefactor is prohibited, even if a market's normal dailytrading volume is not sufficient to absorb thequantity held and placing orders to sell the positionin a single transaction might affect the quotedprice.11

[FN11] The guidance in this Statementapplies for positions in financial instruments(including blocks) held by all entities, includingbroker-dealers and investment companies withinthe scope of the AICPA Audit and AccountingGuides for those industries.

Level 2 inputs

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28. Level 2 inputs are inputs other thanquoted prices included within Level 1 that areobservable for the asset or liability, either directlyor indirectly. If the asset or liability has a specified(contractual) term, a Level 2 input must be observ-able for substantially the full term of the asset orliability. Level 2 inputs include the following:

a. Quoted prices for similar assets orliabilities in active markets

b. Quoted prices for identical orsimilar assets or liabilities in markets that are notactive, that is, markets in which there are fewtransactions for the asset or liability, the prices arenot current, or price quotations vary substantiallyeither over time or among market makers (forexample, some brokered markets), or in whichlittle information is released publicly (for example,a principal-to-principal market)

c. Inputs other than quoted pricesthat are observable for the asset or liability (forexample, interest rates and yield curves observableat commonly quoted intervals, volatilities, prepay-ment speeds, loss severities, credit risks, anddefault rates)

d. Inputs that are derived principallyfrom or corroborated by observable market data bycorrelation or other means (market corroboratedinputs).

29. Adjustments to Level 2 inputs will varydepending on factors specific to the asset or liabil-ity. Those factors include the condition and/orlocation of the asset or liability, the extent towhich the inputs relate to items that are compara-ble to the asset or liability, and the volume andlevel of activity in the markets within which theinputs are observed. An adjustment that is signifi-cant to the fair value measurement in its entiretymight render the measurement a Level 3 measure-ment, depending on the level in the fair valuehierarchy within which the inputs used to deter-mine the adjustment fall.11 The guidance in thisStatement applies for positions in financial instru-ments (including blocks) held by all entities,including broker-dealers and investment compa-nies within the scope of the AICPA Audit andAccounting Guides for those industries.

Level 3 inputs

30. Level 3 inputs are unobservable inputsfor the asset or liability. Unobservable inputs shallbe used to measure fair value to the extent thatobservable inputs are not available, thereby allow-ing for situations in which there is little, if any,market activity for the asset or liability at themeasurement date. However, the fair value mea-surement objective remains the same, that is, anexit price from the perspective of a market partici-pant that holds the asset or owes the liability.Therefore, un-observable inputs shall reflect thereporting entity's own assumptions about theassumptions that market participants would use inpricing the asset or liability (including assumptionsabout risk). Unobservable inputs shall be devel-oped based on the best information available in thecircumstances, which might include the reportingentity's own data. In developing unobservableinputs, the reporting entity need not undertake allpossible efforts to obtain information about marketparticipant assumptions. However, the reportingentity shall not ignore information about marketparticipant assumptions that is reasonably avail-able without undue cost and effort. Therefore, thereporting entity's own data used to developunobservable inputs shall be adjusted if informa-tion is reasonably available without undue cost andeffort that indicates that market participants woulduse different assumptions.

It is evident that a valuation of a closely-held businessinterest is likely to rely on Level 3 inputs.

C. FAIR VALUE (DISSENTERS RIGHTS). Manystates have, through statute or case law, provided that,when a minority owner dissents from a merger or sale ofthe business, the dissenting minority owner is entitled tobe paid the value of his proportionate interest in thecompany, without a minority discount or marketabilitydiscount. Examples of state law on this question are setout below. It is important to recognize that the hypothet-ical sale construct of fair market value forces the valua-tor and the court into considering minority and market-ability discounts that a hypothetical buyer would takeinto account in determining how much to pay to take astake in the company. In a dissenting minority liquida-tion, the public policy in most states is to avoid impos-ing these detriments of sale on the dissenting minorityowner, since they would have the practical effect of

7


unfairly transferring value from the minority dissenter tothe controlling owners of the company.

1. Colorado. In Pueblo Bancorporation v. Lindoe,Inc., 63 P.3d 353, 360 (Colo. 2003), the ColoradoSupreme Court ruled that the proper interpretation offair value is the shareholder's proportionate interest inthe value of the corporation. Therefore, a marketabilitydiscount should not be applied at the shareholder levelto determine the fair value of the dissenter's shares.The applicability of a minority discount was not raisedin the case. In Walter S. Cheesman Realty Co. v. Moore,770 P.2d 1308, 1311 (Colo. App. 1988), the court ofappeals wrote:

Moore contends that the term fair value, as usedin 74124, C.R.S. (1986 Repl.Vol. 3A), is notsynonymous with fair market value and, thus, thetrial court erred in applying a fair market valuemethod of valuing his stock. We agree that theterm fair value as used in the dissenters' rightsstatute imports a broader approach to valuationthan does the term fair market value. However,we conclude that the method of valuation em-ployed by the trial court was, in fact, a fair valuestandard.

The trial judge had used a net asset value approach tovaluing the company, because the company held realestate and the proposed action was to sell the assets anddistribute the proceeds to the shareholders. The court ofappeals approved this method of determining fair value,even though the net asset value approach is a recognizedmethod of determining fair market value. The appellatecourt said:

Here, Cheesman is a close corporation whosebusiness is to own real estate. The major portion ofits assets is real estate. Cheesman's stock has notbeen publicly traded and no market can accuratelybe constructed. The event which precipitatedMoore's dissent was the corporate decision toterminate Cheesman's existence and liquidate theassets. Under these circumstances, any marketvalue attributable to the dissenter's stock would notbe reliable. See Metrmont Materials Corp. v.Pennell, 270 S.C. 9, 239 S.E.2d 753 (1977).

Net asset value, on the other hand, is relevant andentitled to greater weight than other factors if, as inthis case, the business of the corporation is sub-

stantially devoted to the mere possession of assets,such as real estate. See Brown v. Hedahl'sQ B &R, Inc., 185 N.W.2d 249 (N.D.1971). Net assetvalue becomes especially important when, as here,the corporate change in question contemplates acomplete liquidation of the assets and the corpora-tion is dissolved.

2. California. California Corporations Code 2000provides:

2000. Avoidance of dissolution by purchase ofplaintiffs' shares; valuation; vote required; stay ofdissolution proceedings; appraisal under courtorder; confirmation by court; appeal

(a) Subject to any contrary provision in the arti-cles, in any suit for involuntary dissolution, or inany proceeding for voluntary dissolution initiatedby the vote of shareholders representing only 50percent of the voting power, the corporation or, ifit does not elect to purchase, the holders of 50percent or more of the voting power of the corpo-ration (the purchasing parties) may avoid thedissolution of the corporation and the appointmentof any receiver by purchasing for cash the sharesowned by the plaintiffs or by the shareholders soinitiating the proceeding (the moving parties) attheir fair value. The fair value shall be determinedon the basis of the liquidation value as of thevaluation date but taking into account the possibil-ity, if any, of sale of the entire business as a goingconcern in a liquidation. . . .

The Court of Appeals in Mart v. Severson, 95Cal.App.4th 521, 531-32, 115 Cal.Rptr.2d 717, 725-26(Cal. App. 2002), said:

California case law construing section 2000 ap-proves the use of a hypothetical sale model, likethe one employed by the appraisers in this case, tocalculate the fair value of a corporation that can besold as a going concern in liquidation. (Abrams,supra, 114 Cal.App.3d at pp., 248249, 170Cal.Rptr. 656 (Abrams).) In Abrams, the court heldthat appraisers who conducted a section 2000 fairvalue determination acted properly by assumingthat the owners of the corporation would haveagreed not to compete with the corporation after itwas sold as a going concern in liquidation. (A-brams, supra, 114 Cal.App.3d 240, 170 Cal.Rptr.

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656.) The court reasoned that [s]ection 2000states that the appraisers should consider the possi-bility of a sale as a going concern in a liquidation.Under the statute, the appraisers are not onlyentitled, but are required, to consider the manner inwhich the parties to such a hypothetical sale aremost likely to maximize their return. (Id. at p.249, 170 Cal.Rptr. 656.)

Case law also confirms that the potential threat offuture competition by the current shareholdersshould not affect the fair value analysis. (Brown v.Allied Corrugated Box. Co. (1979) 91 Cal.App.3d477, 154 Cal.Rptr. 170 (Brown)). Brown involveda fair value determination conducted pursuant toformer section 4659, the predecessor statute tosection 2000. (Brown, supra, 91 Cal.App.3d at p.480, fn. 2, 154 Cal.Rptr. 170.) The Brown courtfound that the appraisers who conducted thatdetermination erred by considering the negativeimpact of the fact that the shareholder who wasprimarily responsible for developing the corpora-tion's goodwill had not entered into a non-competeagreement with the corporation. (Id. at pp.487488, 154 Cal.Rptr. 170.) The Brown courtreasoned that the goodwill of a business is theindivisible property of the corporation and thevalue of that asset must be reflected in the fairvalue determination. In other words, discountingthe value of the corporation because of the threatof future competition by one of its shareholdersunfairly deprives the moving party of the truevalue of his stock.

The Court of Appeals, in Brown v. Allied CorrugatedBox Co., 91 Cal.App.3d 477, 487, 154 Cal.Rptr. 170,176 (Cal. App. 1979), said:

[T]he statutes suggest that a minority shareholderwho brings an action for the involuntary dissolu-tion of a corporation should not, by virtue of thecontrolling shareholder's invocation of the buy-outremedy, receive less than he would have receivedhad the dissolution been allowed to proceed. Themajority commissioners' decision here to devalueplaintiffs' shares for their lack of control was indirect conflict with this principle.

3. Colorado. In Pueblo Bancorporation v. Lindoe,Inc., 37 P.3d 492, 499 (Colo. App. 2001), the court said:

[W]e hold that in determining the fair value of adissenter's shares in a closely held corporation, thetrial court must first determine the value of thecorporation and the pro rata value of each out-standing share of common or equity participatingstock. In the case of a going concern, no minoritydiscount is to be applied; and, except under ex-traordinary circumstances, no marketabilitydiscount is to be applied.

4. Delaware. In the hallmark case of Cavalier OilCorp. v. Harnett, 564 A.2d 1137, 1144 (Del. 1989), theDelaware Supreme Court held that minority dissenterswere entitled to be paid their proportionate interest inthe company, without minority and marketabilitydiscounts:

A proceeding under Delaware's appraisal statute,8 Del.C. 262, requires that the Court of Chancerydetermine the fair value of the dissenting stock-holders' shares. The fairness concept has been saidto implicate two considerations: fair dealing andfair price. Weinberger v. UOP, Inc., 457 A.2d at711. Since the fairness of the merger process is notin dispute, the Court of Chancery's task here wasto value what has been taken from the shareholder:viz. his proportionate interest in a going concern.TriContinental Corp. v. Battye, Del. Supr., 74A.2d 71, 72 (1950). To this end the company mustbe first valued as an operating entity by applicationof traditional value factors, weighted as required,but without regard to post-merger events or otherpossible business combinations. See Bell v. KirbyLumber Corp., Del. Supr., 413 A.2d 137 (1980).The dissenting shareholder's proportionate interestis determined only after the company as an entityhas been valued. In that determination the Court ofChancery is not required to apply further weight-ing factors at the shareholder level, such as dis-counts to minority shares for asserted lack ofmarketability.

The Court in Cavalier made this important point regard-ing the fact that a hypothetical sale is not the paradigmfor dissenters rights:

The application of a discount to a minority share-holder is contrary to the requirement that thecompany be viewed as a going concern. Cava-lier's argument, that the only way Harnett wouldhave received value for his 1.5% stock interest was

9


to sell his stock, subject to market treatment of itsminority status, misperceives the nature of theappraisal remedy. Where there is no objectivemarket data available, the appraisal process is notintended to reconstruct a pro forma sale but toassume that the shareholder was willing to main-tain his investment position, however slight, hadthe merger not occurred. Discounting individualshare holdings injects into the appraisal processspeculation on the various factors which maydictate the marketability of minority sharehold-ings. More important, to fail to accord to a minor-ity shareholder the full proportionate value of hisshares imposes a penalty for lack of control, andunfairly enriches the majority shareholders whomay reap a windfall from the appraisal process bycashing out a dissenting shareholder, a clearlyundesirable result. [Emphasis added.]

In In re Shell Oil Co., 607 A.2d 1213, 1218 (Del. Supr.1992), the court said: Once a shareholder perfects hisright to appraisal under 8 Del.C. 262(d), the Court ofChancery is required to determine the fair value of hisshares, exclusive of any element of value arising fromthe accomplishment or expectation of the merger . . . .

5. Illinois. The Illinois Supreme Court has ruled thattrial judges maybut are not required toapply minorityand marketability discounts in minority dissent cases.See Stanton v. Republic Bank of South Chicago, 581N.E.2d 678, 681 (Ill. 1991) which held:

With respect to the Bank's argument that theminority and illiquidity discounts were arbitraryand lacked foundation, we find that the trial courtacted within its discretion to apply such discounts,even though not required to do so . . . .

6. Iowa. In Security State Bank v. Ziegeldorf, 554N.W.2d 884, 888-89 (Iowa), the Iowa Supreme Courtsaid:

Given the statutory nature of this action, thestarting point in determining fair value is thedef