125333-Spring 2013

Bridging the GAAP to Tax
n
23

U.S. Bank National Association v. Verizon
Communications, Inc.: The Importance of
Reconciling Valuation Conclusions
n
49
Oil and Gas Minerals: How They and Their Holding
Entities Are Valued
n
66
Should the Pattern Be the Brand?: A Potential
Revenue-Generating Bonanza
n
97
Reasonable Certainty Remains Uncertain
n
102
journal
S P R I N G 2 0 1 3
M&A Market Update:
Weve Jumped Off the
Cliff Who Packed
the Parachute?
n
4
journal
4 M&A Market Update:
Weve Jumped Off the Cliff
Who Packed the Parachute?
Gian G. Ricco
9 Plastics Industry Snapshot
Michael D. Benson and
David M. Evatz
16 Hospital/Healthcare Valuation
and ASC 958-805: Not-For-Profit
Mergers and Acquisitions
John W. VanSanten and
Jason J. Krentler
21 Guest Article: Vesting of
Founders Stock
Jeff M. Mattson
Freeborn & Peters LLP
23 Bridging the GAAP to Tax
Marc C. Asbra
28 Dealing with Commodity
Price Fluctuations
Vincent J. Pappalardo and
Christopher A. Merley
32 Two is Better Than One:
Even a Simplified Analysis of
Ordinary in the Industry is Better
Than None at All
Neil Steinkamp and
Alexandra C. Pierce
34 Defer or Eliminate Capital Gains
Taxes by Selling Your Company
to an ESOP
Mark R. Fournier
38 Guest Article: Uncovering Hidden
Value in Family Businesses
Norbert E. Schwarz
The Family Business Consulting
Group, Inc.
41 The Orchard Enterprises, Inc.:
The Delaware Court Analyzes
Valuation and Whether or Not Only
a Bum Would Utilize the BUM
Jeffrey M. Risius and
Jesse A. Ultz
45 Valuing Forbearance in
Fraudulent Transfer Actions
James H. Millar WilmerHale,
and Neil Steinkamp
49 U.S. Bank National Association
v. Verizon Communications, Inc.:
The Importance of Reconciling
Valuation Conclusions
Brian A. Hock
53 Appraisal Issues Surrounding
the Leveraged Reverse Freeze:
Consult with an Appraiser in the
Early Stages of Planning
Alex W. Howard and
Bradley A. Gates
C
O
N
T
E
N
T
S
2013
journal journal
4
23
53
49
41
34
58 The Valuation of Oil and Gas
Properties: Are They Really
Worth 3x Cash Flow?
Alan B. Harp, Jr.
62 Guest Article: Wandry v.
Commissioner: The Secret
Sauce Estate Planners Have
Been Waiting For?
Tiffany B. Carmona Bessemer
Trust, and Tye J. Klooster
Katten Muchin Rosenman LLP
66 Oil and Gas Minerals:
How They and Their Holding
Entities Are Valued
Alan B. Harp, Jr.
71 E-Discovery Cost-Shifting
Phillip M. Shane
Miller, Canfield, Paddock and
Stone, PLC, and Denise B. Bach
76 Managing Risk Associated with
Occupational Fraud
Michael N. Kahaian, Jason T.
Wright, and Raymond A. Roth, III
81 Using the Monte Carlo
Method to Value Early Stage,
Technology-Based Intellectual
Property Assets
Bruce W. Burton, Scott
Weingust and Jake M. Powers
87 Interview with Former Chief
Judge David Folsom of the U.S.
District Court for the Eastern
District of Texas
John R. Bone and David A. Haas
93 Decisions from the
District Courts
Erich W. Kirr and Matthew Paye
97 Guest Article: Should the Pattern
Be the Brand?: A Potential
Revenue-Generating Bonanza
Marc A. Lieberstein and Kristin
G. Garris Kilpatrick Townsend
& Stockton LLP

102 Reasonable Certainty
Remains Uncertain
Neil Steinkamp, and Regina Alter
Butzel Long
108 In Case You Were Wondering
Double Dipping Revisited
Mary V. Ade
112 Its All Relative: A Fresh Look at
Value in Divorce Cases
Benjamin I.S. Bershad and
Jason E. Bodmer
117 The Taxing Side of Divorce:
Individual Income Tax Returns as
Discovery Tools
Justin L. Cherfoli and
Mary V. Ade
71
62
journal journal journal journal
We welcome any comments, suggestions, or questions. Please refer to the end of each article for the individual
author contact information. The SRR Journal is also available online at www.SRR.com.
The SRR Journal is intended for general information purposes only and is not intended to provide, and should not
be used in lieu of, financial, accounting, legal or other professional advice. The publisher assumes no liability for
readers use of the information herein and readers are encouraged to seek professional assistance with regard to
specific matters. All opinions expressed in these articles are those of the authors and do not necessarily reflect
the views of Stout Risius Ross, Inc. or Stout Risius Ross Advisors, LLC.
2013 Stout Risius Ross, Inc. This work may not be copied, distributed, displayed, or used to make derivative
works without attribution to Stout Risius Ross (SRR).
SRR is a trade name for Stout Risius Ross, Inc. and Stout Risius Ross Advisors,
LLC, a FINRA registered broker-dealer and SIPC member firm.
102
112
97
journal
M&A Market Update:
Weve Jumped Off the Cliff Who Packed the Parachute?
Gian G. Ricco gricco@srr.com
2013 4
Overview nnn
As predicted in our last update, the anticipated rise in capital
gains taxes drove significant capital gains activity among private
companies with the fourth quarter of 2012 particularly robust.
We are now over three years into a strong, bullish cycle fueled
by pent-up demand for deals, accommodative senior lenders,
and a rebound in earnings levels. Given recent history and
the current economic climate, our outlook for 2013 remains
cautious, but favorable:
n Taxes: The rise in the maximum tax rate on capital gains
pulled forward a portion of deals that otherwise would
have fallen into the 2013 tax year. Exactly how many
deals were accelerated cannot be known, but sufce it to
say that transaction activity in the rst quarter of 2013
has ground to a proverbial halt. The second half of this
year should bring a return to normalcy.
n Accommodative credit markets: We see no reason
to believe that senior credit markets, which by some
measures are fully back to 2007 levels, will signicantly
tighten any time soon though some signs of a slight
pullback are beginning to appear according to sources
within the lending community.
n Private equity: A collective $450 billion of dry
powder, combined with 6,500 (and growing) domestic
sponsor-backed companies under private equity
ownership, means that professional investors will
continue to remain quite active and relevant.
n Macroeconomic environment: At the time of this
writing, Congress has yet to approve a plan to resolve
the sequester, which would add up to $85 billion in
budget cuts. These cuts, which would be extremely
damaging and severe, would affect a wide range of
domestic programs including education, public safety,
law enforcement, scientic and medical research,
and national defense. Furthermore, these cuts would
result in the loss of thousands of jobs and would
certainly not help the softness in the economy as
exhibited in the lackluster GDP growth seen in the fourth
quarter of 2012.
For the remainder of this year, the motivation for private business
owners to sell their businesses will not be to avoid taxes,
but rather to exit in the face of uncertainty over the long-term
economic picture and the perceived risk of the United States
falling into a prolonged period of economic stagnation similar to
that experienced by Japan between 1992 and 2010.
2013 5
M&A Market Activity nnn
Improved availability of capital, better
and sustained company performance,
and narrower valuation gaps have driven
increased U.S. M&A transaction activity
since 2010. Activity in 2012 experienced
gains both in number of deals completed
and in aggregate value, with total number
of deals up 3.0% and total deal value
up 8.9% year-over-year. Of course, the
number of transactions are not spread
evenly throughout the year, as the fourth
quarter has historically always shown
a disproportionately larger number of
transactions relative to the first three
quarters of the year (due, no doubt, to
the calendar year-based bonus cutoffs
for investment bankers!). In spite of this,
the fourth quarter was still remarkably
robust, with more transactions completed
in October through December than any
other quarter in recent memory. The
realization that the Democratic party was
going to retain control over much of the
federal government, and raise taxes as
promised, provided strong impetus to
accelerate the harvesting of capital gains
in the 2012 tax year.
U.S. Gross Domestic Product, often
viewed as a proxy for the overall health
of the economy, has recovered from
the contraction experienced during the
recession in the late 2008 and early
2009 timeframe. Although few economists
are predicting another recession in
the near future, neither are forecasters
predicting rampant growth, with GDP
growth (which was unexpectedly
soft in the fourth quarter) projected to
hover around 3% through much of the
remaining decade.
Consumer confidence is generally
improving as the unemployment
situation improves (though the long-term
impact of the apparent structural
unemployment created by the recession
remains to be seen). It should not be
terribly surprising that people feel better
about spending money when that
money will be replaced via a paycheck
vs. unemployment benefits.
A
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)
2.3
2.8
2.9
3.0
2.2
2.5
2.7
2.6
2.0
2.1
2.4
3.0
3.1
3.2 3.2
4.0
3.5
3.7 3.7
4.1
3.6
3.8 3.7
4.4
$0
$50
$100
$150
$200
$250
$300
$350
$400
$450
$500
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
2007 2008 2009 2010 2011 2012
Volume Value
Total U.S. M&A Deal Volume and Value by Quarter
V
a
l
u
e

(
$

b
i
l
l
i
o
n
s
)
Source: S&P Capital IQ
Historical Projected
-9.0%
-7.0%
-5.0%
-3.0%
-1.0%
1.0%
3.0%
5.0%
7.0%
Q
1
Q
2
Q
3
Q
4
Q
1
Q
2
Q
3
Q
4
Q
1
Q
2
Q
3
Q
4
Q
1
Q
2
Q
3
Q
4
Q
1
Q
2
Q
3
Q
4
Q
1
Q
2
Q
3
Q
4
Q
1
Q
2
Q
3
Q
4
Q
1
Q
2
Q
3
Q
4
Q
1
Q
2
Q
3
Q
4PPP
2004 2005 2006 2007 2008 2009 2010 2011 2012 13 14 15

Change in U.S. Gross Domestic Product
U.S. Bureau of Economic Analysis
50
60
70
80
90
100
110
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13
Unemployment
Consumer Confidence
Unemployment and Consumer Confidence
Source: U.S. Bureau of Economic Analysis, University of Michigan Consumer Condence Report
U
n
e
m
p
l
o
y
m
e
n
t

R
a
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e
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r

C
o
n
d
e
n
c
e
2013 6
As mentioned in previous articles, data on lower middle market
transactions is notoriously difficult to come by, but year-over-year
comparisons appear to suggest that smaller deals falling within
the lower middle market (in this context defined as transactions
less than $250 million in total value) demonstrated strength
relative to their larger counterparts. The notable exception to this
was the activity for the very largest deals ($1 billion+) with these
transactions showing double-digit increases in both number and
total value in 2012 versus 2011. As has always been the case,
these smaller transactions dominate total deal flow, accounting
for nearly 98% of total M&A activity over the past 12 months.
Which sectors were hot in 2012? Perhaps somewhat
surprisingly, Financial Services remains the single most active
sector as measured by number of deals, presumably driven by the
continued regulatory pressures and capital threshold requirements
placed upon depository institutions and the resulting need for
further consolidation. However, companies operating within
both consumer-related fields and general manufacturing (as
represented by Industrial & Basic Materials below) also continue to
exhibit strong interest among both strategic and financial buyers.
The continued resurgence in deal volume from the depth of the
recession was facilitated in large part by the renewed relevance
of the strategic buyer. For much of 2005 through 2007, many
strategic buyers found themselves scratching their heads over
the valuations paid by private equity groups for transactions,
valuations achieved purely as the result of financial engineering
(read: leverage) available and not due to potential synergies
available as part of a deal. The chart on the next page shows the
increase, by sector, in total number of deals completed in 2012
vs. 2009, and how many of those deals were financial buyers vs.
strategic buyers. As can be seen, with the exception of Financial
Services, which experienced a relatively equal mix of interest, the
overall return of deal activity can be attributed in large part to the
return of strategic acquirers.
The stimulus for strategic-led deals is
a combination of lower organic growth
prospects absent acquisitions,
more reasonable valuations,
aforementioned accommodative
senior debt markets, and a record $2
trillion in cash and other liquid assets
held by nonfinancial companies,
which as a percentage of total
assets represents a nearly 10-year-
high water mark (though it should
be noted that a portion of this cash
is overseas with structural barriers
against tax-advantaged repatriation).
These large cash holdings are likely
a result of continued skittishness

Recent U.S. M&A Activity by Deal Size
Number of Deals Agg. Value ($ billions)
12 Months Ended % 12 Months Ended %
Deal Size 12/31/11 12/31/12 Change 12/31/11 12/31/12 Change
$ 1 Billion + 132 155 17.4% $487.3 $591.8 21.4%
$500M to $999.9M 161 139 (13.7%) 109.4 96.8 (11.5%)
$250M to $499.9M 280 247 (11.8%) 96.9 84.6 (12.8%)
$100M to $249.9M 510 497 (2.5%) 80.0 77.1 (3.6%)
$50M to $99.9M 585 607 3.8% 42.0 42.6 1.6%
$25M to $49.9M 835 867 3.8% 29.3 30.8 5.4%
$10M to $24.9M 1,199 1,188 (0.9%) 19.6 19.1 (2.3%)
Under $10M 2,600 2,534 (2.5%) 8.8 8.5 (3.0%)
Value Not Disclosed 8,011 8,506 6.2% N/A N/A N/A
Total 14,313 14,740 3.0% $873.2 $951.3 8.9%
2,490
577
4,221
1,122
2,502
1,794
237
Consumer
Energy
Financials
Healthcare
Industrials & Basic Materials
Information Technology
Telecom & Utilities
Full Year 2012 U.S. M&A Volume by Sector
2013 7

borne of the panic that unfolded during the Great Recession,
when capital was a scarce commodity at any cost and lender
covenants were under attack from every direction. The post-
traumatic stress disorder that is driving firms to hoard cash is also
evident in the continued deleveraging of firms balance sheets,
as debt as percentage of total assets remains at one of its lowest
points in the past decade.
Private equity remains a potent force in deal flow, and will
continue to be so for at least the next few years. Favorable credit
markets and an estimated $450 billion capital overhang ($100
billion of which is nearing the end of its investment horizon), will
continue to provide impetus for investors to remain competitive in
transactions. Furthermore, it should be kept in mind that the capital
overhang actually translates into $1 trillion or more in purchasing
power, given leverage available in todays marketplace.
One interesting trend seen within private equity
in 2012 was the volume of exit activity, which
increased for the third consecutive year in both
volume and capital exited. In spite of this volume, the
inventory of domestic sponsor-backed companies
has continued to grow and now sits at more than
6,500; holding periods have crept up as well, as the
median holding time for a portfolio company has
crept above five years for the first time in history.
Another fundamental change in private equity
investing has been the prominence of secondary
buyouts, not only as an exit strategy but also as a
deal-sourcing opportunity. According to PitchBook,
in 2012 for the first time ever sponsors exited more
companies via secondary buyouts than corporate
acquisitions. Furthermore, 17% of transactions
executed in 2012 were one sponsor selling to
another, also a record.
Deal-making declined throughout the year before
the much-predicted December buying spree ensued
ahead of impending tax rate hikes. In fact, deal-
making jumped 79% from November to December
and quarterly deal-making accelerated for the first
time in a year during the fourth quarter despite
November being the slowest month for deal-making
in all of 2012. Investors were particularly keen to
complete large deals with the threat of increased
taxes, as there were 19 transactions of $1 billion
or more in the final quarter of the year. These large
deals helped push the total capital invested in the
last quarter of the year to $102 billion, the second
highest quarterly total in the last four years.
The first quarter of the year has traditionally seen a
slowdown in deal-making, and that slowdown may
be even more pronounced in 2013 as the robust deal activity in
fourth quarter was undoubtedly the result of investors pushing
to execute deals that would have closed in early 2013 under a
normal deal timeline. However, the growing inventory of sponsor-
backed companies and building dry powder reserves will force
investors to sell, if not in the near term then certainly by the end
of this decade.
Private equity investors continued to focus their attention on the
middle market in 2012, as the $25 million to $100 million size
bracket emerged as the sweet spot for sponsor investing. These
deals escalated from 24% of deal flow in 2011 to 29% in 2012,
as the slightly larger $100 million to $500 million size bucket fell
from 28% to 24% during the same period. Transactions less
than $500 million increased their proportion of total private equity
capital invested to 49%, the second highest total since 2005. Deal
flow for transactions of $1 billion or more remained consistent
136
21
1,059
79
143 28
7
424
95
1,187
171
431
292
11
-
500
1,000
1,500
2,000
2,500
Consumer Energy Financials Healthcare Industrials &
Basic
Materials
Information
Technology
Telecom &
Utilities
Sponsor Backed Strategic
Comparison of U.S. M&A Volume by Sector, 2009 vs. 2012
D
e
a
l

V
o
l
u
m
e
15.0%
18.0%
21.0%
24.0%
27.0%
30.0%
33.0%
36.0%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
Cash as a % of Total Assets for Non-Financial Companies in the S&P 500
Debt as a % of Total Assets for Non-Financial Companies in the S&P 500
Cash Holdings and Debt as a Percent of Total Assets for the
Largest Nonfinancial U.S. Publicly Traded Companies
C
a
s
h

a
s

%

o
f

T
o
t
a
l

A
s
s
e
t
s
D
e
b
t

a
s

%

o
f

T
o
t
a
l

A
s
s
e
t
s
2013 8
with 2011, due primarily to the volume of deals that closed at
the end of the year. Private equity firms completed 19 deals of
$1 billion or more in the fourth quarter more than the rest of
the year combined and the highest quarterly total since the heady
investing witnessed in 2007.
As can be seen below, prices paid by private equity investors, as
measured by mutiples of EBITDA, contracted slightly in spite of
ready access to debt financing. While the exact reasons for this
contraction are not clear, it could be the result of uncertainty
over the near term economic outlook (i.e., 5 year horizon or
less) resulting in highly disciplined investment stances. The
contraction could also be a recognition of the fact that a greater
percentage of exits to another sponsor decreases the likelihood of
capturing synergistic-value in a sale to a strategic buyer. All things
equal, lower exit price assumptions drive down exit multiple
assumptions in leveraged buyout excel
models. These lower exit prices assumptions
reduce equity return calculations, resulting in
reduced entry prices that a financial investor
would be willing to pay in order to hold
equity returns (typically, 20-30% annually,
compounded) constant.
As mentioned, one of the interesting
dynamics seen in 2012 was the large number
of sponsor-to-sponsor transactions. There
were a record-breaking 275 secondary
buyouts in 2012, and it was the first year
that secondary buyouts exceeded corporate
acquisitions as an exit strategy. Amazingly,
just three years ago secondary buyouts
represented only one quarter (25%) of exits;
they now account for nearly half (47%).
Beyond the next 24-36 months, leveraged
buyout activity in the lower middle market
will be fueled by the additional private
equity capital raised by lower middle
market-focused funds in 2012, which
represented nearly half of the total private
equity fundraising completed over the
course of the year.
Conclusions and Outlook for
2013 and Beyond nnn
In summary, the conclusion we can draw
for the current market is that, despite
the pull forward of deals from 2013
into the 2012 calendar year due to tax
law changes, and the uncertain federal
government budgetary situation, our
view on the near-term outlook for M&A activity remains cautiously
optimistic. Furthermore, we believe that we should continue to
operate within a relatively normalized M&A environment for the
foreseeable future.
Gian G. Ricco is a Vice President in the Investment Banking Group
at Stout Risius Ross (SRR). In that capacity, he focuses on merger
and acquisition advisory, institutional private placements of debt
and equity, and strategic consulting. Mr. Ricco can be reached at
+1.312.752.3359 or gricco@srr.com.
This article is intended for general information purposes only and is not intended to provide,
and should not be used in lieu of, professional advice. The publisher assumes no liability
for readers use of the information herein and readers are encouraged to seek professional
assistance with regard to specific matters. Any conclusions or opinions are based on the
individual facts and circumstances of a particular matter and therefore may not apply in
other matters. All opinions expressed in these articles are those of the authors and do not
necessarily reflect the views of Stout Risius Ross, Inc. or Stout Risius Ross Advisors, LLC.
4.7
5.3
5.8
4.5
4.9
4.2
4.7
4.1 4.1
2.4
3.2
3.2
4.0
3.8
3.5
3.3
4.1
3.2
7.1
8.5
9.0
8.5
8.7
7.7
8.0
8.1
7.3
0x
1x
2x
3x
4x
5x
6x
7x
8x
9x
10x
2004 2005 2006 2007 2008 2009 2010 2011 2012
Debt / EBITDA Equi ty / EBITDA Val uation / EBITDA
Buyout Purchase Price Multiples
Source: PitchBook
0
50
100
150
200
250
300
350
2012 2011 2010 2009 2008 2007 2006 2005
Corporate Acquisition IPO Secondary Buyout
Comparison of Method of Exit for Private Equity Investors, 2005 through 2012
Source: PitchBook
Michael D. Benson mbenson@srr.com
David M. Evatz devatz@srr.com
9 2013
Plastics Industry Snapshot
There are a number of positive factors and industry dynamics
that could result in continued strong plastics M&A activity
during 2013. Plastics industry valuation multiples continue to
be heavily impacted by end market served, although there are
a number of other drivers, including company size, profitability/
margins, customer concentration, resin pass-through ability,
book of business/future prospects, proprietary products
or processes, and overall amount of value-added content
and niche market leadership.
Plastics Industry Highlights nnn
n Plastics M&A volume increased approximately 26%
in 2012 led by plastic packaging and industrial
plastics transactions, which increased 47% and
30%, respectively.
n M&A activity within the plastics industry outperformed
the overall M&A market, which was down slightly during
2012 as the election, uncertain year-end tax changes,
and other geopolitical events had an effect
on the market
n Industrial plastics continues to represent the largest
number of transactions with 57% of the volume followed
by plastic packaging at 28% and automotive plastics and
medical plastics at 8% and 7%, respectively.
n The plastics industry has beneted from a number
of factors, including high demand and a ight to
quality for less volatile plastic packaging and medical
plastics companies, while more cyclical end markets
such as automotive and heavy truck have been seen
as attractive given the current upswing in their
respective cycles
10 2013
n There are a number of positive factors and industry
dynamics that could result in continued strong plastics
M&A activity during 2013.
n Signicant amount of capital available for both
small and large transactions, including senior debt,
mezzanine debt, and equity
n An estimated $425 billion private equity capital
overhang ($100 billion of which is nearing the end of
its investment horizon) and large cash stockpiles for
strategic buyers
n Continued pent-up demand for high quality
acquisition targets and a general imbalance in
transaction volume (i.e., more buyers than sellers)
n Plastics industry valuation multiples continue to be
heavily impacted by end market served, although there
are a number of other drivers, including company size,
protability/margins, customer concentration, resin
pass-through ability, book of business/future prospects,
proprietary products or processes, and overall amount
of value-added content and niche market leadership.
Enterprise Value / EBITDA
Source: Capital IQ and public lings.
Medical Plastics Plastic Packaging Industrial Plastics Automotive Plastics
2012 M&A Volume by Process
57%
28%
8%
7%
Industrial Plastics
Plastic Packaging
Automotive Plastics
Medical Plastics
35%
28%
14%
7%
5%
3%
3%
2%
2%
1%
Injection Molding
Extrusion
Resin/Compounding
Thermoforming
Machinery
Blow Molding
Tool & Die
Prototyping
Rotational Molding
Distribution
59%
25%
16%
54%
30%
16%
0%
10%
20%
30%
40%
50%
60%
70%
Strategic Financial Hybrid Private Corporate Private Equity
e p y T r e l l e S e p y T r e y u B
57%
28%
8%
7%
Industrial Plastics
Plastic Packaging
Automotive Plastics
Medical Plastics
35%
28%
14%
7%
5%
3%
3%
2%
2%
1%
Injection Molding
Extrusion
Resin/Compounding
Thermoforming
Machinery
Blow Molding
Tool & Die
Prototyping
Rotational Molding
Distribution
59%
25%
16%
54%
30%
16%
0%
10%
20%
30%
40%
50%
60%
70%
57%
28%
8%
7%
Industrial Plastics
Plastic Packaging
Automotive Plastics
Medical Plastics
35%
28%
14%
7%
5%
3%
3%
2%
2%
1%
Injection Molding
Extrusion
Resin/Compounding
Thermoforming
Machinery
Blow Molding
Tool & Die
Prototyping
Rotational Molding
Distribution
59%
25%
16%
54%
30%
16%
0%
10%
20%
30%
40%
50%
60%
70%
2012 M&A Volume by End Market
2012 M&A Volume by Buyer/Seller Type
10.4x
8.9x
9.8x
9.2x
8.4x
9.4x
7.5x
6.5x
7.5x
8.3x
7.5x
8.0x
7.2x
4.6x
6.2x
6.9x
4.8x
6.9x
3.9x
2.8x
4.7x
4.6x
3.7x
4.8x
0.0x
2.0x
4.0x
6.0x
8.0x
10.0x
12.0x
12/07 12/08 12/09 12/10 12/11 12/12 12/07 12/08 12/09 12/10 12/11 12/12 12/07 12/08 12/09 12/10 12/11 12/12 12/07 12/08 12/09 12/10 12/11 12/12
11 2013
Plastics Industry M&A Activity nnn
End Market Trends
n
Plastic packaging transaction volume increased 47% during
2012 and the sector continues to generate some of the largest
deal values in the industry with a strong mix of both strategic and
private equity buyers.
n
Medical plastics transaction volume decreased 7% during 2012,
although the sector has generated some of the highest valuations
in the industry as strategic buyers have driven most of the activity.
n
Industrial plastics transaction volume increased 30% during 2012
and generated a majority of the plastics M&A activity, from both
strategic and financial buyers, as the sector continues to be highly
diverse and fragmented.
n
Automotive plastics transaction volume decreased 11% during
2012, although there has been renewed interest given the industry
recovery and current point in the automotive volume cycle; there
has been a higher percentage of corporate carveouts relative to
other sectors as suppliers focus on core competencies.
Trends by Process
n
In 2012, injection molding and extrusion represented more
than half of all plastics transaction volume, followed by resin/
compounding and thermoforming; while not a significant amount
of volume, M&A activity also occurred in areas such as machinery,
blow molding, tool & die, prototyping, rotational molding,
and distribution.
n
M&A volume for nearly all processes grew in 2012, with
particularly strong growth in machinery, extrusion, prototyping,
and thermoforming.
n
The majority of injection molding activity occurred in industrial
plastics, followed by automotive plastics and plastic packaging.
n
Extrusion and thermoforming were essentially a mix of industrial
plastics and plastic packaging transactions, while blow molding
was primarily related to plastic packaging.
n
There was a consistent mix of buyer and seller type across
the various plastic processes, although strategic buyers were
relatively more active in resin/compounding, machinery, and tool
& die.
Buyer/Seller Trends
n
Both strategic and financial buyers have been active in plastics
transactions, including financial-backed hybrids, which have
made a number of add-on acquisitions.
n
While private sellers represented more than half of plastics M&A
volume during 2012, the number of transactions sold by private
equity firms increased 65% largely due to increased valuation
multiples and portfolio companies that have reached the end of
their investment horizon.
n
While strategic buyers represent the majority of plastics
transaction volume, financial buyer transactions increased 52%
during 2012 largely due to favorable credit markets and an
abundance of equity capital in the marketplace.
n
Strategic buyers represented the largest share of transactions
sold by private or corporate sellers, while financial buyers
acquired a majority of transactions sold by private equity firms
26%
30%
47%
-11% -7%
-20%
-10%
0%
10%
20%
30%
40%
50%
Total
Plastics
Industrial
Plastics
Plastic
Pacakging
Automotive
Plastics
Medical
Plastics
58%
42%
33%
26%
23% 22%
19%
0% 0% -33%
-50%
-25%
0%
25%
50%
75%
100%
M
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E
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&

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M
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d
i
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g
D
i
s
t
r
i
b
u
t
i
o
n
52%
21%
11%
65%
27%
9%
0%
10%
20%
30%
40%
50%
60%
70%
Financial Strategic Hybrid Private Equity Private Corporate
2012 vs. 2011 Growth by End Market
26%
30%
47%
-11% -7%
-20%
-10%
0%
10%
20%
30%
40%
50%
Total
Plastics
Industrial
Plastics
Plastic
Pacakging
Automotive
Plastics
Medical
Plastics
58%
42%
33%
26%
23% 22%
19%
0% 0% -33%
-50%
-25%
0%
25%
50%
75%
100%
M
a
c
h
i
n
e
r
y
E
x
t
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u
s
i
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n
P
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g
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&

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B
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M
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M
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d
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D
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t
r
i
b
u
t
i
o
n
52%
21%
11%
65%
27%
9%
0%
10%
20%
30%
40%
50%
60%
70%
2012 vs. 2011 Growth by Process
26%
30%
47%
-11% -7%
-20%
-10%
0%
10%
20%
30%
40%
50%
Total
Plastics
Industrial
Plastics
Plastic
Pacakging
Automotive
Plastics
Medical
Plastics
58%
42%
33%
26%
23% 22%
19%
0% 0% -33%
-50%
-25%
0%
25%
50%
75%
100%
M
a
c
h
i
n
e
r
y
E
x
t
r
u
s
i
o
n
P
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t
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p
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T
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m
o
f
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m
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d
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T
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D
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I
n
j
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c
t
i
o
n

M
o
l
d
i
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g
B
l
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w

M
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l
d
i
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g
R
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t
a
t
i
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n
a
l

M
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l
d
i
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g
D
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s
t
r
i
b
u
t
i
o
n
52%
21%
11%
65%
27%
9%
0%
10%
20%
30%
40%
50%
60%
70%
2012 vs. 2011 Growth by Buyer/Seller Type
12 2013
Macroeconomic Indicators nnn
n
Gross domestic product has recovered with positive growth
achieved over the past 13 quarters, and is expected to continue
over the next several years.
n
The Institute for Supply Management Purchasing Managers Index
(PMI), an indicator of the economic health of the manufacturing
sector, has expanded in 38 out of the last 42 months.
n
Consumer confidence has gradually improved since 2009, while
the unemployment situation has experienced a similar trend.
n
Both housing starts and existing home sales have experienced
recent gains after several years of flat to declining performance,
which should have a positive impact on the overall economy as
well as plastics companies tied to the industry.
n
Interest rates are expected to remain at historically low levels for
the next several years and inflation has maintained a relatively
consistent level between 1% and 4% since the downturn.
-9.0%
-7.0%
-5.0%
-3.0%
-1.0%
1.0%
3.0%
5.0%
7.0%
Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3Q4Q1Q2Q3 P P P P P P
2004 2005 2006 2007 2008 2009 2010 2011 2012 12 13 14 15 16 17
Historical Projected
GDP Growth
Source: Bureau of Economic Analysis
A
n
n
u
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l
i
z
e
d

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G
D
P

G
r
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w
t
h
30.0
35.0
40.0
45.0
50.0
55.0
60.0
65.0
Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12
Purchasing Managers Index
Source: Institute for Supply Management
>
5
0

=

E
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>
5
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=

C
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0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
5.5%
Federal Funds Target Rate
Federal Funds Rate
Source: Federal Reserve
F
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d
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r
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F
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s

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-3.0%
-2.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
Nov-02 Nov-03 Nov-04 Nov-05 Nov-06 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11 Nov-12
Inflation Rate
Inflation
Source: Inationdata.com
I
n
a
t
i
o
n

R
a
t
e
50
60
70
80
90
100
110
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
Unemployment
Consumer Confidence
Unemployment & Consumer Confidence
Source: U.S. Bureau of Labor Statistics, University of Michigan Consumer Condence Report
U
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0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
0
500
1,000
1,500
2,000
2,500
Nov-02 Nov-03 Nov-04 Nov-05 Nov-06 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11 Nov-12
Housing Starts
Existing Home Sales
Housing Statistics
Source: Bloomberg
H
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)
13 2013
Note: EV = Enterprise value equals market value plus total straight and convertible debt, preferred stock and minority interest, less cash and investments in unconsolidated subsidiaries.
Source: Capital IQ and public lings.
s e l p i t l u M n o i t a u l a V s n i g r a M M T L s a e c i r P r e p e c i r P
Share at % of 52wk Enterprise Gross EV / LTM EV / LTM Price/LTM Debt/
($ millions, except share data) 12/31/2012 High Value Margin EBITDA Revenue EBITDA EPS EBITDA
Medical Plastics
1 ATRION Corp. $196.00 74.8% $356.0 48.3% 35.7% 3.07x 8.6x 16.5x 0.0x
2 ICU Medical, Inc. 60.93 96.2 684.4 48.5 23.5 2.20 9.4 18.9 0.0
3 Medical Action Industries Inc. 2.69 42.3 116.7 14.7 3.2 0.26 8.1 NM 5.1
4 Merit Medical Systems, Inc. 13.90 90.4 644.8 46.8 15.2 1.68 11.1 24.7 1.1
5 West Pharmaceutical Services, Inc. 54.75 97.7 2,104.5 30.3 17.3 1.70 9.8 24.5 1.9
Group Mean 80.3 781.3 37.7 19.0 1.78 9.4 21.1 1.6
Plastic Packaging
6 AEP Industries Inc. $59.23 90.0% $533.3 15.1% 6.6% 0.48x 7.2x 12.2x 2.8x
7 Amcor Limited 8.38 98.5 13,809.4 16.9 10.6 1.11 10.5 24.4 3.0
8 AptarGroup, Inc. 47.72 86.0 3,393.7 31.9 17.6 1.47 8.4 19.7 1.0
9 Ball Corporation 44.75 98.4 10,209.4 17.6 13.2 1.18 8.9 17.0 2.9
10 Bemis Company, Inc. 33.46 98.6 4,833.8 18.0 11.9 0.93 7.8 22.5 2.4
11 Berry Plastics Group, Inc. 16.08 96.6 6,199.5 18.0 14.9 1.30 8.7 NM 6.3
12 RPC Group plc 6.45 88.3 1,368.4 17.1 12.8 0.80 6.2 20.3 1.5
13 Sealed Air Corporation 17.51 81.4 7,803.0 33.4 12.3 1.01 8.2 NM 5.2
14 Sonoco Products Co. 29.73 85.4 4,044.5 17.4 12.2 0.85 7.0 16.7 2.1
15 Winpak Ltd. 14.80 88.7 857.4 29.0 19.0 1.28 6.7 14.0 0.0
Group Mean 91.2 5,305.2 21.4 13.1 1.04 8.0 18.3 2.7
Industrial Plastics
16 A. Schulman, Inc. $28.94 99.8% $939.8 13.2% 6.0% 0.45x 7.5x 16.8x 1.7x
17 Core Molding Technologies Inc. 6.62 65.9 59.3 16.1 10.7 0.35 3.3 5.6 0.6
18 Myers Industries Inc. 15.15 84.3 601.6 27.5 10.6 0.78 7.4 18.7 1.2
19 Nolato AB 12.06 96.3 299.7 14.1 10.4 0.55 5.2 11.9 0.0
20 PolyOne Corporation 20.42 97.2 2,277.8 18.4 6.1 0.77 12.6 23.0 3.9
21 Spartech Corp. 9.07 98.6 413.2 9.7 4.9 0.36 7.4 NM 2.4
22 UFP Technologies, Inc. 17.92 89.8 95.3 29.0 15.1 0.74 4.9 11.8 0.3
Group Mean 90.3 669.5 18.3 9.1 0.57 6.9 14.6 1.4
Automotive Plastics
23 Compagnie Plastic Omnium SA $30.04 98.2% $2,224.7 14.0% 9.1% 0.38x 4.2x 7.6x 1.9x
24 Delphi Automotive PLC 38.25 99.9 13,066.4 17.4 14.0 0.83 5.9 10.1 1.0
25 Faurecia S.A. 15.45 51.3 3,790.6 8.5 5.4 0.18 3.3 4.7 2.6
26 Lear Corp. 46.84 97.1 4,030.1 8.4 6.5 0.28 4.3 9.4 0.7
27 Magna International, Inc. 49.84 99.6 10,596.5 12.3 7.7 0.35 4.6 8.4 0.2
28 Visteon Corp. 53.82 94.4 3,227.8 8.1 6.7 0.44 6.6 NM 1.2
Group Mean 90.1 6,156.0 11.4 8.2 0.41 4.8 8.0 1.3
Public Company Analysis: Select Operating And Market Performance Parameters
Plastic Resin Pricing and Stock Price Performance Last Three Years
Source: Plastics News Source: S&P Capital IQ
R
e
l
a
t
i
v
e

P
r
i
c
e

P
e
r
f
o
r
m
a
n
c
e
0%
20%
40%
60%
80%
HDPE PVC PP ABS Nylon
-20%
0%
20%
40%
60%
80%
100%
Industrial Packaging Auto S&P 500 Index (^SPX) Medical Plastics
14 2013
Select Transactions
Ann. Date Target (Ownership) Acquirer (Ownership)
1 Dec-12 C. Brewer Co. Balda AG (XTRA:BAD)
2 Dec-12 Twin Bay Medical, Inc. Saint-Gobain Performance Plastics
(Compagnie de Saint-Gobain)
3 Nov-12 Thomas Medical Products, Inc. Merit Medical Systems, Inc. (NasdaqGS:MMSI)
(Vital Signs, Inc.)
4 Nov-12 Sage Products, Inc. Madison Dearborn Partners, LLC
5 Oct-12 MedVenture Technology Corp. Helix Medical, LLC (Freudenberg Group)
(Ampersand Capital)
6 Oct-12 Afnity Medical Technologies, LLC Molex Incorporated (NasdaqGS:MOLX)
7 Oct-12 Vortex Medical, Inc. AngioDynamics Inc. (NasdaqGS:ANGO)
8 Oct-12 Coeur, Inc. (The Riverside Company) Illinois Tool Works Inc. (NYSE:ITW)
9 Aug-12 Cambus Medical Ltd Helix Medical, LLC (Freudenberg Group)
10 Jul-12 US Endoscopy, Inc. Steris Corp. (NYSE:STE)
11 Jul-12 Safety Syringes, Inc. Becton, Dickinson and Company (NYSE:BDX)
12 Jun-12 NP Medical Inc., Filter Product GVS S.p.A.
Business (Nypro Inc.)
13 Apr-12 Oliver Products Company Berwind Corporation
(Mason Wells)
14 Apr-12 Austar Pharma Renolit AG (JM Gesellschaft)
(medical lms division)
15 Apr-12 United Plastics Group, Inc. MedPlast Inc. (Baird Capital Partners)
(Aurora Capital Group)
1 Dec-12 Charter Films, Inc. NEX Performance Films, Inc. (Mason Wells)
2 Nov-12 Stull Technologies, Inc. Mold-Rite Plastics, LLC (Irving Place Capital)
3 Nov-12 Hilex Poly Company, LLC Wind Point Partners
(TPG Growth)
4 Oct-12 United States Container Corp. Berlin Packaging, LLC (Investcorp)
5 Oct-12 Scandia Plastics, Inc. Graham Partners
6 Oct-12 WNA, Inc. (Seven Mile, Norwest) Olympus Partners
7 Oct-12 BWAY Company, Inc. Platinum Equity, LLC
(Madison Dearborn Partners, LLC)
8 Jul-12 HCP Holdings Inc. TPG Capital, L.P.
9 Jul-12 Rexam PLC Silgan Holdings Inc. (NasdaqGS:SLGN)
(Thermoformed Food Business)
10 Jun-12 Klckner Pentaplast GmbH Strategic Value Partners, LLC
& Co. KG (Blackstone Group)
11 May-12 Consolidated Container Bain Capital
Company LLC (Vestar Capital)
12 Apr-12 Jet Plastica Industries, Inc. D&W Fine Pack, LLC (Mid Oaks)
(MCG Capital Corporation)
13 Mar-12 The Interex Group, Inc. Nicolet Capital Partners, LLC
(Red Diamond Capital)
14 Mar-12 Solo Cup Co. (Vestar Capital) Dart Container Corporation
15 Jan-12 Polytop Corp. MeadWestvaco Corp. (NYSE:MWV)
1 Dec-12 Tenere, Inc. (Stonehenge Partners) The Watermill Group
2 Oct-12 Spartech Corp. (NYSE:SEH) PolyOne Corporation (NYSE:POL)
3 Sep-12 KraussMaffei Technologies GmbH Onex Corporation (TSX:OCX)
(Madison Capital)
4 Sep-12 Quadion Corporation Norwest Equity Partners
5 Aug-12 TimberTech Limited AZEK Building Products, Inc. (CPG International)
(Crane Building Products)
6 Jul-12 Quality Synthetic Rubber, Inc. Lexington Precision Corp. (Industrial Growth Partners)
(Blue Point Capital Partners)
7 Jul-12 Synventive Molding Solutions, Inc. Barnes Group Inc. (NYSE:B)
(Littlejohn & Co.)
8 Jun-12 Pexco LLC (Saw Mill Capital LLC) Odyssey Investment Partners, LLC
9 Jun-12 Tank Intermediate Holding Corp. Leonard Green & Partners, L.P.
(Olympus Partners)
10 Jun-12 Xaloy Superior Holdings, Inc. Nordson Corporation (NasdaqGS:NDSN)
(Industrial Growth Partners)
11 Apr-12 Plasticolors, Inc. Arsenal Capital Partners, Inc.
12 Apr-12 PolyPipe, Inc. (Halifax Capital Partners) Dura-Line Corporation (CHS Capital Partners)
13 Mar-12 Milacron, LLC (Avenue Capital Group) CCMP Capital Advisors
14 Mar-12 Drilltec, Inc. (Hancock Park) Lubar & Co.
15 Mar-12 Citadel Plastics Holdings Inc. Huntsman Gay Global Capital
(Wind Point Partners)
1 Nov-12 D.A. Inc. Corvac Composites, LLC (Humphrey Enterprises, LLC)
(Kojima Press Industry Co., Ltd.)
2 Oct-12 ACH, LLC (climate control business) Valeo SA (ENXTPA:FR)
3 Sep-12 Century Plastics, Inc. Autometal S.A. (BOVESPA:AUTM3)
4 Sep-12 Nyloncraft, Inc. (Hammond, Dickten Masch Plastics, LLC (Patmian LLC)
Kennedy, Whitney & Company, Inc.)
5 Aug-12 Parker Hannin Corporation ContiTech AG
(air conditioning business)
6 Jul-12 Pyongsan FT Corp. (Pyongsan Corp.) Stant Corporation (H.I.G. Capital)
7 Jul-12 Poschmann Gmbh & Co Kg Nief Plastic Groupe (Sintex France SAS)
8 Jun-12 Ground Effects Ltd. LINE-X (Graham Partners)
9 Jun-12 Edwin Deutgen LPL Technologies Holding GmbH (Amphenol Corporation)
Kunststofftechnik GmbH
10 May-12 ACH, LLC (lighting business) Flex-N-Gate Corp.
11 May-12 ACH, LLC Faurecia S.A. (ENXTPA:EO)
(interior components business)
12 Mar-12 Visteon Corp. Varroc Engineering
(automotive lighting business)
13 Jan-12 A.P. Plasman Corporation Insight Equity
& Invotronics, Inc.
14 Dec-11 Injectech Industries Inc. Engineered Plastic Components
15 Dec-11 Toledo Molding & Die, Inc. Industrial Opportunity Partners
Trends by Plastics Sector
Medical Plastics
n
Strategic buyers were most active in medical plastics during
2012 representing approximately 74% of transaction volume,
with the majority of transactions involving injection molding and
extrusion companies.
n
Transaction multiples for medical plastics companies continue to
be some of the highest in the plastics industry as the relatively few
transactions in the marketplace are in high demand.
n
Medical plastic processors tend to be exclusively focused on the
sector as indicated by the number of corporate divestitures involving
non-medical operations, which have increased.
n
Investment in state-of-the-art facilities with clean room and other
capabilities are required to be a major supplier in the sector.

Plastic Packaging
n
Plastic packaging continues to generate some of the largest M&A
transactions in the industry with both strategic and financial buyers
active in the sector.
n
Many plastic packaging companies have decided to supplement
organic growth with acquisitions.
n
The number of plastic packaging deals involving extrusion,
thermoforming, injection molding, and blow molding increased
and financial buyers acquiring new plastic packaging platform
companies more than doubled.
n
Margins for plastic packaging companies tend to be higher as resin
pass-through ability and other successful resin cost strategies are
more prevalent.

Industrial Plastics
n
Industrial plastics continues to represent the largest number of
plastics transactions, which is highly diverse and fragmented.
n
Injection molding, resin/compounding, extrusion, tool & die, and
machinery saw significant increases in M&A volume during 2012.
n
Strategic buyers and private sellers represent the majority of
industrial plastics transactions, although growth has occurred for all
buyer and seller types.
n
Building products and other markets tied to housing are showing
signs of recovery as the sales of existing homes and new housing
starts begin to improve.
n
Heavy truck and other cyclical end markets have grown over the
past two years and are positioned for additional growth.

Automotive Plastics
n
In 2012, the majority of automotive plastics transactions involved
strategic buyers acquiring injection molding companies.
n
While strategic buyers have historically been most active in the
sector, private equity has renewed, although selective, interest given
the current point in the automotive cycle, which has experienced
more than two years of growth since the trough.
n
Corporate sellers represented the largest number of automotive
transactions in 2012, followed by private sellers and private equity.
n
North American automotive production totaled 15.4 million units in
2012, up from 13.1 million units in 2011, and is expected to increase
further to approximately 15.9 million units in 2013.
2013 7 2013
Michael D. Benson is a Managing Director in the Investment
Banking Group at Stout Risius Ross (SRR). He is responsible for
the execution of investment banking transactions, which include
mergers, acquisitions, divestitures, and the private placement of
senior debt, subordinated debt, and equity securities. Mr. Benson
can be reached at +1.248.432.1229 or mbenson@srr.com.
David M. Evatz is a Director in the Investment Banking Group
at Stout Risius Ross (SRR). He has extensive mergers and
acquisitions experience having participated in a wide variety of
transactions involving both public and private companies. He has
executed numerous M&A transactions, including buy and sell side
assignments, leveraged buyouts, joint ventures, restructurings,
shareholder rights plans, and fairness opinions. Mr. Evatz can be
reached at +1.312.752.3328 or devatz@srr.com.
Are you maximizing the value of your business?
Gregory P. Range
grange@srr.com
+1.310.775.2510
Our services for Middle Market Companies include:
n
Sale advisory and succession planning
n
Capital raises for acquisitions, recapitalizations, and restructurings
(senior debt, subordinated debt, equity)
n
Employee stock ownership plan (ESOP) planning,
formation, compliance, and exit
n
Buy-sell agreement consulting
n
Litigation advisory related to shareholder or
commercial disputes
n
Valuations for financial and tax reporting purposes
Hospital/Healthcare
Valuation and ASC 958-805:
Not-For-Profit Mergers and Acquisitions
John W. VanSanten, MAI, MRICS jvansanten@srr.com
Jason J. Krentler, MAI, MRICS jkrentler@srr.com
2013 16
Approximately 58%
1
of hospitals and health systems in the
United States operate as not-for-profits, whereby all revenues
are utilized in pursuing the organizations objectives as opposed
to owner distribution. As the volume of consolidations within
the industry continues to accelerate, a thorough understanding
of Financial Accounting Standards Board (FASB) Accounting
Standards Codification (ASC) 958 and valuation issues unique
to healthcare are critical. Since tangible assets (in particular the
real estate) often make up the bulk of the assets for not-for-profit
health systems, this article will primarily focus on valuation issues
specific to hospital real estate though intangibles and equipment
will also be touched upon.
There are several important factors that should be considered
when it comes to healthcare valuation. This is largely due to
the ever-changing regulatory environment, advancements in
healthcare technologies and procedures, changing market
demands, and political influence. In recent years, several
changes have occurred that significantly affect the way hospitals
and other healthcare facilities should be valued. Some of these
changes include the following.
n The implementation of ASC 958-805: Not-for-Prot
Mergers and Acquisitions (previously codied as
FASB 164)
n Changing market demands and the creation of new
building standards and codes by the Joint Commission
on Accreditation of Healthcare Organizations (JCAHO)
and the American Institute of Architects (AIA)
n The passage of The Patient Protection and Affordable
Care Act and the potential impact that this and other
current political issues, such as the federal budget crisis,
will have on the performance of the healthcare industry
Each of these areas will be discussed in more detail on the
following pages.
FASB ASC 958-805 nnn
In January of 2010, FASB issued Accounting Standards Update
No. 2010-07, which recodified FASB Statement 164 to ASC
958-805. According to FASB the purpose of this statement
is to: Improve the relevance, representational faithfulness,
and comparability of the information that a not-for-profit entity
provides in its financial reports about a combination with one or
more other not-for-profit activities.
1
According to AHA Hospital Statistics, 2013 Edition.
2013 17
The main provisions of this standard are that it:
1
I
Determines whether a combination is a merger or
an acquisition
2
I
Applies the carryover method in accounting for a merger
3
I
Applies the acquisition method in accounting for an
acquisition, including determining which of the combining
entities is the acquirer
4
I
Amends ASC 350 (formerly FASB 142): Goodwill and
Other Intangible Assets to make it fully applicable to
not-for-prot entities
ASC 958-805 essentially makes the financial reporting
requirements for for-profit mergers and acquisitions (via ASC
805: Business Combinations) applicable to those of not-for-profit
entities. Prior to this statement, the financial reporting requirements
for combinations of not-for-profits was much less stringent and
complex. Both ASC 805 (formerly FASB 141r) and ASC 958-
805 are based on the premise of Fair Value accounting, which is
considered to be more detailed, current, and comprehensive than
cost-based accounting. Further, Fair Value accounting is reflective
of a market value (exit price) and takes into consideration the
highest and best use of an asset. This move toward Fair Value
accounting has increased the need for qualified and experienced
valuation professionals in the financial reporting arena.
According to ASC 958-805, the accounting requirements differ
depending on whether a combination of a not-for-profit entity is
a merger or an acquisition. As previously mentioned, in the case
of a merger, the carryover method is used; and in the case of an
acquisition, the acquisition method is used. Each method is briefly
discussed in the following paragraphs.
A merger occurs when the governing bodies of the combining
entities cede control and, in turn, create a new governing body
that will control the newly combined entity. When this is the case,
the carryover method of accounting is used. This method involves
the combination of the book values of the assets and liabilities of
the merging organizations as of the merger date. The main change
that this makes in accounting for not-for-profit mergers is that prior
to ASC 958-805, the merged entity was required to report their
combined operations retroactively rather than from the merger
date forward. The requirements of accounting for acquisitions are
more complex. Additionally, when an acquisition takes place, it
may be difficult to determine which of the combining entities is the
acquirer. Therefore, identification of the governing party requires
consideration of all aspects of the combination, particularly the
ability of one entity to control the selection of the combined entitys
governing board. Once the acquirer is determined, the value of the
acquired entity must be determined via the following steps.
1
I
All assets and liabilities must be inventoried. This
may involve searching for additional items of value
that were not previously included on the acquirees
nancial statements.
2
I
The Fair Value of each asset and liability must be
determined based on the framework outlined in ASC
820: Fair Value Measurement.
3
I
If the sum of the Fair Value of the assets is greater than
the transaction consideration, the acquirer recognizes
contribution income. Conversely, if the transaction
consideration exceeds the Fair Value of the assets
acquired, the accounting differs depending on whether
the acquirees operations are expected to be primarily
supported by contributions and return on investment
or by revenues in exchange for services provided or
goods exchanged. Healthcare facilities fall into the latter
category and in this case the excess is recorded
as goodwill.
Because ASC 958-805 amends ASC 350 to make it applicable to
not-for-profit entities, opening balances for goodwill and intangible
assets and annual testing for impairment is now necessary. This
is a significant change in the financial reporting requirements of
not-for-profits and increases the need for careful valuation of
both tangible and intangible assets. In the case of not-for-profit
hospitals, intangible assets may not be material. Nevertheless,
they should be considered. Example categories of intangible
assets common in healthcare are:
n Certicate of Need (CON) and/or License
n Essential documents
n Technology and software
n Noncompete agreements
n Contracts
n Practices and procedures
n Goodwill
It is important that not-for-profit healthcare facilities comply with
these recently imposed requirements. Noncompliance can hurt
healthcare organizations in a number of ways, including hindering
their ability for future mergers and acquisitions (which are
becoming increasingly attractive under the current economic and
political environment). Additionally, if auditors realize that a not-
for-profit is not complying, they can issue a qualified report that
could potentially impact the credit rating of the health system and
limit the organizations ability to obtain financing (typically through
the tax-exempt bond market).
2013 18
Unique Real Estate Valuation Issues nnn
Healthcare organizations typically have substantial tangible assets,
including real estate holdings and medical equipment. For financial
reporting purposes, both types of tangible assets typically must
be valued. When it comes to the valuation of a health systems
real estate there are certain distinct characteristics that raise
valuation concerns.
Current real property appraisal theory includes consideration of
several appraisal approaches, including a cost approach, sales
comparison approach, and income capitalization approach.
A specific appraisal assignment may use one or more of these
valuation approaches based on the definition of value and the
quality and quantity of data available for the analysis. When
valuing hospitals and other healthcare facilities, the cost approach
(estimating the underlying land value plus the depreciated value of
the improvements) is often the most applicable approach. This is
because hospitals are considered special use properties, designed
specifically to provide healthcare services to the community. For
special purpose properties, the cost approach is often the most
appropriate method. Application of the sales comparison and
income capitalization approaches for a hospital would typically
reflect the value of the business enterprise, including significant
equipment and intangible assets. This is due to the fact that sales
of hospitals typically include the entire going-concern, not just
the real estate. Therefore, sales of hospitals may be useful for
estimating the value of the going-concern, but may not provide a
reasonable indication of the underlying real estate value. Likewise
with the income capitalization approach, the cash flows generated
by a hospital reflect the business of providing healthcare services,
not just rent for the real estate. Capitalizing a hospitals cash flow
may provide an indication of the going-concern value, but may not
provide a reasonable indication of the underlying real estate value.
For non-clinical buildings such as medical office, application of
the sales comparison and income capitalization approaches may
be appropriate, as these properties are more similar to traditional
real property types.
Based on the preceding, when appraising a hospital campus in
compliance with ASC 958-805, it is typically most appropriate
for the primary real property assets (i.e. main hospital and clinical
buildings) to be valued on a cost approach, while the ancillary non-
clinical buildings are valued via a sales comparison and/or income
capitalization approach.
In the application of the cost approach, it is common for hospital
buildings, especially older facilities, to suffer from functional
obsolescence. This is due to ever-changing market demands
and building standards/codes. Market demands have changed
dramatically in recent years. The old institutional feel of hospitals
is obsolete, and patients now prefer more hotel-like amenities,
including private rooms with flat-screen televisions, wireless
internet access, health clubs and spas, and high-quality food
service/restaurants. Building standards and code requirements
have changed significantly in the past decade in an effort to meet
changing demands, improve patient safety, increase operational
efficiency, and reduce costs. The two bodies governing this
change are the Joint Commission on Accreditation of Healthcare
Organizations (JCAHO) and the American Institute of Architects
(AIS). New standards and guidelines in the healthcare industry
involve many facility types, including general hospitals, outpatient
facilities, and surgical centers. These new guidelines exert
substantial pressure on existing hospitals to compete with the
latest standards to avoid becoming functionally obsolete. Some of
these changes include:
n New AIA guidelines for hospitals that require single-
patient rooms for most new hospital construction.
This requirement is driven by both market and clinical
demand, as numerous studies have shown the rates
of medical errors and the spread of infection drop
dramatically in hospitals with private rooms versus
shared rooms.
n Increased minimum size requirements for operating
rooms (ORs) in hospitals. For example, general operating
rooms are now required to have a minimum clear area
of 400 square feet and minimum xed or wall-mounted
cabinets of 20 feet. This requirement is driven by
changes in technology, which result in more equipment
being utilized in operating room procedures thereby
requiring larger OR spaces.
n As average length of stay decreases, more and more
procedures are being done on an outpatient basis.
Hospitals are constructing facilities with outpatient
centers more frequently to reect this shift in the
industry. Older facilities originally designed for inpatient
procedures tend to be obsolete, and the cost of
retrotting these buildings can be prohibitive.
In summary, new guidelines and standards of the JCAHO and AIA
are creating a more competitive marketplace in the healthcare
industry. The hospitals that offer private patient rooms and larger,
more technologically advanced operating rooms experience higher
demand, better patient safety, increased operational efficiency,
and reduced costs. The value of dated hospitals that have not
catered to these changing industry norms is, consequently,
negatively affected. In fact, many health systems have embarked
upon the process of building replacement facilities for their
existing hospitals, often spending hundreds of millions to keep
pace with industry changes. With limited alternate use potential for
the hospitals that are replaced, the highest and best use for the old
buildings often calls for demolition and redevelopment of the site.
2013 19
Another consideration in the cost approach is the economic
viability of the hospital enterprise. If a separate valuation of the
hospital enterprise is completed, it may indicate the value of the
entire enterprise (the total assets of the business), is less than the
initial value indication for the tangible assets. In this situation, it
may be necessary to apply an economic obsolescence adjustment
to both the real and personal property, under the theory that there
is insufficient cash flow generated by the hospital enterprise to
support the underlying value of the tangible assets. Each situation
is unique, and the specifics of the transaction must be considered
before a final conclusion can be reached. Best practices also
suggest that for ASC 958-805 compliance, valuation professionals
should be on the same page with both the client and the auditors.
Good planning and communication on the front-end can ensure
that there are no surprises on the back-end.
Current Political and Economic Issues nnn
The current political and economic environment is presently
affecting and has the ability to further influence the shape of the
healthcare industry going forward. Items such as the passage of
The Patient Protection and Affordable Care Act and impending
budget crisis have brought healthcare to the forefront of political
discussion. Though much uncertainty remains, it is evident that the
future structure of the nations healthcare system will be affected
one way or the other.
Several recent reports from financial analysts state that the outlook
for not-for-profit hospitals in 2013 is dismal. Fitch Ratings Outlook
for 2013 discusses the ongoing pressure on hospital operations
due to a weak economy and scheduled decreases in hospital
pay under healthcare reform. During the recession, hospitals and
healthcare systems made an effort to reduce expenses and have
continued to do so through the slow recovery. However, it is likely
that these measures will cease to help deliver stable profits. Fitch
believes 2013 is likely to be the last year of stable performance,
as scarcer expense reduction opportunities and looming
reimbursement reductions threaten operating performance, the
report stated. The report goes on to say that health insurance
exchanges created by the healthcare reform bill, which would allow
middle- and low-income households to buy subsidized insurance
starting in 2014, would benefit hospitals, but development of these
exchanges seems to be behind schedule.
Additionally, a recent Moodys Investor Services outlook on
not-for-profit hospitals reports that hospitals will receive lower
payments for services from insurers in coming years as Medicare
cuts approximately $300 billion from hospital reimbursements.
Beyond these scheduled Medicare cuts and private insurer efforts
to temper premium growth, federal deficit reduction measures
and state budgetary challenges will all contribute to a decrease in
hospital revenue.
These potential challenges are creating a great amount of
uncertainty and risk within the industry. Many hospitals will take
precautionary measures in an attempt to lessen the fallout. This
will likely include an increase in merger and acquisition activity
in an effort to create economies of scale and curb costs; this, in
turn, will increase the need for not-for-profit healthcare systems to
comply with ASC 958-805.
Conclusion nnn
As indicated in the preceding discussion, the healthcare industry
continues to evolve, and the ever-changing environment is likely
to continue for the foreseeable future. New financial reporting
standards, distinct real estate valuation considerations, changing
market conditions, and risk created by current political and
economic circumstances have all affected the industry and
will continue to do so. Consequently, the need for valuation
professionals who understand the complexities of healthcare
and nuances of financial reporting requirements, and who have
the expertise to value all asset types (intangible, real estate, and
equipment) is critical.
John W. VanSanten, MAI, MRICS is a Managing Director in the
real estate practice within the Valuation & Financial Opinions
Group at Stout Risius Ross (SRR). He has more than 20 years of
experience in real estate valuations of all types of commercial and
special use properties, with a particular emphasis on healthcare
properties. Mr. VanSanten can be reached at +1.312.752.3384
or jvansanten@srr.com.
Jason J. Krentler, MAI, MRICS is a Director in the real estate
practice within the Valuation & Financial Opinions Group at
Stout Risius Ross (SRR). He is responsible for management,
client liaison, business development, and appraisal
production. Mr. Krentlers concentration is in real estate
valuation and advisory services, where he has 10 years of
national and international appraisal, review, and management
experience. Mr. Krentler can be reached at +1.248.432.1281
or jkrentler@srr.com.
Our services include:
Jay B. Wachowicz, CFA
n
jwachowicz@srr.com
n
+1.248.432.1288
nn
Purchase price allocation and fresh start accounting
nn
Goodwill and long-lived asset impairment testing
nn
Valuation of stock options and stock grants
nn
Fair Value measurement of financial assets and liabilities
nn
Real estate and machinery & equipment valuation
nn
Fair Market Value opinions for internal tax reorganizations and restructurings
nn
Fairness opinions
nn
Solvency and capital adequacy opinions
nn
Private market financings (debt and equity)
nn
Sell side representation for corporate divestitures
nn
Litigation advisory services related to shareholder or
commercial disputes
How do you satisfy the scrutiny from
the capital markets, accounting and tax
regulators, and your board?
Vesting of Founders Stock
Jeff M. Mattson, Esq. Freeborn & Peters LLP
jmattson@freebornpeters.com
21 2013
Guest Article
Founders of a startup are frequently surprised when venture
capital firms or other investors ask for vesting provisions to be
placed on the founders stock. The investors are seeking to
provide sufficient incentive for each founder to work through
the companys critical early formation and development phase.
If a founder leaves the startup early in the process, it would be
unfair to the other founders and the investors for the departing
founder to receive a free ride on the continuing efforts of
the other founders. The vesting terms cause a forfeiture of the
unvested shares, or a repurchase at a low cost, upon termination
of employment, thereby eliminating the free ride.
A typical vesting structure is a period of four years beginning
either upon the formation of the company or the closing of the
first round of outside financing, with a one-year cliff, meaning that
one-fourth of the stock vests on the first anniversary. Thereafter,
the stock vests ratably with one forty-eighth of the stock vesting
each month. In some cases, the stock instead vests annually with
one-fourth of the stock vesting on each anniversary. In either
case, the founder is 100% vested on the fourth anniversary.
The logic of this typical structure is that it takes a full year to
get through the formative stage and, thereafter, the value of the
company increases incrementally. The typical vesting schedule
tracks this common growth pattern, rewarding the founder
proportionately for services during these stages.
But, startups come in many shapes and sizes, and founders can
request and obtain variations from the four-year vesting schedule
in appropriate circumstances. Following are a few of the most
common reasons to adjust the vesting schedule:
1
I
Other Contributions. If a founder has contributed
money, intellectual property, or other assets to
the company, the stock issued in return for those
contributions should be fully vested, because the value
has been provided in full and is not contingent on the
future services. Any remaining stock issued for services
would still be subject to vesting.
2
I
Prior Service. If the VC investment is being made after
the formation of the company, the founders frequently
are able to obtain credit for the prior services. For
example, if the VC investment is made one year after
formation, the stock could be 25% vested upon closing
the investment, and the remaining stock would be
subject to a three-year vesting schedule.
3
I
Shorter Startup Period. If founders reasonably
anticipate a shorter period to bring products or services
to market, protability, or sale of the company, then
investors have a shorter risk period and the vesting
schedule can be reduced commensurately.
22 2013
4
I
Track Record or Expertise. If a founder has a proven
track record or expertise that is particularly needed
by the company, that founder may be able to leverage
this strength into a shorter vesting schedule. But dont
overplay this hand. If the investor is convinced a founder
is critical, the investor may decide that vesting is even
more important to protect against the damage to the
company if this key founder leaves the company.
Vesting stock commonly raises two additional issues: acceleration
of vesting and the tax treatment of vesting stock.
Founders should always ask for the vesting of their stock to
accelerate upon (a) a sale of the company or (b) a termination
of employment without cause. This formulation for vesting is
called single-trigger acceleration, because the acceleration is
triggered upon the occurrence of either one of the two events.
Investors usually want double-trigger acceleration, in which
acceleration only occurs if the founders employment is terminated
without cause following a sale of the company. Investors are
concerned that single-trigger acceleration will make the company
more difficult to sell because, if all stock vests upon sale, buyers
will be unwilling to take the risk of founders leaving the company
shortly following the sale.
Finally, vesting stock creates a tax trap that first-time founders do
not expect. The tax code treats the grant of stock to a company
officer or employee as compensation for services rendered. The
founder is required to recognize income equal to the value of the
stock. When a company is initially formed, the stock usually has
no value, so the taxable income is $0. But, if vesting is placed on
the stock, IRS regulations deem the stock to be granted on the
date of vesting. If the companys value increases over time, as
anticipated, then the stock gains greater and greater value upon
each vesting date and the founder must recognize income on
each vesting date. If the startup goes well, this income is quite
significant, resulting in substantial income tax at a time when the
founder may not have cash available to pay the tax.
Generally, founders can mitigate the previously referenced tax
costs by filing an 83(b) election with the IRS. The 83(b) election
treats the stock, for tax purposes, as if there is no vesting, thereby
eliminating the taxable event upon vesting. But, be careful with
this issue. The 83(b) election must be filed within 30 days of
grant; no extensions are permitted; the election applies only if the
stock is issued in connection with the performance of services;
and the potential tax trap could be huge if you fail to file in the
30-day period. Founders facing this situation should consult
with knowledgeable tax counsel to determine the availability and
effects of an 83(b) election.
Jeff M. Mattson, Esq. is a Partner in and Co-Leader of the Corporate
Practice Group at Freeborn & Peters LLP. His expertise includes
mergers and acquisitions, entity formation, private placements, and
other general corporate matters. Mr. Mattson can be reached at
+1.312.360.6312 or jmattson@freebornpeters.com.
Bridging the
GAAP to Tax
Marc C. Asbra, CFA masbra@srr.com
23 2013
While the capital markets, economic conditions, political
atmosphere, and numerous other factors impact commercial
transactions in any given year, mergers and acquisitions
generally remain a predominant tactic for driving corporate
growth and return on investment. There were roughly 15,000
M&A transactions in the U.S. during 2012, representing over
$830 billion of value.
1

A substantial majority of these transactions require the buyer
to allocate the purchase price for financial reporting purposes
pursuant to Financial Accounting Standards Board Accounting
Standards Codification Topic 805, Business Combinations (ASC
805). In brief, acquirers must perform a purchase price allocation
(PPA) based on the Fair Values of the targets current, tangible, and
identifiable intangible assets. The residual is recorded as goodwill.
Ever since the elimination of the pooling method over a decade
ago, C-suite executives, board members, financial advisors,
securities analysts, and investors have become well versed in the
topic of acquisition accounting due to its effect on the acquirers
GAAP earnings following the transaction. The portion of purchase
price allocated to intangible assets and goodwill has particular
importance, as the post-transaction amortization periods for
acquired intangible assets can range anywhere from one to 20
years, while goodwill produces no amortization expense. Not
surprisingly, the Securities and Exchange Commission (SEC)
and other regulators have also demonstrated a keen interest in
acquisition accounting.
PPA for Financial Reporting Purposes nnn
The transaction price generally establishes a Fair Value of the
targets assets as a whole, but it is silent as to the sources of such
value. There can be numerous sources, such as a cost effective
manufacturing process, a unique patent portfolio, innovative
products based on proprietary technologies, a well-known brand
name that evokes customer loyalty, a defensible market share
due to long-term customer contracts or relationships, or an
exceptional approach to running the business.
At a fundamental level, the analysis performed for the PPA
deconstructs the targets business in an effort to understand
the critical value drivers and, importantly, determine the
Fair Values of the intangible assets that meet the GAAP
requirements for separate identification. The analysis commonly
includes the attribution of the targets company-wide projected
earnings or cash flows to each source of value technology,
brand name, customer contracts, business processes, etc.
The attribution process is often very detailed and can involve
extensive financial modeling.
As required by ASC 805, the PPA analysis is performed on
the basis of the targets reporting units or, if the target has
only a single reporting unit, on a company-wide basis. The
PPA analysis is typically not performed on a legal entity basis,
as the ownership distinction is generally not essential for
financial reporting purposes. The issue of ownership tends to
reside in the world of tax.
1
Source: S&P Capital IQ. Represents announced transactions involving a change of control.
24 2013
Tax Implications nnn
The interest in PPA results for tax reporting purposes generally pales
in comparison to its EPS-driven financial reporting counterpart.
Unless a transaction is structured as a taxable acquisition of the
targets assets, or a taxable purchase of the targets stock with
an Internal Revenue Code (IRC) Section 338 election, the acquirer
assumes carryover tax basis in the acquired assets. None of the
asset step-ups, identifiable
intangible assets, or
goodwill recognized in the
PPA for financial reporting
purposes is deductible for
tax purposes. In transactions
where the acquirer assumes
a stepped-up basis in
the targets assets, all of
the intangible assets and
goodwill are amortized
ratably over the statutory
15-year period per IRC
Section 197.
The tide turns quickly when
an M&A transaction has material tax consequences to the buyer
or seller. The companys tax department and external tax advisors
engage in extensive diligence and planning. While it might be
tempting to isolate these professionals until they determine the
most tax-efficient structure for the transaction or post-integration
plan, in doing so the acquirer would forego opportunities to
leverage Fair Value measurements done for financial reporting
purposes within their tax-planning initiatives.
One such situation can arise when an M&A transaction involves
a target that conducts business through multiple legal entities.
For tax-planning purposes, it may be necessary to allocate the
purchase price to the targets legal entities, as illustrated in the
following example.
Valuation of ABC Legal Entities nnn
ABC Company is a privately held engineering and construction
(E&C) company. The company began its operations in the
Southeast and since expanded into other regions across the
U.S. Separate legal entity subsidiaries were created to coincide
with ABCs geographic expansion. While the founding principal
holds (directly or indirectly) controlling interests in each of the
companys subsidiaries, different key management personnel own
minority positions.
ABC sold its assets on December 31, 2012 to a financial
sponsor for an aggregate purchase price of $150 million, which
was determined based on a multiple of 5.0x the companys
consolidated EBITDA of $30 million. As shown in Table 1 below,
ABC is comprised of two C corporations and two S corporations.
The after-tax transaction proceeds to the founding principal and
each of the minority investors depends on the amount of purchase
price allocated to each of ABCs legal entities.
There are several ways to allocate the purchase price among
legal entities, each with varying degrees of accuracy, complexity,
and ability to withstand the scrutiny of the tax authorities. Three
common allocation approaches include the following:
1
I
Buyer and Seller Negotiations
2
I
Relative Financial Metrics
3
I
Relative Fair Market Values (FMVs)
Buyer and Seller Negotiations. This allocation method could
itself vary greatly in terms of complexity and/or analytical support.
The parties might consider factors similar to those in options #2
and #3 (discussed below, and on the next page), or they might
simply select amounts that seem reasonable and appropriate to
each party.
Relative Financial Metrics. In this method, consideration is
given to the relative financial results of the legal entities, such as
revenue, EBITDA, or some other measure. The analysis for ABC
uses reported revenue and EBITDA for the most recent 12-month
period preceding the transaction; however, other time horizons
could be used (i.e., three-year average EBITDA, budgeted revenue
or EBITDA for 2013, etc.). While this method has intuitive appeal
and is fairly easy to implement, it explicitly assumes that all revenue
and/or profit dollars are equally valuable.
Table 1: ABC Company Corporate Structure
Parent Sub A Sub B Sub C Total
Region Southeast Northeast Texas Southwest
Corporate Structure C Corp S Corp S Corp C Corp
Ownership
Principal 95.0% 85.0% 70.0% 80.0%
Others 5.0% 15.0% 30.0% 20.0%
Revenue $ 65.0 $ 85.0 $ 105.0 $ 55.0 $ 310.0
EBITDA $ 5.0 $ 8.5 $ 12.0 $ 4.5 $ 30.0
EBITDA Margin 7.7% 10.0% 11.4% 8.2% 9.7%
25 2013

As shown in Table 2, the concluded values differ between the
revenue and EBITDA metrics due to the different margin levels of
the entities. The concluded FMVs give primary consideration to the
value indications derived from relative EBITDA metrics rather than
revenue. Subsidiary B is assigned the majority of the purchase
price since it generates the highest amount of EBITDA, while the
opposite is true for Subsidiary C.
Relative Fair Market Values. The third method is a substantial
expansion of the second option. In this case fundamental
valuations are performed for each subsidiary using commonly
accepted valuation techniques, including discounted cash flows
(DCF) and valuation multiples derived from guideline publicly
traded companies or M&A transactions. These methods are not
restricted to static financial metrics used in option #2. Rather, the
nature of the valuation process affords explicit consideration of the
relevant factors that a hypothetical buyer and seller would consider
in determining a purchase price for each legal entity. These factors
could include their (i) nature and operations, including the industry
dynamics and conditions of the target market; (ii) historical financial
performance and trends; (iii) expected performance and financial
outlook; and (iv) degree of risk, among many others.
As shown in Table 3, it
is not expected that a
sum-of-the-parts valuation
of multiple legal entities will
match exactly a transaction
price negotiated on an
aggregate, company-wide
basis. As such, relative
FMVs are used in this
allocation method rather
than absolute FMVs so that
a complete reconciliation to
the $150 million purchase
price is achieved.
All three options described
herein are used in practice. The allocation method ultimately
selected should consider the facts and circumstances of the
transaction, including, but not limited to, the relative similarities
and/or differences between the legal entities and the magnitude of
the tax consequences.
In the case of ABC, all of the legal entities are involved in E&C
operations, and differ primarily with respect to geography. This
fact pattern simplifies the
analysis to some degree.
If the legal entities under
analysis are engaged in
different activities, then the
first and second options
become more difficult to
implement. For example, a
multinational corporation
may have subsidiaries
that are distinctly engaged
in product development,
manufacturing, and
distribution. This more
complicated fact pattern
would likely require option #3 to allocate the purchase price, as
the method must be able to address each legal entitys different
functions, risks, and value drivers.
Other Issues nnn
The aforementioned examples for ABC are relatively simple in
their illustration and implicitly assume that the reported historical
and projected financial data appropriately reflect each legal
entitys operations on a stand-alone basis. This is important as
the objective of the exercise is to achieve valuations for each legal
entity that are reflective of a Fair Market Value standard the price
at which each legal entity would transact between a hypothetical
buyer and seller dealing at arms length.
Table 2: Value Allocation Based on Relative Financial Metrics
Relative Metrics (% of Total)
Revenue 21.0% 27.4% 33.9% 17.7% 100.0%
EBITDA 16.7% 28.3% 40.0% 15.0% 100.0%

Allocated Purchase Price Based on Relative Metrics:
Revenue $ 31.5 $ 41.1 $ 50.8 $ 26.6 $ 150.0
EBITDA 25.0 42.5 60.0 22.5 150.0
Average 28.2 41.8 55.4 24.6 150.0
Concluded FMV $ 25.0 $ 42.5 $ 60.0 $ 22.5 $ 150.0
Table 3: Value Allocation Based on Relative Fair Market Values
FMV Derived from:
DCF $ 21.0 $ 44.0 $ 69.0 $ 19.0 $ 153.0
Public Company Multiples 20.0 42.5 66.0 18.0 146.5
Concluded 21.0 43.0 68.0 19.0 151.0

Allocated Purchase Price Based on Concluded FMV:
% of Total 13.9% 28.5% 45.0% 12.6% 100.0%
Concluded FMV $ 20.9 $ 42.7 $ 67.5 $ 18.9 $ 150.0
26 2013
The real world is often more complex and involves other issues.
Two issues commonly encountered include the following:
1
I
Management and Other Corporate Services
2
I
Legal Ownership vs. Use of Intangible Assets
Management and Other Corporate Services. In certain cases,
companies with multiple subsidiaries provide management and
other corporate services (i.e., finance, IT, HR, etc.) through the
parent company, or another designated entity, which employs the
executive management team and other administrative personnel. It
is important to ensure that the financial results of the legal entities
reflect an appropriate allocation of the income and expenses
related to the provision and receipt of such corporate overhead
services. For example, the executive management team members
of ABC are employed by the Parent. They provide management
assistance to the companys subsidiaries, but only allocate direct
costs (i.e., travel, meals, entertainment, etc.) to each subsidiary for
services provided. No allocations are made for the indirect costs
of executive compensation and other benefits.
Ideally, the allocation of purchase price to ABCs legal entities
would rely on profit levels that reflect an appropriate allocation
of costs commensurate with the benefits provided by the Parent.
Absent this explicit adjustment, the concluded FMVs for the
entities may be incorrect.
A relatively common method to allocate compensation-related
costs is based on the time spent providing services to the
benefit of the companys subsidiaries. For example, if the Parents
human resources (HR) department spends 10% of its time and
effort on behalf on Subsidiary C, then 10% of the HR costs
would be charged to the subsidiary. Of course other methods
could also be considered.
Legal Ownership vs. Use of Intangible Assets. Similar
consequences can result in situations where intangible assets
are owned by one legal entity (say, the Parent), but are used by
the companys subsidiaries
without payment to the
Parent. For example, the
Parent might legally own the
ABC trademark and trade
name, which the Parent
and subsidiaries use in their
business development and
other marketing initiatives.
A trademark and trade
name that is recognizable
among potential clients,
or otherwise helps to
generate future business,
can enhance the value of
the enterprise. The owner of
this intangible asset would seek adequate compensation for its
use. In the case of ABC, however, the Parent does not charge any
amounts to the subsidiaries related to their use of the ABC name.
Similar to unallocated costs for management and other corporate
services, the allocation of purchase price to ABCs legal entities
would ideally rely on profit levels that reflect an appropriate charge
for the use of this important intangible asset (and possibly others).
Absent this explicit adjustment, the concluded FMVs for the
entities may be incorrect.
Charges for the use of intangible assets across legal entities
often take the form of a royalty or license fee. The conceptual
basis for this approach is routinely employed in transfer pricing
programs. Essentially, royalty rates are derived from analysis of
third-party license agreements that involve comparable intangible
assets. For example, in the case of ABC, a search of trade name
license agreements for certain companies characterized as
providing business services yields a range of royalty rates from
0.3% to 1.5% of revenue. If a royalty rate of 0.5% is deemed
appropriate for the ABC trade name, then the subsidiaries would
pay the Parent a license fee based on 0.5% of their respective
revenue. While this method is relatively straightforward to apply,
the degree of accuracy resides in the analytical and other
support for the royalty rate selection. The PPA done for financial
reporting purposes routinely addresses these and other
assumptions related to intangible assets.
Table 4 illustrates the financial results for ABC in the event
adjustments are made for these other items. The Parent incurs
$1.0 million of expense for providing corporate services to the
subsidiaries. Table 4 shows that the subsidiaries are allocated a
corporate services charge in proportion to their revenues, while
the Parent shows the $1 million increase in EBITDA. Likewise,
each of the subsidiaries is assumed to pay a license fee to the
Parent for the use of the ABC trade name, which is determined
based on a royalty rate of 0.5% of revenue. The Parent shows the
corresponding increase in EBITDA.
Table 4: Adjusted Financial Results
Reported
Revenue $ 65.0 $ 85.0 $ 105.0 $ 55.0 $ 310.0
EBITDA 5.0 8.5 12.0 4.5 30.0
EBITDA Adjustment for:
Corporate Services $ 1.0 ($0.3) ($0.4) ($0.2) $ 0.0
ABC Trade Name License 1.2 (0.4) (0.5) (0.3) 0.0
Adjusted
Revenue $ 65.0 $ 85.0 $ 105.0 $ 55.0 $ 310.0
EBITDA 7.2 7.7 11.0 4.0 30.0
EBITDA Margin 11.1% 9.1% 10.5% 7.3% 9.7%
2013 5 2013
While the aggregate financial results of ABC are unchanged, the
composition of profit, and hence the basis for allocating value, are
much different after making these adjustments. For example, the
Parents FMV of $20.9 million shown in Table 3 implies a multiple
of 4.2x the entitys unadjusted EBITDA of $5 million. If the same
multiple is applied to the Parents adjusted EBITDA of $7.2 million
shown in Table 4, its value increases nearly 45% to $30.1 million.
This example assumes that the valuation multiple for the Parent
is unchanged. In practice, however, the valuations of all ABCs
entities would be redone to consider the trade name ownership
issue and the profit impact from the corporate services expense
allocation. The revised FMV for the Parent would likely be above
$30.1 million after performing the more detailed analysis.
Summary nnn
The PPA analysis done for financial reporting purposes can be
extensive. While the analysis is mainly done as a requirement
to issue financial statements in compliance with U.S. GAAP,
in some instances acquirers might be able to take advantage
of opportunities to utilize Fair Value measurements done for
financial reporting purposes within their tax-planning initiatives.
It can be beneficial to perform the PPA and related tax analyses
contemporaneously, as doing so improves the accuracy of each,
reduces management time, and decreases professional fees.
This best practice recommendation, however, comes with one
word of caution. Financial reporting and tax reporting are not
mirror images of one another. Financial reporting requires Fair
Value measurements derived within the framework of ASC 805
and Topic 820, Fair Value Measurement. Tax reporting reflects a
Fair Market Value premise as defined by the Internal Revenue
Service.
2
While similarities exist between the two standards in
many cases, differences can arise that could critically impact
the structure of the analysis and the final conclusions for tax-
reporting purposes.
Marc C. Asbra, CFA is a Managing Director in the Valuation &
Financial Opinions Group at Stout Risius Ross (SRR). He has over
18 years of experience in the valuation of businesses, securities,
and intangible assets for tax and financial reporting purposes.
Mr. Asbra can be reached at +1.310.846.8898 or masbra@srr.com.
2
Rev. Rul. 59-60, 1959-1 C.B. 237; Treas. Regs. 20.2031-1(b) and 25.2512-1.
2012
Patrick A. Brown
pbrown@srr.com
+1.216.373.2993
n
Purchase price allocation and fresh start accounting
n
Goodwill and long-lived asset impairment testing
n
Fair Value measurements for financial assets and liabilities
n
Restricted stock, options, and performance unit valuations
n
Real estate and machinery & equipment valuation
n
Fair Market Value opinions for tax reorganizations
and restructurings
n
Expert testimony for M&A and valuation disputes
Do you have
a worry free
valuation
option for
your clients?
SRR works with accountants and
their clients in the following areas:
Dealing with
Commodity Price
Fluctuations
Vincent J. Pappalardo vpappalardo@srr.com
Christopher A. Merley cmerley@srr.com
2013 28
Commodity prices have been in the news since 2007 when the
economy was overheating and the demand for all raw materials
far outweighed supply. The continued climb of commodity prices
led many to believe that we were not experiencing a bubble, but
rather a long-term shift in commodity prices driven by a growing
proportion of the world population adopting Western-style
consumption habits that left raw materials in permanent short
supply. Despite a challenging year for commodity prices in 2012,
the general premise behind long-term demand for raw materials
remains intact.
The unprecedented drop in demand that occurred in late 2008
left many companies fighting other battles not directly related
to commodity prices. Some managers wondered if commodity
pricing was an addressable issue, and if it was, how could it
be dealt with? Since then, however, commodity prices have
continued on a volatile pace, which has led to the creation of
numerous hedging strategies and products.
The cause of commodity price fluctuations is rooted in the
development of a world market that is not yet adept in anticipating
global fluctuations in demand. Price fluctuations are actually
being exacerbated by the availability of information and the
speed of communication. One may think that better information
would reduce volatility, so this result seems counterintuitive.
When commodity markets were more localized in nature, market
participants had a much better feel for demand levels. This
proximity to supply and demand factors allowed prices to follow
more predictable patterns. However, the fact remains that the
global market has been permanently opened, and this, in turn,
has caused tremendous volatility. The unpredictability of price
levels has led developing countries that understand their own
long-term raw material shortages to enter and exit markets as
prices reach certain levels. This activity, while it has increased the
frequency of price movements, has actually decreased volatility
in the sense of dampening highs and lows. Thus, while market
participants see more frequent price movements, the end result is
actually a certain level of price stability (i.e., move movements but
within a narrower band), which lends itself well to hedging activity.
Supply chains that have not needed to worry as much about the
volatility of input prices historically have made price fluctuations
the responsibility of the supply chain participant best capable of
dealing with them. For example, the initial response to commodity
price volatility from automotive OEMs was to push the risk onto
suppliers. (The other solution was to pass along the risk to the
end consumer. Its not likely that your average car buyer would
feel comfortable with a scrap surcharge as they sit at the car
dealership trying to get financing to buy a car!) In the end, the
automotive supply base could not deal with the risk as effectively
as the OEMs. The steel buying program created by the OEMs
has allowed suppliers to focus on simply manufacturing products
2013 29
instead of trying to anticipate potential movements in steel
prices when developing their (typical) five-year program pricing.
Accordingly, raw material price volatility issues in the automotive
industry have begun to abate as OEMs take on more commodity
risk. Boeing has implemented similar procurement programs for its
suppliers. Other industries will need to follow suit.
The first response by the investment community to the increased
volatility of historically stable commodities was to create
countless new derivative products that would provide raw material
consumers with the ability to hedge their commodity risk. The new
commodity contracts that have become available are primarily
focused on ferrous materials, which include scrap metal, hot
rolled steel coil, and steel billets. Many of these contracts will
become more useful as liquidity improves due to greater trading
volume. Many of these products are somewhat complicated
to deal with, or represent imperfect hedges at best. Addressing
the specific correlations of the derivative products relative to
published commodity prices or how to structure the hedging is
outside the scope of this article. However, suffice it to say, under
GAAP accounting, a hedging instrument must reach a minimum
threshold of 80% correlation to the underlying asset in order to
qualify for hedge accounting treatment.
That leaves the most important question for any member of
a supply chain: Should I be hedging? The quotation marks
are used to emphasize that hedging commodity risk does not
necessarily mean buying financial instruments on the London
Metals Exchange or with the CME Group. We have developed a
simplified chart to decide whether a company should consider
hedging commodity risks. In several cases, the commodity risk
may not be worth hedging or, more importantly, there may be a
more cost-effective way of managing the risk.
The chart below provides a preliminary analysis on dealing with
commodity risks.
The top of the chart depicts the way your customer buys from you:
Either they are buying on a fixed price basis or a floating price basis
(where such floating price is tied to your price of raw material input).
The left-hand side of the chart depicts how you buy raw material
from your suppliers: Either you can fix your purchase price or you
are required to accept a floating price based on spot commodity
prices. Each quadrant of the chart has a diagonal line that
separates the response to price fluctuations. The lighter portion
to the upper right provides the correct response assuming a low
manufacturing yield (we have arbitrarily chosen 50% to make the
point) and the lower left provides the solution if your manufacturing
yield is quite high (we have chosen 98% to illustrate).
Example: A metal stamper has two different customers
requesting two different products. Customer A is
requesting a perfectly square stamped part that the
stamper can produce with only a 2% scrap rate.
Customer B is requesting a round part with hole cutouts
that will result in a 50% scrap rate.
If Customer A will agree to a guaranteed price and the
stamper can x his raw material price from his supplier,
there is no need for the stamper to hedge either its
exposure to Customer A or the price it will get for its
scrap. Both are known at time of pricing and thus can be
built into the cost and revenue estimate.
However, Customer B will not agree to a xed price, but
would rather pay based upon whatever the market is for
that particular product at the time of delivery. In this case,
the stamper may want to protect itself against adverse
changes in both the price Customer B will pay and
what it will be able to sell its scrap for post-production,
depending in part upon the time period between quote
and delivery.
Fixed Customer
Fixed
Supplier
Floating
Supplier
Floating Customer
Note: Assumes customer does not pay on yield loss
Do Nothing
Do Nothing
Hedge Sale
Fluctuation
Hedge Yield
Loss
Hedge
Purchase
Hedge
Yield Loss
Hedge Sale
Fluctuation and
Yield Loss
Hedge
Purchase
50%
Yield
98%
Yield
2013 30
If the solution is to hedge, a small manufacturer need not open up
a trading account with a brokerage firm. Many trading companies
exist to provide solutions to hedging issues on a smaller scale,
taking upon themselves (for a fee) the commodity price risk for
small manufacturers. Using an outside trading company can be
more expensive than hedging the exposure yourself, but the benefit
can be greater flexibility and peace of mind that an experienced
partner is handling the market transactions.
This chart provides a possible framework to hedge exposure in a
typical manufacturing process. Each situation need to be analyzed
independently. For example, manufacturers of products made
with precious metals often do not even own the inventory in the
manufacturing process. It is common for gold product producers
to lease the material or borrow the metal from a commodity trading
lending institution and purchase it upon shipment to their customer
when the market price is set by the current trading price. They do
not need to concern themselves with the cost of the raw material,
except for how it affects demand.
Commodity price fluctuations are not going away anytime
soon and volatility will likely increase before settling down. The
issue of dealing with raw material cost volatility should not be
ignored or passively accepted. Managing inventory and raw
material price risk will be an important part of maintaining a healthy
business for years to come.
Vincent J. Pappalardo is a Managing Director in the Investment
Banking Group at Stout Risius Ross (SRR). In that capacity, he
focuses on mergers and acquisitions advisory for companies
in the production and distribution of both ferrous and
nonferrous metals and alloys, as well as on diversified industrial
sectors. Mr. Pappalardo can be reached at +1.312.752.3392
or vpappalardo@srr.com.
Christopher A. Merley is a Vice President in the Investment
Banking Group at Stout Risius Ross (SRR). His investment banking
experience includes mergers, acquisitions, leveraged buyouts,
capital raising and strategic advisory assignments for privately held,
middle market companies and publicly traded corporations. Mr.
Merley can be reached at +1.312.752.3319.
SRRs resources for Financial Sponsors & Institutional Investors include:
Timothy F. Cummins
n
tcummins@srr.com
n
+1.312.752.3305
nn
Valuations for financial and tax reporting
nn
Fairness opinions
nn
nn
ERISA 103(b)(3)(A) requirements
nn
Evaluation of strategic alternatives
nn
Portfolio valuation services
nn
Mergers & acquisitions advisory
nn
Private market financings (debt and equity)
nn
Litigation advisory
Facing increased
valuation scrutiny?
Neil Steinkamp, CVA, CCIFP, CCA nsteinkamp@srr.com
Alexandra C. Pierce, CPA apierce@srr.com
2013 32
Two is Better Than One:
Even a Simplified Analysis of Ordinary in
the Industry is Better Than None at All
Siegel v. Russellville Steel (In re Circuit City Stores Inc.)
1
uniquely
demonstrates the challenges of proceeding with a preference case
in which certain defenses are not developed for trial. Many times,
counsel and client may consider the objective ordinary course
of business defense of 547(c)(2)(B) of the Bankruptcy Code,
2

which provides that a transfer cannot be avoided as a preference
to the extent it was made according to ordinary business terms,
only to rule out such a defense due to the cost associated
with preparing an extensive analysis. However, while certain
preference actions may require a complex and sophisticated
analysis of ordinary industry terms, a basic analysis of the
objective ordinary course of business defense can often be
developed with limited cost.
3
Significant updates to the Bankruptcy Code were made as part of
the enactment of the Bankruptcy Abuse Prevention and Consumer
Protection Act of 2005 (BAPCPA), which eased the burden of
proof required of creditors in bankruptcy preference actions. Prior
to BAPCPAs enactment, 547(c)(2) required creditors to prove
that the transfer at issue was both ordinary between the debtor
and the transferee (the subjective test) and ordinary in the industry
(the objective test). When BAPCPA became effective, the ordinary
course of business defense became less arduous to creditors as
they no longer had the burden of proving both measures. Rather,
they now only need to satisfy either the subjective test or the
objective test.
4
In In re Circuit City Stores Inc., although the payments made
during the preference period were delayed relative to the net-
30 agreement between the parties,
5
all payments throughout
the relationship were late, as the preliquidity days-to-pay window
ranged from 31-41 days. Other courts have held that late
payments can fall within the ordinary course of business exception
if the prior course of conduct between the parties demonstrates
that those types of payments were ordinarily made late.
6
Here,
the three payments during the preference period were made 45,
46 and 51 days after the invoice date, all of which exceeded the
preliquidity payment window. While some courts have opined
that [i]t seems ill-advised to rely too heavily upon a difference
of a few days,
7
the In re Circuit City Stores Inc., Court, stated
that the totality of the evidence that was presented, ruled that
the payments were not subjectively ordinary between the parties.
1
Siegel v. Russellville Steel (In re Circuit City Stores Inc.), 2012 WL 1981781 (Bankr.
E.D. Va. June 1, 2012).
2
Section 547(c)(2) provides as follows: (c) The trustee may not avoid under this section
a transfer (2) to the extent that such transfer was in payment of a debt incurred by
the debtor in the ordinary course of business or nancial affairs of the debtor and the
transferee, and such transfer was (A) made in the ordinary course of business or
nancial affairs of the debtor and the transferee; or (B) made according to ordinary
business terms; 11 U.S.C. 547(c)(2).
3
Although the Bankruptcy Code sets forth a number of defenses to a preference action,
this article will focus solely on the ordinary course of business defense of 547(c)(2).
4
4. Id. at *4.
5
Id. at *1.
6
Sulmeyer v. Suzuki (In re Grand Chevrolet Inc.), 25 F.3d 728 (9th Cir. 1994); Lovett v.
St. Johnsbury Trucking, 931 F.2d 494, 497 (8th Cir. 1991); Yurika Foods Corp v. United
Parcel Service (In re Yurika Foods Corp.), 888 F.2d 42, 44 (6th Cir.1989).
7
Brown v. Shell Canada Ltd. (In re Tennessee Chemical Co.), 112 F.3d 234, 237
(6th Cir. 1997).
2013 33
Peculiarly, despite the fact that this was a post-BAPCPA case,
the defendant in In re Circuit City Stores Inc. chose not to offer
any evidence regarding the objective ordinary course of business
defense outlined in 547(c)(2)(B).
8
The court noted that [s]ince
the defendant has the burden of proof the court treated the
potential defense afforded by 547(c)(2)(B) as abandoned.
9
It is
not known why the defendant did not present evidence pertaining
to the objective ordinary course of business defense. However, it
does appear that its absence focused the courts analysis solely
to the subjective ordinary course of business defense, which, as
noted, ultimately proved to be unsuccessful.
Had the defendant pursued the objective ordinary course of
business defense,
10
considerations may have included both
quantitative and qualitative industry analysis and research relating
to both the debtor and the creditor and their respective industries.
While defense counsel may consider proofs associated with
the objective ordinary course of business defense to be costly,
complex, sophisticated and requiring expert witnesses, this is not
necessarily true in all cases.
In fact, in certain instances, it is possible to identify significant
information to assist in presenting evidence in support of this
defense utilizing limited and less-costly measures. For example,
the defendant in In re Circuit City Stores Inc. could have
considered a quantitative industry analysis based on payment
days outstanding in the steel and electronics industry. As specific
details for payment days outstanding is often limited in common
research sources, similar metrics, such as accounts receivable
days outstanding (ARDO) and accounts payable days outstanding
(APDO) may be useful in evidencing ordinary industry practices.
Such standard industry metrics can be accessed from multiple
sources, including, but not limited to, Capital IQ, Dun & Bradstreet
and IBIS World. Contingent on the availability of data, defendants
can also define ordinary industry terms using information specific
to the debtor-creditor relationship. Suitable data could include the
creditors internal records with historical invoices and subsequent
payments, which establish a standard timeline in similar transaction
relationships with other similar companies.
11
Finally, the defendant
could have complemented the industry analysis with relevant
macroeconomic or industry-wide factors impacting the time
period under scrutiny. Market expansion, contraction and volatility
can all play an important role in short-term lending practices, as
well as the recessions impact on liquidity and consumer spending
on a macroeconomic scale.
Counsel and clients often believe that this data and the related
analyses are costly and complex. While this can be true, it does
not always have to be the case. In fact, much of the information
necessary to prepare an objective ordinary course of business
defense is available in the clients own records, online or from
other publicly-available sources.
If the defendant in In re Circuit City Stores Inc. had presented
an objective ordinary course of business analyses, there may
have been a different outcome. However, as the defendant
failed to present any evidence with respect to this defense, the
court was left only to consider its subjective ordinary course of
business defense.
Neil Steinkamp, CVA, CCIFP, CCA is a Managing Director in the
Dispute Advisory & Forensic Services Group at Stout Risius Ross
(SRR). He has extensive experience providing a broad range of
business and financial advice to trial lawyers and in-house counsel.
He has covered many industries and matter types resulting in
a comprehensive understanding of the application of damages
concepts and other economic analyses. Mr. Steinkamp can be
reached at +1.646.807.4229 or nsteinkamp@srr.com.
Editors Note: This article was originally published in the November
2012 edition of the American Bankruptcy Institute Unsecured Trade
Creditors Committee Newsletter.
8
Id. at *2.
9
Id. at *1.
10
Id. at *2.
11
For instance, if a debtor consistently pays invoices past their due date throughout the debtorcreditor relationship, these late payments can be considered ordinary although the
related contract may not agree. See, e.g., Payne v. Clarendon National Insurance Co. (In re Sunset Sales Inc.), 220.
Defer or Eliminate Capital
Gains Taxes by Selling Your
Company to an ESOP
Mark R. Fournier, CFA mfournier@srr.com
2013 34
On January 2, 2013, President Obama signed into law the
American Taxpayer Relief Act of 2012 (ATRA). ATRA, among
other provisions, combined with the expiration of the Bush tax
cuts result in a top marginal tax rate on capital gains of 20.0% for
individuals with taxable income over $400,000 per year ($450,000
for a married couple filing jointly) in 2013 (up from 15.0% in
2012). In addition, the Health Care and Education Reconciliation
Act of 2010 will impose a new 3.8% Medicare surtax on certain
investment income, including capital gains on the sale of a
business. As a result, business owners who sell their business
this year, and likely in future years, will be subject to significantly
higher taxes on their gains relative to recent years.
To highlight the potential magnitude of this difference, the chart
to the right presents the potential combined federal and state
capital gains tax liabilities that will be incurred in 2013 relative to
2012 assuming the sale of a $50.0 million company for which the
business owner has no tax basis in the stock of the company.
For simplicity, the state capital gains tax rate is assumed to be
5%. However, states such as California and New York tax capital
gains at rates as high as 13.3% and 8.8% respectively. The higher
capital gains tax rate and Medicare surtax result in a $4.4 million
increase in the business owners tax liability in 2013 as compared
to 2012, or a 44% increase.
Benjamin Franklin once said that the only things certain in life
are death and taxes. While we cant speak to the former, a
properly structured sale of company stock to an employee stock
ownership plan (ESOP) can defer or eliminate capital gains tax
liabilities, including the Medicare surtax. Any business owner
considering the sale of his or her company in this era of higher
capital gains taxes should explore a sale to an ESOP.
ESOP Overview nnn
ESOPs are a type of defined contribution benefit plan (i.e., similar
to a 401(k) plan) that are designed to purchase and own company
stock of the employer. ESOPs are unique in that ESOPs are the
only employee retirement savings plan that the law permits to use
leverage to acquire the employer stock. Although ESOPs have
Impact of Higher Capital Gains Tax Rates
2012 Sale of 2013 Sale of
Company Company
Sale Proceeds $ 50,000 $ 50,000
Less: Federal & State
Capital Gains Taxes 20.0% (10,000) 28.8% (14,400)
Net, After-Tax Proceeds $ 40,000 $ 35,600
$ in thousands
2013 35
been around for decades, recent favorable legislation and greater
realization of their benefits by legal and financial advisors have
increased their popularity as a succession planning tool.
As a buyer of company stock, an ESOP is allowed to pay up to Fair
Market Value for the company stock. Fair Market Value is generally
interpreted to be what a financial buyer (e.g., a private equity fund)
would pay for the stock. As a result, the transaction price paid by
an ESOP for the company stock can be as competitive as other
financial buyers (and often more competitive on an after-tax basis).
In certain situations, a strategic buyer (e.g., a competitor) may
be willing to pay more than Fair Market Value for the stock. In
these situations, the strategic buyers offer will be higher on a
pre-tax basis than what an ESOP could pay. However, given the
tax advantages of an ESOP transaction, a strategic offer may not
always be higher than an ESOP offer on an after-tax basis.
According to the ESOP Association, there are approximately
11,500 companies in the U.S. that are owned in part or completely
by an ESOP. These companies collectively employ over 10.0
million people. In over 60% of these companies, the ESOP owns
more than 50% of the common stock outstanding.
While a sale of company stock to an ESOP can have numerous
advantages for the selling business owner, the management team,
the employees, and the company, the deferral of capital gains
taxes under Section 1042 of the Internal Revenue Code is an
attractive advantage that is even more important in a higher capital
gains tax rate environment.
Deferring Capital Gains Taxes nnn
The sale of company stock to an ESOP can be structured to defer
capital gains taxes and, if structured properly, capital gains taxes
can be deferred indefinitely. This tax advantage has become more
advantageous with the increase in long-term capital gains tax
rates and the Medicare surtax. As presented in the chart below,
if a business owner sells his stock for $50.0 million to an ESOP
instead of in a non-ESOP transaction, the business owner would
net an additional 40.5% or $14.4 million in after-tax proceeds,
assuming his stock had zero basis. Based on this example, the
business owner would have to sell his stock at almost a 40.5%
premium (or $70.2 million) in a non-ESOP transaction before his
after-tax proceeds would be equivalent to the sale to an ESOP.
The primary requirements to qualify for the tax deferral are:
n The company must be treated as a C corporation for
tax purposes at the time of the transaction.
n The seller must have held his stock for at least three
years prior to the sale.
n The ESOP must own at least 30% of the value of the
companys stock following the transaction.
n The proceeds from the sale of stock to the ESOP
must be invested in qualied replacement property
(QRP) within 12 months from the date of sale.
QRPs are securities of domestic operating corporations. This
includes the corporate stocks and bonds of public or private
companies. The seller defers capital gains taxes until the sale of
the QRPs. Only the QRPs that are sold are taxed, allowing the seller
to spread the tax over his lifetime or potentially eliminate the tax
completely if the QRPs are retained until death since the property
would transfer to his heirs with a stepped-up basis. One additional
option available in connection with the QRP requirement is to
purchase floating rate notes with long maturities (30 to 60 years)
and high credit quality. The seller can then receive the interest
from these notes until his death or find a financial institution to
offer him a margin loan against the QRPs. This would allow the
selling shareholder to use the proceeds of the margin loan as he
desires. Not only has the owner deferred or potentially eliminated
capital gains taxes, but he has also diversified his investments.
Conclusion nnn
Tax rates are increasing, including taxes on capital gains, which
will dramatically lower after-tax proceeds for anyone who sells
their company in 2013 and likely for years to come. ESOPs are
an often overlooked and under-utilized liquidity tool. In the right
circumstances, ESOPs are an advantageous succession planning
tool that provides a number of benefits over more traditional
succession planning techniques. During this period of rising taxes,
especially increasing taxes on capital gains,
the sale of stock to an ESOP can both
create a liquidity event for the business
owner(s) and dramatically minimize the tax
consequences of a transaction of stock
relative to other typical liquidity events.
ESOPs are gaining in popularity as a
succession planning option as attorneys,
accountants, and other company advisors
become more aware of their benefits over
traditional succession planning techniques.

Benefit of Tax Deferred Sale to an ESOP
Sale to Non
ESOP Entity -
Sale to an Sale to Non- 40.5%
ESOP ESOP Entity Premium
Sale Proceeds $ 50,000 $ 50,000 $ 70,225
Less: Federal & State
Capital Gains Taxes 0.00% 0 28.8% (14,400) 28.8% (20,225)
Net, After-Tax Proceeds $ 50,000 $ 35,600 $ 50,000
$ in thousands
2013 36
Unfortunately, too few business owners and their advisors explore
this option as part of the succession planning process. While
ESOPs are not the ideal option in every situation, they are worthy
of consideration as a succession planning technique given the
numerous benefits available to all company stakeholders.
Mark R. Fournier, CFA is a Managing Director in the Valuation
& Financial Opinions Group at Stout Risius Ross (SRR). He
has extensive experience providing fairness and solvency
opinions for corporate acquisitions and divestitures; going-
private transactions; leveraged buy-out transactions; leveraged
recapitalizations; and related party transfers. He also has extensive
experience with Employee Stock Ownership Plans including ESOP
security formation; transaction analysis; determination of
transaction fairness and adequate consideration; and annual
valuation updates. Mr. Fournier can be reached at +1.703.848.4946
or mfournier@srr.com.
Will an ESOP achieve
your liquidity needs?
Robert S. Socol
n
rsocol@srr.com
n
+1.312.752.3335
By completing over 1,000 ESOP engagements, SRRs ESOP professionals have
extensive experience in some of the most innovative and complex transactions
involving cutting edge structures.
nn
Pre-ESOP planning
nn
ESOP formation
nn
ERISA compliance
nn
Exit
Uncovering Hidden Value
in Family Businesses
2013 38
Guest Article
Norbert E. Schwarz
The Family Business Consulting Group, Inc.
schwarz@efamilybusiness.com
Many family business corporations are missing a potentially
valuable resource for both the business and the family. Owner/
managers, whether they are founders or successors, should
consider diversifying their board to include independent directors
if they have not done so already. Such a move is particularly
valuable if they are considering transitioning the business to the
next generation.
Our research has shown that only 10 to 15 percent of
mid-sized family-owned companies have significant independent
director representation on their boards. When one considers the
significant benefits of having independent directors, it is difficult
to understand why so many family businesses avoid this resource.
A well-structured board with independent director representation
can benefit the family business in many ways, as outlined.
1
I
As a vehicle to establish a more permanent and professional
form of corporate governance. This can be particularly
beneficial in situations where family-only boards have had
little or no experience as outside directors in other businesses.
Family businesses seeking to professionalize their board have
benefited greatly from having experienced directors available
to guide them through the governance process.
2
I
As mentors and confidants for next-generation managers
in the business. Experienced outside directors can be
particularly valuable in assisting relatively inexperienced next-
generation leaders in becoming more effective in a shorter
period of time. A board with outside directors also has a
better chance of establishing CEO accountability than does
an purely insider, or all-family, board. The outside directors
can play a major role in monitoring top executive performance
and accountability throughout the company as well. This
frequently adds to greater overall credibility of the governance
process with ownership and the maintenance of trust between
shareholders and management.
3
I
As a networking source. Outside directors often have
at their disposal a wealth of contacts, and can share these
contacts and resources with the company they serve. In many
cases, independent directors have shared valued sources
of professional services (e.g., accounting, legal, financial
advisory, etc.). I am also aware of numerous instances where
an outside director has directed the company to profitable
sources of new business and offered recommendations on
improving the marketability of company products and services.
2013 39
Norbert E. Schwarz
The Family Business Consulting Group, Inc.
schwarz@efamilybusiness.com
4
I
As experienced executives. Experienced outside directors
can provide a been there, done that input into major business
decisions. Whether the experience brought to the table is as a
result of successful strategy or lessons learned from a decision
that did not turn out well, such candid reflection by independent
directors could be invaluable to both new and seasoned CEOs.
5
I
As a sounding board. Qualified outside directors offer
management a dedicated body of experienced executives to
bounce ideas, problems, solutions, and opportunities off of in
a highly confidential setting. Active outside directors will offer
challenging questions to owners and management on current
and proposed directions for the company. The CEO can feel
comfortable brainstorming with directors in a manner he/she
may not be able to do with others.
6
I
As strategic consultants. Independent directors are a
valuable source of constructive challenge to managements
thinking on a wide range of strategic issues. Experienced
directors are the individuals best able to challenge and expand
the view from the top. Good directors are strategic thinkers
willing to share their perspectives and offer practical options
and strategies. Behavioral psychologists are well aware of the
self-doubts that frequently set in once decisions are made
doubts as to whether the decision was the best one. In addition
to challenging the decisions before they are made, outside
directors can be helpful in reinforcing good decisions that are
suffering temporary setbacks.
7
I
As a source of added credibility. A well-designed outside
board can add an element of credibility to the existing
credentials of the company. Having a board with independent
directors sends the message that the company is serious about
establishing a professional management process starting
at the top of the organization. In some cases, a good board
can also give comfort to a bank considering granting credit
facilities to a marginally performing company or a company in
a high-risk industry. In fact, a strong audit committee staffed
by experienced outside directors is becoming a must in many
companies seeking outside capital. Some external auditors are
also recommending audit committees with outside directors as
a part of their management letter recommendations.
An independent board can be a valuable asset to the family
business. However, like any other working asset, the business
needs to have the right people in place. Selecting appropriate
candidates for your board can be a difficult but ultimately
rewarding experience. Some of the keys to establishing an
effective independent board include the following:
n Commitment to the process. Commitment is the
most important element in establishing an effective
board. Can the CEO and shareholders accept
perspectives on the business other than their own? Is
the CEO willing to be accountable to a collaborative
rather than an authoritarian process? Afrmative
commitments in these areas are critical to the
establishment of an effective independent board.
n Proper identication of key qualications. The
shareholders, in conjunction with senior management
and the existing inside board, should carefully
identify the skills, experience, and knowledge they
are looking for in independent director candidates.
Candidate qualications should include, but are not
limited to, listening skills, openness, willingness to
challenge, nancial literacy, and good communication
skills. Technical background requirements should
be geared to the strategic needs of the company.
Potential candidates should also be screened for
their commitment to a collegial process, networking
capabilities, potential chemistry with other board
members, and compatibility with the core values
of the family. It will also be important to determine
whether the candidates are willing and able to commit
the time and effort to the board process.
n Sincere understanding that roles and
relationships may have changed. The shareholders
must understand that their roles within the governance
process now include their relationship with the board
and independent directors. Shareholders need to
understand the priorities of the business so they may
elect the best possible slate of directors. In addition,
many families nd it effective to establish a process
that will relay ongoing family priorities to the board
and will likewise provide summary information to
shareholders after board meetings. This will help to
ensure that all shareholders feel both updated on
their business and comfortable that the directors are
serving their best interests.
n Careful selection of trusted advisors. If outside
resources are utilized to identify candidates,
those resources should be very familiar with the
shareholders and the company. When I have recruited
effective independent directors, personal chemistry
with the family and existing board members has been
a very important factor in the overall equation.
2013 3 2013
While all this may at first blush feel like an onerous amount of
work, our research and experience tell us the investment that
family businesses make in a professional governance structure
that includes independent, outside directors provides some of
the best possible returns in terms of both business success and
family harmony. Furthermore, whatever work is needed to prepare
for a board (work that includes providing the materials and
information that directors will require on a regular basis for proper,
effective oversight) is the same work and structure that will be
needed to continue to grow and add value to the family business
into future generations.
Norbert E. Schwarz is Senior Advisor and one of the founding
shareholders of The Family Business Consulting Group, Inc. His
practice focuses on the business and the family, specializing in
governance issues, ownership and management planning, and
transitioning the family business. Mr. Schwarz can be reached at
+1.224.848.7241 or schwarz@efamilybusiness.com.
n
n
Private market financing (debt and equity)
n
Corporate strategic alternatives and
succession planning
n
Fairness opinions
n
n
Litigation advisory related to:
n
Dissenting shareholder actions
n
Shareholder and commercial disputes
n
Post-transaction purchase price disputes
Who do you trust to ensure the
success of your critical transactions?
Thomas J. Hope, CFA
thope@srr.com
+1.646.807.4223
Jeffrey M. Risius, CPA/ABV, CFA, ASA jrisius@srr.com
Jesse A. Ultz, CFA jultz@srr.com
41 2013
The Orchard Enterprises, Inc.:
The Delaware Court Analyzes Valuation and
Whether or Not Only a Bum Would Utilize the BUM
The Orchard Enterprises, Inc. (Orchard or the Company) is
a company that generates revenue from the retail sale (through
digital stores such as Amazon and iTunes) and exploitation of its
controlled, licensed music catalogue. In March 2010, Orchards
controlling shareholder, Dimensional Associates, LLC, offered to
cash out the minority shareholders at a price of $2.05 per share.
As part of the contemplated transaction, Orchard hired a financial
advisor to issue a fairness opinion that the offer of $2.05 was fair
to the minority shareholders from a financial point of view. After
performing a variety of financial analyses, the Company received
a signed fairness opinion and proceeded with the transaction. On
July 29, 2010, Dimensional Associates, LLC took the Company
private and cashed out the minority shareholders at a price of
$2.05 per share. It should be noted that a majority of the minority
shareholders of Orchard voted in favor of the going private merger.
Subsequent to the deal, certain minority shareholders of Orchard
filed suit, claiming that their shares were actually worth $5.42 as
of the date of the transaction. By contrast, the Company claimed
that the merger price was generous and that the shares were
actually only worth $1.53 each. This case was taken before the
Delaware Court of Chancery (the Court) to decide on the Fair
Value of the minority shares in a statutory appraisal action that
took place in 2012. Like many recent cases that have come
before the Court, this case provides some important insights into
the valuation process that other experts should be aware of going
forward, particularly when testifying in Delaware.
While the Court addressed many issues between the experts in
its 55-page opinion, this article is going to focus on the two most
significant valuation issues that impacted the conclusions in this
case. The most hotly contested issues were the treatment of the
preferred stock of Orchard and the appropriate discount rate to
be used in the Discounted Cash Flow (DCF) analysis.
Treatment of Preferred Stock nnn
Based on the capitalization of Orchard, the preferred stockholders,
who were also the controlling common shareholders, had the
right to a $25 million liquidation preference upon the occurrence
of certain events (e.g., liquidation, change of control). Given that
the transaction that was the subject of this proceeding was not a
liquidation or change of control, the liquidation preference was not
triggered by the going private transaction. However, the expert for
the Company subtracted the value of the preferred stock from
the total value of Orchard in order to derive the common equity
value. After a review of the terms of the preferred stock, the Court
disagreed with this position. The Court stated that, For purposes
of an appraisal proceeding, fair value means the value of the
company to the stockholder as a going concern, rather than its
value to a third party as an acquisition. The court should consider
all relevant factors known or ascertainable as of the merger date
that illuminate the future prospects of the company, but any
synergies or other value expected from the merger giving rise to
the appraisal proceeding itself must be disregarded.
n
n
Private market financing (debt and equity)
n
Corporate strategic alternatives and
succession planning
n
Fairness opinions
n
n
Litigation advisory related to:
n
Dissenting shareholder actions
n
Shareholder and commercial disputes
n
Post-transaction purchase price disputes
42 2013
Based on the facts and circumstances of the Companys preferred
stock, the Court noted that, Unlike a situation where a preference
becomes a put right by contract at a certain date, the liquidation
preference here was only triggered by unpredictable events
such as a third-party merger, dissolution, or liquidation. Most
important, according to settled law as originally set forth by the
Delaware Supreme Court in Cavalier Oil Corporation v. Harnett,
the petitioners are entitled to receive their pro rata share of the
value of Orchard as a going concern. This means that the value of
Orchard is not determined on a liquidated basis, and the company
must be valued without regard to post-merger events or other
possible business combinations. The Court concluded that
because the liquidation preference was only applicable upon a
sale or liquidation of the Company, it was not consistent with the
going concern premise that is required in an appraisal proceeding.
The Court noted that in prior cases, where preferred stockholders
had the right to put their shares back to the Company and obtain
their liquidation preference, the going concern value of the
company as of the date of the merger had to take into account the
detriment to common equity of the non-speculative obligation of
the company to pay out the liquidation preference. However, in this
case, the Court stated that, if Orchard remains a going concern,
the preferred stockholders claim on the cash flows of the company
(if paid out in the form of dividends) is solely to receive dividends
on an as-converted basis. That is, in the domain of appraisal
governed by the rule of Cavalier Oil, the preferred stockholders
share of Orchards going concern value is equal to the preferred
stocks as-converted value, not the liquidation preference payable
to it if a speculative event (such as a merger or liquidation) that
Cavalier Oil categorically excludes from consideration occurs . . .
Thus, Cavalier Oil makes clear that in an appraisal action, the
petitioners are entitled to their proportionate interest in a going
concern. Importantly, this means that the value of the company
under appraisal is not determined on a liquidated basis, and the
company must be valued without regard to post-merger events or
other possible business combinations.
Based on this ruling by the Court, it is clear that the specific terms
of any preferred stock need to be analyzed carefully in a valuation
given the going concern nature of a statutory appraisal action. If
the preferred stock holders do not have the right to obtain their
liquidation preference without the occurrence of speculative
future events, it may not be appropriate to subtract the preferred
liquidation amount in order to value the common equity.
Discount Rate to be Utilized in the DCF nnn
The largest disagreement between the opposing experts in the
DCF analysis related to the appropriate discount rate to be used.
Each expert utilized three different methods to derive a discount
rate: the capital asset pricing model (CAPM), the build-up model
(BUM), and the Duff & Phelps Risk Premium Report model
(another form of the traditional BUM). As will be discussed, the
Court ultimately ruled that CAPM is the accepted model for valuing
corporations while the BUM is purportedly not accepted by
mainstream corporate finance (despite the fact that both experts
employed two versions of the BUM).
CAPM vs. BUM n
Before even analyzing the specific inputs and assumptions in
the discount rates determined by the experts, the Court spent a
significant amount of time analyzing the methods themselves, and
effectively eliminating everything other than traditional CAPM. In
its lengthy ruling on this topic, the Court stated the following:
The build-up model is not, in my view, well accepted by
mainstream corporate finance theory as a proper way to come
up with a discount rate. Indeed, its components involve a
great deal of subjectivity and expressly incorporate company-
specific risk as a component of the discount rate. This is at
odds with the CAPM, which excludes company-specific risk
from inclusion in the discount rate, on the grounds that only
market risk should be taken into account because investors
can diversify away company-specific risk. Relatedly, corporate
finance theory suggests that concern about the achievability
of the companys business plan and thus its generation of
cash flows should be taken into account by adjustments to the
cash flow projections, and not by adjusting the discount rate.
The build-up model, however, allows for a variety of risks to be
poured into the discount rate, including so-called projection
risk and other factors.
Because of these factors, this court has been at best
ambivalent about indulging the use of the build-up method,
and has preferred the more academically and empirically-
driven CAPM model when that can be applied responsibly.
In contrast to the build-up model, which has not gained
acceptance among distinguished academicians in the area of
corporate finance, the CAPM method is generally accepted,
involves less (but still more than comfortable) amounts of
subjectivity, and should be used where it can be deployed
responsibly. In deploying that method, this court has taken
into account, as it will here, evolving views of the academy
and market players regarding its appropriate application.
Despite the Courts claims that the BUM is not accepted by
mainstream corporate finance theory, several of the very books
that the Court cites as treatises in its opinion actually devote whole
chapters to the BUM and its application. The most prominent
sources include Ibbotsons SBBI Valuation Yearbook and Cost
of Capital: Applications and Examples, by Shannon P. Pratt and
Roger J. Grabowski. Notwithstanding the Courts decision in this
case, the BUM does appear to be a widely recognized method
to estimate the discount rate for a privately held company.
Nonetheless, if you are testifying in the Delaware Court of
Chancery, it is advisable to be aware of this claim by the Court so
that you are fully prepared to defend your analysis if you consider
the BUM in your DCF method.
43 2013
CAPM Components n
Even within CAPM, there are several areas of debate that the Court
addressed, as outlined in the following paragraphs.
Equity Risk Premium
For the third time in recent years, the Court determined that
when estimating the equity risk premium to include in CAPM,
the supply-side equity risk premium is more appropriate than the
historical equity risk premium. The Court stated that, Golden
Telecoms default acceptance of the supply-side equity risk
premium was recently embraced by this court in Gearreald v.
Just Care, Inc. In that appraisal action, Vice Chancellor Parsons
rejected the respondents use of a historical equity risk premium
under Golden Telecom, finding that the expert had provided no
persuasive substantive financial reason as to why the application
of a supply-side equity risk premium would be inappropriate.
Like the respondent in Just Care, Orchard has not provided
me with a persuasive reason to revisit the supply-side versus
historical equity risk premium debate. I therefore find that the
Ibbotson Yearbooks supply-side equity risk premium of 5.2% is
an appropriate metric to be applied in valuing Orchard under the
CAPM. Based on this ruling, it appears that anyone who would
attempt to utilize the historical equity risk premium in Delaware
had better have convincing empirical data that the supply side
is unreliable, as the Courts viewpoint on this topic appears to
continue to grow stronger.
Size premium
Like the equity risk premium, the size premium to be included in
CAPM has become an accepted component of a discount rate
analysis. In this case, the Court stated that, A size premium is
an accepted part of CAPM because there is evidence in empirical
returns that investors demand a premium for the extra risk of
smaller companies. While the existence of a size premium may
have a consensus, the level of the size premium is still being
contested. The appropriate size premium to utilize for small
companies continues to be analyzed in Delaware, with the
appropriateness of Ibbotsons 10th decile coming under scrutiny.
In this case, both experts relied upon the same size premium of
6.3% in their respective CAPM calculations of Orchards cost
of capital, which is the size premium for the broader 10th decile
published in the 2010 Ibbotson Yearbook. This analysis was well
received by the Court.
In the Orchard opinion, the Court stated that, The parties agree
that Orchard technically falls into sub decile 10z The Ibbotson
Yearbook size premium for sub decile 10z is 12.06%, which is
nearly twice the size premium chosen by the parties experts. But,
a rote application of the 12.06% premium to Orchard is improper
because the 10z sub decile includes troubled companies to which
Orchard, which is debt free, is not truly comparable. The Ibbotson
Yearbook does not exclude speculative or distressed companies
whose market capitalization is small because they are speculative
or distressed. Before one uses the size premium data for 10z, one
needs to determine if the mix of companies that comprise that
sub decile are in fact comparable to the subject company [One
of the experts] explained at trial that he was cautious to use the
10z sub decile because doing so would run the risk of including
companies in there that may be going through financial distress
or other situations that may, in fact, skew [the] size premium
numbers. Based on this ruling, any use of the Ibbotson 10z sub
decile (even if the company being valued technically falls into that
category) should be utilized with great caution given the attributes
of the companies included in that classification.
Company-Specific Risk Premium
The Court once again showed great skepticism toward any
inclusion of company-specific risk in the discount rate. The Court
went so far as to say that, I do not believe that a company-
specific risk premium should be used in a CAPM calculation of
a discount rate, especially in a case like this. To read into this,
the Court is stating not that this company does not warrant a
company-specific risk premium, but that no company does. This
implies that any expert testifying in Delaware should think twice
(or maybe three times) about including this component in a CAPM
analysis. While, once again, well-respected valuation treatises
(e.g., Cost of Capital: Applications and Examples) include a
discussion on the implementation of a company-specific risk
premium, the Court has shown a strong propensity to eliminate
this component of the CAPM consistently. As such, it would likely
be wise to incorporate this admittedly subjective assumption into
your DCF analysis in another way. In fact, the Court addressed
another method of adjusting a DCF analysis for company-specific
risks when it stated the following:
For a corporation that operates primarily in the United States
and where there are sound projections, the calculation of a
CAPM discount rate should not include company-specific
risk for the obvious reason that it is inconsistent with the very
theory on which the model is based. If there are concerns
about projection risk because the projections were generated
by an inexperienced management team, the companys track
record is such that estimating future performance is difficult
even for an experienced management team, or projections
seems to be infected with a bias, it would be better for the
expert to directly express his skepticism by adjusting the
available projections directly in some way, to make plain his
reasoning. Admittedly, this would involve as much subjectivity
as heaping on to the discount rate, but it would also force
more rigor and clarity about the experts concern
44 2013
In terms of projection risk, I suppose I can see the rough
utility of stress testing projections when they are from an
unreliable source. No doubt private equity and venture capital
firms use hurdle rates to see how far off the projections of
unproven managers can be for an investment to still make
sense. Having no way to directly adjust the cash flows in the
manner that some standard valuation treatises suggest is proper
(but do not explain how to do), some market participants no
doubt use the discount rate as a crude way of applying a doubt
factor to the projections. In this way, they are discounting, but
not coming up with a discount rate in a way consistent with
CAPM. Rather, they are conflating what is being discounted
with the discount rate.
Based on this analysis, it appears that the Court would prefer to
see an expert who has doubts about projected cash flows either:
1) adjust the projected cash flows; or 2) utilize multiple scenarios
for projected cash flows and then apply appropriate weightings.
In this case, the expert who was applying the company-specific
risk premium was involved with management in creating the
projections. As such, the Court did not find his testimony on
company-specific risk related to optimistic projections to be
credible. Further, according to the Court, all of the items that he
used to support his company-specific risk premium were known to
management at the time the projections were prepared, and were
therefore inherent in the various projections. Because the expert
already weighted the different projection scenarios based on his
own opinion, the Court determined that he had already dealt with
the projection risk. An expert must be careful not to double count
risk by probability weighting the cash flows and also applying a
company-specific risk premium.
Conclusion nnn
The Delaware Court of Chancery continues to be the leading
business court in the country, so valuation experts would be well
advised to consider the rulings that emerge in future valuation
projects. However, some of the rulings from the Court may be
influenced by a lack of convincing evidence and empirical research,
such that certain precedents could be overturned with the proper
support. As such, as the valuation industry continues to research
important components of our work such as CAPM, BUM, equity
risk premium, and size premium, it is critical for experts to stay
on the cutting edge in order to ensure the most current research
and practices are presented to the judges who are ruling on these
cases and helping to develop the business valuation profession.
Jeffrey M. Risius, CPA/ABV, CFA, ASA is a Managing Director in the
Valuation & Financial Opinions Group at Stout Risius Ross (SRR).
He specializes in valuation in a litigation setting. His experience
includes shareholder disputes, fraudulent conveyance matters,
transaction disputes, bankruptcy and reorganization, and other
litigation involving complex valuation issues. Mr. Risius can be
reached at +1.248.432.1240 or jrisius@srr.com.
Jesse A. Ultz, CFA is a Director in the Valuation & Financial Opinions
Group at Stout Risius Ross (SRR). He provides business valuation
and financial advisory services to public and private companies for
litigation, tax, and corporate matters. Mr. Ultz can be reached at
+1.248.432.1214 or jultz@srr.com.
Valuing Forbearance in
Fraudulent Transfer Actions
James H. Millar, Esq. WilmerHale james.millar@wilmerhale.com
45 2013
As a business descends into financial distress, it commonly
enters into discussions with its creditors concerning a viable
path forward to stave off a bankruptcy filing or liquidation. Either
as the first step in a series of agreements or as part and parcel
of a larger out-of-court restructuring, creditors often agree to
forbear from pursuing collection remedies against the company
or the collateral for a period. In return, the company may transfer
money or property to the creditors transfers that may or may not
reduce the companys obligations or incur additional debt. If, in
a subsequent bankruptcy proceeding, the estate representative
sues a given creditor for a fraudulent transfer based on the
receipt of the money or property or a fraudulent incurrence of
the additional obligation, then the creditor may well defend by
claiming that the forbearance provided value to the debtor.
Perhaps in conjunction with other benefits received by the debtor,
the creditor will argue that it gave reasonably equivalent value
and thus may defeat the fraudulent transfer action. In the resolution
to that litigation, the creditors liability may turn on whether and
to what extent a court ascribes value to the forbearance. Below
we discuss the legal and financial framework for addressing
that question.
The Legal Introduction nnn
Section 548(a)(1)(B) of the Bankruptcy Code the constructive
fraudulent transfer section states in relevant part that a
trustee may avoid any transferof an interest of the debtor in
property, or any obligationincurred by the debtor, that was
made or incurred on or within 2 years before the date of the
filing of the petition, if the debtor voluntarily or involuntarily
received less than a reasonably equivalent value in exchange
for such transfer or obligation and was insolvent on the
date that such transfer was made or such obligation was
incurred, or became insolvent as a result of such transfer or
obligation.
1
Section 548(d)(2) defines value as property, or satisfaction or
securing of a present or antecedent debt of the debtor, but does
not include an unperformed promise to furnish support to the
debtor or to a relative of the debtor. Value has been defined as
that which provides an economic benefit, either direct or indirect,
to the debtor.
2
However, whether the value provided in a given
case rises to the level of reasonably equivalent value requires
a more searching inquiry. There is no fixed mathematical
formula for determining reasonably equivalent value; rather, the
determination depends on all the facts of each case.
3
1
11 U.S.C. 548(a)(1)(B) (emphasis added).
2
Barber v. Iverson (In re Iverson), 2008 WL 2796998, at *5 (Bankr. C.D. Ill. July 21, 2008)
(citing Lisle v. John Wiley & Sons (In re Wilkinson), 319 B.R. 134, 138 (Bankr. E.D. Ky.
2004), affd 196 Fed. Appx. 337, 2006 WL 2380887 (6th Cir. 2006)).
3
First State Bank of Red Bud v. Ofcial Comm. of Unsecured Creditors (In re Schaefer),
2011 WL 1118666, at *4 (S.D. Ill March 28, 2011) (citing Barber v. Golden Seed, 129
F.3d 382, 387 (7th Cir. 1997)).
46 2013
Courts have routinely recognized that forbearance can comprise
a component of reasonably equivalent value with respect to a
fraudulent transfer analysis.
4
Two relatively recent cases, however,
show that courts at times reach a summary conclusion with respect
to valuing forbearance without readily providing significant detail
around the attendant calculations. These decisions demonstrate
that forbearance provides legitimate benefits to the debtor, but
they do not necessarily illuminate the path for parties that may
face the issue in the next case.
In In re Positive Health Management, the debtor operated a pain
management clinic in a building over which First National Bank
held a security interest.
5
The debtor, however, was not directly
obligated on the mortgage debt to the bank; rather, the bank had
a contractual relationship with a different entity.
6
Nevertheless,
the debtor made prepetition transfers directly to the bank,
which then did not pursue foreclosure or other collection efforts
against the property.
7
After the debtor filed for bankruptcy,
the Chapter 7 trustee sued the bank to avoid the payments as
fraudulent transfers.
8
After a trial to the bankruptcy court, the trustee argued to the
district court that the bank had received $367,681.35 in prepetition
payments, but the fair market rental value of the premises was
only $253,333.33.
9
Thus, the bank only gave value to the extent
of the rental value, and the difference between the payments and
the rental value the difference was $114,348.02 should be
avoided as a fraudulent transfer. The court disagreed, finding that
the record at trial showed that the debtor had received value for
the use of the building that is, the rental value and additional
value in the form of the banks forbearance from foreclosing on
the property.
10
That forbearance allowed the debtor to engage
in ongoing business operations to generate continued cash
flow.
11
Thus, while the court did not provide a detailed analysis,
it necessarily concluded that the forbearance provided reasonably
equivalent value to offset the $114,348.02 in payments above and
beyond the rental value.
In In re Propex, the debtor had entered into a prepetition secured
credit agreement with various lenders.
12
Thereafter, on Jan. 26,
2007, the parties amended the credit agreement by waiving the
debtors obligations to comply with certain financial covenants for
the fourth quarter of 2006 and relaxing the covenants for 2007 and
the first quarter of 2008.
13
In exchange, (i) the debtor made a $20
million payment, and (ii) the interest rate on the credit facility was
increased.
14
After the debtor filed for bankruptcy, the committee
brought suit alleging that the amendment was a fraudulent transfer
because the debtor received less than fair consideration for the
cash payment and interest rate increase.
15
On a motion to dismiss, the court quickly concluded that the
debtor had received reasonably equivalent value as a matter of
law with respect to the $20 million cash payment because that
payment satisfied antecedent debt on a dollar for dollar basis.
16

That conclusion is clearly correct as an application of black letter
law. But the court also had to consider the other aspect of the
transaction the interest rate increase.
With respect to the interest rate increase, the court found that the
waiver of the financial covenants for the fourth quarter of 2006 and
the relaxing of the covenants for the next five quarters constituted
reasonably equivalent value as a matter of law for the increase in
interest rate.
17
The committee argued that the waiver and covenant
relaxation had no value, as there was no chance that the debtor
could comply with the financial covenants (even as modified).
18
The court disagreed:
[T]he lenders could have declared Propex in default,
demanded immediate payment on all its obligations, and
pursued all the remedies available to them by virtue of the
default. By agreeing to forbear and to relax the financial
covenants, the lenders gave Propex breathing room an
opportunity to avoid default, to facilitate its rehabilitation, and
to avoid bankruptcy. The court holds that that opportunity
constitutes reasonably equivalent value for the interest rate
increase as a matter of law, irrespective of the fact that [t]he
breathing room turned out to be short-lived.
19
4
E.g., In re Schaefer, 2011 WL 1118666, at *5. See also Geron v. Palladin Overseas Fund (In re AppliedTheory), 330 B.R. 362, 363-64 (S.D.N.Y. 2005) (discussing Cuevas v. Hudson United
Bank (In re M. Silverman Laces), 2002 WL 31412465 (S.D.N.Y. Oct. 24, 2002) and holding that forbearance plus the transfer of a lien equates to reasonably equivalent value as a matter of law
with respect to a creditor that provided a cash loan and reasoning that the fact-based analysis used by other courts in similar circumstances is unnecessary).
5
Williams v. BBVA Compass Bank (In re Positive Health Mgmt.), 2012 WL 3929900 (S.D. Tex. Sept. 7, 2012) (hearing case after bankruptcy court had submitted proposed ndings of fact and
conclusions of law to district court).
6
Proposed Findings of Fact and Conclusions of Law Regarding Trustees Complaint for Avoidance of Transfers and Related Relief at 14, Williams v. BBVA Compass Bank (In re Positive Health
Mgmt.), 2012 WL 3929900 (S.D. Tex. Sept. 7, 2012) (No. 4:11-cv-03436), ECF No. 1.
7
In re Positive Health Mgmt., 2012 WL 3929900, at *1.
8
Id.
9
Id. at *3. Given that the debtor was not obligated on the mortgage debt to the bank, the payments could not fall within the denition of value as payment of antecedent debt.
10
Id.
11
Id.
12
The Ofcial Comm. of Unsecured Creditors of Propex v. BNP Paribas (In re Propex), 415 B.R. 321, 323 (Bankr. E.D. Tenn. 2009).
13
Id. at 323-24.
14
Id. at 324.
15
Id.
16
Id.
17
Id.
18
Id. at 325.
19
Id. (quoting Cuevas v. Hudson United Bank (In re M. Silverman Laces), 2002 WL 31412465, at *6 (S.D.N.Y. Oct. 24, 2002)).
47 2013
Interestingly, the court decided this issue on a motion to dismiss. It
did not, however, set forth in its opinion how it valued the interest
rate increase, on the one hand, or the breathing room, on the
other. Other courts may not be as willing to reach such conclusions
without more quantitative analysis on the relative valuations.
20

We thus turn to how valuation theory and methodology assist in
determining the value of forbearance.
The Financial Introduction nnn
Greek orator Antiphon noted more than 2,000 years ago that the
most costly outlay is time. Hundreds of years later Benjamin
Franklin transformed this into its common form when he wrote:
Remember that time is money. He that idly loses five shillings
worth of time loses five shillings, and might as prudently throw five
shillings into the sea. Indeed, perhaps in no time in history has the
adage Time is Money been more true than today.
However, if time is money, can the two be equated mathematically?
Indeed, fundamental to valuation theory is the concept that an
assets value must incorporate the risks inherent from the passage
of time. Value, generally, is the present value of expected future
cash flows. To arrive at that present value, one must apply
reasonable financial theory to compensate for the passage of time
and the expectation that there is risk in the outcomes that may be
achieved in the future.
In the context of distressed businesses, there are often strategic
risks that are faced and critical decision points. The results of
these decisions may result in businesses surviving or failing. The
efforts to restructure a business can involve many parties working
together to preserve what value may exist in the business, or can
be realized from its liquidation or sale. For lenders, one common
consideration is forbearance simply defined as a refraining from
the enforcement of something (as a debt, right, or obligation) that
is due.
21
However, conceptually, if the lender provides a business
with forbearance, it must receive something in exchange of
reasonably equivalent value. This, of course, raises the question:
What is the value of forbearance. From the perspective of the
debtor, one could ask What would a buyer pay for this option
in the market? or What would the company pay to secure this
option?
22
Of course, the answer involves a complex analysis
of specific facts and circumstances. A complete review of the
methods utilized and information considered for such an analysis
is certainly beyond the scope of this article. However, certain
concepts and calculations are worth considering.
One of the complexities in determining the value of forbearance
is that one must consider several perspectives and several
potential outcomes. Put simply, the value of forbearance could
be conceptualized as the difference between the present value of
expected future cash flows if forbearance is provided and the same
in the circumstance where forbearance is not provided. One could
certainly interpret the opinions of the court in In re Positive Health
Management and In re Propex, as reflective of this perspective.
While the courts did not offer a mathematical or financial method
to determine this value, they suggest that had the forbearance not
been extended, the circumstances would have been very different,
suggesting that value could be measured by the difference.
For these situations, valuation techniques can be employed that
consider the decision tree of reasonable outcomes. Decision
tree valuation techniques can be employed in a wide array of
circumstances, each having certain similarities:
n Real options
23
n Valuation of claims arising out of litigation
n Valuation of contingent assets/liabilities
For each of these, the valuation practitioner typically considers
certain assumptions or inputs to the calculation of value. While
the specifics of each methodology may include or exclude certain
factors, generally, the practitioner considers:
n The different events that are likely to occur under
certain scenarios
n The time it will take for those scenarios to develop
n The probability of the expected outcomes in
each scenario
n The cash ow associated with each of the
potential outcomes
n The risks associated with the receipts of those cash ows
The facts and circumstances often surrounding forbearance lead
naturally to the use of decision tree valuation techniques due to
the multiple potential outcomes and restructuring events that may
arise with or without forbearance. For example, in the circumstance
where forbearance is not received by the company the following
factors may apply:
n The business is able to make other arrangements and is
able to survive Probability: 10 percent
n The business is then able to take advantage of
certain circumstances allowing it to achieve superior
protability Probability 5 percent
n The business continues to struggle achieving only
modest protability Probability: 95 percent
n The business is unable to remain solvent and pay debts
as they become due, resulting in ling for bankruptcy
protection Probability: 95 percent
20
See, e.g., Ofcial Comm. of Unsecured Creditors v. Credit Suisse First Boston (In re Exide Techs.), 299 B.R. 732, 748 (Bankr D. Del. 2003) (denying a motion to dismiss and stating: The
value of the forbearance may constitute reasonably equivalent value, but only based on a showing of what the value of the forbearance was.); see also, e.g., Stillwater Natl Bank and Trust
Co. v. Kirtley, 299 B.R. 626, 638 n.50 (10th Cir. BAP, 2003) (stating with respect to forbearance that [i]ndirect benets that cannot be quantied do not constitute value.).
21
Forbearance Merriam-Webster.com, Merriam-Webster, 2012 (Web, Nov. 16, 2012).
22
Note that the value of this forbearance may be perceived differently by the creditor and debtor, depending on the circumstances.
23
Such as decisions to expand geographically, invest in a new manufacturing line or lay off employees to achieve greater capacity.
48 2013
Contrast this to the following set of outcomes if forbearance
is provided:
n The business is able to survive without any further
nancial accommodations Probability: 75 percent
n The business is able to capitalize on certain
circumstances and is able to achieve superior
protability Probability: 40 percent
n The business continues to struggle achieving only
modest protability Probability: 60 percent
n The business is able to survive but requires further
nancial accommodations in 6 months Probability:
25 percent
n The business further restructures and is able to
survive with modest protability Probability:
80 percent
n The business is unable to further restructure and is
required to le for bankruptcy protection
Probability: 20 percent
As illustrated in the scenarios herein, typically the first step in
developing an analysis using decision-tree valuation techniques
involves estimating the amounts and timing of the future cash
flows estimated under multiple scenarios. These amounts are
discounted to a present value utilizing a rate of return consistent
with the risk inherent in the projected cash flows. The present value
of the total cash flows in each scenario is then weighted based on
the probability of each scenario occurring, as projected.
24
In these
scenarios there is a significant amount of additional information that
would be required to reasonably estimate the value of forbearance
to the debtor. However, the application of this framework could
result in a reasonably certain estimate of the value of forbearance,
if applied correctly utilizing reasonable inputs. These scenarios
illustrate, as is common with distressed business, the significance
of the decisions that affect the business chance of survival and
profitability.
The decision-tree framework described herein provides for
flexibility not typically found in the Discounted Cash Flow Method.
However, decision-tree valuation techniques can also require
additional assumptions which can be challenging to quantify. In
addition, there are practical limitations to the number of possible
scenarios that can either be modeled or reasonably estimated.
As such, one must carefully weigh the benefits of additional
flexibility with the challenges and complexity of the resultant
financial models.
Conclusion nnn
Courts have made clear that forbearance has value. Further they
have stated that forbearance is an element of consideration when
reviewing reasonably equivalent value for purposes of fraudulent
transfers. That said, the published opinions have provided
little guidance as to the specific factors considered in valuing
forbearance or specific methods that are to be applied. However,
the essential characteristics of forbearance are similar to other
circumstances in which valuation theory is commonly applied.
In these circumstances, such as the valuation of claims arising
out of litigation (often considered a contingent asset or liability),
decision-tree valuation methodologies are employed to assess the
value of assets based on the probabilities, cash flows and risks
of cash flows associated with certain expected outcomes. This
analysis is certainly complex and requires a careful analysis of
available facts in any matter, however, the value of forbearance
can be determined if sensible inputs are applied reasonably.
James H. Millar, Esq. is a Partner in the Bankruptcy and Financial
Restructuring Practice Group at WilmerHale. He has extensive
experience in the areas of corporate restructuring and bankruptcy,
including representation of debtors, creditors committees,
and bondholders in Chapter 11 cases and representation of
industry players in cross-border insolvency matters, out-of-court
restructurings, bankruptcy-related litigation and insolvency-
sensitive transactions. Mr. Millar can be reached at +1.212.295.6411
or james.millar@wilmerhale.com.
(SRR). He has extensive experience providing a broad range
of business and financial advice to trial lawyers and in-house
counsel. Mr. Steinkamps experience has covered many industries
and matter types resulting in a comprehensive understanding
of the application of damages concepts and other economic
analyses. Mr. Steinkamp can be reached at +1.646.807.4229 or
nsteinkamp@srr.com.
Reprinted with permission from the December 3, 2012 edition of the New York Law
Journal 2013 ALM media Properties, LLC. All rights reserved. Further duplication without
permission is prohibited. For information, contact 877-257-3382, reprints@alm.com or visit
www.almreprints.com.
24
See generally Tom Copeland, Vladimir Antikarov, Real Options A Practitioners Guide (New York: Cengage Learning, 2003); Steven Kam, Annika Reinemann, Caroline Puiggali, Jason
Ruiz, The Valuation of Litigation, Valuation Strategies.
U.S. Bank National Association v.
Verizon Communications, Inc.:
The Importance of Reconciling Valuation Conclusions
Brian A. Hock bhock@srr.com
49 2013
A 10-day bench trial was concluded on October 26, 2012,
in the case of U.S. Bank National Association, as Litigation
Trustee of the Idearc, Inc. et al. Litigation Trust (Plaintiff),
v. Verizon Communications, Inc., Verizon Financial Services,
LLC, GTE Corporation, and John W. Diercksen (collectively the
Defendants).
1
This bench trial was conducted for the purpose
of the court deciding the following factual question: what was
Idearc, Inc.s (Idearc) value at the time it was spun off from
Verizon Communications Inc. (Verizon) in November of 2006.
2

Idearc was a wholly owned subsidiary of Verizon prior to a spin-off
on November 17, 2006 (the Valuation Date). Subsequent to the
spin-off, Idearc operated as an independent and publicly traded
company (NYSE:IAR) until filing a petition for reorganization under
Chapter 11 of the Bankruptcy Code in March 2009. The Idearc,
Inc. et al. Litigation Trust was created to pursue, among other
things, potential claims against the Defendants.
Both the Plaintiff and Defendants presented expert testimony
at trial as to the value of Idearc as of the Valuation Date. The
Plaintiffs expert considered several approaches, but placed
primary weight on a discounted cash flow method and testified
that the market price of Idearcs stock was unreliable. The
Defendants experts provided rebuttal testimony, arguing the
opposing experts assumptions resulted in primary weight being
placed on an approach that was a significant outlier in relation
to other valuation methodologies. This article focuses on the
courts interpretation of market information and other factors
as of the Valuation Date and the importance of reconciling
valuation approaches.
The Spin-Off nnn
On November 17, 2006, Verizon contributed its domestic print and
internet yellow pages directories publishing operations to Idearc
in exchange for approximately $7.115 billion in Idearc debt, $2.5
billion in cash, and 146 million shares of Idearc common stock.
In connection with the spin-off, Verizon transferred to Idearc
all of its ownership interest in Idearc Information Services LLC,
formerly Verizon Information Services, and other assets, liabilities,
businesses, and employees primarily related to Verizons
domestic print and internet yellow pages directories publishing
operations. As a result of the spin-off, Idearc was recapitalized
with approximately $9.1 billion in debt, as presented in the
following table.
3
1
U.S. Bank National Association, Litigation Trustee of the Idearc Inc. et al. Litigation
Trust, Plaintiff, v. Verizon Communications Inc., et al., Defendants, Civil Action No.
3:10-CV-1842-G. United States District Court, Northern District of Texas, Dallas
Division. January 22, 2013.
2
See Order of August 22, 2012 (docket entry 504).
3
Idearc Inc. Form 8-K/A dated November 16, 2006.
50 2013
Valuation Issues nnn
Plaintiffs Expert n
The Plaintiffs expert utilized three different approaches to
determine the enterprise value (EV) of Idearc as of the Valuation
Date. The approaches consisted of a method utilizing the EV to
earnings before interest, taxes, depreciation, and amortization
(EBITDA) multiples of a group of public companies ostensibly
similar to Idearc (the Market Multiple Method), a method
based on the EV to EBITDA multiples implied by transactions
involving public companies ostensibly similar to Idearc (the
Comparable Transaction Method), and a discounted cash flow
(DCF) method.
Summary of Conclusions
The following table summarizes the conclusions reached by
the Plaintiffs expert. As presented below, the Plaintiffs expert
calculated the weighted average of each methodology utilized
in order to determine the concluded range of EV. The Plaintiffs
expert concluded that the value of Idearc on November 17, 2006,
was $8.15 billion, the midpoint of that range.
When calculating the concluded range of EV, the Plaintiffs expert
only gave 15% weight to the Market Multiple Method due to: 1)
Idearcs inferior financial performance relative to comparable
companies; 2) the companies selected in this analysis were not
comparable enough to warrant higher weighting; 3) only one
comparable company, R.H. Donnelly, Inc., was an incumbent
print company operating in the United States; and 4) R.H.
Donnelly, Inc. received significant tax benefits in association with
a previous acquisition that would not be available to Idearc. The
Comparable Transaction Method was also given 15% weight
due to the Plaintiffs experts assertion that the 17 transactions
compiled by Houlihan Lokey,
4
which were utilized by the Plaintiffs
expert, did not involve reasonably comparable companies and the
fact that a Tax Sharing Agreement between Verizon and Idearc,
in the experts opinion, prevented Idearc from accessing the
transactions market.
Publicly Traded Value of Idearc
Idearcs common stock became publicly traded on the New York
Stock Exchange (NYSE) as a result of the spin-off. The Plaintiffs
expert did not include a determination of what EV would be as
implied by Idearcs trading price. The Plaintiffs expert testified
that investors overvalued Idearc because of the following alleged
misrepresentations and omissions made by Verizon: 1) Verizon
failed to disclose significant differences in EBITDA margins
generated by Idearcs incumbent print and electronic business; 2)
Verizon concealed year-over-year declines in revenue in specific
northeast urban markets; 3) management had consistently failed to
meet its projections, but had not disclosed the missed projections
to the market, which rendered Idearcs stock price unreliable;
and 4) Verizon did not disclose a pessimistic report prepared by
McKinsey & Company about the future prospects of the directories
business, which rendered Idearcs stock price unreliable.
Idearc Debt Post Spin-Off
Principal Interest
Outstanding Rate
Revolving Credit Facility [a] $ 0 6.9%
Tranche A Term Loan Facility 1,515 6.9%
Tranche B Term Loan Facility 4,750 7.4%
Senior Unsecured Notes 2,850 8.0%
Total Indebtedness $ 9,115
[a] The revolving credit facility has a $250 million capacity.
In Millions of USD

Reconciliation of Enterprise Value
Indicated Range of
Enterprise Value
Low High Weighting
Market Multiple Method $ 11.7 - $ 13.2 15%
Comparable Transaction Method 13.4 - 15.8 15%
DCF Method 5.4 - 6.3 70%
Concluded Range of Enterprise Value $ 7.5 - $ 8.8
Concluded Enterprise Value (Midpoint) $ 8.15
In Billions of USD
4
Houlihan Lokey, Inc. prepared an independent valuation analysis that was performed in connection with a solvency opinion for Idearc in 2006.
51 2013
Defendants Rebuttal n
The Defendants presented multiple experts to testify and offered
other evidence to rebut the case made by the Plaintiff. A few issues
highlighted by the Defendants are listed below.
n The Defendants expert testied that without correction,
the opposing experts DCF method resulted in a value
that was a signicant outlier in relation to the calculations
under the opposing experts Market Multiple Method and
the Comparable Transaction Method.
n The Defendants expert testied that typical valuation
practice, according to a treatise authored by Shannon
Pratt, dictates that in such a situation one would normally
do one of the following: 1) disregard the outlier; 2) weight
the outlier valuation lower than the other, more-consistent
valuations; or 3) inquire further into the model that
generated the outlier in order to determine what went
wrong in producing such an outlier.
n The Defendants also presented a demonstrative that
indicated the Plaintiffs experts DCF valuation resulted
in an EV multiple range of 3.5x to 4.2x Idearcs 2006
EBITDA, which were substantially below the EBITDA
multiples of Idearcs competitors.
n The Defendants expert testied that the closing price
of Idearcs common stock, as quoted on the NYSE,
was $26.25 per share on the Valuation Date. Idearcs
common stock was also traded on a when-issued basis in
the 11 days prior to the Valuation Date, trading between
$25.80 and $28.15 per share, with an average daily
trading volume of 1.45 million shares. Furthermore, the
Defendants expert testied that, based on Idearcs cash
and outstanding debt balances on the Valuation Date, the
total EV of Idearc implied by trading on the NYSE was no
less than $12.8 billion.
The Courts Findings nnn
The court addressed the multiple points of contention between
the opposing experts. The court stated that there is no dispute
that the Plaintiffs experts valuation of Idearc using the DCF
method produced an indication of value that was an extreme
outlier even within the experts own analysis (i.e., compared
to the indications of value via the Market Multiple Method and
Comparable Transaction Method). The court was not persuaded
that the DCF valuation provided by the Plaintiffs expert was more
reliable than these other methods, which showed that Idearc was
solvent on the Valuation Date. However, the court was persuaded
by the testimony of the Defendants expert, who showed that the
opposing experts valuation was flawed in significant ways with
respect to its most important inputs.
The court reviewed voluminous records in order to determine
whether material information was withheld from the market or
material misrepresentations were made to the market, as was
alleged by the Plaintiff. The court found that information the Plaintiff
alleged was withheld from the market was actually disclosed or
was immaterial to Idearcs value.
Ultimately, the court concluded that the total EV of Idearc on the
Valuation Date was at least $12 billion.
5

Reconciliation of DCF Value with Market
Indications of Value nnn
The Plaintiffs expert concluded on values via the Market
Multiple Method and Comparable Transaction Method that
were approximately 110% to 150% different than the value
indicated by the DCF method. This substantial difference clearly
supported the opposing experts claim that the DCF conclusion
was an outlier. While the Plaintiffs expert attempted to discount
the market approaches and the publicly traded value of Idearc,
the court found that the evidence presented by the Plaintiff was
not convincing enough to disregard the market indications of
Idearcs value.
The court found that the Plaintiffs expert utilized a DCF valuation
that relied on generally unsupportable methods and inputs, or
unsupportable combinations of methods and inputs. Furthermore,
the court found that the testimony of the Plaintiffs expert, that the
expert looked deeply at any potential flaws in the DCF valuation,
was not credible. The court took issue with the fact that the
Plaintiffs expert did the opposite of disregarding or assigning low
weight to the DCF method and actually assigned low weight to
the consistent valuations (i.e., the Market Multiple Method and the
Comparable Transaction Method).
The court also addressed the assumptions made by the Plaintiffs
expert in the DCF method. Specifically noting that the Plaintiffs
expert selected inputs that forced Idearcs value lower at nearly
every step in the DCF analysis.
Other Factors Contributing
to the Courts Decision nnn
Not every decision made by the court was based on the testimony
of the opposing experts. Other evidence was presented during
this trial that supported the Defendants case. Multiple forms
of evidence were presented that refuted the Plaintiffs claims of
Idearc being a harvest business that was dying and did not have
much growth potential. Furthermore, evidence was presented by
the Defendants supporting the market price of Idearcs stock,
given the information that was made available to the market.
Some of this evidence consisted of: memoranda submitted
to credit committees of Idearcs debt investors, analysis from
5
The court found it likely that $12.8 billion accurately represents the value of Idearc on November 17, 2006 and remains agnostic as to the precise nal gure, but nds it clear that Idearcs
value was at least $12 billion on the date of the spin-off.
2013 4 2013
Morgan Stanley presented to Verizon, the demand for Idearcs
debt securities resulting in an oversubscription of each tranche of
Idearcs debt, and independent valuation conclusions prepared by
major banks (i.e., Morgan Stanley, Citibank, and Goldman Sachs).
The court found that this evidence contradicted the Trustees claim
of Idearc attempting to present a false picture of its historical and
future prospects to the market. In addition, given the extensive
evidence presented, the Plaintiffs expert had less support for the
exclusion of the value of Idearc implied by its publicly traded stock.
Conclusion nnn
A tremendous amount of evidence was presented by both the
Plaintiff and Defendants for this bench trial. It should be noted
that the court did not explicitly opine that the market approach
is a preferred valuation methodology. However, the consistency
of the market indications of value in this case clearly outweighed
the Plaintiffs outlying DCF valuation conclusion. In any valuation,
the expert must evaluate the applicability of multiple valuation
approaches. Furthermore, the courts findings in this case
emphasize the importance of having appropriately reconciled
conclusions when utilizing multiple valuation approaches or having
supportable evidence for a valuation conclusion that implies a
significantly different conclusion from other methodologies.
Brian A. Hock is a Vice President in the Valuation & Financial
Opinions Group at Stout Risius Ross (SRR). He has provided
business valuation and financial advisory services for numerous
purposes. Mr. Hock can be reached at +1.248.432.1298
or bhock@srr.com.
SRR has significant experience assisting distressed
companies, stakeholders, and their advisors in both
out-of-court and in-court situations.
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363 Bankruptcy sales
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(debt and equity)
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valuation services
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recovery actions
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Expert testimony
Distressed?
Know your alternatives
to maximize or
preserve value.
Michael D. Benson
mbenson@srr.com
+1.248.432.1229
SRR is a trade name for Stout Risius Ross, Inc. and Stout Risius Ross
Advisors, LLC, a FINRA registered broker-dealer and SIPC member firm.
Appraisal Issues
Surrounding the
Leveraged
Reverse Freeze:
Consult with an Appraiser in
the Early Stages of Planning
Alex W. Howard, CFA, ASA ahoward@srr.com
Bradley A. Gates, CFA, CPA/ABV bgates@srr.com
53 2013
A freeze transaction is an estate planning technique that uses the
interplay of the differing financial and valuation characteristics
of preferred equity and common equity securities to transfer
assets from one generation to another while minimizing estate
and gift taxes. A reverse freeze is a wealth transfer strategy that
uses a limited partnership (LP) or a limited liability company
that is structured to have both preferred and common interests
(we will assume the use of an LP structure). In a reverse freeze
transaction, the transferred partnership interest is the preferred
interest. The preferred partnership (PP) interest is structured to
receive a preference return that is senior to any distributions made
to the common partnership (CP) interest. As discussed later, the
preference rate is tied to the risk profile of the partnership. The
preferred LP interest is generally structured to be cumulative and
compounding, so that the preference rate will compound for any
arrearages of preference payments not paid within a four-year
grace period. The common LP interest of the partnership only
shares in partnership income after the preferred payments have
been made to the preferred interest holder.
A leveraged reverse freeze, which is a modification of the
traditional reverse freeze, involves the sale of the PP interest to a
family member in return for a note or a transfer of the PP interest
to a grantor retained annuity trust (GRAT) or other estate
planning vehicle (both with interest paid at the applicable federal
rate (the AFR) or the Internal Revenue Code Section 7520 rate).
Generally, the seller or transferor of the PP interest retains the
CP interest in the partnership. Thus, the family member or GRAT
will receive a significant portion of the appreciation and cash
flow generated by the partnership in excess of the installment
payments or GRAT annuity payments, which is the ultimate goal
of a leveraged reverse freeze. For the reverse freeze strategy to
be effective, the preference rate for the PP interest necessary
to sustain a value equal to its face value should be significantly
higher than the AFR or the Section 7520 rate.
Appraisers have several important roles in leveraged reverse
freezes. These include: 1) acting as a consultant to the estate
planner regarding the structure of the partnership; 2) determining
the appropriate preference rate; 3) determining the percentage of
PP interests in the partnership; and 4) calculating the Fair Market
Value (FMV) of the CP interest, if required. Ideally, the family
should consult with the appraiser prior to forming the partnership,
rather than having to amend its agreement at a later date.
We will discuss these items later using a hypothetical example
that assumes that a husband and wife who own a portfolio of
assets consisting of corporate bonds, domestic stocks, and
government bonds are interested in a leveraged reverse freeze.
54 2013
History nnn
The freeze transaction has been around for many years.
Initially, these transactions involved operating companies that
recapitalized their capital structures into preferred and common
stock. The founders transferred the common stock and retained
the preferred stock. The preferred stock typically had voting
rights but was generally noncumulative and often did not pay its
dividend. The preferred stock represented a significant percentage
of the capital structure and the possibility of a dividend to the
preferred shareholders depressed expected earnings allocable
to the common stock. Of course, no dividends could be paid to
the common shareholders unless the preferred shareholders were
paid their dividends first.
In subsequent years, taxpayers could transfer passive assets
through transactions using either holding companies or
partnership interests. The 1987 Tax Court case, Estate of Harrison
v. Commissioner
1
, was a prime example of this technique. The
spectacular success of the taxpayers in that case led to provisions
of the Tax Reform Act of 1986, which prohibited transactions of
this type. The anti-Harrison provisions effectively ended planning
using interests that might be perceived as preferred securities.
For several years, the Internal Revenue Service failed to issue any
guidance on the definition of a preferred interest. In late 1990,
tax legislation authorized Chapter 14, Sections 2701 through 2704
of the Internal Revenue Code (the IRC), which sought to clarify
various aspects of preferred interests, retained interests, buy-sell
agreements, and applicable restrictions.
In essence, Chapter 14 set standards that must be met for a
preferred interest to be appraised at face value for valuation
purposes. They include paying a fixed rate of income after a safe
harbor and having market terms and rates. If these standards are
not met, the preferred interest will be valued at its FMV with that
amount being subtracted from the total value of the company.
Since the freeze involved the senior generation retaining the
preferred security and gifting or selling the common security to
the next generation, unintentional gift taxes could result based on
these new standards.
By contrast, the reverse freeze is appropriate in situations in which
assets are not expected to appreciate and involves the transfer,
through sale or gift, of the preferred interest and retention of the
common interest. The preferred security is expected to absorb
asset value and cash flow, thereby lowering the value of the
retained common interest.
Structuring the Partnership nnn
During the formation of the partnership, appraisers should work
with the estate planner to determine the optimal terms of the
partnership. Although most appraisers are not attorneys (and
cannot provide legal advice or legal opinions), there are several
important issues that can affect the ultimate efficacy of a leveraged
reverse freeze. These issues include:
1
I
the proportion of PP interests that can be issued
2
I
which asset types are most suitable for the maximum
benet of a leveraged reverse freeze
3
I
whether other provisions should be considered (for
example, payment-in-kind (PIK) interest)
Generally, planners use a fixed preference rate due to its simplicity.
Fixed rate comparables are more plentiful and are easier to study
than other, more complex, securities. It may be best, however, to
employ a floating preference rate or a participation PIK structure
when income is inadequate to allow for a market rate to achieve
the objective of a fairly valued PP interest. In addition, the PP
interest is generally cumulative and compounding.
Probably the greatest contributions an appraiser can make during
this portion of the planning are recommending the asset mix of the
partnership, the percentage of preferred securities in the capital
structure, and the preference rate. It is critical that the underlying
assets be able to support the required GRAT payments. Generally,
we advise our clients that a combination of risky and cash-flowing
assets (such as dividend paying stocks and corporate bonds)
are best for a leveraged reverse freeze strategy they provide
a healthy yield, but are still risky investments that may enable
high returns for the partnership and warrant a high preference
rate. The chart Reverse Freeze presents the initial ownership
of the partnership and a diagram of the flow of funds between
the GRAT and the partnership in our hypothetical example
involving a husband and wife.
In our example on the next page, we have assumed that the
husband and wife decide to form a partnership with a fixed
preference rate that is cumulative. In addition, they elect to
contribute $50 million in investment grade corporate bonds
(trading at par and yielding 6 percent) and $50 million of
dividend-paying stocks (with an expected appreciation rate of
8 percent and a dividend yield of 2 percent) to the partnership.
We typically would not advise the couple to include their
government bond portfolio, as these assets are often too
conservative for a leveraged reverse freeze. Upon formation of the
partnership, the couple will transfer the PP interest to a five-year
GRAT. Assume that the five-year Section 7520 rate is 3.2 percent.
1
Estate of Harrison v. Commissioner, T.C. Memo 1987-8.
55 2013
Preference Rate/Percentage nnn
The determination of the preference rate and the percentage
of the preferred class in the partnership are intertwined. The
greater the percentage of the partnership that is preferred, the
greater the preference rate must be, due to interest coverage
issues. Appraisers should advise the estate planner of the most
economically reasonable proportion of the partnership that may
be accounted for by PP interests. The limit to the proportion of PP
interests occurs when there is a reasonable probability that the
partnership will default on its preference payments. It is important
that appraisers run sensitivity analyses to determine this threshold.
The relationship between the preference rate and the percentage
of the preferred class can be modeled by calculating the pro forma
cash flow of the partnership and applying a minimum coverage
ratio based on the riskiness and volatility of the assets. The
coverage ratio depends, in part, on the stability of the underlying
assets of the partnership. The resulting cash flow is then divided
by a range of yields derived from an analysis of the bond and/
or preferred stock markets that will result in a range of preferred
interest values.
The chart How Much Preferred Interest Can the Partnership
Support? indicates the general relationship between the
characteristics of the assets held by the partnership and the
amount of preferred interest the partnership can support.
2
Internal Revenue Code Section 2701(d)(2)(c).
Reverse Freeze
Bonds Publicly Traded Stock
Heres a sample structure for the ow of funds between the grantor retained annuity trust (GRAT) and the partnership
First
Generation
Preference return
Class A preferred LP interest
99% Class B LP interest 1% GP interest
GRAT
GRAT
Beneciaries
(second generation)
Note interest (Section 7520 rate)
and principal
Limited
Partner (LP)
General Partnership
Limited Partnership
How Much Preferred Interest Can the Partnership Support?
A diversied portfolio of xed income and risky investments is ideal in the absence of high cash ow investments
Preference rate
P
r
o
p
o
r
t
i
o
n

o
f

c
a
p
i
t
a
l
Low
Low
High
High
Fixed income
Government bonds
Investment-grade debt
High-yield debt
Cash ow investments
Income-producing real estate
High-dividend equities and convertibles
High cash ow company
Producing/stable oil and gas
Risky investments
Low- or no-dividend equities
Hedge fund interests
Private equity interests
56 2013
In determining the preference rate, appraisers should consider
factors relating to the credit quality of the PP interest, as indicated
by distribution, total return, and asset coverage ratios, the terms
and provisions of the PP interest, and an analysis of the assets
of the partnership and its risk profile. Revenue Ruling 83-120
provides guidance for determining the preference rate. Rev. Rul.
83-120 was issued to
amplify Rev. Rul. 59-60, 1959-1 C.B. 237, by specifying
additional factors to be considered in valuing common and
preferred stock of a closely held corporation for gift tax and
other purposes in a recapitalization of closely held businesses.
Although a PP interest is not exactly the same as preferred stock
in a corporation, its structure is very similar the PP interest is
generally structured to have a liquidation preference and preferred
return that may only be paid from cash flow and asset appreciation.
Some of the issues that the appraiser should consider in setting
the preference rate are:
1
I
current market conditions
2
I
the underlying risk prole of the assets of
the partnership
3
I
the percentage of partnership interests that are
preferred versus common
4
I
the lack of marketability of the PP interest
Marketable securities portfolios tend to have low dividends but
high appreciation potential. At first glance, they might not appear
to satisfy the cash-flow requirement to pay preferred distributions.
However, the safe harbor allows for a four-year grace period in
making distributions.
2
The yield can be satisfied through capital
gains as well as ordinary income. This approach is based on total
return rather than current cash flow. Distributions can be made by
selling securities, equity participation, or a PIK.
To select an appropriate preference rate, we must first understand
the factors that impact the credit analysis of securities similar to
the PP interest. We will then assign the PP interest a credit rating
and analyze the yields of publicly traded securities with a similar
credit rating. To determine the applicable credit rating for the PP
interest, we conduct an analysis of various ratios (such as interest
coverage, return on capital, and debt ratio) of the partnership and
compare such ratios to publicly traded debt and preferred equity
securities. Ideally, we will locate publicly traded securities that
have features similar to the PP interest such as maturity, issuance
date, PIK feature, and conversion.
Given the factors discussed in Rev, Rul. 83-120 and based
on the expected profile of the partnership, the PP interest
frequently will be considered non-investment grade (although,
it is possible to have a lower yield than non-investment grade
securities depending on the partnerships underlying assets).
However, the reasonableness of the leveraged reverse freeze
structure can become questionable if the credit rating of the PP
interest is too low. Generally, we advise planners to structure the
partnership so that the proportion of preferred interests in the
partnership equates to a below investment grade credit rating
of BB or B. The combination of the preference rate and the
associated interest coverage ratio corresponding to a BB or
B credit rating should provide the appraiser with the proper
percentage of total PP interests.
In addition to the specific risk factors of a PP interest quantified
by credit analysis, other specific risk factors impact the
preference rate. These primarily relate to the PP interests lack
of marketability, lack of an indenture, potential for subordination
(if the partnership were to incur any debt), and lack of
industry or governmental regulation. These specific risk factors
serve to increase the preference rate beyond that of publicly
traded non-investment grade securities. Typically, we apply a
risk adjustment to the preference rate indicated by comparable
publicly trade securities in the range of 50 to 300 basis points
(in other words, a yield of 8 percent for a similar publicly traded
security would be adjusted upward by 0.5 percent to 3 percent to
account for these factors).
Assume that in our hypothetical example, we determined that 40
percent of the partnership interests should be PP interests having
a preference rate of 11 percent. If the partnership earns 5 percent
before income taxes, there will be enough income to satisfy the
preferred payment to the PP interest. At the end of the GRATs
term, the remainderman will receive the cumulative value of the PP
interest, tax-free (following a return of capital to the donor).
FMV of CP Interest nnn
Appraisers may also be asked to calculate the FMV of the
partnerships common partnership interests. This analysis
is generally the same as that applied for traditional family
limited partnerships (FLPs). In selecting the appropriate
discounts for lack of control and lack of marketability, appraisers
should consider:
1
I
the risk prole of the partnership
2
I
the subordinated nature of the CP interest
3
I
the projected distribution stream to the common
partnership interest
4
I
the term of the partnership
5
I
any voting rights afforded to the CP interest
The primary difference between our hypothetical CP interest and
a standard LP interest in a partnership without a PP interest is
the subordinated nature of the CP interest. The CP interest is
subordinate to the PP interest in that it receives distributions
only after the preference return payments have been made.
2013 5 2013
Further, upon liquidation, the CP interest will receive its liquidation
proceeds after the PP interest. All else equal, this subordination
will require discounts that are greater than for a traditional LP
interest in an FLP.
Alex W. Howard, CFA, ASA is a Managing Director in the Valuation
& Financial Opinions Group at Stout Risius Ross (SRR). He has
extensive experience in providing valuation opinions, transaction
services, and financial advice for middle market private and small
capitalization public companies. He has provided opinions for
corporate and estate planning; estate-, gift-, and income-tax
requirements; fairness opinions; mergers and acquisitions; and
employee stock ownership trusts, among others. He has advised
boards of directors and trustees regarding mergers and acquisitions,
reorganizations, and recapitalizations. Mr. Howard can be reached
at +1.713.221.5107 or ahoward@srr.com.
Bradley A. Gates, CFA, CPA/ABV is a Managing Director in the
He has extensive experience participating in financial analysis
and valuation of corporate securities and partnership interests
of private and closely held companies as well as publicly traded
corporations for estate-, gift-, and income-tax requirements;
fairness opinions; mergers and acquisitions; reorganizations;
financial reporting; litigation support; estate planning; and employee
stock ownership plans. Mr. Gates can be reached at +1.713.221.5108
or bgates@srr.com.
Who do you
trust with your
most important
clients?
Aaron M. Stumpf
astumpf@srr.com
+1.312.752.3358
Our Private Client services include:
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Business valuation
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Sale advisory and
succession planning
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Discount studies (FLP/LLC)
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Tax controversy and
expert testimony
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Real estate appraisal
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Forensic accounting
n
Complex illiquid financial
instrument valuation
Alan B. Harp, Jr., CFA, ASA
aharp@srr.com
2013 58
The Valuation of Oil and Gas Properties:
Are They Really Worth 3x Cash Flow?
Valuing oil and gas properties held by individuals or estates at three
times (3x) annual cash flow (3x Cash Flow) has been a widely
used rule of thumb for decades. More sophisticated users of the
rule might apply it only to working interests and apply a higher (say
5x) multiple for royalty or overriding royalty interests (ORRIs).
The convention is to simply multiply the trailing 12-month cash
flow figure generated by the subject property or collection of
properties by three (3) and the result presumably represents the
market value of such properties. Numerous CPAs and attorneys
have filed estate or gift tax returns using this methodology.
Furthermore, many bank trust departments regularly use this
methodology when valuing oil and gas properties.
Because the approach is so simple and avoids petroleum
engineering or appraisal fees, it is widely used, particularly for
smaller, nominal properties. However, this rule of thumb is often
applied in situations beyond its useful bounds and can result in
conclusions that differ dramatically from the actual market value
of the subject properties.
The Likely Origin of the 3x Cash-Flow Rule
of Thumb nnn
The 3x Cash Flow rule probably gained significant traction
decades ago in oil- and gas-producing regions like Texas and
Oklahoma where legacy oil fields had relatively predictable
declines. Property buyers probably set the acquisition standard
based on their expectation of field declines, and their desire
to create some margin for error (not having sufficient time or
resources to perform detailed due diligence) as well as earn a
spread for making a market in the interest. As the interests were
passed down through family lines and further fractionalized, the
cash flows were likely less material and the sellers often not
sophisticated enough to know whether they were receiving Fair
Value for their properties.
The Impact of Technology nnn
Technological advances in recent decades have increased the
value of oil and gas properties. The combination of horizontal
drilling with hydraulic fracturing have unlocked the enormous
shale plays the Barnett Shale in the late 1990s/early 2000s and
more recently the liquids-oriented Bakken/Three Forks and Eagle
Ford Shales during 2009 and 2010. This and other technology has
breathed new life into legacy oil- and gas-producing regions in the
U.S. Also, the advent of the auction houses such as EnergyNet,
Inc. (EnergyNet) or The Oil and Gas Asset Clearinghouse have
increased the efficiency of the market for oil and gas properties
resulting in higher values.
Potential Distortions in Valuation nnn
Sophisticated buyers and sellers of oil and gas properties know
that there can be significant value attributable to non-producing
properties. Use of the 3x Cash Flow multiple applied to a
collection of producing and non-producing properties implicitly
2013 59
gives little or no value to the non-producing properties. Consider a
1,000 acre mineral tract in the Eagle Ford or Marcellus shale that
has been producing cash flow of approximately $100,000 per year
from a non-shale depth. Under the rule, the minerals would have an
implied value of $300,000. A closer examination might show that
the property has significant upside potential related to the shale
play and that the lease bonus on the shale depth minerals alone
might approximate $2,500 to $5,000 per acre or $2.5 to $5 million
on a 1,000 acre tract. Clearly, the magnitude of such a lease bonus
(and the expected royalty cash flow stream from future production)
implies a substantially higher value for the property than the rule
of thumb approach.
Market Data nnn
In a recent issue of Oil and Gas Investor, Bill Britain, the president
and CEO of EnergyNet, reported that cash flow multiples on royalty
and ORRIs auctioned from January 2007 to June 2010 ranged
from a low of 54 months (4.5x annual cash flow) for Gulf Coast
properties (typically, short-lived properties), to about 90 months
or higher (7.5x annual cash flow) for Permian, Mid-Continent, and
ArkLaTex properties. The properties sold at auction are typically
broken into the lowest definable strategic unit and are therefore
undiversified and do not include a non-producing component.
Mineral portfolios that have upside potential through significant
non-producing acreage positions typically trade at higher valuation
multiples. In March 2010, Dorchester Minerals, LP, acquired a
diverse collection of producing and non-producing royalty and
mineral properties (the Maecenas properties) located in 206
counties in 17 states (mostly Texas and North Dakota) at about
11x annualized cash flow.
Conclusion nnn
Use of the 3x Cash Flow rule of thumb could grossly understate
value if the subject property base includes a significant amount
of non-producing minerals and especially if those minerals have
significant known upside potential (located in or near an active
shale play, for example). For smaller properties where engineering
studies are not available, the auction house data on specific
transactions is useful for valuation purposes, but such data is
not publicly available and is difficult to obtain. Ultimately, the
location and other characteristics of the subject properties (type
of interest royalty vs. working, diversification by geography and
by operator, upside potential, and years of production history)
should be considered in the valuation of the subject properties.
Alan B. Harp, Jr., CFA, ASA is a Managing Director in the
Valuation & Financial Opinions Group at Stout Risius Ross
(SRR). He has over 20 years of experience determining the Fair
Market Value of interests in closely held businesses. He has
provided valuations in a wide range of industries primarily for
estate, gift, and income tax purposes. Mr. Harp can be reached
at +1.713.221.5113 or aharp@srr.com.
Business
Services
Michelle M. Brower
mbrower@srr.com
Consumer
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aharp@srr.com
Financials
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jvansanten@srr.com
Owner and operator of hospitals
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Marine construction and
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Wandry v. Commissioner:
The Secret Sauce Estate Planners
Have Been Waiting For?
Tiffany B. Carmona Bessemer Trust carmona@bessemer.com
Tye J. Klooster Katten Muchin Rosenman LLP tye.klooster@kattenlaw.com
2013 62
Guest Article
Introduction nnn
A common estate planning technique is a transfer (by gift or sale)
to an irrevocable trust. If the transfer is of a hard-to-value asset,
such as an interest in a closely held business, the taxpayer risks
that the IRS will challenge the valuation of the transferred interest
and assert a gift tax deficiency.
As an example, suppose T desires to transfer by gift to
an irrevocable trust Ts interest in a closely held business,
Company. T retains a qualified appraiser to determine the value
of Ts interest in Company. Based on the appraisal, T transfers
that portion of Ts interest in Company that will make use of Ts
remaining gift tax exclusion. However, the IRS is not bound by
the appraisers valuation. Therefore, if it is determined that the
appraisal report understates the value of the transferred interest,
T will be required to pay gift tax.
Taxpayers have grappled with this dilemma for years. In many
instances, taxpayers counsel have attempted to draft around
the risks associated with a valuation challenge by making a
separate provision in the transfer documents for the portion of
the transferred interest that would trigger gift tax. The IRS has
challenged with mixed success these drafting fixes to the
valuation risk. While the first significant case, Commissioner v.
Procter, 142 F.2d 824 (4th Cir. 1944), held against the taxpayer,
recent cases have been more favorable. Indeed, the most recent
taxpayer victory, Wandry v. Commissioner, T.C. Memo 2012-88,
may be a game-changer on this issue altogether.
Procter and the Evolution of Formula
Allocation Clauses nnn
In Procter, the donor assigned to his children his remainder
interests in two trusts. To avoid the imposition of gift tax, the
assignment was subject to a qualification in the transfer document
that if it was later determined by a final judgment of a court of
last resort that any portion of the transfer would be subject to
gift tax, then the portion subject to gift tax would automatically
be deemed excluded from the conveyance and would remain the
donors property.
The Fourth Circuit held that this clause was ineffective to eliminate
a taxable gift. The courts holding speaks to a procedural defect
with the provision, namely, that the clause created a condition
subsequent that could not become operative until a final judgment
had been rendered, but once a judgment had been rendered, it
could not become operative because the matter involved had
already been concluded by such final judgment. Notwithstanding
that the decision turned on this narrow procedural defect, Procter
has been frequently misinterpreted to mean that a clause
cannot have an effect following the transfer. But it does not seem
that the Procter court went that far. Instead, the court in Procter
[held] that because the adjustment was intended to take effect
2013 63
Tiffany B. Carmona Bessemer Trust carmona@bessemer.com
Tye J. Klooster Katten Muchin Rosenman LLP tye.klooster@kattenlaw.com
subsequent to the courts judgment, it cannot avoid the imposition
of gift tax, because the tax is imposed on the judgment, and is
then final. Diana S.C. Zeydel and Norman J. Benford, A Walk
Through the Authorities on Formula Clauses, ESTATE PLANNING,
December 2010, at 4.
The misapprehension of the Fourth Circuits narrow procedural
holding in Procter caused many practitioners to avoid formula
clauses altogether that involve adjustments between the transferor
and the transferee in the event of a successful valuation challenge.
Instead, estate planners began to make use of formula allocation
clauses to address the revaluation risk. While Procter involved a
provision that resulted in the deemed exclusion from the transfer
of that portion of the interest that would trigger gift tax, formula
allocation clauses operate differently. Specifically, with a formula
allocation transfer, the quantity and identity of property that
is conveyed is certain and fixed at the outset, but the formula
allocation clause operates to adjust the allocation of that property
between two transferees based on the ultimate valuation of the
transferred property. The preferred transferee typically receives
that portion of the transferred property that has a value equal
to a fixed sum (such as the annual exclusion or the transferors
remaining gift tax exemption) and any excess would spill over
to a second transferee, which is a person or entity that would not
trigger gift tax, such as the transferors spouse (either outright or
in a qualifying marital trust), an incomplete gift trust, a charitable
organization, or a zeroed-out GRAT. Therefore, if a revaluation
occurs, there is a reallocation between the transferees, but the
quantity and identity of property transferred away from the
transferor does not change.
While estate planners have long made use of formula clauses
in other contexts without IRS challenge (i.e., marital and credit
shelter trust funding formulas and formula disclaimers), the IRS
asserted that formula allocation clauses used in this context were
invalid, principally because these provisions violated various public
policies. The IRS made the public policy argument in four recent
cases and lost each case. See McCord v. Commissioner, 461
F.3d 614 (5th Cir. 2006); Estate of Christiansen v. Commissioner,
130 T.C. 1 (2008) (affirmed by Estate of Christiansen, 586 F.3d
1061 (8th Cir. 2009)); Estate of Petter v. Commissioner, T.C. Memo
2009-280 (affirmed by Estate of Petter v. Commissioner, 653 F.3d
1012 (9th Cir. 2011)); and Hendrix v. Commissioner, T.C. Memo
2011-133.
While formula allocation clauses have been met with much
success in the courts, they have a number of significant practical
drawbacks. The most significant issue with formula allocation
clauses has been the selection of the spillover transferee. Each of
the recent cases approving formula allocation transfers involved a
charitable organization as the spillover recipient. However, even
charitably inclined clients may not be comfortable with a charitable
organization owning an interest in a closely held business. In those
situations, estate planners have no court precedent confirming
that a formula allocation clause involving a non-charitable spillover
transferee would be respected. Another issue is the cost and
administrative inconvenience of implementing another trust or
entity to receive the spillover amount. For example, if a GRAT is
designated as the recipient of the spillover and the regulations
under Section 2702 are not followed precisely (e.g., an annuity
payment is missed or not timely), it is doubtful the GRAT will be
recognized as a qualified annuity interest.
Formula Transfer Clauses and Wandry nnn
An alternative to a formula allocation clause is a formula transfer
clause. While a formula allocation clause fixes the quantity and
identity of property transferred and self-adjusts the allocation of
such transferred property between two transferees based on the
ultimate value of the property conveyed, a formula transfer clause
instead fixes the value transferred and self-adjusts the quantity
of the property conveyed to achieve the fixed value. Formula
transfer clauses have been analogized to asking for $10 worth
of gasoline rather than a certain number of gallons of gas
[opening] up the simplicity of giving $13,000 worth of LLC units
to make sure the gift does not exceed a desired monetary amount,
or giving [$5,120,000] worth of LLC units to make sure that the
transferor does not have to pay gift tax as a result of the transfer of
a hard-to-value asset. Steve R. Akers, Wandry v. Commissioner,
T.C. Memo 2012-88 (March 26, 2012), BESSEMER TRUST, March
2012. Notably, the formula transfer does not require a second
transferee, as there is no excess value to spill over.
While the simplicity of a formula transfer clause is appealing, many
estate planners have been hesitant to make use of it, fearing that
the formula transfer clause is too similar to the clause rejected in
Procter. Recall that in Procter, a transfer had been completed, only
to be undone if gift tax resulted and, importantly, the ruling focused
on the narrow procedural defect of the timing of the operation of
the condition subsequent. With a formula transfer clause, the only
transfer made is that portion of the transferors property equal to
the fixed value. Accordingly, the transfer is not undone because
no transfer of excess value was made in the first instance. It is a
key distinction, albeit a subtle one, and drafters fear that a court
may not appreciate that distinction has resulted in the proliferation
of the formula allocation clause, notwithstanding its drawbacks.
As a result of the limited implementation of the formula transfer
clause, it had not been tested judicially until last year. In its first
challenge, the formula transfer clause resulted in a victory for the
taxpayers. Indeed, Wandry v. Commissioner, T.C. Memo 2012-88
(March 26, 2012), may be the secret sauce estate planners have
been waiting for.
In the Wandry case, the taxpayers engaged in a gifting program
that involved the transfer of interests in two family entities. The
taxpayers had been advised by their counsel that the value of
2013 64
the gifts on any given date would not be known until a later date
when a valuation could be completed. As a result, the taxpayers
counsel advised them to make gifts of interests in the entities
equal to a specific dollar amount, rather than a set number of
interests in the entities.
The transfers at issue were made on January 1, 2004. The
taxpayers executed separate assignments, which transferred
among nine donees a sufficient number of my [u]nits [in the
company] so that the fair market value of such [u]nits for federal
gift tax purposes shall be $1,099,000 (i.e., the amount that
would fully consume the available $1 million gift tax exemption and
the $11,000 per donee annual exclusion amount). Each assignment
went on to provide that although the gift of units was fixed on the
date of the gift, the number of units gifted was based on the Fair
Market Value of the units, which was not known as of the date
of the gift and could be challenged by the IRS. So, if the IRS
challenges such valuation and a final determination of a different
value is made the number of gifted [u]nits shall be adjusted so
that the value of the gifted units equals $1,099,000 in the same
manner as a federal estate tax formula marital deduction amount
would be adjusted for a valuation redetermination by the IRS and/
or a court of law.
The IRS audited the gift tax returns and revalued the units for gift
tax purposes. The IRS and the taxpayers ultimately agreed on an
upward adjustment to the valuation of the transferred units. The
issue before the Tax Court was whether or not a gift had been
made in 2004 as a result of the subsequent revaluation given the
formula used in the assignments. The IRSs central argument was
that the taxpayers transferred a fixed number of units and that the
adjustment clause was an invalid savings clause because it created
a condition subsequent that was void as contrary to public policy.
The taxpayers argued that they made a transfer of units equal to
specific dollar amounts, not a fixed number of units, and that the
cited public policy concerns were not applicable. Judge Harry A.
Haines, in a memorandum decision, held for the taxpayers.
Judge Haines began his review by examining the evolution of the
case law, including Procter, which he described as the cornerstone
of a body of law. and the recent cases of McCord, Christiansen,
and Petter (Hendrix apparently had not yet been decided when
Judge Haines wrote his opinion). The memorandum opinion noted
that in Petter the Tax Court drew a distinction between a savings
clause and a formula clause. A savings clause is invalid because
it operates to take property back as a condition subsequent,
whereas a formula clause is valid because it transfers a fixed set
of rights. The difference, according to Judge Haines, depends on
an understanding of just what the donor is trying to give away.
Judge Haines concluded that the only gifts taxpayers intended to
give were gifts of dollar amounts equal to the amount they could
transfer free of gift taxes and that they understood and believed
that the gifts were of a specified dollar value, not of a specified
number of units. Taxpayers were advised by their counsel that if
a subsequent revaluation occurred, nothing would be returned to
them; rather, simple accounting entries would be made to reflect
the actual gifts.
The IRS attempted to differentiate this case from Petter, arguing
that this case is different because the clause at issue operates to
take property back upon a condition subsequent. Judge Haines
disagreed with the IRSs interpretation of the Ninth Circuits
decision in Petter and reviewed each part of the Ninth Circuits
holding to the facts of this case. Ultimately, Judge Haines
concluded that each donee was entitled to a predefined interest
in the family entity expressed through a formula. The formula did
not allow the taxpayers to take property back, but rather adjusted
the allocation of interests among the taxpayers and the donees
because of the understated value. As such, the clauses at issue
were valid formula clauses.
As to the IRSs public policy concerns, Judge Haines observed
that the Commissioners role is to enforce tax laws, not merely to
maximize tax receipts. Judge Haines pointed out that mechanisms
outside of the IRS audit exist to ensure accurate valuation
reporting, such as the fact that transferors and transferees have
competing interests in ensuring that capital accounts properly
state owners interests. (Candidly, the authors do not follow this
logic, as a transferor is incented to transfer as much as possible
to remove those assets and the appreciation thereon from the
transfer tax base and the transferee obviously would like to
receive as much as possible.) Finally, Judge Haines concluded by
addressing squarely the lack of a charitable presence: In [prior
cases] we cited Congress overall policy of encouraging gifts to
charitable organizations. This factor contributed to our conclusion,
but it was not determinative. The lack of charitable component
in the cases at hand does not result in a severe and immediate
public policy concern.
On August 28, 2012, the IRS filed a Notice of Appeal with the Tenth
Circuit. On October 17, an Order dismissing the appeal was filed,
following a stipulation by the parties on October 16 that the case be
dismissed with prejudice. Notwithstanding the failure of the IRS to
pursue its appeal, on November 13 the IRS published a statement
in Internal Revenue Bulletin 2012-46 that the Commissioner would
not acquiesce to the Tax Courts decision in Wandry. The authors
speculate that the IRS abandoned its appeal in Wandry due to
binding precedent unfavorable to the government, namely King
v. Commissioner, 545 F.2d 700 (10th Cir. 1976), which upheld a
taxpayers purchase price adjustment clause in a sale transaction,
finding that the taxpayers attempt to avoid valuation disputes with
the Internal Revenue Service (by employing such clause) was not
contrary to public policy.
2013 65
Conclusion nnn
There has been a demonstrated trend in the courts to uphold
formula allocation clauses, and planners now have the first
reported case upholding a formula transfer clause as well. Formula
transfer clauses offer a simple solution to the taxpayers dilemma
of wanting to make a transfer of a specified dollar amount of a hard
to value asset without risking a revaluation of such transferred
property that would result in a gift tax.
The timing of Wandry could not have been more fortuitous, as
planners worked hastily in the last quarter of 2012 to make use of
the increased $5,120,000 gift exclusion that many believed would
be unavailable in 2013 and beyond. The American Taxpayer Relief
Act of 2012 made permanent the increased exclusion, as may
be further adjusted for inflation (subject, of course, to any future
changes to the tax laws). Therefore, for those clients who have
not yet utilized their entire exclusion and have been reluctant to
do so because of the risk of revaluation, Wandry may provide the
added comfort those individuals need to move forward. Naturally,
the drafter can use the language from Wandry as a guide, but
there are additional factors that should be considered during
implementation as well:
n The transferee should be a grantor trust, if possible, to
avoid the need for corrective income tax returns if the
formula transfer clause results in an adjustment on the
books to the quantity of property transferred.
n The Wandry court was focused on the intent of the
transferors, so the drafter should document well the
intention to transfer a xed value. For example, the
drafter might prepare contemporaneous correspondence
to the transferor to reafrm the transferors desire to
transfer a predened interest in the company worth
a xed dollar amount expressed as a formula that
references that if a subsequent revaluation occurs,
nothing will be returned to the transferor. (Rather, simple
accounting entries would be made to reallocate the
interests to reect the actual transfer).
n The gift tax return should not reect a gift of a specied
interest in the hard-to-value asset, but should instead
reect a gift of an amount of that portion of the hard-
to-value asset having a Fair Market Value of the xed
dollar amount, as nally determined for federal gift tax
purposes. (This was a bad fact in the Wandry case that
Judge Haines overlooked on the grounds that petitioners
consistent intent and actions prove that dollar amounts of
gifts were intended.)
n It may be advisable to obtain a contemporaneous
written disclaimer by the transferee of any portion
of the gift in excess of the value that the transferor
intends to convey. The regulations have long
recognized formula disclaimers, so any excess gift
should be avoided, even if the formula transfer for
some reason fails. (The planner will need to determine
under applicable state law where any disclaimed
assets will pass.)
n Signicantly, the appraisal should be reasonable
and from a reputable valuation company.
Of course, the value of Wandry should not be overstated. Wandry
is a Tax Court memorandum opinion, which means the content
is attributed only to the particular Tax Court Judge who wrote it,
namely, Judge Haines. More importantly, the non-acquiescence
may suggest that the IRS will vigorously challenge a formula
transfer once, in its view, a winning case presents itself.
Published in substantially this form in Probate and Property,
Volume 26, Number 6, 2013 by the American Bar Association.
Reproduced with permission. All rights reserved. This information
or any portion thereof may not be copied or disseminated in
any form or by any means or stored in an electronic database
or retrieval system without the express written consent of the
American Bar Association.
Tiffany B. Carmona is a Member of the Legacy Planning
Department at Bessemer Trust. She works with Bessemer clients
and their attorneys and other advisors to develop wealth transfer
plans. Ms. Carmona can be reached at +1.312.416.2330 or
carmona@bessemer.com.
Tye J. Klooster, Esq. is a Partner at Katten Muchin Rosenman
LLP. He represents high net worth individuals and business
owners in wealth transfer and estate planning matters. He has
extensive experience in designing and implementing sophisticated
estate plans, leveraged wealth transfer techniques and business
succession planning. Mr. Kloosters practice also includes
representing fiduciaries in the administration of estates and trusts
and the formation and operation of private foundations. Mr. Klooster
can be reached at +1.312.902.5449 or tye.klooster@kattenlaw.com.
necessarily reflect the views of Bessemer Trust, Katten Muchin Rosenman LLP, Stout Risius
Ross, Inc. or Stout Risius Ross Advisors, LLC.
Oil and Gas Minerals:
How They and Their Holding
Entities Are Valued
Alan B. Harp, Jr., CFA, ASA aharp@srr.com
2013 66
Oil and natural gas valuation in an estate-planning context is
becoming more important, as mineral ownership has created
vast amounts of wealth in the past decade. New technologies
have unlocked shale
1
plays and brought older oil fields back to
life. Furthermore, due to the proliferation of independent and,
in many cases, private equity-backed oil and gas companies,
oil and gas wealth is in the hands of more and more individuals.
Estate planners advising clients who hold these assets need
to know how minerals, especially non-producing minerals, and
oil and gas holding entities are valued and what the Treasury
regulations have to say about determining the Fair Market Value
(FMV) of oil and gas interests.
Nature of Interests nnn
Before you can understand the valuation techniques, its important
to know the exact nature of the oil and gas interests being valued.
Does the client hold primarily working interests, royalty interests,
or a combination of the two? Are the interests held directly or
indirectly through an entity such as a family limited partnership
(FLP)? The answers to these questions dictate valuation data
sources and methodology.
Heres a simplified example, which helps to convey the definitions
of, and differences among, various types of mineral interests. The
most basic type of mineral interest is the fee mineral interest,
representing a perpetual ownership of the mineral rights on
a property, which may be separate from the land ownership.
Consider a rancher who owns his land (surface rights) and
underlying minerals in fee and is approached by an oil and gas
company that has reason to believe oil and gas deposits may be
found on (under) the ranch. The rancher may lease his minerals
to the oil company in exchange for an upfront signing payment
(a lease bonus) and a royalty interest in future oil and/or gas
revenues. The oil company is the leasehold or working interest
owner and pays all costs to drill and operate the lease. The
rancher is the royalty interest owner and doesnt bear any share
of such expenses. If the rancher hasnt leased his minerals, his
ownership is called a non-producing fee mineral interest.
2

1
Shale is a type of sedimentary rock composed of silt and clay. New technology has
allowed extraction of many shale deposits, which were once thought to be uneconomical.
2
Except for cases in which an oil company owns the fee mineral interest, its very rare for
a fee mineral interest owner to have the expertise or capital to drill a well and explore his
own mineral base; therefore, for the purpose of this article, unleased mineral interests are
essentially considered non-producing mineral interests.
Here are the three typical property holdings by entity type
Whats Being Valued?
Family Holding Entity Privately
(Family Limited Held
Partnership/Limited Oil & Gas
Entity Level Liability Company) Company
Non-Producing
Fee Minerals Typical Rare
Royalty Interests Typical Occasional
Working Interests Typical Typical
A
s
s
e
t

L
e
v
e
l
2013 67
3
EnergyNet, Inc.s database isnt publicly available, but it will assist clients with the sale of their oil and gas properties and will make valuation metrics available to such clients.
EnergyNet, Inc. is unique in that it markets not only traditional oil and gas properties, such as working and royalty interests, but also numerous fee mineral properties, including
non-producing fee minerals.
4
I combine working and royalty interests for this discussion. Market evidence described later in this article shows that cash-ow multiples for royalty interests are higher than working
interests. This implies that a distinction should be made in the valuation of the two property types, although such distinction is rarely made.
Most of the research on oil and gas valuation focuses on working
interests. Very little research has been published, and the Internal
Revenue Service offers no guidance that Im aware of, on the
valuation of non-producing minerals.
Non-Producing Fee Minerals nnn
Non-producing fee minerals are often owned directly by individuals
or indirectly through FLPs or limited liability companies and often
are involved in estate-planning transactions. For example, family
ranches or farms (and underlying minerals) in south Texas (Eagle
Ford shale), North Dakota (Bakken shale), West Virginia/Ohio (Utica
shale) or Pennsylvania (Marcellus shale) have created dramatic
wealth in recent years. Petroleum engineers (PEs) usually dont
want to provide valuations of non-producing minerals if geological
and reservoir data dont exist, so there are a limited number of
valuation experts in this area.
In some cases, non-producing minerals are simply included with
producing minerals in a valuation. For example, if the producing
minerals (royalty interests) are valued using a cash flow multiple,
the non-producing minerals often get overlooked and are implicitly
assigned no value. Some clients will value the non-producing
minerals at a token $1 per net acre, not knowing how else to do so.
The best and most defensible approach for valuing
non-producing minerals is to use a price per net acre multiple
(the market approach) for an arms-length comparable mineral
sale (as opposed to a working interest sale) that occurred
near the valuation date. While this information has rarely been
available in the past, our relationship with EnergyNet, Inc.,
an oil and gas advisory firm headquartered in Amarillo, Texas,
allows us access to such data.
3

In situations in which there isnt sufficient market data or the subject
non-producing minerals have significant value (because theyre
located in an active area of exploration), an income approach can
be used. Sophisticated mineral buyers who have geoscience and
engineering professionals on staff rely on this approach. These
professionals will develop a cash flow projection based on:
n Type curves or expected production proles for nearby or
analogous wells
n The number of rigs operating in the area
n Oil and gas price levels and economic return to operators
working interest
n Lease terms in area or actual terms, if minerals
are leased
n Unit sizes/current eld spacing requirements in
the area (number of wells expected to be drilled
on subject tract(s))
The following factors impact the selected discount rate applied to
the projected cash flow stream:
n Whether minerals are already leased and, if so, the
operational and nancial strength of the operator
n Operational and mechanical risk
n Environmental risk (hydraulic fracturing and water use/
discharge issues)
n Commodity price risk
Its important to remember that a sophisticated valuation model
may be built, but the subject minerals may never be leased,
because oil operators in the area might, ultimately, deem them
not prospective for exploration. The valuation must, therefore,
consider the probability that the subject minerals wont be leased
and wont generate income.
Another method for valuing non-producing minerals in an estate
or gift tax valuation context is to rely on a simplistic approach
called the Multiple of Lease Bonus. The method is to multiply the
lease bonus per acre in effect at the valuation date, by the number
of net mineral acres held by the client. The selected multiple or
lease bonus per acre is increased if nearby drilling and production
results are favorable.
Working and Royalty Interests nnn
Income and market approaches can be used to value working and
royalty interests.
Income approach. The predominant methodology for valuing
working interests and royalty interests
4
is an income approach,
since it can be tailored to the specific property interest in question.
The reserve (or engineering) report is the basis for this approach.
A PE prepares a reserve report, which contains a projection of the
net cash flow the oil and gas interests are expected to generate.
The PE will consider various geological and reservoir data to
estimate the amount of remaining economically recoverable
volumes of oil, gas, and natural gas liquids (the reserves) and the
time at which such reserves will be brought to the surface and
sold. The projection for each lease or well (the 8/8ths interest) is
then netted to the subject interest. For valuation purposes, NYMEX
oil and gas futures prices (NYMEX strip pricing), adjusted for basis
differentials, are most commonly used. Lease operating costs
(electricity, labor, and maintenance), taxes (severance and ad
valorem), and capital expenditures for drilling additional wells are
deducted. A pre-income tax cash flow projection results from this
analysis. The reserve report will show a matrix of values resulting
from discounting the cash flow stream at various discount rates.
2013 68
For instance, the present value of the projected cash flow stream
using a 10 percent discount rate is referred to as the PV-10 value
of the reserves.
The discount rate applied to the projected cash flows should
properly account for the riskiness of the subject cash flow stream.
The reserve report facilitates this process by categorizing the
projected cash flow streams into various risk categories. The least
risky category is the proved developed producing (PDP) reserves.
The next categories on the risk spectrum include proved developed
not producing (PDNP) and proved undeveloped (PUD) reserves.
The sum of these three categories is known as proved reserves
or 1P reserves. Additional unproved reserve categories include
probable and possible reserves.
There are three common methods for converting a reserve
report to an FMV:
1
I
Perhaps the most accurate, but admittedly anecdotal,
approach is to interview or survey investment bankers
or property brokers in the oil and gas acquisition and
divestiture (A&D) market regarding discount rates
in effect at the valuation date. Discount rates are
dependent on reserve category, location, product type
(oil versus gas) and size of transaction. For example,
an A&D rm might show statistics indicating that oil-
weighted Permian Basin PDP properties were transacting
at PV-7
5
near the valuation date.
2
I
Another approach involves using data contained in
an annual survey (the SPEE survey) conducted by the
Society of Petroleum Evaluation Engineers.
6
The SPEE
survey polls about 100 experienced PEs and other
experts who work in the context of A&D transactions.
The section of the survey most commonly cited deals
with risk adjustment factors (RAFs) used for acquisitions.
The RAF isnt a discount rate in the traditional sense, as
used in the rst method, but rather a haircut factor.
While this methodology is simple, and the valuation
conclusion is clear (and presumably defensible), it can
be overused as a one-size-ts-all solution. For example,
I interviewed an active property buyer in the Gulf of
Mexico recently and found that use of the SPEE RAFs,
without any further adjustment, would have signicantly
overvalued the offshore properties.
3
I
Another source for the discount rate is the cost of
capital
7
for publicly traded guideline companies. The
reserve base of the guideline public companies should
be sufciently comparable to the subject properties,
particularly the ratios of PDP and PUD reserves to
total reserves. This approach requires a number of
adjustments to reect the public companies general
and administrative cost structure, growth prole and
marketability, which arent characteristics of the subject
static oil and gas reserve base.
Market approach. The market approach involves applying
comparable transaction metrics to the subject oil and gas
propertys measures. Typical market approach valuation metrics
are shown above, and sample valuation metrics by producing
basin from January 2012 to December 2012 are shown on the
following page. The drawback to this approach is the difficulty
in finding comparable transactions. Oil and gas properties arent
generic, and each property set can have its own unique profile. In
determining whether a transaction is sufficiently comparable to the
subject interest, consider whether the transactions have a similar:
5
That is, PV-7 instead of the PV-10 shown in the reserve report. The projected cash ows in the reserve report would be discounted at 7 percent instead of 10 percent.
6
Survey of Parameters Used in Property Evaluation.
7
The (pre-tax) weighted average cost of capital is used.
[a] mcfepd: thousand cubic feet equivalent per day
[b] boepd: barrels of oil equivalent per day
[c] mcf: thousand cubic feet
[d] boe: barrels of oil equivalent
Data Source Valuation Metrics
Online Marketplace Price/cash flow (monthly)
Transactions (EnergyNet, Inc.)
Price/net daily flowing volume
Price/mcfepd (a)
Price/boepd (b)
A&D Database (IHS Herold) Price/proved reserves
Price/mcf (c)
Price/boe (d)
Price/net daily flowing volume
Price/mcfepd (c)
Price/boepd (d)
Price/net acre (unproved properties)
These vary based on the data source
Market Approach Valuation Metrics
2013 69
n Time period (a similar oil and gas price environment)
n Basin and, if possible, same producing horizon
n Asset size
n Oil percentage of reserves
(oil versus gas-oriented transactions)
n Percentage of reserves developed/undeveloped
n Reserve life ratio (proved reserves divided by current
production rate on annual basis the r/p ratio)
n Upside potential, a subjective factor
Entities Holding Properties nnn
In most cases, valuation of the oil and gas properties is the first
step in entity valuation. You may also need to value other assets,
such as hedges, midstream assets, and leasehold acreage not
previously considered. Using these values, the balance sheet
is marked to market, and a net asset value is calculated once
liabilities are subjected. I also consider the potential impact of
the entitys general and administrative cost and tax structures on
valuation. Discounts for lack of control/minority interest and lack
of marketability are also considered in an entity level valuation.
Publicly traded guideline companies can also assist in the valuation
if sufficiently comparable to the subject entity.
Treas. Regs. Section 1.611 nnn
While not specifically addressing estate and gift tax purposes,
Treasury Regulations Section 1.611 provides some guidance with
respect to determining the FMV of oil and gas properties. Treas.
Regs. Section 1.611-1(d)(2) provides that the fair market value
of an [oil and gas] property is the amount which would induce a
willing seller to sell and a willing buyer to purchase. This language
is consistent with the definition used for estate tax valuation (Treas.
Regs. Section 20.2031-1(b)).
Section 1.611-2(d)(1) provides that the value should be
determined in light of conditions and circumstances known at the
valuation date, regardless of later discoveries or developments.
This language is consistent with the general framework for estate
and gift tax valuation precluding post-valuation date information.
Section 1.611-2(d)(2) says the market approach (comparable
transactions) is preferred to the income approach (discounted
projected cash flows). This provision isnt consistent with current
industry practice, which favors the income approach based on
a reserve report as discussed previously. Treas. Regs. Section
1.611-2(g) lists information to be submitted in an FMV analysis.
The IRS Oil and Gas Handbook (Section 4.41.1.3.7.6) doesnt add
any new guidance on oil and gas property valuation, but rather
refers back to Treas. Regs. Section 1.611.
Alan B. Harp, Jr., CFA, ASA is a Managing Director in the
He has over 20 years of experience determining the Fair Market
Value of interests in closely held businesses. He has provided
valuations in a wide range of industries primarily for estate, gift,
and income tax purposes. Mr. Harp can be reached at
+1.713.221.5113 or aharp@srr.com.
Valuation Metrics by Region
[a] Using 20:1 eqivalency measure. Net daily gas volume in mcf/20 + net daily oil volume
[b] Average monthly cash ow during six months prior to sale
Royalty and Overriding Royalty Interests Working Interests (Operated and Non-Operated)
Region Price/boepd (a) Price/monthly cash flow (b) Price/boepd (a) Price/monthly cash flow (b)
Appalachian $156,844 80.3x $38,690 21.2x
Ark-La-Tex $262,224 88.6x $97,465 44.0x
Gulf Coast $209,831 71.7x $69,138 26.6x
Michigan Basin $297,181 91.2x $50,230 29.9x
Mid-Continent $270,027 106.9x $85,792 43.7x
Permian $257,108 99.4x $97,396 41.6x
Rockies $236,391 95.2x $90,408 54.7x
South Texas $122,463 65.3x $53,442 23.7x
Source: www.EnergyNet.com
From January 2012 to December 2012
2013 70
Elements of an Oil and Gas Mineral Appraisal
Pertinent information required by
Treasury Regulations Section 1.6112(g) Comments
Map(s) and legal description of subject properties Number of gross and net acres involved
Acreage associated with producing and proved properties
Counties or parishes involved
Description of the character of the property Type of interest (working, royalty, other?) Operated or non-operated?
Exploratory or developmental drilling?
History of the property and lease terms, including dates of expiration Leases near expiration or held by production?
Cost basis in property From accounting records
Reserve estimate, in volumes of oil/liquids and natural gas What percentage of reserves and annual production are
oil/liquids (versus gas)?
Method used (decline curve, volumetric, analogy or probabilistic)
Grade/gravity of oil and BTU content of gas
Historical production volumes by product Allows determination of average prices received
(Daily production rate at valuation date barrels of oil equivalent Important pricing metric in the market approach
per day or million cubic feet per day of production)
(R/P ratio proved reserves divided by annual production rate) Known as the reserve life ratio
Historical sales revenues From income statement or lease operating statement
Number of producing wells
Number of wells completed and abandoned (and date thereof) during recent period
Initial production rates of recent wells
Producing reservoir zones, depth and thickness
Operating conditions of subject lease or unit Reservoir drive (depletion drive, water flood, tertiary recovery)
Geologic and engineering information having a bearing on valuation Bottom hole pressures, oil-gas ratio, porosity of rock, percentage
of recovery, etc.
Other helpful items
Historical spot and futures prices for oil and natural gas Shows impact of prices of historical results and potential
impact on projected results
Hedging information; marked to market values of hedges as of The reserve report rarely reflects the hedging program
valuation date
Typical drill and complete costs for subject wells Newer horizontal wells with long laterals and many frac stages
are very expensive
Details of acreage not included in reserve report
Historical cash flow from subject properties (sales less expenses) Important pricing metric in the market approach
Assumptions used in the reserve report:
Projected oil and natural gas prices NYMEX strip, SEC, or bank case pricing used?

Differentials assumed How do benchmark prices compare to actual prices received
at wellhead?

Operating expenses Held flat or escalated; any overhead charges (COPAS) included?

Plug and abandonment requirements Does reserve report assume salvage value of equipment
offsets this amount?
Here are the items that should be included, if possible
E-Discovery
Cost-Shifting
Phillip M. Shane, Esq. Miller, Canfield, Paddock and Stone, PLC
shane@millercanfield.com
Denise B. Bach dbach@srr.com
71 2013
Introduction nnn
Its no secret that responding to a discovery request for
electronically stored information (ESI) during litigation can be
costly. Employees create, use, and save copious amounts of
discoverable ESI every day with little incentive to delete any of
it, thanks to dramatic decreases in the cost of data storage and
services like cloud computing. While its cheap to create, use, and
store ESI, it can be very expensive to collect, process, review,
and produce that same ESI to an adverse party or in response
to a subpoena. Unlike some foreign jurisdictions, litigants in
the United States (as well as non-parties) have historically paid
their own costs to comply with discovery requests or respond
to subpoenas.
1
In recent years, however, some U.S. courts have
become more sensitive to the rising costs of electronic discovery
(E-Discovery) and have displayed a willingness to shift those costs
in certain situations. The purpose of this article is to articulate
when, why, and how litigants and their counsel might seek relief
from the cost of E-Discovery compliance.
The Producing Party Pays nnn
The history of the United States is filled with ambition,
expansionism, and pioneers. Weve blazed trails and explored
vast wildernesses, built skyscrapers, developed nuclear
weaponry capable of destroying entire cities, and sent men to
the moon. In the States, one of our most time-tested themes has
been the bigger, the better. The same holds true in American
jurisprudence with respect to discovery. The Federal Rules of Civil
Procedure broadly define the scope of discovery in civil litigation
to include any nonprivileged matter that is relevant to any partys
claim or defense, and clarify that [r]elevant information need
not be admissible at the trial if the discovery appears reasonably
calculated to lead to the discovery of admissible evidence.
2

Despite this expansive standard, state and federal courts,
including the U.S. Supreme Court, have made it clear that when
it comes to discovery compliance costs, the presumption is that
the producing party pays.
3

1
See Oppenheimer Fund, Inc. v. Sanders, 437 U.S. 340, 358 (1978).
2
Fed. R. Civ. P. 26(b)(1).
3
See Oppenheimer Fund, Inc. v. Sanders, 437 U.S. 340, 358 (1978) ([t]he presumption
is that the responding party must bear the expense of complying with discovery
requests); Toshiba Am. Electronic Components, Inc. v. Super. Ct., 21 Cal Rptr. 3d
532, 538 (2004) (The general rule in both state and federal court is that the responding
party bears the expense typically involved in responding to discovery requests, such
as the expense of producing documents.).
72 2013
Expanding Data Volumes nnn
The volume of potentially relevant, discoverable information that
companies create every day continues to increase exponentially
as the years pass. The number of bits
4
in our digital universe is
nearly as many as the number of stars in our physical universe,
and in 2010 we created and replicated more than a zettabyte (one
trillion gigabytes) of information.
5

Within a large company or organization, the same ESI may be
located in a dozen or more digital repositories. When an employee
sends an e-mail, that e-mail is typically stored in the e-mail
accounts of the sender and the recipients on a corporate server.
That same e-mail may also be captured on the smartphones
of the sender and recipients. It can be archived by employees
to their local hard drive, or archived to a shared drive location.
And, that same e-mail will likely be housed on one or more
backup tapes. Collecting, processing, reviewing, and producing
data from one or more of these sources remains the biggest
cost-component of civil litigation.
Changing Viewpoints nnn
Fed. R. Civ. P. 26(b)(2)(C) and Fed R. Civ. P. 26(c) provide federal
courts with the ability to limit discovery if its burden or expense
outweighs its likely benefit, or if the court determines that it needs
to protect a party or person from undue burden or expense.
Yet, courts have historically been reluctant to sway from the
presumption that the producing party bears the cost of complying
with discovery requests, even in the context of E-Discovery.
6

So, as the song says, what can a poor boy (or a savvy litigant)
do?
7
As reflected herein, courts have been more open to shifting
E-Discovery costs from the producing party or person to the
requesting party in certain circumstances.
Nonparty Subpoenas nnn
One instance where courts have found cause to shift E-Discovery
costs to the requesting party in recent years is when the responding
person or entity is not a party to the underlying litigation. In United
States v. Blue Cross Blue Shield of Michigan, the U.S. Department
of Justice (DOJ) filed suit against Blue Cross alleging violations
of federal antitrust laws.
8
The DOJ issued nonparty subpoenas
to two hospitals pursuant to Fed. R. Civ. P. 45. The hospitals
objected to producing documents, in part on grounds that the
production would impose an undue burden on them. Addressing
a motion to compel by the DOJ, Magistrate Judge Mona Majzoub
of the Eastern District of Michigan ordered the documents to be
produced, but acknowledged that under Rule 45, the court had an
obligation to protect a person who is neither a party nor a partys
officer from significant expense resulting from compliance.
9

Given the absence of Sixth Circuit precedent on the topic, the
court looked to cases from other jurisdictions to evaluate whether
cost-shifting is mandatory under Rule 45. The court determined
that when a nonparty is subject to an undue burden, the court
must determine (1) if compliance with the subpoena imposes an
expense on the nonparty, and (2) if so, whether that expense is
significant. Linder v. Calero-Portocarrero, 251 F.3d 178, 182
(D.C. Cir. 2001). If that expense is indeed significant, the court
found that it must shift at least enough of the expense to the
requesting party to render the remainder non-significant. Finding
that the production would cause the hospitals to incur costs that
might be significant, the court ordered the hospitals to submit
cost estimates for complying with the subpoenas.
10

After reviewing the hospitals compliance cost estimates, which
averaged out to approximately $15,000, the court in a separate
opinion examined several cases from other jurisdictions, in
which costs ranging from $9,000 to $200,000 were found to be
significant.
11
Based on these cases, the court concluded that the
hospitals costs of compliance were significant. The court went on
to balance the equities and concluded that a percentage of the
hospitals costs should be shifted to the United States.
Pre-Class Certification nnn
Another situation where courts have found discovery cost-shifting
appropriate in recent years is in the pre-certification stages of
potential class-action litigation. In Boeynaems v. LA Fitness
International, LLC, five plaintiffs who were former members of
LA Fitness alleged that they had difficulty cancelling their gym
memberships, and sought discovery from LA Fitness on whether
class-certification was warranted (as well as on the merits).
12

Disputes among the parties led the court to issue a memorandum
ordering the plaintiffs to bear the costs associated with pre-class
certification discovery. Using the guidepost that [d]iscovery need
not be perfect, but discovery must be fair, the court established
a two-part test to determine the appropriateness of shifting
E-Discovery costs in a putative class action.
4
Eight bits equals a byte.
5
International Data Corporation and EMC, Extracting Value from Chaos (June 2011), available at http://idcdocserv.com/1142.
6
Ronni Solomon and Andrew H. Walcoff, E-Discovery Cost-Shifting, The Metropolitan Corporate Counsel, 23 (Oct. 2011) (citing Barrera v. Boughton, 2010 WL 3926070, at 3 (D. Conn. 2010)).
7
The Rolling Stones, Street Fighting Man, Beggars Banquet (1968).
8
2012 WL 4513600 (Oct. 1, 2012).
9
Id. at 7 (quoting Fed. R. Civ. P. 45(c)(2)(B)(ii)).
10
Id.
11
U.S. v. Blue Cross Blue Shield of Michigan, 2012 WL 4838987 *3 (Oct. 11, 2012).
12
2012 WL 3536306 (E.D. Pa. Aug. 16, 2012).
73 2013
The court determined that E-Discovery costs should be shifted
when the case involves (1) pending class certification, and (2)
very extensive discovery, compliance with which will be very
expensive.
13
In fashioning the rule, the court noted the asymmetry
in the discovery burden that typically disfavors defendants in class
actions, and would disfavor LA Fitness in the underlying litigation
against the five named plaintiffs. According to the court:
If the class action is denied, perhaps another small group of
individuals will intervene to join them as named parties. Even
in aggregate, these individuals have very few documents.
Perhaps they have kept a copy of their membership contract,
or copies of correspondence with LA Fitness. On the other
hand, Defendant LA Fitness has millions of documents and
millions of items of electronically stored information (ESI).
Thus, the cost of production of these documents is a
significant factor in the defense of the litigation.
14
In balancing the equities, the court also found it significant that the
plaintiffs were represented by a well-known, highly successful law
firm that had made hundreds of millions of dollars in prosecuting
class actions for their clients over the years, and that a firm of that
caliber surely had the resources to invest in discovery if it believed
the case to be meritorious.
15
Not Reasonably Accessible nnn
Besides nonparty subpoenas and pre-class certification
discovery, courts of late have also found good cause to shift
the cost of discovery compliance to the requesting party if
the source of the requested ESI is not reasonably accessible
pursuant to Fed. R. Civ. P. 26(b)(2)(B). In Annex Books, Inc. v. City
of Indianapolis, a discovery dispute arose over the production
of the plaintiffs bookkeeping data, which was stored on a
server called Platinum.
16
The plaintiffs produced four discs of
bookkeeping data to the City, which were apparently unreadable.
In response to the Citys assertions, plaintiffs argued that they
had done all that was reasonably required of them to produce the
bookkeeping data, including hiring computer experts at a cost
of over $9,500 and purchasing bookkeeping software suggested
by the City (QuickBooks Pro). The court found that plaintiffs
bookkeeping data was relevant, important, and reasonably likely
to lead to admissible evidence, but also considered plaintiffs
good faith attempts to comply with the Citys discovery requests
and determined that the plaintiffs had demonstrated that the
bookkeeping data was not reasonably accessible because of
undue burden and costs, in light of the apparent incompatibility
between Platinum and QuickBooks. The court ordered that the
City pay all future costs associated with any additional efforts to
compile the plaintiffs bookkeeping data.
Cost Recovery under 28 U.S.C. 1920(4) nnn
In addition to the bigger, the better, another time-tested theme
in American history is if at first you dont succeed, try, try again.
Prevailing parties who were denied cost-shifting relief during the
discovery stage of litigation have an opportunity to seek fee awards
for E-Discovery costs under 28 U.S.C. 1920(4). The statute
provides, in part, that [a] judge or clerk of any court of the United
States may tax as costs the following: Fees for exemplification and
the costs of making copies of any materials where the copies are
necessarily obtained for use in the case. Prior to 2008, 1920(4)
had been limited to [f]ees for exemplification and the costs of
making copies of papers.... In light of the increasing importance of
E-Discovery in the judicial process, the statute was amended and
papers was changed to any materials. This change has paved
the way for prevailing parties to seek awards for costs incurred
during the process of producing electronically stored information,
and for courts to award them. However, the circuits are divided
on the question of how broadly to interpret the language in the
statute, and what E-Discovery services may be taxed as costs.
17

Conclusion nnn
Given the amount of discoverable information created and
stored at companies and organizations on a daily basis, and the
sometimes shocking costs of producing that same information
during litigation or in response to a subpoena, responding parties
and their counsel should consider seeking judicial relief from
discovery if it would impose an undue burden or expense. As a
practical matter, a person or party arguing that compliance is a
burden should be prepared to demonstrate to the court specifically
and particularly what that burden is and why it should be shifted.
Conversely, parties contemplating a discovery request should
13
Id. at 11.
14
Id. at 3.
15
It is worth noting that at least one court has taken a critical view of the Boeynams decision. See Fleischer v. Phoenix Life Ins. Co., 2012 WL 6732905 (S.D.N.Y. Dec. 27, 2012) (The
presumption created by Boeynaems has never been adopted in this circuit, and, more importantly, it runs counter to the relevant principle announced by the Supreme Court[.]). The
Fleischer court also disagreed with the reasoning that the resources of a requesting partys attorney(s) should be considered in cost-shifting analysis. Id. at *4 ([I]f the assets of counsel
were to be taken into consideration, the ability of clients to engage an attorney of their choice would likely be hampered.).
16
2012 WL 892170 (S.D. Ind. March 14, 2012).
17
In the Ninth Circuit, courts have awarded considerable e-discovery costs to prevailing parties under 1920(4) in recent years. See Jardin v. DATAllegro, 2011 WL 4835742 (S.D.Cal. 2011);
In re Online DVD Rental Antitrust Litigation, 2012 WL 1414111 (N.D.Cal. April 20, 2012). In contrast, a Third Circuit panel reduced an e-discovery cost award from the Western District
of Pennsylvania by more than 90% last year. Race Tires America, Inc. v. Hoosier Racing Tire Corp., 674 F.3d 158 (3d Cir. 2012). The panel in Race Tires found that the lower court failed
to distinguish between e-discovery charges that constitute [f]ees for exemplication, and charges that constitute costs of making copies. After taking a critical look at the language
of the statute, the court concluded that none of the e-discovery vendor activities during the course of discovery could be regarded as exemplication of materials under 1920(4), and
only scanning and le format conversion could be considered making copies. The court paid particular attention to the invoices from e-discovery vendors submitted by the prevailing
parties in support of their Bill of Costs, noting a lack of specicity and clarity as to the services actually performed, and ultimately reduced an award of more than $365,000 to a little over
$30,000. 674 F.3d at 166. Attorneys for Hoosier Racing and DMS led a petition for a writ of certiorari to the U.S. Supreme Court seeking review of the Third Circuits decision in Race
Tires, but the high court declined to hear the case. Race Tires America, Inc. v. Hoosier Racing Tire Corp., 674 F.3d 158 (3rd Cir. 2012), cert. denied, 133 S.Ct. 233 (Oct. 1, 2012). (No. 11-
1520). For now, it seems, the circuits will remain divided on this issue.
74 2013
consider whether the source of discovery is reasonably accessible,
and whether they may be better served by attempting to obtain the
same information from some other, less-costly means. As these
cases demonstrate, courts are becoming more inclined to charge
fishing expeditions to the fishermen, rather than the lake, if the
circumstances warrant it.
Phillip M. Shane, Esq. is an Attorney at Miller, Canfield, Paddock
and Stone, PLC. He specializes in electronic discovery and
records management, including the identification, preservation,
collection, review, and production of electronically-stored
information. Mr. Shane can be reached at +1.269.383.5886 or
shane@millercanfield.com.
Denise B. Bach is a Director in the E-Discovery Practice of the
(SRR). She has a background in computer forensics, E-Discovery,
database management, document automation, scanning, and
coding with extensive experience working with law firms, corporate
counsel, litigation support managers, and paralegals to bridge the
gap between the legal process and technology. Ms. Bach can be
reached at +1.248.432.1278 or dbach@srr.com.
How do you effectively
and efficiently minimize risk?
Expert advisors to General Counsel in connection with:
Michael N. Kahaian, CPA/ABV, CFE, CFF, CVA
n
mkahaian@srr.com
n
+1.248.432.1205
nn
Internal investigations
nn
Labor and employment disputes
nn
Transaction and valuation disputes
nn
Intellectual property disputes
nn
Commercial litigation damages
nn
Fraudulent conveyance actions
nn
Preferential transfer actions
nn
E-Discovery in litigation and investigation
nn
Compliance and regulatory matters
Managing Risk
Associated with
Occupational Fraud
Michael N. Kahaian, CPA/ABV, CFE, CFF, CVA
mkahaian@srr.com
Jason T. Wright, JD, CFE
jwright@srr.com
Raymond A. Roth, III, CPA, CFE
rroth@srr.com
2013 76
The perception of todays economic climate is as tumultuous as
ever; recent headlines have included fears over sovereign debt,
the fiscal cliff, mortgage and housing markets, and jobless claims,
among many others. Responsible managers from companies of
all sizes are looking for operational efficiencies, synergies, and
cost-reduction techniques to maximize their organizations
profitability. Many savvy managers and executives have included
anti-fraud programs in their cost-cutting initiatives, saving their
organizations an average of 5% of their annual revenues.
1

The effectiveness of these measures has been demonstrated
in research conducted on fraud, waste, and abuse, and an
organization that does not incorporate anti-fraud measures will
find itself being outperformed by those that do.
The Association of Certified Fraud Examiners (ACFE) publishes a
study on occupational fraud every two years titled, Report to the
Nations on Occupational Fraud and Abuse (RTTN). A comparison
of the 2008, 2010, and 2012 global fraud studies reveals that
the Distribution of Fraud Losses and the Median Cost of Fraud
have been decreasing. An explanation for this trend is that fraud
education, deterrence, and protection programs are at some of
the highest levels ever, in part due to organizations like the ACFE
as well as legislation passed by government bodies (e.g., new
accounting rules such as Statement on Auditing Standards 99
and national legislation such as the Sarbanes-Oxley and Dodd-
Frank Acts).
According to estimates provided by the Certified Fraud Examiners
who investigated the 1,388, 1,843, and 959 cases of occupational
fraud reported in the 2012, 2010, and 2008 studies, respectively, a
typical organization lost approximately 5% of its annual revenues
to fraud in 2012 and 2010, down from 7% in 2008.
2
In addition, the
median loss of each fraud was $140,000 per fraud in 2012, down
from $160,000 in 2010 and $175,000 in 2008.
3
Occupational fraud
is defined as the use of ones occupation for personal enrichment
through the deliberate misuse or misapplication of the employing
organizations resources or assets.
4
In addition, more than one-
fifth of those frauds involved losses of at least $1 million, down
from approximately one quarter from 2010 and 2008.
5
The study
also notes that smaller organizations were disproportionately
exploited by occupational fraud because they typically lack the
anti-fraud controls that larger, more sophisticated organizations
routinely enact.
6
See Chart 1 on the next page for a breakdown of
the distribution of dollar losses attributed to fraud.

1
Report to the Nations on Occupational Fraud and Abuse (Association of Certied Fraud
Examiners, (2012) 4.
2
Report to the Nations on Occupational Fraud and Abuse (Association of Certied Fraud
Examiners, 2008, 2010, & 2012) 4.
3
Ibid.
4
Ibid., 6.
5
Ibid., 4 and 9.
6
Ibid., 4.
2013 77
Questions All Stakeholders
Should be Asking nnn
Question 1
One question that business owners, audit committees, corporate
boards, and executive level management should be asking is
whether the controls in place at their organizations are sufficient
to deter and/or detect fraud. The RTTN states: anti-fraud controls
appear to help reduce the cost and duration of occupational
fraud schemes.
7
The research shows that those organizations
with controls in place had significantly lower losses and time-
to-detection than organizations without those same controls.
8

A comparison of organizations with anti-fraud controls in place
and without anti-fraud controls reveals that organizations with
anti-fraud controls in place experienced a lower median loss and
overall duration of 45.9% and 62.5%, respectively.
9
Charts 2 and
3 provide the median loss and duration until detection based on
the presence of anti-fraud controls, respectively. As one can see,
the implementation of these controls, even a single one, can help
to reduce the frequency, duration, and monetary loss associated
with occupational fraud and abuse.
7
Ibid.
8
Ibid.
9
Report to the Nations on Occupational Fraud and Abuse (Association of Certied Fraud Examiners, (2012) 36-37.
Chart 1 Distribution of Dollar Losses
Chart 2 Median Loss Based on Presence of Anti-Fraud Controls
Source: 2012, 2010, and 2008 Report to the Nations on Occupational Fraud and Abuse
Less than
$200,000
2008 2009 2010
51.4%
10.6%
7.3%
3.3% 2.1%
25.3%
51.9%
12.7%
6.9%
2.9% 2.0%
23.7%
55.5%
12.8%
5.7%
3.5% 1.9%
20.6%
$200,000
$399,999
$400,000
$599,999
$600,000
$799,999
$800,000
$999,999
$1,000,000
and up
Source: 2012 Report to the Nations on Occupational Fraud and Abuse
% of Cases Control in Control Not in Percent
Control Implemented Place Place Reduction
Management Review 60.5% $100,000 $185,000 45.9%
Employee Support Programs 57.5% $100,000 $180,000 44.4%
Hotline 54.0% $100,000 $180,000 44.4%
Fraud Training for Managers/Executives 47.4% $100,000 $158,000 36.7%
External Audit of ICOFR 67.5% $120,000 $187,000 35.8%
Fraud Training for Employees 46.8% $100,000 $155,000 35.5%
Anti-Fraud Policy 46.6% $100,000 $150,000 33.3%
Formal Fraud Risk Assessments 35.5% $100,000 $150,000 33.3%
Internal Audit/FE Department 68.4% $120,000 $180,000 33.3%
Job Rotation/Mandatory Vacation 16.7% $100,000 $150,000 33.3%
Surprise Audits 32.2% $100,000 $150,000 33.3%
Rewards for Whistleblowers 9.4% $100,000 $145,000 31.0%
Code of Conduct 78.0% $120,000 $164,000 26.8%
Independent Audit Committee 59.8% $125,000 $150,000 16.7%
Management Certification of F/S 68.5% $138,000 $164,000 15.9%
External Audit of F/S 80.1% $140,000 $145,000 3.4%
60%
50%
40%
30%
20%
10%
0%
2013 78
Question 2
While these controls can help, a logical next step is to consider
what type of investment an organization should make in controls
such as those referenced in Charts 2 and 3. Unfortunately,
the perceived cost of establishing and/or implementing such
controls to protect against, deter, or detect fraud schemes often
discourages organizations from effectively protecting their assets.
While it is true that certain anti-fraud controls such as proper
separation of duties, job rotations, internal audit groups, and
the use of continuous auditing software can be cost-prohibitive,
particularly for small and mid-sized organizations, there are many
low-cost, yet highly effective options organizations can deploy.
For instance, providing fraud training to employees at all levels
is a low-cost, high-yield alternative that can be effectively
implemented by organizations of all sizes. Even in instances where
resources are severely limited, significant benefits can be gained
by simply setting the right tone at the top of an organization.
When management, executives, and owners set an ethical tone
for their organization by implementing a code of conduct and
demonstrating integrity in their actions, organizations experience
lower fraud-related losses.
Question 3
Another question that needs to be asked is whether stakeholders
are prepared to identify or recognize specific warning signs that
fraud perpetrators often display. According to the RTTN, the
most common behavioral red flags exhibited by the transgressor
were living beyond their means and having personal financial
difficulties.
10
Chart 4 provides a list of behavioral red flags often
exhibited by perpetrators of fraud as reported in the RTTN.
Becoming aware of and being sensitive to these red flags can
increase the likelihood of earlier detection and reduced exposure to
fraud and its related costs. By making employees aware, perhaps
during the low-cost fraud training provided to all employees, that
fraudsters lived beyond their means in 35.6% of the occupational
fraud and abuse cases,
11
those same employees can be the first
line of defense in helping to reduce fraud at an organization.
Question 4
The final question that business owners, audit committees,
corporate boards, and executive level management should be
asking is whether a fraud-reporting mechanism is in place at their
organization. Hotlines, be they phone-based or web-based, that
receive tips from both internal and external sources are a critical
component of any fraud prevention and detection system.
12
Such
mechanisms should guarantee confidentiality and anonymity.
13
In
addition, a well-documented whistleblower protection policy must
be implemented and strictly followed to encourage cooperation
by potential reporters. Finally, making certain that employees,
customers, contractors, or other third parties are aware of the
hotline will ensure the effectiveness of such a hotline. According to
the RTTN, tips were the most common method for detecting fraud,
nearly three times more than the next closest method of detection.
14

Chart 5 provides a list of the type of method used in detecting
occupational frauds and the corresponding percentage of cases.
10
Ibid., 57 - 59.
11
Ibid.
12
Ibid., 5.
13
Ibid.
14
Ibid., 14.
Chart 3 Duration Based on Presence of Anti-Fraud Controls
% of Cases Control in Control Not in Percent
Control Implemented Place Place Reduction
Job Rotation/Mandatory Vacation 16.7% 9 months 24 months 62.5%
Rewards for Whistleblowers 9.4% 9 months 22 months 59.1%
Surprise Audits 32.2% 10 months 24 months 58.3%
Code of Conduct 78.0% 14 months 30 months 53.3%
Anti-Fraud Policy 46.6% 12 months 24 months 50.0%
External Audit of ICOFR 67.5% 12 months 24 months 50.0%
Formal Fraud Risk Assessments 35.5% 12 months 24 months 50.0%
Fraud Training for Employees 46.8% 12 months 24 months 50.0%
Fraud Training for Managers/Execs 47.4% 12 months 24 months 50.0%
Hotline 54.0% 12 months 24 months 50.0%
Mgmt Certification of F/S 60.5% 12 months 24 months 50.0%
Independent Audit Committee 59.8% 13 months 24 months 45.8%
Internal Audit/FE Department 68.4% 13 months 24 months 45.8%
Management Review 68.5% 14 months 24 months 41.7%
Employee Support Programs 57.5% 16 months 21 months 23.8%
External Audit of F/S 80.1% 17 months 24 months 29.2%
2013 79
Case Example
Being cognizant of and asking these
hard questions can and will help in real-
world situations. Take, for example, Joe,
a multi-year, in-house-grown CEO of a
manufacturing company. Joe reported
to the companys board of directors,
which consisted of a private equity fund
that owned the company and was given
complete authority to run the company
with very little oversight. Joe had regular
meetings and provided performance
reports to the board of directors and
was pressured to keep a struggling
company solvent. However, Joes
superiors did not foresee his ability to
forge company invoices and manipulate
account receivable and inventory
records to overstate the borrowing base
from the companys senior lender. Joes
scheme of issuing phony invoices and
manipulating the borrowing base resulted
in multi-million dollar loans being given
to the company that were ultimately
unsecured and never recovered. In
addition, Joe also accumulated nearly a
half a million in personal expenses on his
expense report through personal travel
and shopping at high-end retailers that
he never repaid.
Interviews conducted by the fraud
examiners in this case revealed that a
number of current and former employees
complained about numerous red flags
that, if known by the board of directors,
may have led to an identification of
this scheme earlier, thus minimizing or
eliminating the monetary damage. For
example, fellow employees noticed that
Joe drove a six-figure luxury automobile,
dressed in haute couture clothing,
and was secretive about the contracts
that documented the companys
relationship with its customers. These
are prime examples of how a fraud-
reporting mechanism that was known
to the employees could have led to an
earlier detection of the perpetrator
assuming the board of directors and/or
the employees were properly trained in
identifying the behavioral red flags.
Chart 4 Behavioral Red Flags of Perpetrators
Chart 5 Initial Detection of Occupational Frauds
Living beyond means
Financial difficulties
Unusually close association with vendor/customer
Control issues, unwillingness to share duties
Divorce/family problems
Wheeler-dealer attitude
Irritability, suspiciousness or defensiveness
Addiction problems
Past employment-related problems
Complained about inadequate pay
Refusal to take vacations
Excessive pressure from within organization
Past legal problems
Complained about lack of authority
Excessive family/peer pressure for success
Instability in life circumstances
Tip
Management Review
Internal Audit
By Accident
Account Reconciliation
Document Examination
External Audit
Notified by Police
Surveillance/Monitoring
Confession
IT Controls
Other
0% 5% 10% 15% 20% 25% 30% 35% 40%
0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
Percent of Cases
Percent of Cases
D
e
t
e
c
t
i
o
n

M
e
t
h
o
d
B
e
h
a
v
i
o
r
a
l

R
e
d

F
l
a
g
4.1%
1.1%
1.1%
1.9%
1.5%
3.0%
3.3%
4.4%
4.8%
7.0%
14.4%
14.6%
43.3%
4.7%
4.8%
5.3%
6.5%
6.5%
7.9%
8.1%
8.4%
12.6%
14.8%
14.8%
18.2%
19.2%
27.1%
35.6%
2013 80
Certainly, Joes company had controls in place, but the question
remains whether those controls were adequate and/or properly
monitored in order to avoid the circumvention of such controls.
For example, items identified during the fraud examiners
analysis that related to customer invoices and work-in-process
inventory included:
n Ineligible invoices included in the borrowing base
n Invoice numbers with multiple dates
(kept the invoice from being aged out)
n Customers billed in advance of achievement of
certain contract milestones
n Invoices for which no contract existed
n Forged shipping documents to support existence
of invoices
n Manipulated billings in calculation of
Work-In-Process Inventory
These items would likely have been identified by either a surprise
audit or an external audit of internal controls over financial reporting.
In addition, a tip line would have likely alerted this scheme much
earlier as interviews of key company personnel revealed that
certain individuals were not comfortable making some entries, but
did not have any avenues to report their suspicions. In fact, two
employees even resigned from the company because they felt the
CEO was engaging in illegal/unethical practices.
Conclusion nnn
Through increased anti-fraud education, controls, and legislation,
the cost, occurrence, and duration of occupational fraud has
been on a decline since 2008. Executives and decision makers
looking to make a meaningful impact on their bottom lines should
examine their organizations anti-fraud programs for relevance and
effectiveness. It is important to examine factors such as whether
the right controls are in place, what type of investments should
be made in those controls, whether the stakeholders can identify
or recognize specific warning signs, and whether a proper fraud-
reporting mechanism is in place. These measures have a proven
impact in the fight against occupational fraud, waste, and abuse.
Recapturing some, or all, of the 5% in revenue a business may
be losing each year due to fraud can go a long way toward
strengthening an organizations profitability. There are a number
of ordinary Joes out there; the question is: Does he work for you?
Michael N. Kahaian, CPA/ABV, CFE, CFF, CVA is a Managing
Director in the Dispute Advisory & Forensic Services Group at
Stout Risius Ross (SRR). He specializes in complex commercial
litigation and forensic investigations. Mr. Kahaian can be reached at
+1.248.432.1205 or mkahaian@srr.com.
Jason T. Wright, JD, CFE is a Senior Manager in the Dispute
Advisory & Forensic Services Group at Stout Risius Ross (SRR).
He specializes in forensic accounting, internal investigations,
and royalty audits. Mr. Wright can be reached at +1.312.752.3382
or jwright@srr.com.
Raymond A. Roth, III, CPA, CFE is a Manager in the Dispute
He specializes in complex commercial litigation and forensic
investigations. Mr. Roth can be reached at +1.248.432.1337
or rroth@srr.com.
Using the Monte Carlo
Method to Value Early Stage,
Technology-Based
Intellectual Property Assets
Bruce W. Burton, CPA, CFF, CMA, CLP bburton@srr.com
Scott Weingust sweingust@srr.com
Jake M. Powers jpowers@srr.com
81 2013
Valuing early stage, technology-based intellectual property assets
is challenging, in large part due to the difficulty in incorporating
the effects of risk and uncertainty inherent in these assets into
their valuation. Monte Carlo methods were originally designed to
model physical and mathematical problems. However, variations
of this method also provide valuation analysts with a powerful
tool to effectively address risk and uncertainty, particularly in
the context of determining intellectual property values related to
transactions or strategic decision-making.
The challenge of assessing and incorporating
risk into various methods used for valuing
intellectual property nnn
Technology-based intellectual property (IP) assets, usually
protected as patents and/or trade secrets, are typically valued
using the same three common approaches as are used to
value businesses or other assets. These approaches include,
1) income approach,
1
2) market approach,
2
and 3) cost approach.
3

However, technology-based IP assets (and many other IP assets
including patents and trade secrets unrelated to technology,
along with trademarks and copyrights) pose many unique
challenges to a valuation analyst. A few illustrative examples of
such challenges include:
nIncome approaches are often difcult to implement for a
variety of reasons, including the difculty in quantifying
the portion of a product or services cash ows that are
attributable to the subject IP asset.
nMarket approaches are often difcult to implement for
many reasons, including the fact that IP assets are,
by denition, unique. As such, comparable market
transactions are often difcult or impossible to nd. In
addition, because IP assets are not traded on public
markets and the transactions themselves are typically
condential, there are few public sources that reveal deal
details that would be sufciently comparable to be used
to implement a market approach, and the data available
from sources that do exist is often incomplete.
nCost approaches are often difcult to implement
because the cost to create the subject assets is almost
always unrelated to the value of the asset (e.g., income
generation, cost savings, etc.) that can be gained from
use of the asset.
1
Per the International Glossary of Business Valuation Terms, Appendix B to the
Statement on Standards for Valuation Services (SSVS) promulgated by the American
Institute of Certied Public Accountants (AICPA), the income approach is dened as
a general way of determining a value indication of a business, business ownership
interest, security or intangible asset using one or more methods that convert
anticipated economic benets into a present single amount.
2
Per the International Glossary of Business Valuation Terms, Appendix B to the SSVS
promulgated by the AICPA, the market approach is dened as a general way of
determining a value indication of a business, business ownership interest, security or
intangible asset by using one or more methods that compare the subject to similar
businesses, business ownership interests, securities or intangible assets that have
been sold.
3
Per the International Glossary of Business Valuation Terms, Appendix B to the
SSVS promulgated by the AICPA, the cost approach is dened as a general way
of determining a value indication of an individual asset by quantifying the amount of
money required to replace the future service capability of that asset.
82 2013
However, in addition to these challenges, perhaps the most
difficult issue associated with valuing technology-based IP assets
is accounting for the significant risks associated with many of
these assets. Accounting for risk is particularly difficult in the
very common situation when technology-based IP assets are
valued prior to any (or significant) commercialization success;
i.e., when the assets are early stage.
Early stage, technology-based IP assets are inherently risky for a
variety of reasons, including, but not limited to:
nClaims included in the patent applications may not
survive to the issued patents and the scope of surviving
claims may be uncertain
nIssued patents may prove to be invalid when challenged
nTrade secret protections are not guaranteed
nSuccessful completion of an in-process technology is
not guaranteed
nImplementation of the subject technology into products
and services may be difcult or impossible
nManufacturing scale-up may not be technically viable
nCosts of R&D, product integration, and manufacturing
scale-up may be much higher than anticipated, perhaps
even prohibitively high
nMarket success has not been convincingly proven and
often cannot even be tested until late in the product
development process
nAnticipated regulatory approvals may be delayed
or denied
nUnanticipated safety and efcacy issues may arise
related to the in process or nished product
nNon-infringing alternatives to the subject assets
or design-around options may be difcult to identify
and assess
nInnovation may be moving at a rapid pace, causing the
economic life of a particular technology to be unknown
and, perhaps, short-lived
Risk and uncertainty associated with early stage, technology-
based IP assets can be addressed by the valuation analyst through
a number of methods, including:
nPerforming signicant due diligence to identify,
understand, and assess the various areas of risk and
uncertainty
nWhen using an income approach, adjusting the discount
rate used as part of a discounted cash ow (DCF)
model upward to reect the identied and assessed risks
4
nUsing sensitivity analysis to understand the effect on
value from changing certain variables
nDeveloping various scenarios (best, likely, worst
case, etc.)
nImplementing decision-tree analysis
nUsing option pricing techniques
In addition to these and other methods, the use of Monte Carlo
simulations in conjunction with the Income Approach provides
the valuation analyst with a flexible, powerful tool for performing
valuations of early stage, technology-based IP assets. Given the
nature of Monte Carlo simulations, they are particularly useful
when the valuation is being performed to support transactions or
strategic decision-making.
An explanation of the Monte Carlo method nnn
The Monte Carlo method is a probabilistic technique that allows the
analyst to run many what-if scenarios to arrive at a probability-
weighted distribution of possible asset values rather than arriving
at a single value as is the case for many other valuation methods.
The Monte Carlo method is most often used in conjunction with
the application of an Income Approach to valuing early stage,
technology-based IP assets. Compared to a traditional DCF
model that generates a single net present value (NPV) result, the
Monte Carlo model, available through various software programs
and Microsoft Excel plug-ins, gives the user the flexibility to
assign various probability distributions to key assumptions and
run a large number of trials to determine a distribution of NPVs
based on the variability assigned to key assumptions. In doing
so, the users of the model are able to better account for the
inherent uncertainty in predicting the future value of key
assumptions and, therefore, provide a more holistic look at the
potential value of relevant IP assets.
As mentioned earlier, estimating the value of early stage,
technology-based IP assets often involves a considerable degree
of uncertainty, given the vast number of possible values of many
of the key assumptions that can affect a DCF model. As one
example, an estimate of total future research and development
(R&D) costs expected to be incurred to complete or implement
an in-process technology, and the timing of such expenditures,
could vary significantly as of the date of the valuation. The Monte
Carlo method allows the analyst to account for this inherent
uncertainty of values related to key DCF assumptions in the model
by assigning 1) various potential values, or a range of values, for
each relevant assumption/variable and 2) a probability distribution
of varying types. The DCF model can then be run multiple times
to generate a range of potential values using these different
potential inputs. It is not uncommon to run tens of thousands of
trials, if not more, to generate an accurate distribution of possible
4
From our experience, and supported by various third parties, discount rates used in conjunction with discounted cash ow models for valuing early stage, technology-based intellectual
property assets commonly range from 20 percent to 75 percent (and sometimes higher). This is in stark contrast to discount rates used, for example, when valuing businesses, which
typically reect the subject business weighted average cost of capital (WACC). Per Morningstar, as of December 31, 2012, the median WACC for a sampling of 381 large-capitalization
companies was 7.73 percent.
83 2013
NPVs. Essentially, the program is simulating all the possible NPV
outcomes, given the variables, variable ranges, linkages between
the variables, and distributions of these variables provided by the
valuation analyst.
Many assumptions are used when valuing early stage, technology-
based IP assets. When using the Monte Carlo method, the user
has the capability to decide whether each assumption is a single
value or whether it would be best to use a probability distribution
to assign a range of values to an assumption. The type of
probability distribution assigned to the assumptions are flexible
in that the user can define the type and shape of the distribution
5

along with the mean, standard deviation, and any upper
or lower bounds. For instance, one of the reasons we decided to
use the Monte Carlo method in the example we describe later in
this article was the significant variability of the possible outcomes
from our key value drivers.
Some of the variables and related potential outcomes were
discreet such as, Will the product receive U.S. Food and Drug
Administration (FDA) approval? The answer to this question would
be a simple yes or no with assigned ranges of probabilities
associated with each. However, other variables had three or four
possible outcomes with differing probabilities of occurrence. In
addition, other variables had continuous distributions of various
kinds, such as a normal or Pareto distributions.
Once all variables have been identified and their ranges and
probability distributions selected, the valuation analyst can
perform many runs of the model to determine the resulting
unique NPV. For each run the software selects a specific value
for each of the variables based upon the range, distribution, and
probability of outcomes provided for each variable. The distribution
of possible NPVs, or outcomes, generated as a result of running
the DCF model many, many times with various combinations of
values for the variables provides a probability-weighted range
of NPV outcomes accurately reflecting the myriad combinations
of the ranges, distributions, and probabilities input for each the
key variables.
As mentioned earlier, risk and uncertainty are often addressed in
a DCF model through the determination of a single, appropriate
discount rate. However, when dealing with early stage, technology-
based IP assets, this approach may have certain challenges. In
particular, by compressing many individual risk elements into one
discount rate, the analyst may be challenged to focus on and
evaluate any one individual risk when the risks are many and the
future is very uncertain. An advantage of the Monte Carlo method
is that it allows the valuation analyst to shift the recognition of
risk and uncertainty away from the discount rate to the cash
flow projections. This is an advantage because the specific risks
formerly bundled together in the discount rate can be much more
closely analyzed and quantified through their effect on the NPV
of projected future cash flows. Especially where there is great
uncertainty and complexity, the Monte Carlo method allows the
user to explicitly model the distribution of risks around key value
drivers based on the best current information and expectations.
The software performs the tens of thousands of computations
necessary to model the interactions of the various key variables
into a resulting range of probability-adjusted NPV outcomes. As
a result, the Monte Carlo method allows the valuation analyst to
visualize and make statistical statements around various predicted
outcomes of the DCF model.
A Case Study for the Application
of the Monte Carlo Method nnn
By way of illustration, we present below an example of one of our
actual applications of the Monte Carlo method.
6

We were asked to assist a medium-sized medical device company
ExampleCo in its evaluation of the possible introduction of a
new, patent-protected, cutting-edge medical device. Introduction of
this product was capital intensive, requiring substantial long-term
expenditures in R&D as well as investment in a capital-intensive
manufacturing process. At the date of the valuation, investment-
to-date was over $150 million and prospective investment was
expected to be another $100 million. This investment was viewed by
our clients management and their board of directors as a bet the
company decision and they invited us in to help them to research,
evaluate, and model their options so that they could make a well-
informed decision regarding how to proceed with the project.
The company was facing substantial uncertainties on many fronts
related to its prospective new product. To name but a few, it was
facing such issues as:
n Its ability to complete the product and make
it function properly
n Its ability to complete the project on time
and on budget
n Market acceptance and the level of worldwide demand
for its product
n The extent of cannibalization of its own existing
products by the new product
n Emerging competing products and technologies
n Regulatory acceptance such as FDA approval
n Reimbursement under federal medical
insurance programs
n Eligibility for, and rate of reimbursement under,
medical insurance coverage
5
Illustrative standard distribution types that can be used include: Normal, Triangular, Uniform, Lognormal, Beta, Gamma, Exponential, Pareto, Poisson, etc. In addition, the valuation analyst
can typically create his/her own custom distribution type.
6
Note that the facts and results regarding the project have been modied to preserve condentiality.
84 2013
Initially, we created a traditional multi-year DCF model addressing
issues such as sales revenues, services revenues, costs of goods
sold (COGS), service and warrants costs, selling, general and
administrative (SG&A) costs, royalties payable,
7
development
costs, taxes, and other cost items specific to the new product
introduction. When completed, this model provided us with a
point-estimate of the IP embodied in the new product under
development. In this initial valuation analysis, all of the risk and
uncertainty associated with the values of each of these variables
was incorporated into the discount rate used to discount future
cash flows to the present in the form of an NPV. Because risks
associated with many or all of the variables were pervasive,
complex, and/or interactive among the variables, we decided to
use the Monte Carlo method. We took advantage of the initial DCF
analysis that generated the point estimate and used it as the
base upon which we built the Monte Carlo simulation.
As an early step in the process, we described the expected range
of possible outcomes and the expected shape of the distribution
of the reasonably possible outcomes associated with the key
value drivers. See Figure 1 below as an illustration of assigning a
distribution to a value driver. This figure represents the distribution
of outcomes and their related probabilities associated with total
R&D costs. The graph depicts a Pareto distribution of outcomes,
with a 50 percent probability that the total R&D costs would finish
on budget (we assigned no chance that the new product research
would be completed under budget) and generally diminishing
probabilities of overrun amounts up to approximately a maximum
50 percent overrun of the R&D budget. Our R&D cost estimation
was informed by discussions with the project leaders, study of the
clients similar prior projects, and identification and examination of
competitors comparable projects.
An attractive feature of the Monte Carlo method is that it allows
the valuation analyst to establish a positive correlation, or linkage,
between value drivers. Both the number of the linkages to other
variables and the extent of correlation between variables can be
determined and specified by the modeler. In this particular case,
there was a linkage with a positive 50 percent correlation between
total R&D cost overruns and another relevant variable, number of
months delay in product launch.
After following a similar process of assigning low and high values
and distributions to the other value drivers, we proceeded to run
the DCF model using the Monte Carlo tool for individual lines on
the cash flow forecast such as price per unit, unit sales, COGS,
and SG&A expenses. This intermediate step was performed to, 1)
understand how these revenue or cost items were behaving based
on the modeled distributions and linkages between variables, and
2) determine the relative effect of the individual value drivers within
each revenue or cost category. For instance, Figure 2, shows an
illustrative distribution of unit sales in thousands.
After the DCF model was run through the Monte Carlo simulator
10,000 times, the unit sales summary variable had the distribution
shown in Figure 2. The distribution of results ranges from 0 units
sold to almost 140,000 units sold. As can be seen from the figure,
this distribution turned out to resemble a normal distribution
with, 1) an outlier probability of 10 percent that there would be
zero units sold, and 2) a slight skew toward the higher-value side
of the distribution. In this example, both the mean and median was
56,000 units sold as indicated by the tall dark blue bar. The other
tall bar at zero units sold represents our judgment that there was
a 10 percent chance that the project would fail and, as a result,
never produce any commercial sales.
7
Material royalties were payable on licensed technologies embedded in the products being introduced.
Figure 1 Distribution and Probability of R&D Expense Variable
1.000 1.040 1.080 1.120 1.160 1.200 1.240 1.280 1.320 1.360 1.400 1.440 1.480
P
r
o
b
a
b
i
l
i
t
y
Pareto Distribution
85 2013
When all variables were combined, our total project NPV estimate
looked like the distribution shown in Figure 3, which portrays the
results of 100,000 separate simulations of the projects results for
the company. As can be seen, the projects distribution of NPV
results is still approximately a normal distribution skewed slightly
to the higher project values
with an offsetting pillar of
negative NPV outcomes
assuming project failure
and zero commercial sales.
The mean of the distribution
is $40.6 million and the
median is $39.0 million.
The point where the bars
change in color from orange
to blue represents the
NPV at which the client
determined a go/no-go
decision would be made.
This ability to visualize and
make statistically valid
statements regarding the
results of the analysis is
one of the key advantages
of using the Monte Carlo
method over point-estimation techniques. Another major
advantage is the unbundling of risk adjustments from residing
solely in the discount rate. In fact, in this instance, we reduced the
discount rate we used when implementing the Monte Carlo method
from over 40 percent that was used in the initial DCF model that
generated a point-estimate NPV to just above 12 percent in our
Monte Carlo analysis.
8

As an illustration of the
modeling capabilities of the
Monte Carlo software we
used, note that the zero-
value results in Figure 3
do not look the same as
the zero units bar in Figure
2. The reason is that we
modeled that the no-go
decision could be made at
different times after differing
types and amounts of
investments; hence there
are different levels of losses
associated with the different
dates at which the project
might be terminated. Figure
3 also shows that there is
some possibility that the
new product may actually
enter production but never make it to profitable levels. On the other
hand, the graphic in Figure 3 demonstrates that there is almost a 5
percent chance of NPV results in excess of $120 million.
In this article we introduced the Monte Carlo method, one of
several commonly used financial modeling tools employed by IP
valuation analysts. The Monte Carlo method is particularly effective
when used to determine the value of early stage, technology-
based IP assets and is well suited to address valuation issues
in the context of transactions and strategic decision-making.
However, compared to the use of many other valuation tools,
implementation of the Monte Carlo method has certain challenges.
8
The rationale and mechanics underlying this reduction is beyond the scope of this article.
Figure 2 Distribution of ExampleCos Potential Expected Unit Sales
0.10
0.09
0.08
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0.00
1000
900
800
700
600
500
400
300
200
100
0
P
r
o
b
a
b
i
l
i
t
y
F
r
e
q
u
e
n
c
y
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140
Total Cumulative Unit Sales Distribution of Outcomes
Units Sold
Median = 56
Mean = 56
Figure 3 Distribution of Total NPV (Before cost to exercise option)
0.03
0.02
0.01
0.00
3,800
3,600
3,400
3,200
3,000
2,800
2,600
2,400
2,200
2,000
1,800
1,600
1,400
1,200
1,000
800
600
400
200
0
P
r
o
b
a
b
i
l
i
t
y
F
r
e
q
u
e
n
c
y
$(90,000) $(60,000) $(30,000) $0 $30,000 $60,000 $60,000 $120,000 $150,000 $180,000
Total Value
Median = $39,021
Mean = $40,562
2013 6 2013
For instance, use of the Monte Carlo method can involve some
initial investment of time devoted to understanding the technique
and related software. In addition, the use of the technique often
requires additional time not necessarily required of other methods
to model the variables and to perform due diligence to support the
more detailed modeling. Consequently, it is prudent for the analyst
to carefully evaluate each particular valuation opportunity in light
of the particular costs and benefits associated with the Monte
Carlo method before making the choice to use this method. With
that said, it has been the authors experience that if the choice is
made to invest in the Monte Carlo method, the analyst is typically
rewarded with insightful and intuitive outputs accurately reflecting
the various risks associated with the IP being valued.
Bruce W. Burton, CPA, CFF, CMA, CLP is a Managing Director
in the Dispute Advisory & Forensic services Group at Stout Risius
Ross (SRR). The focus of Mr. Burtons practice is commercial
litigation with a special emphasis on IP litigation and IP valuation.
Mr. Burton can be reached at +1.312.752.3391 or bburton@srr.com.
Scott Weingust is a Director in the Dispute Advisory & Forensic
services Group at Stout Risius Ross (SRR). He has over 16 years
of experience providing consulting services to corporations, law
firms, and universities primarily in the areas of intellectual
property litigation and valuation. Mr. Weingust can be reached at
+1.312.752.3388 or sweingust@srr.com.
David A. Haas, CLP
dhaas@srr.com
+1.312.752.3343
Does your IP expert appreciate how
evolving case law affects analyses?
SRRs advisors understand the changing standards
affecting damages and other monetary relief issues.
Our IP dispute experience includes:
n
Patent, trademark, copyright, and
trade dress infringement
n
Trade secret misappropriation
n
Breach of license agreements
n
Unfair competition
n
Antitrust counterclaims
Interview with Former Chief Judge
David Folsom of the U.S. District Court
for the Eastern District of Texas
John R. Bone, CPA, CFF jbone@srr.com
David A. Haas, CLP dhaas@srr.com

87 2013
SRR Managing Directors John Bone and David Haas had an
opportunity to sit down and discuss various patent damages
topics with the former Chief Judge of the United States District
Court for the Eastern District of Texas, David Folsom.
SRR Journal: Thank you for joining us this afternoon, Judge
Folsom. Maybe well start with a few background questions.
Please tell us a little bit about yourself. Where did you grow up?
Judge Folsom: I was born and raised in a small town in southwest
Arkansas called Murfreesboro, in a small county, Pike County,
Arkansas. I graduated from high school in 1965 in a class of
36 students.
SRR Journal: Wow. A very small class.
Judge Folsom: When I graduated from high school, there was not
a stoplight in the entire county, and theres not one in 2013 either.
So I was born and raised in a very small town, but a community of
very good people and I was so fortunate to grow up where I did. I
wouldnt take anything for my childhood experiences.
SRR Journal: So how did you go from Murfreesboro to the
bench?
Judge Folsom: Well, its a long journey. Where would you like
to start?
SRR Journal: Well, what did you study either in high school or in
college that gave you a taste for law?
Judge Folsom: Well, people often ask me when did you decide
you wanted to be a lawyer? I laugh and say one hot summer day
when I was about eight or nine years old, I managed to have a
quarter, and some of my friends and I decided to go up to the
local drugstore to have a milkshake. And we were walking by
the office of a country lawyer, a storefront office, and it was after
lunch. The lawyer had cleared the top of his desk and was taking
a nap. I said my dad was a construction worker and I said,
Thats the type of job I want. (Laughter.)
Thats not really the case, but I remember that as if it were
yesterday. But, no, I really dont have any explanation. I never had
any members of my family in the legal profession. I always had a
keen interest in government, history, politics, and I think that just
probably naturally led me to the practice of law.
SRR Journal: Please tell us a little about your practice before
going on the bench.
Judge Folsom: I graduated from undergraduate school in 1969.
Taught high school for two years in Texarkana. Went to law school
and graduated in 1974 and decided to come back to Texarkana
and was in private practice for some 21 years before going on to
the bench. Prior to going to law school, I had never set foot in a
lawyers office my entire life. I didnt know what the practice of law
was all about, but was very fortunate in working for two fine trial
lawyers, Damon Young and Nick Patton. I had an early chance
to be in the courtroom often, and over the next 20 years had an
opportunity to be in front of some very fine judges who I learned
a great deal from.
Chief Judge David Folsom
88 2013
SRR Journal: How did you decide that youd like to be a judge?
Judge Folsom: I never had any interest or desire in being a judge
myself. There was a vacancy in the district in 1993, and some local
attorneys approached me about applying for the vacancy. After a
couple of weeks of encouraging me, I submitted an application to
the Senate committee that was filling the vacancy. And two years
to the day from the day I submitted my written application, I was
raising my hand to be sworn in, so Im fond of saying be careful
what you wish for you may receive it. I became the first resident
judge in Texarkana, Texas, since 1929 and served for 17 years
before retiring in March of 2012.
SRR Journal: How did your early days as a trial lawyer differ from
current practice?
Judge Folsom: Its hard now for younger lawyers to gain
experience in the courtroom. In my younger days, we had workers
compensation, personal injury, and subrogation work that was
important to us and our clients, but they didnt have the aspect
of betting the company on the case. So, as a result, we were
given more of an opportunity to be in the courtroom. I think its so
unfortunate now that its so much harder for younger lawyers with
all the tort reform to get opportunities to appear in court to gain
that valuable experience.
SRR Journal: Right. Particularly in the IP area.
Judge Folsom: Thats what I meant. Particularly in IP. So when
young lawyers come by to see me, I encourage them to take
criminal appointments, maybe work for the Department of Justice
if possible and the U.S. Attorneys office, those sorts of avenues to
gain some much-needed court experience.
SRR Journal: Was it an easy transition to the bench for you?
Judge Folsom: When I went on the bench, I immediately started
trying cases. Ill never forget that just before I was sworn in, Judge
Hannah, who had the Marshall docket, said, David, why dont
you come down and watch me select a jury this Monday in a
products case. So I go down to Marshall and Im seated in the
courtroom as Judge Hannah introduces himself to the jury panel
and the lawyers. Then he introduces me and he said, This is David
Folsom. Hes about to be our new district judge. Hell be sworn in
Friday. Were going to start this case next Monday and hes going
to be your presiding judge. So, I had a moment of shock, but it
was my first case; I was sworn in on Friday and I started trying a
products case on Monday.
SRR Journal: Not like you thought it would be?
Judge Folsom: Judge Hannah a few years later told me in a
conversation, he said, David, we were taking bets around the
chambers whether you would agree to try the case or try to find
some reason to not try it. And I said, Which way did you bet,
Judge Hannah? He laughed and said, Ill never tell.
SRR Journal: Why do you think the docket in East Texas expanded
so much?
Judge Folsom: Early on, the docket in Marshall was almost
entirely personal injury-related, products liability, automobile
accidents, those sorts of cases. The docket in Texarkana was
almost nonexistent, so in 1996, lawyers are quick to find out where
theres a possibility to obtain a quick trial in a matter.
I had a case filed in my court, I think the plaintiff was Bell Atlantic,
a Sherman Act case against AT&T, and that was my first complex
case that was filed on the Texarkana docket. Within a few months
of the filing of that case, a second case was filed that took a
considerable amount of my time for the next couple of years. The
State of Texas filed the tobacco litigation in my court, so I had both
of those cases going on parallel tracks. Soon after that, I started to
see more commercial litigation, more Sherman Act cases.
We saw for a period of time a lot of class action cases. Then,
sometime in the late 90s, I probably saw my first patent case. It
was the case Ericsson v. Qualcomm and I thought what on earth
is this creature? I had never had one of those before, didnt know
anything about that area of the law, and the rest is somewhat
history, so to speak.
When Judge Ward went on the bench in 2000, as you probably
know, he developed an interest and fascination in that area of
the law, and he was quick to adopt some local patent rules. And
after those rules were put in place, and it became known that he
enjoyed those sorts of cases, many of them started to be filed. And
I always had at least some portion of the Marshall docket.
SRR Journal: So you think that the particular judges and their
interest in taking on these patent cases was what made East
Texas a popular venue?
Judge Folsom: I think thats an important factor because as you
know theyre a lot of work. Theyre difficult cases, not only from a
technology standpoint, but also from simply the sheer amount of
work involved. I think a certain amount of assurance that a judge
was likely not to transfer those cases is obviously important from
the plaintiffs standpoint.
Generally, in the early time period of those cases being filed, Judge
Ward and I always tried to maintain a scheduling order that would
have the case ready for trial within 18 months, maybe 24 months
of the filing date.
SRR Journal: Okay. What should a litigant in the Eastern District of
Texas expect that would be different than he or she could expect
in other federal districts?
Judge Folsom: Well, Im not so sure you should expect anything
different. Ive seen lawyers from all over the United States. Ive seen
excellent lawyers that relate well to local juries. Whether youre
trying cases in New York or East Texas, I think the techniques are
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the same being professional, being courteous, communicating
well, being sincere, not trying to mislead. The same also holds true
with your witnesses. All of those things that work in East Texas I
think work equally well in any district, regardless of where you are.
SRR Journal: Is there anything unique about East Texas juries?
Judge Folsom: After cases were concluded in my courtroom, I
would tell the jury panel, Very shortly, Im going to come back in
the jury room not to discuss your service in this case, but to hear
your comments on how we can make the system work better to
serve you and your needs in the time that you are away from your
work and family. And I would go back in the jury room with a law
clerk, generally my courtroom deputy, and spend as much time as
the jury wanted to on discussing whatever topics they wished to. I
never tried to probe or pry into the reason for their verdicts. Some
juries would like to discuss the case; others wouldnt. I always
respected their desires in that regard. More often than not they
would ask, Well, did we reach the right decision, Judge? And I
would routinely say, because rarely if ever did I disagree, I think
your verdict was supported by the evidence in the case.
But my point is, over interviewing just countless juries over 17
years, I was always impressed with how hard juries work, and
I think this is true whether its East Texas or New York or the
West Coast.
SRR Journal: Were there any common complaints that you heard
from jury panels?
Judge Folsom: Their number one complaint was, Judge, they
would say, Why do lawyers have to ask the same question 10
different times? Its really annoying to jurors and they wonder
whether youre questioning their intelligence. I often heard that,
Judge, do they think we were not intelligent enough to hear it the
first time? And I said, No, thats certainly not what they thought.
What I routinely tell lawyers, and I think professional witnesses,
expert witnesses, should be the same, is simply dont repeat,
retread on the same subject matter. Juries are quick to understand
the case, generally speaking, and quick to pick up on the themes.
Be respectful of their time.
Theyre also quick to pick up on unprofessional conduct. I often
tell lawyers, Let me assure you when you walk in to the courtroom
and a jury is in the jury box, that theyre looking at your every
move, your every comment, your interaction, whether youre
being courteous, whether youre being professional, whether its
to each other, witnesses, court personnel. I never understood
lawyers who wanted to particularly be disrespectful of a judge
because juries bond with the judge, and when a lawyer makes
an unprofessional comment or reply or gesture, jurors are really
upset by that.
SRR Journal: Any particular thoughts regarding expert testimony?
Judge Folsom: From an expert witness standpoint, I think its
very important to listen to the questions, address the questions,
be responsive, and not change your entire style when you go
from direct examination to cross-examination. Dont change your
personality. Dont all of a sudden become difficult and overly
cautious and refuse to respond. Juries are not pleased with that
sort of conduct, particularly from a professional witness.
SRR Journal: From your perspective, does it matter where the
expert is from? Weve heard it said that its difficult to bring an
expert in from say New York City into the Eastern District of Texas.
Judge Folsom: I dont think so. As long as that expert is able to
relate to people and hes qualified and intellectually honest, I think
that wins the day regardless of where theyre from.
SRR Journal: During your time on the bench, Judge Folsom,
non- practicing entities, or NPEs, became a much bigger factor
in patent litigation. How do you think NPEs have affected the
litigation process?
Judge Folsom: Well, I think we see a lot more litigation as a result.
But may I comment again on my jury experience in that regard?
Early on, in the NPE cases, I saw a lot of defendants defend the
case from the standpoint of this plaintiff is an NPE. They dont
manufacture anything; therefore theyre not entitled to a remedy as
a result. And I saw that it wasnt working with the juries. And Ive
interviewed or asked many jurors if the fact that the plaintiff didnt
manufacture anything did that matter with you? And I dont think
I ever heard a juror say, yes, it mattered to me.
In East Texas, plaintiffs attorneys would routinely use the example
of; say you own 40 acres of property 50 miles from here. You dont
live on it. You dont do anything with it. Does that allow someone
to come in and clear-cut the timber? Youre not going to find
anyone in East Texas that will say that would be okay. So Ive just
never seen that being a big issue with the juries.
SRR Journal: Weve seen over the years, again staying with the
NPEs, that its become more difficult for NPEs to win large damages
awards, primarily based on legal decisions and precedents. We
had the eBay v. MercExchange case, which made it more difficult
for NPEs to obtain injunctions in patent cases. Weve also had
over the last few years more cases that have tended to crack down
on application of the entire market value rule.
Judge Folsom: Right.
SRR Journal: And weve also seen that its become more difficult
for NPEs to join multiple defendants in the same lawsuit. A question
for you do you think the courts have gone either far enough or
too far in instituting reforms that are affecting NPE litigation?
90 2013
Judge Folsom: Thats one area I dont think its particularly
appropriate for me to say one way or the other. As a judge I just
simply tried to follow whatever case law we had from the Federal
Circuit or whatever legislation we had from Congress. So I think
thats more of a question for the Federal Circuit and Congress than
for David Folsom, retired judge.
SRR Journal: In our previous interview of Chief Judge Rader from
the Federal Circuit, he discussed his thoughts that courts might
be able to tailor the courts timing and procedures differently in
large-dollar cases as opposed to smaller cases. Is that something
with which you agree?
Judge Folsom: Well, I think we should always give thought to
how to move the docket; do it quickly. Judge Davis made efforts
in the Parallel Network case where he did exactly that. In that
case, Judge Davis was confronted with hundreds of cases, and
these were all pre-AIA cases. And he quickly had a special status
conference of all the cases to discuss the plaintiffs litigation plan.
Judge Davis then determined the three or four claims that would
perhaps move the case on early claim construction, set the case
for early claim construction combined with motion for summary
judgment practice within a few months of the initial status
conference, granted summary judgment on all of those cases, and
it was recently affirmed by the Federal Circuit, and I think there
were comments as to the innovative manner in which Judge Davis
had moved those cases along.
SRR Journal: Not too long ago, Chief Judge Rader sat by
designation in a number of cases in East Texas. Did you have the
chance to interact with him when he was down there?
Judge Folsom: Well, I was the chief judge at the time, and we
were so pleased to have him down. As far as being able to interact
at that time, I think I was actually trying a case over in a criminal
case in Sherman when he was trying that case in Marshall, so I
didnt at the time. But weve had a lot of discussions about I think
the benefit of that practice.
I had the pleasure and privilege, Judge Ward did also, and I think
Judge Clark, serving by designation in the Federal Circuit. Judge
Leonard Davis did that as recently as a couple of weeks ago, and
I think it certainly makes us better district judges. And I read your
article and Ive discussed this with Chief Judge Rader. I think he
feels it helps helped him greatly as a circuit judge to appreciate
the problems of the district judge.
I think its a wonderful method for us all to learn how difficult
the other judges job is. I think we as district judges feel that
occasionally appellate judges dont appreciate the number of
decisions and how quickly we have to make them, and then
I assure you I never gave enough thought to all the problems
and issues that occasionally district judges create when you
dont have an adequate record for appellate judges to make
adequate decisions.
I just think its a wonderful practice, and I wish more of the judges
from the Federal Circuit would take advantage of it, and likewise
a wonderful learning experience for a district judge to serve at the
Federal Circuit level, or on regional circuit.
SRR Journal: How does it work when a Federal Circuit judge sits
by designation? Does he or she actually hand pick a case or do
you, as chief judge, assign cases?
Judge Folsom: You know how that always works. We give away
hard cases that we dont want to try. (Laughter.) No, when now-
Chief Judge Rader was here, I think I carved out a few cases that
were ready for trial.
SRR Journal: When you were sitting by designation at the Federal
Circuit, what were the one or two things that you took from that
experience that helped make you a better judge when you got
back to the district court level?
Judge Folsom: I was always, I like to believe, cautious at trying to
have a full record, that any appellate judge that reviewed a record
of one my cases would understand what I did and why. They might
not agree with it, but at least they would know how and why I
arrived at a particular decision. The Federal Circuit experience
impressed upon me how important it was, because occasionally
you would read a record in a case and youd be scratching your
head saying, well how did this judge go from Step A to Step D?
What were the steps in between? I was so impressed when I went
to the Federal Circuit to see how well prepared the judges were.
SRR Journal: Lets switch gears a little bit and talk about your
current practice.
Judge Folsom: Okay.
SRR Journal: Youre currently at Jackson Walker. Obviously you
had a lot of choices. What influenced your decision to choose
Jackson Walker?
Judge Folsom: Well, over the years I had experience dealing
with various Jackson Walker attorneys. I was always impressed
by their professionalism. Im an old-fashioned guy. I believe very
much in professionalism and courtesy. I just always observed that
professionalism and courtesy with the Jackson Walker firm. They
were a regional firm. So all of that factored in with me making the
decision to go with Jackson Walker, and Ive been so pleased with
my decision. I hope theyre half as pleased as I am and were both
happy, so to speak.
SRR Journal: So how has that transition gone from presiding over
cases to mediating cases and counseling clients?
Judge Folsom: Its been vastly different. Judge Bob Parker was a
district judge in our district, and then he went on our circuit court
of appeals. And Judge Parker told me, David, youre going to
discover that after you take off the robe, youre forever respected
but no longer feared. So now I dont have any particular control
91 2013
over anyone. Its just the power of persuasion and communication
and I cannot in the mediation process require anyone to do
anything. To be quite honest, its refreshing to not have that power
to order someone to do something, particularly to order them to
go to the Bureau of Prisons. Thats absolutely something I havent
missed. But perhaps the biggest change is the lack of authority to
order anyone to do anything. Youre left with communication skills
and trust and credibility.
SRR Journal: Right. So do you find yourself mediating certain
types of cases?
Judge Folsom: Well, the vast majority of my cases have been
patent related, but Ive mediated a few cases in other areas of the
law, and certainly will mediate those.
SRR Journal: Under what conditions do you find cases to be most
appropriate for mediation?
Judge Folsom: I think generally my experience has been that
when youre on the eve of trial, the judge has already decided
most of the issues that are to be decided in the case. The parties
have had rulings on Markman, summary judgment, all of those
issues. They filed motions to strike each others experts, which
you routinely see. A lot of the uncertainty is gone, and come
next Monday theyre facing a jury panel. Thats generally when
mediation is most effective.
I do it at all stages of the litigation and, occasionally, its very helpful
early on. Even though the case may not resolve, it oftentimes helps
frame issues.
SRR Journal: What do you see as the biggest obstacles to settling
a case through mediation?
Judge Folsom: Well, what I see oftentimes is let me try to be
diplomatic about this. I think parties being a little unreasonable,
and this could be on either side of the case, on their assessment
of the case. Maybe plaintiffs who dont want to bend any on their
damage model. And I often say, Well, not many defendants are
going to pay 100 percent of your damage model without a trial.
And then, occasionally, the flip side of that, defendants who refuse
to pay any sum other than token amounts, and again I basically
tell them, Well, most plaintiffs are not going to give up their case
without a reasonable settlement offer.
SRR Journal: When you are mediating a case, do you typically
prefer to have outside counsel involved in those mediations or do
you prefer to deal directly with the parties? Have you noticed any
differences in results?
Judge Folsom: I often assess it on a case-by-case basis.
Sometimes youd much rather be mediating and talking to the party
representatives. Occasionally, for whatever reason, emotionally or
whatever, thats unwise. Occasionally, you want the lawyers out of
the process. I dont think theres one size that fits all. Generally, if
I can have the decision makers present that have a good working
relationship, I always think thats a very productive way to try to
resolve a case, but thats not always possible.
SRR Journal: Right.
Judge Folsom: Sometimes those decision makers, the emotion
and anger of maybe the case doesnt allow them to talk to each
other in a productive manner.
SRR Journal: If you could provide a couple of suggestions to
mediation participants to make the mediation process more
successful, what would your suggestions be?
Judge Folsom: I always require a mediation statement, and I think
its very helpful to understand clearly the procedural history of the
case. I think its very important to understand the past settlement
history in the case and a concise summary of the law. I have a
mediation statement guide that sets forth what I request in about
a 10-page document. I always request that the statement contain
a candid assessment of the weaknesses of your case because I
think its important for parties to acknowledge and understand that
cases do have weaknesses.
SRR Journal: Do you typically suggest that the parties perform
or look at some type of economic assessment in advance of the
mediation session to get a sense of what kind of dollars youre
talking about?
Judge Folsom: Thats routinely contained in the section on
settlement. I like to know about their damage model, particularly
if you have a case where a number of defendants have already
settled. Its real helpful from the mediators standpoint, so you
can compare apples to apples and oranges to oranges. What was
the damage model to Defendant A that settled for X dollars and
Defendant B, and that way it gives you a real feel or comparison of
the range of settlement on the case youre mediating.
SRR Journal: Okay. Just a couple of wind-up questions here.
From your time on the bench, youve probably heard some very
interesting arguments. Were there any particularly unusual or
creative arguments that you recall hearing?
Judge Folsom: I loved Judge Raders comment in your prior
article. Maybe the most effective arguments were not arguments. I
think he referred to it as a conversation. I think thats very effective.
I heard a lot of really fascinating what Ill call life stories, and
particularly these cases that I heard from inventors and how the
invention came to mind and what drove their invention. I just think
that plays so well with juries and fascinates them so much that
those things really, really stand out.
SRR Journal: What do you, Judge Folsom, consider to be your
greatest accomplishment on the bench?
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Judge Folsom: Im going to let others reserve judgment on that.
SRR Journal: Okay. Do you have any additional goals for your
legal career?
Judge Folsom: With the blessing of good health, I hope to
continue what Im doing for another five to 10 years, and then,
maybe it will be time for me to take a break and do a few things
Id like to do. As long as I continue to enjoy myself, then Im going
to continue working in the legal professional. I just hope generally
that I am judged as observing the Constitution and being fair and
courteous to people. And if Im judged by that standard, I couldnt
ask for much more.
SRR Journal: Thats a good goal for any of us. So when you do
take a break from your legal work, what do you like doing?
Judge Folsom: Well, I used to like to play golf. You need to
complain to Bob Latham and John Jackson and others that are
working me too hard. I havent played golf in about three or four
months. My wife, Judy, and I also love to travel. Judy and I are
very active in animal rights issues. I was on the local animal shelter
board for about 10 years while I was serving as a judge, so weve
always had an interest in those issues.
Im an exercise person. I used to run a lot until I wore out my knees
and back, so now Im more of a walker. So I guess my primary
hobby right now is exercising, not much golf, but maybe when the
grass is greener and I transition into this new career, Ill be able
to play a little golf.
SRR Journal: Thank you for your time and your thoughtful
responses.
Endnotes nnn
SRR Journal would like to thank Digital Evidence Group for
providing court reporting services to transcribe our interview of
former Chief Judge Folsom.
John R. Bone, CPA, CFF is a Managing Director in the Dispute
He has 20 years of experience serving as either an expert
witness or consultant in an array of litigation matters, including
commercial contract disputes, intellectual property disputes, and
antitrust matters. Mr. Bone can be reached at +1.312.752.3378
or jbone@srr.com.
David A. Haas, CLP is a Managing Director in the Dispute Advisory &
Forensic Services Group at Stout Risius Ross (SRR). He has served
as an expert witness in an array of litigation matters, including
intellectual property disputes and commercial contract disputes.
Mr. Haas can be reached at +1.312.752.3343 or dhaas@srr.com.
Decisions from
the District Courts
Erich W. Kirr, CLP ekirr@srr.com
Matthew Paye mpaye@srr.com
93 2013
This is one in a running series intended to highlight rulings and/
or issues from the District Courts that may be relevant to the
calculation of damages in intellectual property matters. While
rulings from the District Courts may not establish general precedent
outside of their particular district, they can involve thought
provoking issues and can also reflect how the District Courts are
interpreting and responding to rulings by the Court of Appeals
for the Federal Circuit (Federal Circuit). The goal of this article
is to provide a synopsis of particular issues, rulings, and cases.
For certain cases, documentation and/or a more comprehensive
discussion of a particular case and the relevant issues can be
found at SRR.com/DecisionsFromTheDistrictCourts.
Novel Approach to Determining
RAND Royalty Rate nnn
In Microsoft Corporation v. Motorola, Inc., et al. (Microsoft
v. Motorola), a case from the Western District of Washington,
Motorola filed a Daubert motion to exclude certain testimony
from three of Microsofts expert witnesses. Motorola argued that
the experts opined to a royalty rate that was derived by using
an unsupported methodology. Motorolas patents-at-issue were
essential to certain standards established by the Institute of
Electrical and Electronics Engineers (IEEE) and the International
Telecommunication Union (ITU), organizations of which both
Microsoft and Motorola are members. Such organizations often
require or encourage their members to license standard essential
patents on reasonable and non-discriminatory (RAND) terms to
anyone who requests a license.
As is customary, Microsofts experts utilized the framework of
a hypothetical negotiation to determine a reasonable royalty.
However, they utilized two atypical assumptions in structuring
the hypothetical negotiation. First, rather than assuming the
hypothetical negotiation took place on or about the date of first
infringement, they assumed that it would have occurred prior to
the date when the standard was adopted. Second, rather than
contemplating a bilateral negotiation between Microsoft and
Motorola, they assumed a multilateral negotiation involving the
full participation of standard essential patent holders and potential
standards implementers.
Microsoft argued its framework addressed two key risks
presented by licensing of standard essential patents, namely: 1)
the improper capture of the hold-up value of the standard as
the result of the patentees ability to leverage its monopoly over
implementers of the standard; and 2) [the] stacking of royalties
by many holders of essential patents resulting in unreasonable
royalty burdens to implementers.
1

1
Microsoft Corporation v. Motorola, Inc., et al., No. 10-1823 (W.D. Wash. Oct. 22, 2012)
(order denying motions to exclude testimony), p. 21-22.
94 2013
Motorola countered by arguing that its agreements with IEEE and
ITU clearly indicate that RAND license agreements are bilateral
in nature, involving only the patentee and the implementer.
Motorola also argued that industry participants and academics
understand that a RAND license is the product of a bilateral
negotiation and that Microsofts own experts have previously
testified this to be the case.
The Court acknowledged that Microsofts proposed framework
was not typical and that it has not been subjected to peer review
and publication. However, the court indicated that [w]here peer
review and publication are absent, the experts must explain
precisely how they went about reaching their conclusions and
point to some objective source a learned treatise, the policy
statement of a professional association, a published article in a
reputable scientific journal, or the like to show that they have
followed the scientific evidence method, as it is practiced by (at
least) a recognized minority of scientists in their field.
2

The Court ultimately found that Microsofts proposed
framework reasonably relies upon and logically addresses widely
acknowledged and published concerns of hold-up and stacking
found in licensing standard essential patents.
3
And while
Microsofts proposed framework is subject to criticism, the Court
did not exclude the testimony of Microsofts experts, reasoning
that issues raised by Motorola could be addressed at trial
through cross examination.
Admissibility of Defendants Decision
to Stop Commercialization of the
Accused Product nnn
In Monsanto Company and Monsanto Technology LLC v. E.I. Du
Pont Nemours and Company et al. (Monsanto v. DuPont), a case
from the Eastern District of Missouri, Monsanto accused DuPont of
infringing one of its patents related to genetically modified (GM),
herbicide-resistant soybeans. The accused activity occurred
while DuPont was attempting to develop its herbicide-resistant
soybeans, a process which can take years, if not decades, to
ultimately result in a commercial product. At some point during
the development process, DuPont stopped development and
terminated its plan to commercialize the GM soybean. Monsanto
sought reasonable royalty damages for DuPonts infringing use of
its patented technology.
DuPont requested the Courts approval to present evidence to
the jury regarding its current lack of intent to commercialize the
product. Monsanto was opposed to such information being
presented to the jury. Monsanto argued that only DuPonts
intentions at the time of the hypothetical negotiation are relevant to
assessing damages and not any subsequent decision to terminate
the development/commercialization process.
The Court sided with Monsanto, finding that Defendants present
intentions concerning commercialization of [the accused] soybeans
are irrelevant and inadmissible under Federal Rule of Evidence
402.
4
The Court reasoned that any remote probative value
of this evidence was greatly outweighed by the danger of confusing
the jury, wasting time, and unfairly prejudicing Monsanto and
would be excluded under Federal Rule of Evidence 403. The
Court did, however, allow DuPont to present evidence that no
sales have occurred to date.
Post-Verdict Royalty Rate nnn
In Soverain Software LLC v. J.C. Penney Corporation, Inc., et
al., a case from the Eastern District of Texas, Soverain accused
multiple defendants of infringing three of its patents that
generally related to the use of shopping cart features and online
statements in performing electronic commerce transactions over
the internet. After a five-day trial, the jury found for Soverain and
awarded damages of approximately $18 million.
5
Both parties
filed post-verdict motions, which included Soverains motion for
post-verdict damages.
Soverain requested that the Court impose a post-judgment
royalty rate that was quadruple the royalty rate implied by the
jury verdict. Soverain argued that a higher royalty rate than that
found by the jury was warranted since factors/circumstances
considered in the hypothetical negotiation have changed.
Soverain argued that in consideration of those changes, the
implied royalty rate should be doubled. Moreover, Soverain
requested that the royalty rate be doubled again based on
defendants continued willful infringement.
The Court noted that Soverains expert utilized the book of
wisdom and considered post-1998 evidence in arriving at his
damages model. Moreover, this evidence was presented to and
considered by the jury. As such, the Court found that the rate
implied by the verdict already reflected the evidence of changed
circumstances and consequently an adjustment based on this
argument was not warranted.
The Court then considered the Read factors, which provide
guidance in determining whether and how much damages
should be enhanced in light of a defendants ongoing and
willful infringement.
6
After evaluating the Read factors, the
Court determined that a 2.5x enhancement to the jurys implied
royalty was appropriate.
2
Id. at p. 23.
3
Id. at p. 25.
4
Monsanto Company and Monsanto Technology LLC v. E.I. Du Pont Nemours and Company et al., No. 09-686 (E.D. Mo. July 11, 2012) (memorandum and order), p. 2.
5
Soverain Software LLC v. J.C. Penney Corporation, Inc., et al., No. 09-274 (E.D. Tex. August 09, 2012) (memorandum opinion and order), p. 3.
6
Read Corp. v. Portec. Inc., 970 F.2d 816 (Fed. Cir. 1992).
95 2013
Appropriate Consideration of Acceptable,
Non-Infringing Alternatives nnn
In Carnegie Mellon University v. Marvell Technology Group, LTD,
and Marvell Semiconductor, Inc. (CMU v. Marvell), a case from
the Western District of Pennsylvania, Carnegie Mellon University
(CMU) filed suit against defendants alleging infringement of
its patents related to high density magnetic recording sequence
detectors. CMU sought damages in the form of a reasonable
royalty. During the course of the litigation, CMU filed a Daubert
motion asking the Court to exclude the testimony of two witnesses,
one a technical expert and the other a damages expert.
CMU argued that neither experts reports were reliable because
they failed to analyze whether certain allegedly alternative
technologies were, 1) available and/or 2) acceptable during the
period of the alleged infringement.
Defendants countered, maintaining that there is no requirement
that the alternatives be on the market to be considered
available.
7
Rather, they argued that the question of alternatives
is more accurately stated as whether it could have used,
built, and/or implemented the alternatives.
8
With regard to
acceptability, defendants argued that the alternatives considered
by the witnesses address the key benefit of the patents, namely an
improved signal-to-noise-ratio (SNR) gain.
9

In addressing the issue of availability, the Court cited the opinion
in Mars, Inc., v. Coin Acceptors, Inc.,
10
where the Federal Circuit
found that even though [t]here was no available and acceptable
noninfringing alternative to which [the defendant] could have
switched at the time of the hypothetical negotiation, the fact that
there was a possibility that the defendant could have come up
with one was sufficient since it was shown that [defendant]
had the ability, resources and desire to design around the
[plaintiffs] patents.
11
Likewise, in the instant case, the Court
found that [d]espite the lack of evidence on availability, the mere
existence of [alternatives as proffered by defendants witnesses]
is indicative that not only had others discovered different
means of improving SNR gain, but that Marvell probably could
have come up with one as well.
12

With respect to acceptability, the Court acknowledges that
defendants technical expert addressed the alleged key feature
of the patents: improved SNR. Assuming improved SNR is a
key characteristic, the Court found that the experts opinion
showed that the important properties of the various alternatives
were effectively identical to that of the patented technology.
As such, the Court found, they would qualify as acceptable.
Moreover, the Court found that the existence of noninfringing
alternatives is a question of fact and should, therefore, not be
addressed in a Daubert review.
CMU also challenged the damages experts testimony for failing to
price the alleged alternatives in a manner that would enable him
to properly compare the alternatives to the technology at issue.
In making this argument, CMU pointed to an opinion in Grain
Processing in which the Federal Circuit essentially said that the
high cost of an alternative can render it unavailable.
13

The Court found that while availability is clearly affected by the
price of the alternative technologies, the burden is not on Marvell to
establish what CMUs damages are; that burden lies with CMU.
14

Furthermore, considering that CMUs position had effectively been
that Marvell would be willing to pay almost any price to license the
advantages resulting from CMUs technology, the Court reasoned
that it must be that the price of licensing an alternative would have
been inconsequential to Marvell as well. As such, the Court denied
CMUs Daubert motion.
Cap on Reasonable Royalty Damages nnn
In Ergotron, Inc., v. Rubbermaid Commercial Products, LLC,
a case from the District Court of Minnesota, Ergotron, Inc.
(Ergotron) filed suit against Rubbermaid Commercial Products,
LLC (Rubbermaid), alleging infringement of a patent covering a
lift system for a flat panel monitor and keyboard that is vertically
adjustable and stores in a minimum profile.
Rubbermaids damages expert opined that damages should be
calculated using a royalty rate of 0.4% of net sales, and in no event
greater than 2.4% of net sales.
15
The expert arrived at the 2.4%
maximum royalty rate by comparing the estimated profit margin
on the accused products (42.4%) with Rubbermaids target profit
margin of 40%. As a reasonableness check, Rubbermaids expert
also considered the cost of implementing a design around, the
cost of which reflected a royalty rate of 1.0% to 1.6% of net sales.
7
Carnegie Mellon University v. Marvell Technology Group, LTD, et al., No. 09-290, (W.D. Pa. August 24, 2012) (memorandum opinion), p. 6.
8
Id. (emphasis added in brief).
9
Marvell maintained that CMUs position has been that the key benet of its patents is an improved SNR gain.
10
Mars, Inc., v. Coin Acceptors, Inc., 527 F.3d 1359, 1373 (Fed. Cir. 2008).
11
Carnegie Mellon University v. Marvell Technology Group, LTD, et al., No. 09-290, (W.D. Pa. August 24, 2012) (memorandum opinion), p. 7. Citing Mars, Inc., v. Coin Acceptors, Inc.,
527 F.3d 1359, 1373 (Fed. Cir. 2008).
12
Carnegie Mellon University v. Marvell Technology Group, LTD, et al., No. 09-290, (W.D. Pa. August 24, 2012) (memorandum opinion), p. 7.
13
Grain Processing Corp., v. American Maize-Products Co., 183 F.3d 1341, 1354 (Fed. Cir. 1999).
14
Carnegie Mellon University v. Marvell Technology Group, LTD, et al., No. 09-290, (W.D. Pa. August 24, 2012) (memorandum opinion), p. 9. Citing Lucent Techs., Inc. v. Gateway, Inc.,
580 F.3d 1301, 1324 (Fed. Cir. 2009).
15
Ergotron, Inc., v. Rubbermaid Commercial Products, LLC, No. 10-2010 (D. Minn. August 28, 2012) (memorandum opinion and order), p. 6.
96 2013
Ergotron filed a Daubert motion requesting the Court exclude the
testimony of Rubbermaids damages expert. Ergotron argued it
is settled law that a defendants profit expectations and design-
around costs do not reflect an absolute ceiling on damages.
As such, Ergotron contended that the methods employed by
Rubbermaids expert were unreliable because they misapplied
existing damages law.
The Court found that while Rubbermaids expert did repeatedly
state that 2.4% would be a cap on the royalty rate, that conclusion
was drawn not from a misapplication of the law, but rather from the
experts analysis of the facts of the case. Specifically, the fact that
Rubbermaid personnel were available to engineer a non-infringing
alternative at a low cost led Rubbermaids expert to conclude that
Rubbermaid would not agree to a royalty rate that would result in
profits below the 40% target.
In denying the Daubert motion, the Court also stated that it is not
improper for an expert to consider the profits of an infringer or
the costs of non-infringing alternatives in determining a reasonable
royalty, rather, it is endorsed.
Use of Infringers Selling Price in
Calculating Lost Profits nnn
In Illinois Tool Works, Inc., v. MOC Products Company, Inc., a case
from the Southern District of California, MOC Products Company
(MOC) filed a Daubert motion seeking to preclude Illinois Tool
Works (ITWs) expert from opining to lost profits damages in
part because MOC claimed his damages calculation was based
on an incorrect and unsound methodology.
16

As the Court noted, [g]enerally speaking, [t]he measure of
lost profits is the difference between the patent owners cost of
production and the price at which the patent owner would have
sold the product.
17
In performing his calculation, ITWs expert
used MOCs selling price less ITWs cost of production/sales.
MOC argued that it was improper to use MOCs price with ITWs
costs and that doing so resulted in lost profits damages that were
overstated and unreliable.
ITW argued that the Daubert motion should be denied since MOC
could cross-examine that witness with regard to all of the Panduit
factors including his use of the ITWs selling price.
The Court researched the topic and while it found no case law
supporting the methodology of using the infringers price and
the patentees cost, it also found no case law discrediting the
method. As such, the Court doubted that methodology was
so unreliable as to warrant exclusion. Moreover, the Court
emphasized that the measure of lost profits damages need only
be a reasonable approximation.
18
As such, the Court denied
MOCs Daubert motion.
Erich W. Kirr, CLP is a Director in the Dispute Advisory & Forensic
Services Group at Stout Risius Ross (SRR). He has worked
on a variety of litigation and valuation engagements and is
experienced in matters involving intellectual property disputes,
commercial contract disputes, securities fraud, accounting fraud,
post-acquisition disputes and bankruptcy/solvency matters.
Mr. Kirr can be reached at +1.312.752.3360 or ekirr@srr.com.
16
Illinois Tool Works, Inc., v. MOC Products Company, Inc., No. 09-1887, (S.D. Cal. August 17, 2012) (order on motions in limine), p. 7. More generally, MOC sought to preclude ITW
from seeking lost prots damages at trial.
17
Illinois Tool Works, Inc., v. MOC Products Company, Inc., No. 09-1887, (S.D. Cal. August 17, 2012) (order on motions in limine), p. 13. Citing Beckon Marine, Inc. v. NFM, Inc., 2007
U.S. Dist. LEXIS 21916, at *7 (W.D. Wash. Mar. 27, 2007) (citing Kori Corp. v. Wilco Marsh Buggies & Draglines, Inc., 761 F.2d 649, 655 (Fed. Cir. 1985)).
18
Illinois Tool Works, Inc., v. MOC Products Company, Inc., No. 09-1887, (S.D. Cal. August 17, 2012) (order on motions in limine), p. 13. Citing Kori Corp., 761 F.2d. at 655.
Should the Pattern
Be the Brand?:
A Potential Revenue-
Generating Bonanza
Marc A. Lieberstein, Esq. Kilpatrick Townsend & Stockton LLP
mlieberstein@kilpatricktownsend.com
Kristin G. Garris Kilpatrick Townsend & Stockton LLP
kgarris@kilpatricktownsend.com
97 2013
Patterns are all the rage on clothing, footwear, interior and
exterior design, textiles, and more. Designers have even
associated entire lines or seasons with particular patterns and
had great success.
So, can a pattern, by itself, become the brand? And if so, are
there revenue-generating opportunities for pattern owners that
emanate from the bridge between trademark and copyright rights
that can protect the pattern simultaneously? The answer to both
questions, as discussed in this article, is yes. And while the bridge
has not always been utilized fully to create a brand identity in
a pattern, if properly used, this bridge could not only deliver a
strong brand to the marketplace, but also supplement protection
for the pattern/brand by giving pattern owners additional
enforcement tools, as well as opening doors to a broader array of
revenue streams by way of licensing, product-line expansion, or
other ventures.
Patterns as Brands (Trademarks). Nearly every consumer
can think of a pattern that is identified solely with one brand
owner the plaid lining of a BURBERRY coat, the monogram or
checkerboard pattern on LOUIS VUITTON bags, the stylized GG
pattern on GUCCI handbags, and even the varied and colorful
patterns of LILLY PULITZER-branded or MISSONI-branded
apparel all comprise distinctive patterns that immediately act as
source-identifiers.
1
Put another way, consumers consider certain
patterns to be brands (trademarks), even if the consumer, and
in some cases the pattern owner, is not aware that the pattern
serves the legally defined role of a trademark; i.e., identifying the
source of the products.
LILLY PULITZER Pattern
See www.lillypulitzer.com
MISSONI Pattern
See www.missoni.com

1
For an example of how patterns or prints are used to enhance branding, see the web
page at <http://blog.lillypulitzer.com/2012/11/05/a-print-worth-celebrating-in-the-
beginning/>, where LILLY PULITZER prints can be downloaded as a background for
your mobile device, iPad, computer, and Facebook cover photo. See also the Shop
Prints page at <http://www.lillypulitzer.com/section/Shop-Prints/9.uts>.
Guest Article
98 2013
The U.S. Patent & Trademark
Office (USPTO) database
shows that many patterns are in
fact registered as trademarks.
Louis Vuitton Malletier
Corporation (LVM) owns
U.S. Trademark Reg. No. 1653663
for its classic pattern shown here:
More recently, LVM secured
U.S. Trademark Reg. No.
3576404 for a different pattern
that LVM describes as a mark
[that] consists of squares with
a checkered pattern of light and
dark with the unusual contrast
of weft and warp . . . The pattern
appears over substantially the
entire surface of the goods.
Burberrys classic plaid pattern
to the right is registered
under U.S. Trademark Reg.
No. 3529814, among others,
and is described as follows:
The mark consists of a tan
background, light tan vertical and
horizontal lines, black vertical and
horizontal lines, white squares,
and red vertical and horizontal lines, forming a plaid pattern. The
mark also consists of a repeating check design applied in whole or
in part on or in connection with the goods or services. The mark is
not limited to position or placement.
The aforementioned pattern owners clearly see that their
patterns serve as trademarks, not just fabric designs. And
these pattern owners represent the current trend where
designers are increasingly using their patterns to build new
brands, attract new customers, and expand their branded
product lines. Pattern owners appear to no longer rely solely
on their word marks or logos to distinguish their products.
New patterns may be used each season to set a designer or
seasonal collection apart from others. Christina Brinkley said
it well in her 2012 Wall Street Journal article titled A Pattern
Emerges: This season, Pradas rumbling car prints represent the
label loudly and clearly . . . More subtle and creative than a logo,
prints are a way for designers to brand their creations without
slapping initials on them.
2

The maturity of patterns to now serve as brands results in new
ways for their owners to increase revenue. Instead of just licensing
word marks and logos, pattern owners can license the pattern
separately, and expand into areas of the marketplace where
the word marks or logos might not be able to go; e.g., a foreign
country where the word mark or logo is not protectable or carries
a derogatory or unsavory connotation when translated. Such
patterns are also endowed not only with protection as a trademark
under federal and state law
3
, but also usually have an added layer
of copyright protection under federal law and in most foreign
countries, provided the patterns satisfy certain requirements.
4

This dual-protection scheme, and the enforcement measures it
provides, should empower the pattern owner to more effectively
thwart infringers and counterfeiters.
Protecting Patterns as Brands
(Trademark and Copyright) nnn
Trademark and copyright rights have different origins and
purposes, but can work together or separately to protect the
pattern and prevent copying.
1. Trademark Protection
The purpose of a trademark is to identify the particular source of
goods or services. A trademark can be a word, symbol, design,
or even color (TIFFANY blue, for example).
5
In the United States,
trademark rights are created by use of the mark, not registration.
Patterns that are not registered, but which serve as trademarks,
may be protected under federal law, which prohibits false
representations, false descriptions, and false designations of
origin in the sale of goods and services. They are also protected
under common law in all states, and most states have laws
governing deceptive trade practices, fair business practices, or
false advertising statutes that prohibit unfair competition, including
trademark infringement.
A pattern owner with a registered trademark may sue for federal
statutory trademark infringement, unfair competition, and dilution
in some cases, and has equitable and monetary remedies available
when the owners trademark rights are infringed, including seizure,
recall orders, and injunctive relief and/or damages (statutory
damages for counterfeiting, actual damages, profits, and/or fees
and costs, as applicable).
6

2
Christina Brinkley, Wall Street Journal, A Pattern Emerges (Feb. 25, 2012).
3
In addition to building common law trademark rights through use over time, a trademark owner can build trade dress rights over time as well. See Vaughn Mfg. Co. v. Brikam Intl Co., 814
F.2d 346, 348 n.2 (7th Cir. 1987) (A products trade dress is the overall image used to present it to purchasers; it could thus include, to give a partial list, the products size, shape, color,
graphics, packaging, and label.).
4
Another form of protection for patterns may be provided by a design patent (as opposed to utility patents), although this form of pattern protection is beyond the scope of this article. A
design patent protects the ornamental characteristics (the appearance) of an object, not its functional features. See 35 U.S.C. 171. In 2012, Lululemon Athletica Canada Inc. sued Calvin
Klein and G-III Apparel Group, Ltd., claiming that certain of the defendants running tights and waistband pants infringed two design patents owned by Lululemon for the design elements
found in the plaintiffs pant style and waistband design. See Case No. 1:12-cv-01034-SLR (D. Del. 2012). See generally http://www.uspto.gov/patents/resources/types/designapp.jsp for
additional information on design patents.
5
U.S. Trademark Reg. No. 2416795.
6
See 15 U.S.C. 1114 et seq.

99 2013
Trademark infringement under federal and state law is found when
a person or entity uses a mark or imitation of a mark that is likely
to cause consumer confusion, to cause mistake, or to deceive
consumers.
7
Determining whether a likelihood of confusion exists
requires considering a number of factors.
8
A mark owner is not
required to prove that all, or even a majority, of these factors favor
a likelihood of confusion.
9

There are other significant benefits to trademark registration for
patterns. For example, having a registered trademark and taking
advantage of customs recordal procedures for such registered
patterns in the U.S. (and other jurisdictions such as Canada, China,
or the European Union) can help a brand owner keep counterfeit
and gray market
10
goods out of the U.S. Owners of U.S. trademark
registrations may record these with U.S. Customs and Border
Protection, an agency under the auspices of the Department of
Homeland Security, to assist that group in its efforts to prevent
importation of goods that infringe registered marks.
11

2. Copyright Protection
A copyright protects the expression of an idea original works of
authorship fixed in a tangible medium. Copyrights are generally
not available for words, symbols, slogans, common designs, or
monograms, but a copyright does protect the elements of a work
that are original. Copyright protection is available for a work that
contains sufficient originality and expressive elements. A pattern,
for example, can be protected by copyright if it is 1) independently
created, and 2) possesses a spark or minimal degree of creativity,
even if parts of the pattern (circles, squares, etc.) existed previously.
Copyrights can give pattern owners protection for things that may
not otherwise have protection under trademark or patent law.
For fashion designers, for example, the particular style or design
of a dress or jacket may not be copyrightable
12
, but the pattern
used on the dress or jacket, or even the hang tag or label, may
very well be.
13
Copyright owners must show that their designs
are nonfunctional. However, even the design of a useful article
is eligible for copyright protection if that design incorporates
pictorial, graphic, or sculptural features that can be identified
separately from, and are capable of existing independently of, the
utilitarian aspects of the article.
14
Think of the plaid on BURBERRY
clothing or the LOUIS VUITTON patterns shown above.
Unlike trademarks, copyright rights do not depend on use.
15

Copyright rights are established when a work is created in a fixed
tangible medium of expression
16
although in order to sue for
copyright infringement under U.S. federal law you must 1) have a
copyright registration (some jurisdictions in the U.S. allow you to
sue if you have an application in process), and 2) register the design
within three months of its first publication or the infringement.
17
Copyright rights can even extend outside the U.S., as many
countries recognize and offer protection to foreign copyrights under
certain conditions through treaties and conventions such as the
Berne Convention.
18
For trademarks, there is no worldwide treaty
under which you can enforce your rights; separate enforcement
efforts are necessary in each country. Additionally, a copyright can
cover instances where the copied pattern appears on any goods,
regardless of whether they compete with the pattern owners
products or if they are listed in the trademark registration. Finally,
the copyright application process is inexpensive and usually non-
contentious, unlike the USPTO trademark registration process.
Copyright rights can in some cases be easier to enforce than
trademark rights.
19
Like trademark registrations recorded in the
7
Id. at 1114(1).
8
See factors set forth in In re E.I. du Pont de Nemours & Co., 476 F.2d 1357, 1361 (C.C.P.A. 1973):
(1) similarity or dissimilarity of the marks in their entireties as to appearance, sound, connotation, and commercial impression
(2) similarity or dissimilarity and nature of the goods or services as described in an application or registration or in connection with which a prior mark is in use
(3) similarity or dissimilarity of established, likely-to-continue trade channels
(4) conditions under which and buyers to whom sales are made, i.e. impulse vs. careful, sophisticated purchasing
(5) fame of the prior mark (sales, advertising, length of use)
(6) number and nature of similar marks in use on similar goods
(7) nature and extent of any actual confusion
(8) length of time during and conditions under which there has been concurrent use without evidence of actual confusion
(9) variety of goods on which a mark is or is not used (house mark, family mark, product mark)
(10) market interface between applicant and the owner of a prior mark. (11) The extent to which applicant has a right to exclude others from use of its mark on its goods
(12) extent of potential confusion, i.e., whether de minimis or substantial
(13) any other established fact probative of the effect of use.
9
See id. at 1362; In re Mighty Leaf Tea, 601 F.3d 1342, 1346 (Fed. Cir. 2010) (Not all of the DuPont factors are relevant to every case, and only factors of signicance to the particular mark
need be considered.).
10
Gray market goods are goods that are legitimately sold abroad under a particular mark and then imported into the U.S. and sold in competition with goods offered by the trademark owner.
They typically are genuine goods not intended for sale or distribution in the U.S., which are then sold at a price below that of the authorized U.S. goods bearing the identical trademark.
Some products are constructed or formulated in different ways to suit national conditions, standards, tastes, or laws/regulations.
11
See <https://apps.cbp.gov/e-recordations/> and 19 C.F.R. 133.0 et seq. See also Section 526 of the Tariff Act (19 U.S.C. 1526) and Section 42 of the Lanham Act (15 U.S.C. 1124).
12
See, e.g., Eve of Milady v. Impression Bridal, Inc., 957 F. Supp. 484 (S.D.N.Y. 1997) (citing Knitwaves, Inc. v. Lollytogs Ltd. (Inc.), 71 F.3d 996, 1002 (2d Cir. 1995)).
13
Id. (fabric designs are considered writings for purposes of copyright law and are accordingly protectible and plaintiffs lace designs are copyrightable (quoting
Knitwaves Inc., 71 F.3d at 1002)).
14
Id.
15
While trademarks require maintenance and use, trademark rights are unlimited in terms of the time period for which an owner can have protection. However, copyright protection (for
works created after Jan. 1, 1978) has time limits: 70 years after authors death, or, if it is a work made for hire, 95 years from year of rst publication or 120 years from year of creation,
whichever comes rst.
16
Copyright protection (for works created after January 1, 1978) vests as soon as the copyrightable work is xed in a tangible medium.
17
If the registration was not within this three-month window, recovery is limited to actual damages and non-duplicative prots of the infringer. But, if the copyright application is led within
ve years of the rst publication of the work, the registration certicate will be prima facie evidence of the validity of the copyright and of the facts stated in the certicate.
18
See Berne Convention for the Protection of Literary and Artistic Works, Sept. 9, 1886, 828 U.N.T.S. 221, S. TREATY DOC. No. 99-27 (1989) (codied in various sections of 17 U.S.C.
106A (2006)). There is no worldwide copyright, and international recognition and enforcement is generally contingent on laws of the country in which recognition is sought.
19
See Lisa Pearson, Andrew Pequignot, and Ashford Tucker, US copyright protection for logos, packaging, and products, Intellectual Property, 37 (Oct. 2010); 1 J. THOMAS MCCARTHY,
MCCARTHY ON TRADEMARKS AND UNFAIR COMPETITION 6:14 (4th ed. 2010) (MCCARTHY).
100 2013
USPTO, copyright registrations may be recorded in the U.S.
Copyright Office. Unlike trademark infringement cases, which
may require survey evidence or testimony from experts, copyright
infringement may be less expensive to prove. For copyright
infringement, you must show: 1) ownership of a valid copyright,
and 2) copying of copyrightable, protected elements of the work
or, when evidence of direct copying is lacking, you must prove (a)
access to the copyrighted work, plus (b) substantial similarity.
20
The
trademark infringement test, however, requires finding a likelihood
of confusion after evaluating several factors, including those
concerning consumers and marketplaces or distribution channels.
Supra note 8. The substantial similarity test for copyrights does not
require an evaluation of the marketplace or consumer perspective.
Also, an infringer violates an exclusive copyright at the moment the
infringer copies (or adapts, distributes, performs, or displays) the
work.
21
Under trademark law, mere reproduction alone does not
necessarily constitute infringement; an infringer violates trademark
law only when the infringer causes a likelihood of confusion, or
dilution, or unfairly competes; i.e., when the infringer jeopardizes
a trademark owners goodwill in a mark by use of a confusingly
similar mark or dilution of a famous mark.
22
The U.S. Copyright
Act provides remedies such as awards of statutory damages
and attorneys fees for works that are timely registered
23
, so a
copyright owner would not have to prove actual damages or show
that the infringement was exceptional, as a plaintiff would for a
trademark infringement case, in order to get attorneys fees.
Copyright enforcement tools can therefore be useful in addition
to those used to protect patterns that also may serve as
trademarks. And copyright rights can even cover certain patterns
or other designs while a brand owner is simultaneously developing
trademark rights in such patterns.
One cautionary note for pattern owners: it is important to secure
your rights if a non-employee or independent designer creates
your pattern. If an independent contractor was used, you will
need ideally prior to creation of any pattern a work-for-hire
agreement signed by the contractor.
24
Otherwise, if the work is
created before you have such an agreement, you should secure an
assignment of the contractors rights. With respect to assignments,
the independent contractor, as the author, retains the right to
terminate the assignment after 35 years.
25
Also note that you will
want to have all rights in the pattern conveyed to you, including the
right to sue and the right to create derivative works. Otherwise, the
independent contractor may be able to exploit those rights even
after the assignment.
Revenue Opportunities nnn
A pattern that serves as a protectable brand and, separately, a
protectable copyright is likely to be in a position to provide its
owner with multiple forms of revenue.
Brand licensing of a pattern can generate revenue beyond the
owners particular use of the pattern to different geographic areas,
demographics, products, services, and/or distribution channels.
Such licensing generates considerable revenue for both brand
owners (through royalty payments) as well as their licensees (who
benefit from the use of the trademark in which the owner has
built goodwill and reputation over many years). As noted above,
sometimes the pattern can be used and protected in territories
in which the word mark or logo may not extend. And the pattern
can often be translated or morphed into use in connection with or
on products never contemplated with respect to the word mark
or logo. For example, the pattern owner could license use of the
pattern for furniture, bedding, or other housewares, or even on the
packaging, hang tags, or labels for such products.
Licensing the copyright in a pattern can result in different revenue-
generating opportunities. A copyright license of the pattern to
manufacturers in completely different industries could generate
significant royalties. For example, a wallcovering designer could
create a pattern for a wallcovering, but then license the copyright
in the pattern to an upholstery or carpet manufacturer, or even for
use in posters or other products like clothing or accessories. The
cache and goodwill built in the pattern in the wallcovering arena
could add significant value to these copyright licenses for the
pattern owner and its licensees.
Another benefit to building a pattern brand/copyright asset is that
it could significantly increase the purchase price and value of the
business associated therewith. And the pattern owner may more
easily part with the pattern to be sold because the owner could
always develop a different or new pattern.
A licensor can earn revenue in various ways; e.g., a one-time flat fee
to the licensor, or a use-based royalty which itself can be fixed or
variable.
26
Royalties are generally based on net sales: the licensee
pays royalties on the actual sales revenue it receives. A licensor
also generally requires a minimum guaranteed royalty payment by
the licensee as an incentive to the licensee to generate sales.
27

20
With respect to patterns for which there are copyright rights, a designer can even embed unique designs to make it easier to detect copying. When a designer or brand owner suspects
copyright infringement, these unique embedded elements can help prove copying. This type of embedding can be used, by the way, in other ways by copyright owners. Unique codes can
be embedded in written works so that persons or entities can search for and nd unauthorized copies of the works on the Internet.
21
See 17 U.S.C. 501; 2 MELVILLE B. NIMMER & DAVID NIMMER, NIMMER ON COPYRIGHT 8.01 (Matthew Bender, rev. ed.) (NIMMER); MCCARTHY 6:14.
22
5 MCCARTHY 6:14, 23:1; 4 Louis Altman & Malla Pollack, CALLMANN ON UNFAIR COMPETITION, TRADEMARKS & MONOPOLIES 22:17 (4th ed. 1997).
23
If the work is registered within 3 months of its publication, the copyright owner is entitled to seek statutory damages (in lieu of actual damages and prots that are otherwise available) and
attorneys fees.
24
See id. (specic limitations on, and the denition of, a work-for-hire).
25
Id. at 203.
26
When a license is royalty-free, this is usually stated explicitly in the license.
27
R.C. Henn Jr., A.G. Jones, L.S. Ralls, and L.A. Linder, Trademark Licensing Basics, Kilpatrick Stockton LLP Intellectual Property Desk Reference (6th ed.) (2009).
101 2013
In addition to the different types of royalties and rates, other key
considerations in formulating a pattern license agreement include
the following:
n scope (exclusive or non-exclusive)
n which products can use the pattern as a brand or as
a copyright;
n the length (term) of the license, whether it can be
renewed, and whether the licensee will have the right of
rst refusal or rst negotiation
n distribution channels in which the licensed products can
be sold and distributed (even listing specic retail stores
or websites, or specically denying permission to sell
through the Internet or off-price stores)
n countries in which the products can be sold
n quality assurances and controls, including standards for
manufacturing and prohibitions on the use of child labor
or slave labor (or even prohibitions on the manufacturing
of licensed products in certain countries), and instructions
on the approval process (the extent to which the licensor
must approve the licensed products and specic uses of
licensed mark(s))
n requirements concerning how sales/revenue are reported
to the licensor
n indemnication provisions
n enforcement particularities and how the license
can be terminated
28

As with any business venture, there can be drawbacks to license
arrangements. So a pattern owner interested in licensing its
patterns as a brand or a copyright must recognize the benefits and
drawbacks and take them into consideration during the license
negotiation.
29
Drawbacks can include: the loss of complete control
over the brand or design; the fact that only a percentage of the
sales revenue is earned; the risk that a licensee will damage the
reputation or image and hinder future growth; and the risk that the
owners rights can be deemed abandoned if the owner does not
appropriately monitor the licensees use and exercise sufficient
quality control.
30
Crafting license agreements to address these
issues carefully is important in protecting the pattern, and ensuring
a long and valuable revenue stream for years to come.
Conclusion nnn
In sum, pattern owners stand in the unique position of creating not
only brands, but also at the same time valuable copyrightable works
that, if strategically licensed or sold, could generate significant
revenue from unexpected, new sources. And because the rights
in a pattern may be subject to dual protection and enforcement,
they stand to survive attempts to copy and dilute the strength of
the pattern, thereby increasing the life and value of the pattern as
a brand and a copyright.
Marc A. Lieberstein, Esq. is a Partner with Kilpatrick Townsend
& Stockton LLP. His practice focuses on intellectual property
licensing in the consumer products, industrial design, and fashion
industries; implementation of branding and commercialization
objectives; and counseling clients on creating strategies for
procuring, protecting, and enforcing their global intellectual property
assets. Mr. Lieberstein can be reached at +1.212.775.8781 or
mlieberstein@kilpatricktownsend.com.
Kristin G. Garris is an Associate in the New York office of Kilpatrick
Townsend & Stockton LLP. Her practice focuses on trademark
and copyright litigation and counseling, domain name and other
Internet-related disputes, and trademark licensing. Ms. Garris can
be reached at +1.212.775.8786 or kgarris@kilpatricktownsend.com.
28
For more information about trademark licensing, and details not covered in this article, see M. Lieberstein, S. Feingold, C. James, and P. Rosenblatt, Current Developments and Best
Practices in Trademark Licensing (Parts I and II), The Licensing Journal (Part I, Vol. 31, No. 2, Feb. 2011; Part II, Vol. 31, No. 3, Mar. 2011).
29
Id.
30
R.C. Henn Jr., A.G. Jones, L.S. Ralls, and L.A. Linder, Trademark Licensing Basics: Depending on the particular industry and/or the products at issue, quality control provisions may
address a number of issues to ensure adequate quality control and prevent abandonment, including, by way of example:
(1) Being involved in the design process for the product;
(2) Reviewing early models and prototypes;
(3) Reviewing packaging, advertisements, labels, and other materials to ensure that the mark is used properly and appears in a manner consistent with the licensors trademark
guidelines; and
(4) Requiring access to the licensees facilities, raw material, nished products, personnel, and records to monitor the licensees adherence to the licensors quality standards.
Reasonable Certainty
Remains Uncertain
Regina Alter, Esq. Butzel Long alter@butzel.com
2013 102
Introduction nnn
Many legal and financial practitioners are facing increasing
challenges on whether alleged damages have been proven with
reasonable certainty. This article explores the theoretical and
practical considerations of reasonable certainty.
1

Achieving reasonable certainty as to the calculation of damages is
a critical goal in any matter for which damages are to be proven.
If a party cannot demonstrate that their damages calculations are
reasonably certain, the court is obligated to exclude the testimony.
Without this testimony, even successful proof on liability may lead
to an award of no damages. Courts have stated it this way:
In order that it may be a recoverable element of damages,
the loss of profits must be the natural and proximate, or
direct, result of the breach complained of and they must also
be capable of ascertainment with reasonable, or sufficient,
certainty absolute certainty is not called for or required.
2

Professional literature, court opinions, rules of evidence, and
other bodies of knowledge and works of law often use the phrase
reasonable certainty when discussing damages. However,
the threshold for reasonable certainty remains ambiguous. It is
important to note that this discussion does not define a specific
checklist, mathematical formula, or mechanical manner of
deducing whether damages opined by the expert is reasonable
certainty. No such specific mechanism exists that can be applied
to all matters. Indeed, as described herein, most courts agree
that reasonably certainty as to damages is a flexible, inexact
concept.
3
Rather, this piece provides a discussion of the factors,
elements, and/or characteristics of expert opinions that can
generally be considered for any matter to determine the extent
to which damages opined on by an expert rise to the level of
reasonable certainty.
The article is segmented into several sections. In the first
section, we briefly review the Federal Rules of Evidence
on the admissibility of expert testimony. We then consider
certain sources from professional literature for discussion and
commentary on achieving reasonably certain expert opinions
as to the calculation of damages. Finally, we review the recent
opinion of one notable judge, Judge Richard Posner, in the case
of Apple v. Motorola. In this opinion, Judge Posner provides his
guidance and interpretation on the efforts experts should take to
achieve a reasonably certain opinion as to damages, at least as it
applies in that case. Taken together, these sections are intended
to provide guidance to lawyers and experts toward achieving a
reasonably certain result.
1
Of course, with a topic of this breadth and signicance, this piece is not meant to serve
as a comprehensive analysis of all relevant aspects of reasonable certainty.
2
Morris Concrete, Inc. v. Warrick, 868 So. 2d 429 (Ala. Civ. App. 2003).
3
Milikowsky, A Not Intractable Problem: Reasonable Certainty, Tractebel, and the
Problem of Damages for Anticipatory Breach of a Long-Term Contract in a Thin Market,
Columbia Law Review, Vol. 108, Page 467.
2013 103
The Federal Rules of Evidence
The Federal Rules of Evidence (Rule 702) provide guiding
principles meant to hold expert testimony to account. Rule 702
has four components:
1
I
The experts scientic, technical, or other specialized
knowledge will help the trier of fact to understand
the evidence or to determine a fact in issue
2
I
The testimony is based on sufcient facts or data
3
I
The testimony is the product of reliable principles
and methods
4
I
The expert has reliably applied the principles and
methods to the facts of the case
4
These four criteria provide the general framework for damages
experts to consider in developing their opinion. However, whether
an experts opinion actually meets the threshold of reasonable
certainty in any particular court or for any particular matter involves
a more significant assessment of the efforts undertaken by the
expert to determine damages.
Attempts to Define Reasonably Certain
In many cases, courts and learned commentators have provided a
definition or interpretation of what reasonably certain means in the
context of damages calculations. The following is a collection of
certain of those interpretations (emphasis added in each):
n Does the court think that, given all of the circumstances,
this plaintiff has presented sufcient evidence to make
it fair to award it the damages in question.
5

n Damages for future lost prots must be capable of
measurement based upon known reliable factors without
undue speculation.
6

n While it is true that such damages need not be
proved with mathematical certainty, neither can they
be established by evidence which is speculative and
conjectural.
7

n The plaintiff has the burden to present evidence with
a tendency to show the probable amount of damages
to allow the trier of fact to make the most intelligible
and accurate estimate which the nature of the case
will permit.
8

n The amount of alleged loss could not be
speculative, possible or imaginary, but must be
reasonably certain.
9

n Lost prots damages should not be too dependent
upon numerous and changing contingencies to
constitute a denite and trustworthy measure of
damages.
10

n Lost prots damages should not be based on too
many undetermined variables and competent proof
addressing these variables could have removed the
lost prot claim from the realm of impermissible
speculation.
11
n [D]amages need not be proved with mathematical
certainty, but only with reasonable certainty, and
evidence of damages may consist of probabilities and
inferences Although the law does not command
mathematical precision from evidence in nding
damages, sufcient facts must be introduced so
that the court can arrive at an intelligent estimate
without conjecture.
12

n [A]nticipated prots may be recovered when
they are reasonably certain by proof of actual
facts, with present data for a rational estimate
of their amount.
13
As noted, attempts to define reasonably certain have considered
phrases such as rational estimate; impermissible speculation;
intelligent estimate; imaginary; and intelligible and accurate
estimate. These phrases demonstrate courts attempts to
better convey expectations and to frame their evaluation of the
damages testimony.
In an article for the Business Litigation Section of the Dallas
Bar Association in 2011, Hon. Martin Marty Lowy noted that
[w]hatever methods are used, the final calculation, as well as all of
its elements, should be reasonable. Put another way, the expert,
like the jurors, should not leave common sense behind.
14

(Emphasis added.)
4
Federal Rules of Evidence (As amended Apr. 26, 2011, eff. Dec. 1, 2011).
5
Lloyd, The Reasonable Certainty Requirement in Lost Prots Litigation: What It Really Means, November 2010, Page 6.
6
Lloyd, The Reasonable Certainty Requirement in Lost Prots Litigation: What It Really Means, November 2010, Page 7 (citing Bykowsky v. Eskanazi, 2010 N.Y. App. Div. LEXIS 3317
(Apr. 27, 2010).
7
Lloyd, The Reasonable Certainty Requirement in Lost Prots Litigation: What It Really Means, November 2010, Page 26 (citing Katskee v. Nev. Bobs Golf of Neb., Inc., 472 N.W.2d 372,
379 (Neb. 1991).
8
Banks, Lost Prots for Breach of Contract: Would the Court of Appeals Apply the Second Circuits Analysis?, Albany Law Review, Vol. 74.2, 2010/2011, Page 643 (citing Duane Jones Co. v.
Burke, 306 N.Y. 172, 192, 117 N.E.2d 237, 24748 (1954) (quoting SUTHERLAND ON DAMAGES 70 (4th ed. 1916)).
9
Banks, Lost Prots for Breach of Contract: Would the Court of Appeals Apply the Second Circuits Analysis?, Albany Law Review, Vol. 74.2, 2010/2011, Page 644 (citing Kenford, 67 N.Y.2d
at 25960, 493 N.E.2d at 234, 502 N.Y.S.2d at 131.
10
Banks, Lost Prots for Breach of Contract: Would the Court of Appeals Apply the Second Circuits Analysis?, Albany Law Review, Vol. 74.2, 2010/2011, Page 644 (citing Witherbee, 155 N.Y.
at 453, 50 N.E. at 60).
11
Banks, Lost Prots for Breach of Contract: Would the Court of Appeals Apply the Second Circuits Analysis?, Albany Law Review, Vol. 74.2, 2010/2011, Page 644 (citing 155 N.Y. at 405, 624
N.E.2d at 1012, 604 N.Y.S.2d at 917.
12
Delahanty v. First Penn. BK, N.A., 318 Pa. Super. 90, 464 A.2d 1243 (1983).
13
Independent Business Forms, Inc. v. A-m Graphics, Inc., 127 F.3d 698 (8TH Cir. 1997).
14
Hon. Martin Marty Lowy, Proving and Defending Lost Prots Damages, Dallas Bar Association, Business Litigation Section, June 2011, Page 11.
2013 104
Regarding the courts varied assessments of reasonably certain,
in 1929, Professor Charles T. McCormick succinctly noted:
[A]n examination of a large number of the cases, in which
claims for lost profits are asserted, leaves one with a feeling
that the vagueness and generality of the principles which are
used as standards of judgment in this field are by no means
to be regretted. It results in a flexibility in the working of the
judicial process in these cases a free play in the joints of
the machine which enables the judges to give due effect to
certain imponderables not reducible to exact rule.
15
Indeed these quotes from various courts demonstrate the free
play in the joints described by McCormick. This supports the
concept of a best efforts doctrine when evaluating the threshold
of reasonably certain. However, a comparison of the following
three opinions demonstrate the wide latitude courts have used
when evaluating whether best efforts necessarily results in a
reasonably certain result.
n If the best evidence of damage of which the situation
admits is furnished, this is sufcient.
16

n Though plaintiffs proof not without fault, it was sufcient
because it was the best reasonably obtainable under the
circumstances.
17

n The quantity of proof is massive and, unquestionably
represents business and industrys most advanced and
sophisticated method of predicting the probable results of
contemplated projects. Indeed, it is difcult to conclude
what additional relevant proof could have been submitted
by [the plaintiff] in support of its attempt to establish,
with reasonable certainty, loss of prospective prots.
Nevertheless, [the claimants] proof is insufcient to meet
the required standard.
18

A review of the case referred to in the latter quote is instructive. In
that matter, the courts concerns appear to rest with the foundation
for the analysis of the expert. That is, while the expert may have
utilized business and industrys most advanced and sophisticated
method in the calculation, if the foundation of such analysis is
speculative or unreliable, the result may be speculative or unreliable,
as well. The court in that case appears to emphasize the importance
of the foundation of the expert analysis in its determination of
whether the result is a reasonably certain measure of the damages
in that case.
19
The importance of a stable foundation was also
noted in Contemporary Mission, Inc. v. Famous Music Corp.,
557 F.2d 918, 926 (2d Cir. 1976) where the court indicated the
plaintiff must show a stable foundation for a reasonable estimate
of damages.
20

In November 2010, Robert Lloyd of the University of Tennessee,
Knoxville, published The Reasonable Certainty Requirement
in Lost Profits Litigation: What it Really Means.
21
This research
paper provides a comprehensive review of court opinions which
considered the reasonable certainty of lost profits damages. In this
research paper, Lloyd concludes that there are six factors courts
consider to determine whether a party has proven lost profits with
reasonable certainty.
22
Lloyd notes that these factors are:
23

1
I
The courts condence that the estimate is accurate
2
I
Whether the court is certain that the injured party has
suffered at least some damage
3
I
The degree of blameworthiness or moral fault on the
part of the defendant
4
I
The extent to which the plaintiff has produced the best
available evidence of lost prots
5
I
The amount at stake
6
I
Where there is an alternative method of compensating
the injured party
Several factors listed by Lloyd are seemingly beyond the
calculations that are typically prepared by an expert, but may be
relevant for counsels consideration. Lloyd notes that [i]n most
cases, courts deciding whether lost profits have been proven with
reasonable certainty consider all or almost all of these factors but
also indicates that [t]he vast majority of opinions focus on only
one or two factors.
24

This discussion illustrates the challenges that experts face: If the
courts provide varied guidance on what is or is not reasonably
certain, how is an expert to know whether his or her work is
reasonably certain? A common theme in the materials and
opinions described is that the expert must develop a foundation
for his or her work that is based on reasonable facts and build on
that foundation with the experts best effort using the documents
and information reasonably available to them. An expert must
then consider what is his or her best effort. This term, much
like reasonable certainty, does not have a standard, clearly
articulated definition. In the following section, we review the recent
15
Lloyd, The Reasonable Certainty Requirement in Lost Prots Litigation: What It Really Means, November 2010, Page 36 (citing Charles T. McCormick, The Recovery of Damages for Loss of
Expected Prots, 7 N.C. L. Rev. 235, 248 (1929)).
16
Lloyd, The Reasonable Certainty Requirement in Lost Prots Litigation: What It Really Means, November 2010, Page 37 (citing Charles T. McCormick, Handbook on the Law of Damages
27 at 101 (1935).
17
Lloyd, The Reasonable Certainty Requirement in Lost Prots Litigation: What It Really Means, November 2010, Page 37 (citing Koehring Co. v. Hyde Const. Co., 178 So.2d 838, 853 (Miss.
1965).
18
Lloyd, The Reasonable Certainty Requirement in Lost Prots Litigation: What It Really Means, November 2010, Page 40 (citing 493 N.E.2d at 236).
19
Banks, Lost Prots for Breach of Contract: Would the Court of Appeals Apply the Second Circuits Analysis?, Albany Law Review, Vol. 74.2, 2010/2011, Page 645 (citing Kenford, 67 N.Y.2d
at 262, 493 N.E.2d at 336, 502 N.Y.S.2d at 133.
20
Wathne Imports, Ltd. v. PRL USA, Inc. (63 A.D.3d 476 (2009), 881 N.Y.S.2d 402)(citing Contemporary Mission, Inc. v. Famous Music Corp., 557 F.2d 918, 926 (2d Cir. 1976).
21
Lloyd, The Reasonable Certainty Requirement in Lost Prots Litigation: What It Really Means, November 2010.
22
Id. at 6.
23
Id.
24
Id. 6.
2013 105
decision of Judge Posner in Apple v. Motorola. The opinion of
Judge Posner provides another, recent, review of one judges
assessment of both reasonable certainty and best effort as it
pertains to damages. The opinion of Posner is not likely shared
by all damages practitioners, or all judges, but it does provide a
thorough discussion of issues pertinent to this article.
Apple v. Motorolan
In Apple v. Motorola, Judge Posner took a stern approach in
affirming that any step that renders the analysis unreliable
renders the experts testimony inadmissible. Posner proposed
three tests of adequacy that the court should consider when
exercising its duty as gatekeeper. Of particular interest are
the reasons the Apple and Motorola experts failed to meet the
threshold of reasonable certainty.
Judge Posner specified three tests to assess the merits of expert
testimony:
1
I
[w]hether the expert has sufciently explained
how he derived his opinion from the evidence that
he considered
25
2
I
whether the expert [e]mploys in the courtroom the same
level of intellectual rigor that characterizes the practice
of an expert in the relevant eld
26
3
I
[e]ven where expert testimony is admissible it may be
too weak to get the case past summary judgment
27

By using these tests, Posner evaluated whether the expert
exercised best efforts to develop a:
n sound opinion based on
n an accepted method applied to
n relevant data
n judged against the intellectual rigor of an
industry expert.
Test 1:
The first test of the adequacy of proposed expert testimony for
Posner is whether the expert has sufficiently explained how he
derived his opinion from the evidence that he considered. Any
step that renders the analysis unreliable renders the testimony
inadmissible. This is true whether the step completely changes
a reliable methodology or merely misapplies that methodology.
Federal Rule of Evidence 702(d) states that testimony may be
admitted if the expert has reliably applied the principles and
methods to the facts of the case.
28
Thus, Posner takes Rule
702(d) one step further. For Posner, a best effort at reasonable
certainty to reliably apply principles to the facts of the case no
longer appears sufficient.
29

Sound opinion: The court looks to several key variables to assess
whether testimony has achieved reasonable certainty. These
variables include sound data, acceptable methodology, and
logical opinion. Posner offers an example during his discussion of
Expert Ms (expert for Motorola) patent valuation. In this instance,
Expert M assigned the patent in question 2% of the total portfolio
value despite the fact that the actual patent represented only
1% of the total number of patents in that portfolio. Ultimately,
Posner concludes that Expert Ms testimony would be excluded,
because Expert Ms declaration does not answer that essential
question: How to pick the right non-linear royalty.
30
Posners
criticism indicates his distaste with the unsubstantiated number.
It may well be that the patent portfolio consisted of patents of
various values (i.e., 100 patents do not necessarily retain 1% each
of the total value). Indeed, Expert M may well have had good,
qualitative reason to attach a premium to the patent in question.
Nevertheless, Expert Ms inability to attach this premium to some
quantifiable variable rendered it a gap in his analysis. Once
again, Posner takes a hard line approach in affirming that, any
step that renders the analysis unreliable renders the experts
testimony inadmissible. This indicates Posners consideration
of a judicial duty to exclude testimony where it falls short of this
first test. Indeed, this appears consistent with the case of ATA
Airlines v. Federal Express Corporation wherein Posner stated
that, the evaluation of [expert testimony] may not be easy; the
principles and methods used by expert witnesses will often be
difficult for a judge to understand. But difficult is not impossible.
The judge can require the lawyer who wants to offer the experts
testimony to explain to the judge in plain English what the basis
and logic of the testimony are If a partys own lawyer cannot
understand the testimony the testimony should be withheld
from the jury.
31
He even proposes that, in particularly complex or
technical situations, the court should hire an aid to help the judge
gauge the validity of testimony.
32

Test 2:
The second test states that an expert should employ in the
courtroom the same level of intellectual rigor that characterizes the
practice of an expert in the field. Sufficiency and Reliability,
for Posner, seem to be evaluated as a best effort analysis
25
Apple, Inc. And NeXt Software Inc., (f/k/a NeXT Computer, Inc.) v. Motorola, Inc. and Motorola Mobility. Inc., No 1:11-cv-08540. (E.D. Ill. (May 22, 2012).
26
Id. at 3.
27
Id. at 4.
28
Federal Rules of Evidence (As amended Apr. 26, 2011, eff. Dec. 1, 2011).
29
Apple, Inc. And NeXt Software Inc v. Motorola Inc and Motorola Mobility, No 1:11-cv-08540, (E.D. Ill. May 22, 2012). Notably, this particular requirement was rst suggested in the case
of ATA Airlines, Inc. v. Federal Express Corporation, No 11-1382,11-1492 (S.D. Ind. December 2011). Here, Judge Posner indicated that the burden for sufcient explanation is to be
shouldered by the expert, counsel, and judge. He stated, it is the [Judges] responsibility, as painful as it may be, to screen expert testimony, however technical; we have suggested aids
to the discharge of that responsibility. Posner continued, [i]f a partys lawyer cannot understand the testimony of the partys own expert, the testimony should be withheld from the jury.
Evidence unintelligible to the trier or triers of fact has no place in a trial.
30
Apple, Inc. And NeXt Software Inc., (f/k/a NeXT Computer, Inc.) v. Motorola, Inc. and Motorola Mobility. Inc., No 1:11-cv-08540, (E.D. Ill.May 22, 2012).
31
ATA Airlines, Inc. v Federal Express Corporation. No 11-1382,11-1492, (S.D. Ind. December 27, 2011).
32
Id. at 27.
2013 106
defined as the rigor that could be expected of an industry expert.
This standard is a high one, and particularly relevant to the
(a) quality of data, (b) the experts chosen methodology, and
(c) the general standards of analysis (for example: did the expert
consider alternatives?).
Quality of data and methodology: Judge Posner in Apple v.
Motorola largely melded these two areas by virtue of the fact that
he did not believe that the method for obtaining data was sound.
Twice Posner finds Expert A (expert witness for Apple) falls short of
best efforts when compared against the standard of intellectual
rigor of the industry expert. Posner appears to further Rule 702
by qualifying the word reliable and supplanting the metric
intellectual rigor of the expert in the field. The following example
serves as an illustration: Posner states, I am merely asserting
that the survey that Motorola did conduct, which did not look for
aversion to partial obstruction and so far as I can tell had nothing
to do with its pricing, but rather with helping the company to
determine which programs and features are particularly important
to users, is not the kind of survey that Expert A assuming him to be
a responsible adviser on marketing or consumer behavior would
have conducted.
33
The inference, therefore, is that sound financial
analysis alone may not be sufficient for admissibility of the financial
experts testimony. Indeed, his burden may be greater; a best
effort at achieving the reasonably certain threshold appears to
be judged by Posner against the benchmark of the intellectual
rigor of an industry expert. Second, Posner dismissed Expert A on
the grounds that his due diligence was not to the standard of the
industry expert. Suppose Expert A had been hired by Motorola to
advise on how Motorola might obtain the functionality of the 263
[patent] at lowest cost without infringing on that patent. Obviously,
he would not have gone to the patentee for that information! For
it would be in the patentees interest to suggest a method of
inventing around that was extremely costly because the costlier
the invent-around, the higher the ceiling on reasonable royalty.
34

Posners disagreement on the method used to aggregate data for
the purposes of the experts analysis demonstrated to him that
the expert fell short of Posners interpretation of best efforts and
consequently the threshold of reasonable certainty. Specifically,
he takes issue that the hypothetical expert in the industry would
not have followed this procedure of market research.
General standards of analysis: On the third point, it appears
that a failure to consider alternatives would fall short, at least
for Posner, of the vigorous standard expected of an industry
professional. This is one fatal defect in Expert As proposed
testimony (referencing the survey criticized), but there is another,
and that is a failure to consider alternatives to a 35mm royalty that
would enable Motorola to provide the superior gestural control
enabled by the relevant claim in the Apple patent. In reference
to this situation, Posner once again compares Expert A to the
hypothetical industry by creating a hypothetical skit in the text of
his judgment. Posner asks his reader to imagine a conversation
between Expert A and Motorola, which Ill pretend hired Expert A to
advise on how at lowest cost to duplicate the patents functionality
without infringement:
n Motorola: What will it cost us to invent around, for
that will place a ceiling on the royalty well pay Apple.
n Expert A: Brace yourself: $35 [million] greenbacks.
n Motorola: That sounds high; where did you get
that gure?
n Expert A: I asked the engineer who worked
for Apple.
n Motorola: Dummkopf! Youre red!
35

This dialog serves to illustrate several key points: 1) Posner
once again compared Expert As performance against that of
the hypothetical industry expert in this case, a consultant; 2) A
failure to consider alternatives will undermine expert testimony
admissibility. Indeed, in Posners later consideration of a separate
Motorola expert, Expert M-2, Posner reinforced this position by
excluding her testimony because Expert M-2 failed to consider
the range of plausible alternatives.
Posner seemed to advocate preclusion of expert testimony that
falls short of the above thresholds where an [expert] failed to do
so then his proposed testimony should be barred. Note the
definitive nature of his language; he states that testimony should
be barred, not that it may be barred.
Test 3:
Posners third test [e]ven where expert testimony is admissible
it may be too weak to get the case past summary judgment is
less revealing. Simply put, it appears to serve to reaffirm the wide
judicial discretion enjoyed by the court in its role as gatekeeper.
Here, Posner cited the case of Hirsh v. CSX Transportation
Inc.,
36
wherein the court distinguished between the admissibility
of evidence and its sufficiency. As circumstances would have it,
the court permitted a summary judgment despite the fact that
opposition expert testimony was admissible under Daubert.
37
In
other words, despite a valid expert opinion, the merits of the case
may be that the testimonys validity does not compel the court to
entertain a trial.
33
Apple, Inc. And NeXt Software Inc., (f/k/a NeXT Computer, Inc.) v. Motorola, Inc. and Motorola Mobility. Inc., No 1:11-cv-08540, (E.D. Ill. May 22, 2012).
34
Id. at 16,17.
35
Id. at 17.
36
Hirsch v. CSX Transp., Inc., 656 F.3d 359, 362 (6th Cir. 2011).
37
CSX Transp., Inc. v. United Transp. Union, 879 F.2d 990, 1004-05 (2d Cir. 1989).
6 2013
Conclusion nnn
A reasonably certain threshold for expert testimony is a function
of best efforts having regard for the merits of the case. The
courts enjoy a wide judicial discretion in determining whether
or not the experts testimony qualifies as a best effort and it
appears that the courts will look toward several potential variables
including, but not limited to: (a) soundness of opinion based
upon (b) an acceptable methodology underpinned by (c) relevant
data, all of which is to be judged against and, at least according
to Posner, (d) the intellectual rigor that could be expected of an
industry expert. Finally, where expert testimony falls short of the
standard, Judge Posner believes that the trial judge should
throw out the testimony in question. The word should may serve
as fertile ground upon which the seeds of a new duty to exclude
testimony may grow.
(SRR). He has extensive experience providing a broad range
of business and financial advice to trial lawyers and in-house
counsel. Mr. Steinkamps experience has covered many industries
and matter types resulting in a comprehensive understanding
of the application of damages concepts and other economic
analyses. Mr. Steinkamp can be reached at +1.646.807.4229 or
nsteinkamp@srr.com.
Regina Alter, Esq. is a Shareholder in the New York office of Butzel
Long, P.C. She concentrates her practice on wide-ranging complex
commercial litigation and dispute resolution matters in areas
including financial services, employment, intellectual property, real
estate, securities, and bankruptcy. Ms. Alter can be reached at
+1.212.905.1501 or alter@butzel.com.
In addition, the authors would like to thank Stephen McMullin
for his research and assistance with developing the content
for this article.
Is your case receiving
the attention it deserves
from the experts it needs?
Neil Steinkamp,
CVA, CCIFP, CCA
nsteinkamp@srr.com
+1.646.807.4229
Our services for Litigators include:
n
Pre-litigation consulting
n
Discovery and investigative services
n
Complex financial damages and
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and testimony
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Forensic accounting & white collar
crime investigations
In Case You Were
Wondering
Double Dipping
Revisited
Mary V. Ade
made@srr.com
2013 108
One of the leading cases addressing the concept of double
dipping is Grunfeld v. Grunfeld, 94 NY 2d 696 (2000), which
stated in part, the following:
We agree with the defendant that the Supreme Court
impermissibly engaged in the double counting of income in
valuing the license, which was equitably distributed as marital
property, and in awarding maintenance to wife Once a
court converts a specific stream of income to an asset, that
income may no longer be calculated into the maintenance
formula and payout. There is no double counting to the extent
that maintenance is based upon spousal income which is
not capitalized and then converted into and distributed as
marital property.
Other courts have addressed the double dipping issue
with varying results. Some of the more recent cases are
discussed in this article.
LEE v. LEE, 755 NW 2d 631
Minn: Supreme Court, 2009 nnn
Facts of the Case: Elaine and Raymond Lee were divorced in
1993, having been married for 25 years. During the marriage, Mr.
Lee accumulated benefits under various pension plans, some
of which had been earned prior to the marriage. The portion of
the benefits accrued during the marriage was divided equally
between the parties.
Ms. Lee was awarded $700 per month in spousal maintenance,
which was later increased to $850. Mr. Lee retired in 2005 and
began collecting his pension benefits. At that time, he petitioned
the court for a reduction in his monthly support obligation on the
basis that his income had decreased.
Trial Court Decision: The trial court compared the incomes
of the parties, finding that Mr. Lees total income was $4,023
monthly, consisting of $1,555 in Social Security benefits and
$2,468 in pension benefits. Ms. Lees income consisted of $878 in
Social Security benefits and $796 from her share of Mr. Lees
pensions earned during the marriage. The court determined
that Mr. Lees income available for support was $3,277 (the
total minus $796 which had been awarded to him as property in
the divorce settlement). As a result, Mr. Lees monthly support
obligation was reduced to $700.
Mr. Lee appealed the decision to the Court of Appeals.
2013 109
Appellate Court Decision: The Court of Appeals reversed the
trial court, finding that the pre-marital pension benefits should be
characterized as property rather than income. Further, the court
held that Mr. Lees post-divorce pension benefits should not be
considered income until Mr. Lee had received the full value of
the marital portion of the benefits and that for the foreseeable
future, the monthly benefit payments will not equal that full value.
The case was remanded to the trial court with the instruction
that maintenance may not be ordered to be paid until he has
received from the pension an amount equivalent to its value as
determined in the original property division. Ms. Lee appealed to
the Supreme Court.
Supreme Court Decision: The Supreme Court reversed the
appellate court decision holding that Mr. Lees monthly pension
payments represented the cumulative benefit earned before,
during, and after the marriage. Further, any amount in excess
of the $796 awarded to him as property settlement should be
included in the income available to pay support.
LOUTTS v. LOUTTS, Mich: Court of Appeals,
No. 297427, September 20, 2012 nnn
Facts of the Case: At the time of the parties divorce in 2010, Mr.
Loutts owned QPhotonics, a stock distributor of light emitting
diodes (LEDs), laser diodes (LDs), and related products.
After hearing testimony from experts on behalf of both parties,
the court determined that the value of QPhotonics was
$280,000 using a capitalization of income approach. In computing
this value, Mr. Loutts market compensation was determined
be $130,000 with the balance of the earnings capitalized into
value. Ms. Loutts was awarded $140,000 as her marital share
and awarded spousal support based on the $130,000 market
compensation used in the valuation.
The court reasoned that the value of a business cannot be used for
both property division and spousal support. Ms. Loutts appealed
the decision.
Appellate Court Decision: The Court of Appeals reversed the trial
court and remanded the case for further consideration. The Court
of Appeals declined to adopt a bright-line rule with respect to
excess income and held that courts must employ a case-by-
case approach when determining whether double dipping will
achieve an outcome that is just and reasonable. The case was
remanded to the trial to determine whether the equities warranted
utilizing the value of the company for both property division and
spousal support.
BLAZER v. BLAZER, California Court of
Appeals, H031574 (2009) nnn
Facts of the Case: The parties were married in 1982 and
separated in 2002. Husband was a partner in Blazer-Wilkinson,
LLC (BW), a brokerage company that bought and sold produce.
Temporary spousal support was set at $57,224 per month during
the pendency of the divorce.
Trial Court Decision: In 2004, the trial court valued the community
interest in BW at $5,600,000. Wife received other property plus an
equalizing payment of $1,340,000 for her share of the business.
Temporary spousal support was reduced to $52,000 per month
pending further findings of the court.
In 2006, temporary spousal support was reduced to $30,000
per month retroactive to August 2004 and permanent spousal
support was set at $20,000 per month beginning January 1, 2006.
In determining Husbands income available to pay support, the
court excluded profits from the business, which were needed to
maintain adequate capitalization and to diversify. All other profits
were considered as available to Husband. The court specifically
rejected Husbands argument that his buyout of Wifes interest in
BW was a factor that should eliminate spousal support.
Wife appealed the decision, arguing that the trial court abused
its discretion by excluding a portion of husbands income when
considering his ability to pay support. Husband cross-appealed
on the grounds that the support order unfairly allowed the wife to
double dip into the income stream from his business.
Court of Appeals Decision: The court disagreed with Wife, finding
that there was a need to diversify and to maintain adequate capital
in the business. In reaching its decision, the court relied in part
on the California child support statute, which excludes income
required for the operation of a business from income. Thus,
amounts required to achieve such were not available to Husband.
The court also disagreed with Husband. The courts decision was
based primarily on the lack of evidence before it that BW had
been valued using a stream of future income. Although Husbands
expert testified that he assumed that BW had been valued using
the capitalization of excess earnings method that implicitly ties the
value to Husbands future earnings, the court was not convinced.
In fact, the court stated that even though the experts testimony
had not been contradicted, it was not conclusive to either the trial
court or the Court of Appeals.
2013 110
RATEE v. RATEE, 146 NH 44
NH Supreme Court (2001) nnn
Facts of the Case: Husband owned 49.6% of Capitol Fire
Protection Company (CFP), a company founded by his father.
Husbands earnings from CFP in the five years prior to filing for
divorce ranged from a high of $577,800 to a low of $255,600. Both
child support and spousal support were at issue in the case.
Trial Court Decision: In its final decision, the trial court considered
the Husbands average income of $369,000 in determining monthly
child support. However, for purposes of determining spousal
support, the court limited Husbands income to $100,000, finding
that his income in excess of $100,000 had already been taken into
account in valuing his interest in the company.
In his appeal, Husband argued, in part, that the court had abused
its discretion by double counting a portion of his income by using
the same income to value the company and to determine his
income available to pay child support.
Supreme Court Decision: The court affirmed the trial court
decision reasoning that while each parent receives something in
a division of property, children receive nothing from the property
division. Thus, there can be no double counting when determining
the amount of income available to pay child support.
It is of particular interest that both the trial court and the Supreme
Court found it appropriate to limit Husbands income available for
spousal support to the $100,000 salary used to value the business.
Both courts acknowledged that to include income in excess of
$100,000 would double count income taken into account in valuing
his business interest.
STENEKEN v. STENEKEN, 843 A. 2d (2004),
367 N.J. Super. 427 nnn
Facts of the Case: This is the second appeal in this case. Husband
was the sole owner of Esco Corporation, a manufacturer of optics
and optical components. The original trial court found that the
value of Esco was $768,000 based on a capitalization of excess
earnings and awarded Wife 35% of the value. The court also
awarded Wife alimony based on assuming income for Husband of
$150,000, the amount considered reasonable compensation in the
valuation of Esco.
Wife appealed from the amount of alimony and distribution awarded
to her, as well as from the valuation of Esco. The Superior Court
affirmed the equitable distribution award and valuation of Esco
but remanded the alimony issue to the trial court. The Superior
Court found that it had not been provided sufficient findings of
fact and conclusions of law to make a meaningful determination
regarding the alimony.
Trial Court Decision: On remand, the trial judge interpreted the
Superior Court decision to mean that it was error to limit Husbands
income for spousal support to the $150,000 and issued a revised
award based on Husbands entire income. This increased monthly
spousal support from $4,000 to $5,500.
Husband appealed the decision, arguing that the use of his
actual earnings was inappropriate because earnings in excess of
$150,000 were considered in the value of the business and his
Wife had received a 35% distributive share.
Superior Court Decision: The court denied Husbands appeal.
In its opinion, the court discussed the methodology used to
value Esco, finding that the calculation involved Husbands past
earnings, not future earnings. Thus, there was no double counting
because the valuation did not include future earnings.
Finally, although the court denied Husbands appeal, it did not
summarily dismiss the double dipping concept, stating:
We decline to adopt the either-or notion inherent in the
so-called double-counting rule, certain that in appropriate
instances, proper adjustment to equitable distribution on the
one hand, or the alimony award on the other, or both, may
be made to satisfy its underlying goal of fairness. In our view,
the extent to which the asset may be looked to as a source
of support should be influenced by the extent to which its
value was distributed to the supported party as part of the
equitable division of marital property. Although in certain
circumstances it would be unfair to look to a marital asset as a
source for both alimony and equitable distribution, it is simply
too categorical to conclude that because an asset is treated
as marital property for purposes of equitable distribution, it
can never be regarded as a partial source of alimony.
HELLER v. HELLER, 2008 Ohio 3296
Ohio Court of Appeals nnn
Facts of the Case: The parties were married in 1974 and divorced
in 2007. Two of the primary issues in the divorce were the value of
Husbands 39.5% interest in H&S Forest Products (H&S) and the
amount of spousal support to be awarded to Wife. Husband and
Wife each employed experts to value H&S, both of whom valued
H&S using a capitalization of earnings method.
Trial Court Decision: Based on the expert testimony, the
court found that the value of H&S was $700,000 and awarded
other marital assets totaling $350,000 to equalize the division
of the marital property. Wife was awarded spousal support of
$8,000 a month based on Husbands normalized earnings
of $300,000 used in the valuation of H&S. In addition, the court
awarded Wife 20% of each additional payment of gross income
paid to Husband by H&S.
2013 111
Husband appealed, arguing that the court had abused its
discretion by basing additional spousal support on his entire
income, including his share of future profits.
Court of Appeals Decision: The Court of Appeals agreed with
Husband, stating, It is basic valuation theory that the value of
a business is equal to the present worth of the future benefits of
ownership. The concept of the time value of money is at the core
of the income valuation approach. Namely, the income streams
or cash flows the buyer of the business anticipates he or she will
receive in the future can be translated into their present worth.
The court added that trial courts may treat a spouses future
business profits either as a marital asset subject to division, or
as a stream of income for spousal support purposes, but not
both. When the trial court treated Husbands share of H&Ss
future profits as both an asset and as income for spousal support
purposes, this constituted an abuse of discretion.
The case was remanded to the trial court, which again awarded
Wife 20% of Husbands future income from H&S. Husband filed a
second appeal.
Court of Appeals Decision After Remand (Heller v. Heller,
2010 Ohio 6124 Ohio Court of Appeals): The Court of Appeals
remanded the case for a second time finding that the trial court
had used a methodology that contained an unfair double dip.
Conclusion nnn
As evidenced by the few cases discussed in this article, there is no
consensus as to how to address the double dipping. Depending
on the jurisdiction, double dipping may be prohibited completely,
allowed in total, or allowed in part based on the facts and
circumstances of a particular case.
Mary V. Ade is a Director in the Dispute Advisory & Forensic
Services Group at Stout Risius Ross (SRR). She has over 20 years
of experience in the field of Family Law. Ms. Ade can be reached at
+1.248.432.1336 or made@srr.com.
Its All Relative:
A Fresh Look
at Value in
Divorce Cases
Benjamin I.S. Bershad, CVA bbershad@srr.com
Jason E. Bodmer, CPA/ABV, ASA jbodmer@srr.com
2013 112
The role of a financial expert can be divided into three main
focuses: 1) discovery and information gathering; 2) analysis and
the formation of opinions; and 3) case resolution. It is in this third
area that a settlement can be reached and perceived equitability
is paramount. The value that each party receives in settlement
will be the measure of equity they take with them as they begin to
rebuild their separate lives. But, as much as lawyers and experts
like to see value in terms of dollars and cents, the emotional and
intangible aspects of divorce often complicate this simplistic
view of what value really is. The purpose of this article is to
explore the relative nature of value, and show through examples
how settlement can be reached when the gap between clients
perceptions of value is bridged.
Value: An Economic Definition nnn
In discussing the concept of value, it may be useful to first
understand what the term economics truly means. Many
people exclusively think of stock market charts and mortgage
rates when they hear the word economics, assuming the term
is purely a financial concept. This, in truth, is not the case.
Economics refers to the study of human action, specifically the
decision-making process. Economist Alfred Marshall provided
a widely-accepted definition in his textbook Principles of
Economics, writing:
Economics is a study of man in the ordinary business of life.
It enquires how he gets his income and how he uses it. Thus,
it is on the one side, the study of wealth and on the other and
more important side, a part of the study of man.
Given that the study of economics is primarily concerned with
understanding the methods by which people acquire things, use
them, and make decisions concerning how to acquire and/or
use more of them, it is crucial to understand how people make
these decisions. Said differently, how does a person evaluate the
potential outcomes of their impending decision? The answer to
this question lies in the definition of value. Economist Ludwig von
Mises discusses value in his work titled, Theory and History:
An Interpretation of Social and Economic Evolution. Mises states:
Judgments of value are voluntaristic. They express feelings,
tastes, or preferences of the individual who utters them
Guided by his valuations, man is intent upon substituting
conditions that please him better for conditions which he
deems less satisfactory.
Considering this definition, we can better see how one spouse may
value an asset differently than another. A dentist wife may refuse
to sell her business for an otherwise reasonable amount because
she enjoys the autonomy of being her own boss. Similarly, a real
estate mogul husband may value a piece of property more than
his wife values it because he thinks he can improve and sell it at
a higher price later. These differences result from personal value
judgments that reflect the differing feelings, tastes, expectations
and preferences of each individual spouse.
2013 113
Rational Decision Making nnn
If one devalues rationality, the world tends to fall apart.
Lars von Trier
Economists assume that people make decisions rationally. That is
to say, when a person makes a decision, they make that decision
with the assumption that their life will be enriched in some way
as a result. This can be applied to every choice a person makes
throughout the course of a day, consciously or subconsciously,
for decisions both significant and insignificant. What color shirt will
you put on this morning? What will you eat for breakfast? What
college will you send you children to? Will you pursue a new job
opportunity? When faced with these questions, people will choose
the option they feel best improves their life. These are inherently
economic decisions.
Of course, that is not to say people do not make bad decisions.
Bad decisions are made every day. However, it is important to
understand these bad decisions are typically not born out of
irrationality, but rather incomplete or inaccurate information
or emotional interference that prevents full consideration of
potential outcomes.
Working in the divorce arena, it is tempting to conclude that
clients regularly make irrational decisions. For example, a wife
might inform you that she would like to investigate her husbands
spending habits through a full forensic review of his bank and
credit card accounts. The rationale is so she can finally know
what he is spending their money on. While it may seem that
spending thousands of dollars to investigate what is likely to be
a financially or legally trivial issue is irrational behavior, the wife
may in fact not be acting irrationally. Rather, given her present
state of mind and her understanding of the situation, her perceived
personal satisfaction resulting from the investigation, regardless of
its outcome, is worth more to her than the thousands of dollars it
will cost. However, because the attorney and expert may have a
more complete and accurate understanding of the total costs and
benefits associated with such an endeavor, they can provide value
by helping the client make a good decision.
Value to Whom? nnn
Dont tell me what you value, show me your budget,
and Ill tell you what you value.
Joe Biden
Generally speaking, when a valuation expert expresses an opinion
of value, he or she concludes that a rational person would be
equally indifferent toward owning the asset in question or an
amount of cash equal to his or her conclusion of value. In this
regard, the valuation expert is contemplating a hypothetical
transaction involving two parties one holding the cash and the
other holding the asset.
Value represents a decision point, and decisions are made based
on the judgment of individuals who are as unique as the decisions
they make. Therefore, the process of valuing an asset must be
expressed as an opinion and it must be augmented by the phrase
value to whom? In the field of business valuation, we refer to
this as the Standard of Value. Commonly employed Standards
of Value include Fair Market Value (or Market Value), Investment
Value, and Fair Value. The table below briefly summarizes these
three Standards of Value.
To illustrate the concept of value to whom?, imagine a thirsty man
standing in front of a soda machine. The stated price of a Coke in
the machine is $1.50. If the man values the Coke more than he
values the $1.50 in his pocket, he will buy the Coke. Conversely,
if he does not value the Coke more than the $1.50 he holds in his
pocket, he will pass on the transaction. After consideration, the
man decides to buy the Coke. So, based on this transaction, is the
value of the Coke $1.50? The answer is, it depends. We can draw
certain factual conclusions about each party in the transaction that
will help us to better understand the value of the Coke, but first we
must answer one very important question: value to whom?
In our soda machine example, there are only two parties and one
asset: the buyer, the seller, and the bottle of Coke. While it may not
be possible to determine the Fair Market Value of the bottle without
a market of participants, what we do know is that to the consumer,
Standard of Value Value to Whom?
Fair Market Value
Investment Value
Fair Value
The price, expressed in terms of cash equivalents, at which property would change hands between a
hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open
and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable
knowledge of relevant facts.
The value of an asset to a specific person, including all benefits and costs associated with the asset specific
to that buyer, seller or holder. This includes Holders Interest Value, which is used in some jurisdictions to
mean the value to the current owner assuming no fundamental changes to the operations of the business and
no transactions with a third party.
The definition of this standard depends on the context and jurisdiction in which it is used.
2013 114
the Coke was worth at least $1.50, while to the vendor, the Coke
was worth at most $1.50. If the man would not have paid a penny
more than $1.50 and the vendor would have accepted no less than
$1.50, then this common point of value at which the transaction
actually happened would either have been an example of perfect
market positioning, segmentation, and pricingor perhaps just a
serendipitous coincidence of Investment Value!
Now, lets assume our soda machine is placed in a well-traveled
area of a shopping center with many other vending machines
owned by many other vendors. Every day hundreds of people
pass our soda machine and make a decision whether to purchase
a soda from our vendor, purchase a soda from another vendor,
or continue on their way. Given the economic laws of supply and
demand, the owner of the soda machine has attempted to price
the soda at an amount that best positions his soda to be sold
to the greatest number of people given his competition, but also
maximize his profits. This illustrates the concept of market value.
A valuation expert tasked with determining the market value of an
asset will take steps to determine at which price a specific asset
would hypothetically transact if the seller were in roughly the same
shoes as the owner of the soda machine, and the buyer were a
member of a pool of potential buyers in roughly the same shoes as
the group of passersby.
Finally, and perhaps most applicable to settling a divorce case
with emotions running high, lets assume that the soda being
valued is not in a machine at all. Rather, it is a vintage bottle of
Coke-a-Cola that was given to a man by his father when he was
a young boy. Even if similar bottles regularly sell at auction for
$15, this particular man would not consider selling this particular
bottle for even 10 times the auction value. This is an example of
how, under the Investment Value standard, the unique features of
a person and an asset can combine to give rise to unique value.
These examples illustrate just how varied the value of an asset
can be depending on how one answers the question, value
to whom?
Settlement Examples: When Market Value
Becomes Meaningless nnn
Case I
In a recent case, SRR was jointly engaged to value a manufacturing
business that had once been a large tool and die shop, but had
fallen on hard times and as of the divorce, only owned two pieces
of machinery, a 3D printer and a CNC machine. Combined, the
machines had a value of less than $200,000. Each machine had
a separate and reliable, but small customer base. The divorcing
parties had few other assets. The husband ran the business, and
while the wife had worked in the office at the business in the past,
she was supporting herself during the divorce as an hourly worker
earning minimum wage. Since the breakdown of the marriage,
the wife had been romantically involved with the CNC machine
operator. Significant distrust existed between the parties and the
wife was afraid the husbands lack of business acumen and/or
spite would prevent her from reliably receiving alimony or future
property settlement payments.
Two full days of mediation were unproductive as the wife
repeatedly dismissed settlement proposals that attempted to
structure various pay-off scenarios. Finally, on the third day she
articulated a concern that after a 25-year marriage of being a co-
business owner, she would spend the rest of her life working for
minimum wage and her settlement would not provide a reliable
source of income. Her husband would have a business with which
he could attempt to build a future, and she would only have a
promise from him to pay.
The resulting settlement split the business in two, with each spouse
taking one of the machines. They would each set up individual
shops, with the husband running his 3D printer, and the wife
and her new romantic interest running the CNC machine. Even
though the CNC machine was worth less than the printer, she was
willing to forego any property settlement payments or alimony to
effectively buy herself a job.
Irrespective of the appraised market value of the machines, the
wife valued owning a business, and a machine that would provide
her the security of continued employment, more than she valued a
promissory note from someone she could not trust.
Case II
In another recent case, SRR was hired by a successful medical
device manufacturer who was divorcing his wife. After months
of investigation and analysis, both SRR and the wifes expert
valued the company at approximately $10,000,000. Complicating
matters, however, the wife was convinced the business was worth
at least $15,000,000, and was simply unwilling to settle for less
than what she believed the value to be. The husband, on the other
hand, feared uncertainty under new health care laws and felt the
valuations had failed to appropriately consider the risk, thus over-
valuing the company. In short, he was unwilling to pay his wife half
of the $10,000,000 business value and assume the risk of keeping
the doors open to recover her buyout.
Despite the complete agreement of the valuation experts on the
Fair Market Value of the company, each of the parties in this
case was unwilling to accept any concluded value other than
their own for the company. The impasse was finally overcome by
both parties agreeing to sell the company and split the proceeds.
This arrangement allayed the husbands fears of having to fund a
fixed buyout price with a failing company and afforded the wife
the peace of mind that she would receive 50% of the actual
value of the company, even if ultimately proven wrong about her
$15,000,000 assessment of value.
2013 115
Conclusion nnn
As shown in the examples within this article, divorcing parties
often make decisions that are not necessarily based on which
outcome will provide them with the most money. As a result, the
right settlement in any divorce may seem illogical to attorneys or
experts, yet allows each party to feel as they have walked away
with equitable value. Giving this creative consideration to security,
liquidity, long-term financial stability, and yes, emotional comfort,
can open up possibilities that go beyond a simple division of a
predetermined pie of wealth and give your clients the value they
need to begin the rest of their lives.
Benjamin I.S. Bershad, CVA is a Senior Manager in the Dispute
Advisory & Forensic Services Group at Stout Risius Ross (SRR). He
has provided valuation, dispute advisory, and forensic accounting
services for numerous purposes including marital dissolutions,
shareholder disputes, estate and gift taxation, reasonable
compensation, executive stock options, and other corporate
and litigation related matters. Mr. Bershad can be reached at
+1.248.432.1305 or bbershad@srr.com.
Jason E. Bodmer, CPA/ABV, ASA is a Manager in the Dispute
Advisory & Forensic Services Group at Stout Risius Ross (SRR). He
has provided valuation, dispute advisory, and forensic accounting
services for numerous purposes including marital dissolutions,
shareholder disputes, estate and gift taxation, reasonable
compensation, financial reporting (e.g., purchase price allocations,
asset impairment testing, and mark-to-market valuations),
transaction advisory, Subchapter C to Subchapter S conversions,
and other corporate and litigation related matters. Mr. Bodmer can
be reached at +1.248.432.1245 or jbodmer@srr.com.
Does your financial expert offer the full suite
of services your high-net worth client requires?
Justin L. Cherfoli, CPA/ABV, CFF
n
jcherfoli@srr.com
n
+1.248.432.1242
SRR provides independent valuation analysis, forensic accounting, and
expert witness testimony. SRRs resources for Family Law Attorneys include:
nn
Business valuation
nn
Valuation of complex financial instruments
nn
Real property appraisal
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Forensic accounting
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Expert testimony
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Settlement consulting
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Lifestyle analysis and income determination
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E-Discovery and computer forensics
The Taxing Side of Divorce:
Individual Income Tax Returns
as Discovery Tools
Justin L. Cherfoli, CPA/ABV, CFF jcherfoli@srr.com
Mary V. Ade made@srr.com
117 2013
U.S. Individual Income Tax Returns
(Form 1040) nnn
Individual tax returns can provide a general picture of the
parties financial standing and provide a road map to additional
discovery. At the outset of the case, request copies of individual
income returns and amended returns, if any, for the past five
(5) years, including all supporting schedules and underlying
documentation (W-2s, 1099s, K-1s). Also, ask if the clients
returns have been audited by the IRS and, if so, request a copy
of the final audit report.
1040 Page 1 nnn
Filing Status Most married taxpayers file joint tax returns.
If your client has consistently elected married filing separately
status, inquire as to the reason. In some situations, it may be
advantageous to file this way. However, in other situations it may
indicate a desire on the part of one of the parties to keep financial
information from the other.
Wages, Salaries, Tips A close look at a W-2 can provide a wealth
of information above and beyond taxable wages.
n By comparing Box 1 (taxable wages) with Box 5
(Medicare wages), you can determine if there is income
in excess of that reported as wages on the 1040.
n Income from nonqualied plans is reported in Box 11.
This may indicate that one of the parties participates in a
deferred compensation plan the balance of which would
presumably be a marital asset.
n Box 12 provides valuable information about elective
deferrals, specic types of income, and certain
employer-provided benets. The nature of the item is
indicated by a letter next to the amount. Some of the
more common entries in Box 12 are as follows:
C Taxable cost of group-term life insurance over
$50,000. Employer-provided life insurance is often used
to secure child support and spousal support obligations.
D Elective deferrals to a section 401(k) cash or
deferred arrangement. Also includes deferrals under
a SIMPLE retirement account that is part of a section
401(k) arrangement. You will want to request a copy of
the most recent statement for the 401(k).
118 2013
G Elective deferrals and employer contributions
(including non-elective deferrals) to a section 457(b)-
deferred compensation plan indicating that there is a
deferred compensation account to be considered in the
division of assets.
V Income from exercise of non-statutory stock options.
If there is an amount in this box, you should request
information concerning any other unexercised stock
options including the date the options were granted, the
date on which the options vest, the number of shares
granted, the exercise price for each of the grants, and
the expiration of each option.
W Employer contributions (including amounts the
employee elected to contribute using a section 125
(cafeteria plan) to your health savings account. Health
savings plans are qualied plans and, as such, can be
divided by qualied domestic relations orders.
AA and BB Designated Roth contributions under
section 401(k) 402(b) plans, respectively. Again,
request the most recent statement showing the
balance in the plan.
DD Cost of employer-sponsored health coverage.
Taxable Refunds, Credits, Offsets for State and Local
Income Taxes These are tax refunds from the State or City from
the prior year. Two different things could have happened to this
money. They were either (1) applied to the current tax year, or (2)
they were refunded. If applied to the current year, the taxpayers
can agree how to allocate to their separate tax returns. Be sure to
address this in negotiations; it is a marital asset.
Other Income Miscellaneous income such as directors
fees and consulting fees may be reported here and indicate
business relationships that warrant further discovery. Gambling
winnings are also reported on this line. If you see gambling
winnings consistently, or suspect that a spouse may be a high
roller, you may also wish to inquire about any house accounts
held at local casinos. Individual records can be subpoenaed
directly from the casino.
1040 Page 2 nnn
Payments Taxes withheld from wages are reported on page 2.
Verify the amount of taxes withheld for the current year to date to
determine if the taxpayer(s) have made significant changes in the
historical level of withholding. Over-withholding of taxes can
give rise to a significant refund, which may inure to the benefit
of only one of the clients. This is a marital asset that should be
considered in the settlement.
Estimated tax payments made during the year and amounts
applied from the previous years return are also reported here.
For those taxpayers required to make estimates, the payments are
due quarterly on April 15, June 15, September 15, and January
15 of the following year. Be sure to inquire as to the amount of
estimated taxes paid to date for the current year. As with over-
withholding, excess estimated payments can give rise to an
overlooked marital asst. Also, if the taxpayers are going to be
divorced by the end of the year and thus filing separate returns,
address how the estimated payments made during the year are
going to be divided. If you dont address it, the IRS will.
Refunds Overpayments of tax can either be refunded or applied
to the next years return. If the refund is applied to the next years
tax, the parties can allocate the refund against their respective tax
liabilities as they deem appropriate. Again, if the parties do not
agree, the IRS will determine how the refund is to be allocated.
If an overpayment was refunded, make sure that it is accounted for
either in a marital account or used for living expenses. Also, check
to see if the refund was direct deposited in a known bank account.
Preparers Signature All paid preparers are required to sign
individual income tax returns. Ask your client to authorize you to
speak with the preparer regarding the returns and other financial
issues. Frequent changes in preparers may be a red flag as to the
accuracy of the returns.
Schedule A Itemized Deductions nnn
Interest Home mortgage interest is the most common interest
deduction. A quick review of the deducted amount should indicate
whether the expense is reasonable in relation to the known
mortgage balance. If the deduction has increased from one year
to the next, it may indicate that the principal residence has been
further encumbered by a home equity loan or the parties may have
acquired a second residence. Interest may be deducted on the
taxpayers principal residence and one other home. Mortgage
interest paid is reported on Form 1098.
A deduction for investment interest expense frequently indicates
the existence of a margin loan in a brokerage account.
Taxes Paid Are the property taxes deducted appropriate for the
known real property holdings of the parties? If none are deducted
and the parties own the marital home, it may indicate a significant
marital debt. Conversely, if the tax deduction is high in relation to
the value of the home and local tax rates, it may indicate that the
parties own additional real property.
Automobile license fees based on the value of the vehicle
are deductible as ad valorem property taxes that should be
commensurate with the value of the parties vehicles.
Miscellaneous Deductions If the parties have a safe deposit
box, the annual fee will be reported here. You should inquire
as to the contents and make sure that both parties are aware
of its existence.
119 2013
Schedule B Dividends and Interest nnn
This schedule is extremely useful in identifying bank accounts,
brokerage accounts, and interest-bearing and/or dividend-paying
investments. Reviewing the entries on Schedule B can assist in
identifying bank accounts, money market accounts, bonds, and
brokerage accounts at both the personal and the entity level (for
pass-through entities).
If interest from a business owned by one of the parties is reported
here, it probably means that there is a shareholder loan that should
be taken into account as a marital asset.
Schedule C Business Income nnn
Schedule C is used to report the annual financial performance of
sole proprietorships. The owner of the business, the nature of the
business, and the accounting method used by the business are all
reported on this schedule.
Schedule C businesses are great places for people to claim
everyday life expenses (e.g., auto expenses, travel expenses,
entertainment, office expense, etc.) as business expenses. If the
claimed expenses appear to be inappropriate for the nature of the
business, you may wish to challenge such expenses and attribute
them back to the individuals income.
If the expenses seem excessive in relation to the reported receipts,
it may indicate that not all income has been reported. Many sole
proprietorships have a significant number of cash transactions
that can fly under the IRS radar.
Further investigation may be warranted if either the income or
expenses seem questionable. You can then attempt to verify
the amounts by requesting copies of checkbooks, electronic
accounting systems, and receipts. Or, you may want to engage
the services of a forensic accountant.
Schedule D and Form 8949
Capital Gains and Losses nnn
Any capital asset sold during the year is reported on Form 8949
and the total of all sales is carried to Schedule D. For each sale,
the nature of asset (e.g., 100 shares IBM), the date and cost of the
original purchase, and the date of sale and proceeds received is
required to be reported. The proceeds may have been reinvested
in other capital assets or converted to cash. If converted to cash,
you may want to inquire as to the disposition of the proceeds.
A capital loss carryforward can be a valuable asset. Because
taxpayers are limited to a $3,000 deduction annually, there may
be significant losses that can be carried forward to future years.
If the losses were generated jointly (e.g., from a joint brokerage
account), the loss carryforward can be divided evenly between
the parties. Under IRS regulations, the capital losses belong to
the party who generated them. If only one of the parties is going
to benefit from the carryforwards in the future, you may want to
attribute value by using an assumed tax rate and an assumed
period in which the losses will be used.
Schedule E Rental Real Estate, Royalties,
Partnerships, S Corporations, Trusts nnn
Income from rents and royalties is reported on Page 1 of Schedule
E. Significant information is provided regarding rental properties
including, but not limited to:
n The address of the property
n Gross rents received
n Interest expense, which indicates there is an underlying
debt on the property
n Depreciation expense, a non-cash expense which may be
available to the owner as additional cash ow
n Potential personal expenses of the owner such as excess
travel or vehicle expense
Royalties reported on Schedule E are often associated with
publications, inventions, and oil and gas investments. The
existence of royalties may indicate the existence of a valuable
asset requiring further investigation.
Income or loss from partnerships, LLCs, and S corporations
is reported on Page 2 of Schedule E. The IRS requires that all
partners/shareholders be provided a K-1 from any entity in which
they have an ownership interest. Information to be gleaned from
a K-1 includes:
n Percentage ownership interests at the beginning of the
year and the end of the year. Note any changes and
determine the impact on the marital estate.
n Guaranteed payments to partners may indicate the
existence of partnership agreements, which can be
subpoenaed from the entity.
n Distributions and withdrawals, which may be either
more or less than the income required to be included
in the taxpayers income. This can be a critical factor in
determining the actual amount of income available
to pay support.
n Repayment of shareholder loans may indicate the
existence of another marital asset. Request verication
of the current balance of any shareholder loans.
n Capital contributions made during the year.
120 2013
Income from trusts and estates reported on Page 2 of Schedule
E can indicate the existence of significant inheritances. While the
beneficiary may claim the interest as separate rather than marital
property, this may provide an additional source of income available
to pay child and/or spousal support.
Be sure to request copies of the tax returns for any entity
reported on Schedule E!
Conclusion nnn
If you have reason to believe the returns you have been provided
may not be the actual returns filed, you can request tax returns
(and amended returns) directly from the IRS using Form 4506 or
4506 T (for transcripts only). A power of attorney can be signed
to enable consultants to contact the IRS directly to ask questions
about historical taxes actually owed and paid versus taxes
reportedly owed and paid.
Justin L. Cherfoli, CPA/ABV, CFF is a Managing Director in the
(SRR). He has provided valuation, dispute advisory, and forensic
accounting services for numerous purposes including marital
dissolutions, shareholder disputes, commercial litigation, estate and
gift taxation, financing, purchase and sale advisement, Employee
Stock Ownership Plans, C corporation to S corporation conversions,
intellectual property valuations, reasonable compensation,
executive stock options, and other tax, corporate, and litigation
related matters. Mr. Cherfoli can be reached at +1.248.432.1242 or
jcherfoli@srr.com.
Mary V. Ade is a Director in the Dispute Advisory & Forensic
Services Group at Stout Risius Ross (SRR). She has over 20 years
of experience in the field of Family Law. Ms. Ade can be reached at
+1.248.432.1336 or made@srr.com.
#
1
Advisor Rank
Stout Risius Ross, Inc. 1
JP Morgan 2
Houlihan Lokey 3
Duff and Phelps 4
Sandler ONeill Partners 5
Barclays 6
Evercore Partners 7
Credit Suisse 7
Bank of America Merrill Lynch 9
Morgan Stanley 10
RBC Capital Markets 10
Goldman Sachs & Co 10
Greenhill & Co, LLC 13
Citi 13
Perella Weinberg Partners LP 13
Lazard 13
Deutsche Bank 17
Moelis & Co 17
Stifel Financial Corp 19
Keefe Bruyette & Woods Inc 19
#
1
Fairness Opinion
Advisor in the United States
*

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*2012 rankings are based on number of transactions
Source: Thomson Reuters M&A Financial Advisory Review
www.SRR.com
One South Wacker Drive, 38th Floor
Chicago, IL 60606
INVESTMENT BANKING VALUATION & FINANCIAL OPINIONS DISPUTE ADVISORY & FORENSIC SERVICES
www.srr.com
SRR is a trade name for Stout Risius Ross, Inc. and Stout Risius Ross Advisors, LLC, a FINRA registered broker-dealer and SIPC member firm.
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