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Summing It Up

Keeping you ahead of the curve with timely news & updates.


How can you ensure divorce cases are equitable?

By Ron Soluri, Jr. CPA Director

In typical divorce cases, courts will try to split assets equitably between both spouses. But, at times, the parties can make the court’s job quite difficult by hiding assets or performing their own valuations. The key to a fair settlement is hiring an experienced financial expert to accurately appraise the assets.

Inadequate Discovery

A common roadblock to an equitable asset split in a divorce is inadequate discovery. When the divorcing spouses own a business, it can be their biggest and most illiquid asset. But a spouse who controls a business can often be reluctant to release certain information, such as tax returns, financial statements, contracts, business plans and marketing materials.

Divorcing spouses may also resort to unscrupulous behavior and actually hide income or assets. Others may argue that giving an appraiser access to such information will breach the company’s security and interrupt its business operations.

When valuing a company, an appraiser must have access to information that’s usually known only to insiders. Make sure you involve your financial expert early on in the process to help improve the scope of discovery. And be sure to ask him or her for a complete list of documents and procedures that’s needed to complete the job.

Digging Out Fraud

At times, spouses might try to hide assets in anticipation of an impending divorce. Or a business owner might delay reporting his or her income or even overstate expenses until the divorce is settled.

Let’s look at an example of such behavior. Mrs. Moneybags opened a bank account under her adult son’s name and set aside $200,000 over three years. She suspected that her husband was being unfaithful, and she wanted to tuck away some funds, just in case he left her. Trouble is, the $200,000 legitimately belongs in the Moneybags’ joint marital estate — regardless of which spouse is in the wrong.

If you or a client thinks the other spouse is concealing income or assets, the actual scope of an assignment may need to be expanded to investigate any asset misappropriation or financial misstatement. Financial experts in such divorce proceedings often have a background in forensic accounting, so make sure you tap into their fraud expertise.

Solving the problem of subjectivity

As you know, divorce cases can be fraught with subjective issues. For instance, it may be unclear whether discounts for lack of control and marketability (common in Tax Court cases) apply in divorces. There are other relevant issues that might apply when appraising a business. They may include the appraisal date, the appropriate standard of value, and the local courts’ treatment of goodwill and buy-sell agreements.

Although it’s quite necessary to look at applicable case law in the appropriate state, having an understanding of legal precedent in other jurisdictions can be helpful, as well. For example, family courts sometimes consider cases in other states, especially if the state hasn’t ruled on a similar case or if state case law is contradictory.

The parties might also argue whether it’s appropriate to subtract built-in capital gains tax liabilities when the joint marital estate includes C corporation stock. If the economy is volatile, the parties might argue over whether the court date or the filing date is actually the more appropriate “as of” date for valuing retirement accounts, stock and other marital assets.

Points of contention like those expressed above can slow down a divorce case and even add an element of uncertainty to court-imposed settlements and judges may have different interpretations of these issues. Sometimes, the parties are simply better off negotiating their own out-of-court settlements.

Avoiding the DIY scenario

If a client brings up the idea of a do-it-yourself (DIY) assessment of assets as a way to save money, don’t let him or her do it. Professional appraisers use highly sophisticated methods to help value assets, particularly businesses. Such methods often include the adjusted book value, merger and acquisition, guideline public company, capitalization of earnings and discounted cash flow methods. Such techniques are preferred by the courts.

Shortcuts, such as net book value, industry rules of thumb, or buy-sell formulas, will likely be inadequate. And any attempts to fraudulently hide or misrepresent assets could lead to even more legal trouble that will make the original divorce action seem like a walk in the park.

It is wise to consult with valuation analysts and CPA’s who can provide solid litigation support in these cases and provide adequate comparables, as well as analyzing financial results that ultimately lead to an accurate determination of value assets.

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The 101 on Patent Infringement Damages

By: Joseph Aquino, CPA Director

 

 

Calculating damages in patent infringement cases still poses a challenge in today’s world. In addition, expert testimony on the matter typically comes under heavy Daubert scrutiny. In the case of Brandeis University, et al, v. Keebler Co., et al, Judge Posner of the Seventh Circuit Court of Appeals (sitting by designation in a federal district court) pretty much excluded most of an expert’s proposed damages testimony — despite finding her to be “highly qualified” and quite competent to estimate reasonable royalties.

Infringing a patent

This case involved patents for a certain type of margarine that doesn’t contain any trans-fats. The plaintiffs alleged that the Keebler Company’s reduced-fat biscuit, cookie, cookie dough and crescent roll products infringed the patents. What was at issue here? The reasonable royalty that Keebler would have paid the licensor if it had just negotiated a license before it started using the infringing product rather than risk being sued.

Judge Posner stated that Keebler wouldn’t have paid a royalty that’s higher than the cost of switching to a noninfringing substitute for the plaintiffs’ margarine . . . or otherwise reworking its manufacturing process to help avoid making the infringing margarine. Posner rejected the plaintiffs’ expert’s conclusion on the basis that no noninfringing alternatives to the patented margarine could be found. (See the sidebar “Why you shouldn’t go it alone.”) But he also explained that just the lack of a perfect substitute by itself wouldn’t allow the estimation of a reasonable royalty. That royalty would depend on the costs of higher production expenses and loss of business to competitors to create the best imperfect substitute. The expert offered no evidence on either cost.

Instead, the expert based the calculation of a maximum reasonable royalty on the business’s maximum profits that she deemed to be at risk if Keebler didn’t get a license. So, she relied on three “comparable” licenses in order to project the maximum amount of profits that Keebler put at risk by simply failing to obtain a license.

Understanding the licensing issue

The court actually rejected the expert’s reliance on two of the licenses out of hand. One license resulted from the settlement of a patent infringement suit. Judge Posner found that licensee to be “wholly dissimilar to Keebler.”

As to the second license, it was also granted in settlement of litigation. The stated payment for the license was just a one-time payment, but it seemed to have been returned to the licensee as consulting fees over the next several months. Moreover, the settlement allowed for changing a strategic partnership between the licensee and a subsidiary of the licensor. And, in return for those benefits, the licensor agreed to dismiss the lawsuit and grant a license.

Judge Posner postulated that the expert had made no attempt to value any individual component of the settlement agreement that produced the second license. Therefore, she really couldn’t “responsibly” value the patent license itself.

Only the third license came even close to providing a reasonable comparable. Like the Keebler company, the licensee was a large food conglomerate that creates baked goods alleged to infringe, thus allowing an inference that Keebler would have paid just as much as the licensee. Changes occurring since that license was negotiated in 2005 would thus drive the licensor to insist on a higher royalty.

Using reasonable methodology

In the end, Judge Posner found that the plaintiffs’ expert had truly failed to use a reasonable methodology when calculating the damages by reference to two of the licenses. He also noted that the expert had failed to calculate the profits at risk or even assess the cost of noninfringing alternatives. But, he did allow her to testify on the third license, which remained a “possible basis” for estimating a reasonable royalty, and on the general principles of patent damages.

Sidebar: Why you shouldn’t go it alone

The plaintiffs’ expert in Brandeis University, et al, v. Keebler Co., et al (see the main article) got into a lot of trouble because she simply didn’t make proper use of input from other types of experts. The damages expert testified that there was simply no cheap and satisfactory substitute to the patented margarine. The expert also testified that, in order to avoid both trans-fats and use of an infringing margarine, Keebler would have had to consider all the possible effects of substituting a noninfringing margarine (which would likely cause sogginess) on consumer demand.

But the expert was an economist, and not an expert on consumer demand for cookies, and she didn’t consult with a sales or marketing expert. She did, indeed, consult with a biochemist specializing in food, but he wasn’t a food scientist. Judge Posner also faulted the expert for not consulting with an industrial baker on the cookie’s sogginess issue. He ruled that the damages expert couldn’t rely on the biochemist’s conclusion that no noninfringing alternatives were available that would cost Keebler less than a “hefty royalty to the plaintiffs.”

In conclusion, it is critical in cases such as these to make sure that input from qualified experts are chosen to verify the information utilized in each particular case.  Valuation analysts and CPA’s can provide solid litigation support in these cases by researching and providing adequate comparables as well as analyzing financial results that ultimately lead to an accurate determination of value or calculation of damages.

 

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Goodwill: Fueling the debate in divorce cases

By: Joseph Aquino, CPA, CVA Director

 

There is a distinction between two types of goodwill depending upon the type of business enterprise: institutional goodwill and professional practice goodwill. Goodwill in a professional practice entity may be attributed to the practice itself and to the professional practitioner.

Goodwill continues to fuel debate in divorce cases that involve professionals, such as physicians and attorneys. In an Arizona case law, Walsh v. Walsh, the court of appeals reversed the family court’s ruling that limited a law firm partner’s goodwill to the amount he would receive under a stock redemption agreement.

Disagreement over goodwill

During the divorce proceedings between Cheryl and E. Jeffrey Walsh, the parties couldn’t come to terms about the value of Jeffrey’s intangible professional (or personal) goodwill. He claimed that his interest in the law firm should be $140,000, which was the stock redemption value pursuant to the firm’s stockholder’s agreement. Jeffrey’s expert testified that, while he had professional goodwill, the only realizable benefit from his employment as of the date of divorce was the $140,000 redemption value.

Cheryl’s expert applied a capitalization-of-earnings valuation approach and examined documents related to the husband’s tax returns, earnings sustainability, historical income performance, client loyalty, and reputation. Based on those factors, and giving very little weight to the stockholder’s agreement, the expert valued Jeffrey’s professional practice at about $1.3 million.

The family court agreed with Jeffrey’s expert and found that his interest in the firm (including goodwill) and the value of his law practice were limited to $140,000. Cheryl appealed, contending that the lower court shouldn’t have limited Jeffrey’s professional goodwill as an attorney to his stock redemption interest in his firm.

Appellate court sides with Cheryl

The appellate court explained that future earning capacity isn’t goodwill per se. On the other hand, goodwill may exist when future earning capacity has been enhanced because reputation leads to probable future patronage from potential and existing clients. Like other Arizona professionals, lawyers face evaluation of their professional goodwill as a community asset under the state’s divorce law.

To determine the existence and extent of goodwill, the court noted it may consider as “determinative factors” the practitioner’s age and health, past earning power, reputation in the community for judgment, skill and knowledge, and, finally, comparative professional success.

Added to this are terms of a lawyer’s partnership agreement that may also be considered when determining the value of goodwill in a divorce context, but only as a single factor. As noted by the appellate court, “Partnership agreements are designed to deal with particular aspects of the business, and simply do not address the considerations involved in valuation for a marital dissolution.”

The court of appeals faulted the family court for failing to consider Jeffrey’s professional goodwill beyond his stock redemption interest in the firm. The court also pointed out that it had previously rejected the lower court’s approach of requiring goodwill to be realizable (something that can be bought or sold on the open market).

The court acknowledged that, when goodwill has no immediate cash value, it must apply its own discretion and judgment in making a determination. The determination, of course, isn’t limited to corporate documents setting a shareholder’s interest in the company’s assets. Instead, the court can use expert testimony and the “determinative” factors to help guide its examination of enhanced future earning capacity.

The court of appeals concluded that the family court had conflated the firm’s net assets, which were subject to the stockholder’s agreement, along with Jeffrey’s own goodwill. It also decided that he possessed goodwill beyond the amount that the family court had designated.

However, the appellate court emphasized that its ruling should not be interpreted as equating future earning capacity with goodwill. While future earning capacity may be evidence of goodwill, the earning capacity isn’t itself a divisible community asset.

 


Sidebar: Professional goodwill: Community property or not?

The husband in Walsh v. Walsh (see main article) argued that professional goodwill is separate from “enterprise goodwill” and isn’t divisible marital property. The Arizona court of appeals acknowledged that some states do hold that professional goodwill may not constitute marital property. But, in Arizona, the court said that consideration of the “determinative” factors demonstrates that the state does consider qualities that are attributable to the individual when determining community property values.

The husband further argued that professional goodwill is already accounted for in spousal maintenance and realized through future earnings. The court disagreed, however, comparing the divisible component of professional goodwill with an interest in pension rights — value is generated (at least partly) during the marriage, and will be realized later. Courts must ensure that they don’t divide as community property future earnings that are based exclusively on post divorce efforts.

It is critical to understand your specific state’s position on whether professional goodwill constitutes martial property due to the fact that it could have a significant impact on stock redemption value in divorce proceedings.

If you have questions regarding professional goodwill, or any other litigation concerns please contact Freed Maxick CPAs litigation support team today.

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IRS Victory Highlights the Importance of Careful Estate Planning

IRS Undermines a Family Limited Partnership 

Author: Joe Aquino

Recently, the IRS celebrated another victory in its long-running campaign to challenge family limited partnerships (FLPs). In Estate of Lockett v. Commissioner, the agency attacked an FLP for being an invalid partnership under state law. Ultimately, however, it was the decedent’s estate planning that undermined the FLP, thus handing the IRS another win.

Widow takes ownership

Lois Lockett was predeceased by her husband, whose will established a trust for her benefit (Trust A). In 2000, as part of her estate planning, Lockett formed Mariposa Monarch, LLP under Arizona law. The partnership’s formal agreement, signed in 2002, named her sons Joseph and Robert as general partners. Lockett, the sons and Trust A were named as limited partners. At that point the parties hadn’t yet agreed on initial capital contributions or their percentage interests in Mariposa.

Shortly after the agreement was signed, Lockett and Trust A began funding Mariposa. Joseph and Robert never made any contributions. In 2003, Trust A was terminated, and Lockett became the owner of her limited partnership interest in the partnership. An amended agreement was executed to reflect this. The agreement continued to list the sons as Mariposa’s general partners, but an exhibit listed their mother as holding 100% of the partnership and each of the sons holding 0%.

When Lois Lockett died in 2004, Mariposa held assets worth more than $1 million. On its tax return, the estate valued Lockett’s 100% ownership interest in Mariposa at $667,000 after applying control and marketability discounts.

IRS raises state law

Initially, the IRS argued that Mariposa wasn’t a valid partnership under Arizona law. In that state, partnerships are defined as an association of two or more persons and are formed to operate a business for profit. The IRS contended that only Lockett contributed assets to Mariposa and that Mariposa wasn’t operated for profit.

Nevertheless, the court found that Mariposa was a valid partnership. Although the sons didn’t hold interests in it, Trust A contributed assets and was therefore a limited partner, satisfying the requirement of an association of two or more persons.

The court also found no requirement that an Arizona business engage in a certain level of economic activity. Moreover, it determined that Mariposa was operated to derive a profit. The partnership hired a financial advisor to manage its stock portfolio, purchased real estate that it leased and made loans requiring annual interest payments. It thus operated as a business for profit.

Trust termination found faulty

Unfortunately for the estate, the IRS had an alternative argument. Even though a valid partnership was formed, it had terminated at the time of Lockett’s death because she had acquired 100% of the interest in it. This occurred when Trust A was terminated in May 2003 (effective Dec. 31, 2002). At that point, Lockett had become the owner of Trust A’s limited partnership interest in Mariposa as well as being its sole partner.

Arizona law provides that a partnership is dissolved when a dissolution event previously agreed upon in the partnership agreement occurs. The Mariposa agreement established that the FLP would be dissolved when one partner acquired all of the other partners’ interests. So on Dec. 31, 2002, Mariposa dissolved and Lockett became the legal owner of its assets.

Many potential errors

Because the FLP had dissolved by the time of Lockett’s death, its assets were included in her gross taxable estate. If her sons had made contributions to fund their general partnership interests or she had gifted them with small interests in Mariposa, the FLP may well have withstood scrutiny and removed the assets from the estate.

Lockett’s mistakes were only a few of the many errors that can sabotage an FLP. To protect your clients from IRS attack, work with financial experts when drafting partnership agreements and making estate plans.

If you have any questions about FLPs or any other issue, give us a call at 716.847.2651, or you may contact us here.

Family Limited Partnerships

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How a Company’s Value Can Change When an Executive Leaves

What to Do When One Employee Holds the Key to Business Value

Author: Ron Soluri Jr.


A company’s earnings and cash flows can suffer significantly when an executive or other critical employee leaves. Small and service-oriented businesses and professional practices are particularly vulnerable to such financial losses.

To account for this risk, professional valuators may apply a key-person discount. These discounts don’t apply to all business appraisals and they’re rarely one-size-fits-all. Thus, a valuator must ask several questions specific to the subject company and its key employees.

Which appraisals are affected?

Choosing when a key-person discount is appropriate can be tricky. Smaller closely held businesses are likely to depend on one or more critical employees, but such risk is often accounted for in a separate “size premium.” Larger closely held companies or public companies usually are able to replace key management personnel and thus minimize potential losses.

In general, businesses that sell products are better able to withstand the loss of a key person than service businesses, which depend to a greater extent on key employees’ knowledge, reputation and relationships. However, a product-based company that relies heavily on technology or intellectual property may be at risk if a key person possesses specialized technical knowledge.

Who are the key people?

Key people provide value in different ways, depending on the roles they play in their companies. For example, a key person might:

  • Drive the company’s strategic vision,
  • Handle day-to-day management responsibilities,
  • Offer technical expertise,
  • Lend his or her excellent reputation, or
  • Provide access to an extensive network of contacts.

Personal relationships are a critical factor in identifying key employees. If clients, customers and vendors deal primarily with one person, they may decide to do business with another company if that person is gone. On the other hand, it’s easier for a company to retain customer relationships when they’re spread among several people within the company.

A key person may also have a financial impact on the business. It’s not unusual for the CEO or another executive in a closely held business to personally guarantee the company’s debts. Lenders may call in such debts if the key person is no longer with the company.

How deep is the bench?

When determining key-person discounts, valuators must assess the ability of others to fill key employees’ shoes. To survive without a key person, existing management must have the knowledge, skills and business acumen to continue normal operations without interruption.

Another key factor is whether there exists a comprehensive succession plan that formally outlines which individuals assume control after key people leave. In the absence of a plan, the departure of one key person could trigger power struggles or require the company to bring in a replacement who isn’t familiar with the organization.

What’s the impact?

Identifying risks associated with key persons is one thing; estimating the impact of those risks on business value is quite another. Valuators generally use one of three methods to incorporate key-person discounts into their calculations: 1) Adjust future earnings to reflect the risk of losing a key person (typically used when a key person’s departure is imminent), 2) adjust the discount or capitalization rate, or 3) discount calculated value by a certain percentage (similar to a marketability or minority interest discount).

Quantifying the discount can be challenging because little empirical support for across-the-board key-person discounts exists. However, research has shown that, in cases where a discount was appropriate and a departure was reasonably certain, the applicable decrease in value associated with a key person’s loss ranged between 4% and 6%.

Best outcomes 

Among the many legal contexts in which key-person discounts can arise are marital dissolutions, shareholder disputes, mergers and acquisitions, and tax court challenges. To ensure the best outcome for your client, work with a valuator who has experience estimating such discounts and is capable of defending his or her appraisal methodology in court.

If you have any questions about valuations or any other issue, give us a call at 716.847.2651, or you may contact us here.

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Litigation Support: Weight vs. Admissibility

Court Allows Lost Profits Expert Testimony

Author: Tim McPoland
When an opposing party in a lawsuit challenges the admissibility of an expert’s testimony, the matter often comes down to one of two interpretations: whether the court believes the party’s arguments go to the admissibility of the evidence or to the weight of the evidence. The ruling in a federal district court case, BK Cypress Log Homes v. Auto-Owners Insurance Co., illustrates such determinations and highlights the need to present relevant expert testimony.

2 calculations

BK Cypress Log Homes sued Auto-Owners Insurance Company, alleging bad-faith conduct in the handling of a third-party claim. The defendant moved to exclude the plaintiff’s damages expert’s testimony on the grounds that his techniques weren’t generally accepted in the economic community. The expert used a two-part model, estimating lost profits with both the before-and-after and yardstick methods.

In his first calculation, he determined the plaintiff’s profit margins before and after the loss period. He attributed the difference to effects created by BK Cypress owner Jim Keeton’s participation in dispute-related activities that should have been handled by the defendant and that resulted in operational inefficiencies.

In the second calculation, the expert considered what the plaintiff’s sales would have been if the company had matched the industry average sales for the loss period. He used sales information from a log-home industry publication, as well as a “sample survey” of members of the Log Homes Council. Together, these sources yielded growth rate numbers for six companies.

Court rejects challenge

In the Florida court, the defendant asserted that the plaintiff’s before-and-after analysis wasn’t acceptable because it assumed that all loss in profitability was attributable to the defendant’s bad faith. In particular, Auto-Owners faulted the lack of data documenting:

  1. The amount of time Keeton spent attending to dispute-related matters, and
  2. The failure to account for time he would have expended on such matters even in the absence of bad faith.

The court concluded that the defendant’s criticisms should be raised through cross-examination of the expert and other witnesses regarding the assumptions underlying the damages calculation.

The defendant also argued that the yardstick analysis wasn’t acceptable because, among other things, the expert’s report didn’t establish that the businesses used to measure the losses were sufficiently similar to BK Cypress. The court denied the motion to exclude this part of the analysis — but without prejudice to the defendant’s right to exclude the testimony at trial if the plaintiff was unable to establish the survey data’s reliability through other evidence.

Rebuttable witness also rebuffed

Notably, the court also rejected the testimony of the defendant’s financial expert because he didn’t provide an estimate of damages. It characterized that expert’s testimony as a rebuttal opinion that failed to offer an alternative analysis methodology.

In the end, the court decided that the defendant’s expert’s testimony wouldn’t aid the jury in determining damages and would in fact be “redundant and unduly prejudicial.” Instead, the defendant was instructed to explore the criticisms in its expert’s report during cross-examination of the plaintiff’s expert and other witnesses.

If you have any questions about lost profits, testimony or any other litigation support issue, give us a call at 716.847.2651, or you may contact us here.

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Litigation Support: The Gift Tax Exclusion

Court Determines the Gift Tax Exclusion Applies to FLP

Author: Ron Soluri Jr.

litigation supportRecently, we discussed a case where the U.S. Tax Court held that gifts of interests in a family limited partnership (FLP) qualified for the federal annual gift tax exclusion. The decision in Estate of Wimmer v. Commissioner came as a surprise to some because, in three previous cases, the same court held that the exclusion didn’t apply to gifts of limited partnership interests.

Keeping it in the family

A married couple formed an FLP in 1996, funding it with publicly traded and dividend-paying stock. The FLP was established in part to restrict nonfamily rights to acquire family assets. The husband and wife made gifts of limited partnership interests in the FLP to various family members.

In 1996, the FLP began receiving quarterly dividends from the stock. To allow the limited partners to pay federal income tax, the FLP made distributions from 1996 through 1998. Beginning in 1999, the FLP continuously distributed all dividends — net of partnership expenses — to the partners when they were received. These were made in proportion to partnership interests. Limited partners were also given access to capital account withdrawals and they used such withdrawals for, among other things, paying portions of their residential mortgages.

After the husband died and his estate filed an estate tax return, the IRS returned a tax deficiency of $263,711. The estate asked the Tax Court to find that the gifts of limited partnership interests qualified for the annual gift tax exclusion.

Present benefits

Annual gift tax exclusions are available for “present interest gifts” only, not to gifts of future interests in property. As the court clarified, a gift in the form of a transfer of an equity interest in a business or property, such as limited partnership interests, isn’t necessarily a present interest gift.

To qualify as a present interest gift, the gift must confer on the recipient a substantial present economic benefit by reason of use, possession or enjoyment of either the property or income from the property. In this case the court decided that, because of the significant transfer restrictions in the FLP’s partnership agreement, the donees didn’t receive the rights to immediately use, possess or enjoy the limited partnership interests themselves.

3 requirements

However, the court found that the estate satisfied three requirements for income from the limited partnership interests to qualify the gifts of the interests as present interest gifts: 1) the partnership would generate income; 2) some portion of that income would flow steadily to the limited partners; and 3) that portion of income could readily be ascertained. The court concluded that the limited partners received a substantial present economic benefit.

Wimmer provides an example of the right way to administer an FLP. It’s possible to put restrictions — which often are used to create valuation discounts — on gifted limited partnership interests while still satisfying the requirements for the gifts to qualify for the annual gift tax exclusion. To ensure your clients’ FLP operating agreements walk this fine line, work with an experienced financial advisor.

If you have any questions about the gift tax exclusion or any other litigation support issue, give us a call at 716.847.2651, or you may contact us here.

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Litigation Support: Damage Calculation Method Used in Recent Case

Court Confirms the “Gold Standard” of Valuation

Author: Tim McPoland

business interruption and litigation supportBusiness valuation arises in many legal contexts, including damages calculations in commercial litigation. In a recent case we have discussed, Malik v. Falcon Holdings, LLC, Seventh Circuit Court of Appeals Chief Judge Frank Easterbrook turned to what he called the “gold standard of valuation” to help determine damages for plaintiffs.

Promises, promises

Aslam Khan held 40% of the common units in Falcon Holdings, a limited liability company that owned and operated 100 fast-food restaurants. Khan allegedly told Falcon’s managers that when he acquired full ownership of the company one day he would reward top managers with 50% of Falcon’s equity.

In 2005, Khan bought out Falcon’s other owners and became the company’s sole equity owner. When he failed to distribute common units to any of the managers, five of them took him to court.

The plaintiffs used the price Khan paid in the buyout to calculate that the company was worth about $48 million. They also determined that because 20 managers qualified for units under the terms of Khan’s offers, each plaintiff lost about $1.2 million ($48 million × 50%/20).      

District court’s ruling

In summary judgment the district court found that Khan had promised the plaintiffs an equity stake in Falcon. But it held that the managers hadn’t adequately estimated their damages.

The court reasoned that the other owners didn’t own 100% of Falcon, making it impossible to derive the value of the whole firm from the amount Khan paid for their interests. Also, the amount the other owners were paid depended on how much Khan and Falcon could borrow — not on Falcon’s true value. Therefore, the plaintiffs’ approach was flawed.

Easterbrook questions analysis

On appeal, Judge Easterbrook rejected the district court’s analysis. That court’s two propositions ignore the fact that the “gold standard of valuation” is what a willing buyer will pay a willing seller in an arm’s-length transaction. Easterbrook concluded that the buyout of the other owners involved a willing buyer and a willing seller dealing at arm’s length, so the price they agreed on was the value of the asset.

But the judge also found fault with the plaintiffs’ damages estimate. The interest that plaintiffs valued and the interest Khan owned were different. The plaintiffs valued the entire company — or the sum of Falcon’s debt plus its equity. However, while Khan owned 100% of the equity, the bank held the debt interest. The judge found it unsound to assume that Khan’s equity interest in Falcon was worth 100% of the company’s total value.

Easterbrook also questioned the plaintiffs’ assumption that Khan would give each of the 20 managers 2.5% of Falcon’s equity units without attaching terms or conditions to them. He characterized this proposition as “a disaster not only for the ownership structure of a closely held firm but also from a tax perspective.”

Plaintiffs hold out hope

Easterbrook vacated the district court judgment and remanded the case for proceedings consistent with his opinion. The plaintiffs are still expected to receive something if they calculate damages according to the “gold standard,” but that amount will likely be less than the $1.2 million each manager had hoped for.

If you have any questions about the “gold standard” of valuation or any other litigation support issue, give us a call at 716.847.2651, or you may contact us here.

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