2nd Quarter 2017 Articles
Business Valuation Year in Review 2016 for U.S. and Abroad
It was an eventful year for the business valuation profession in 2016, both from a U.S. and global perspective. Here is a wrap-up of some of the more notable developments, some of which set the stage for 2017 and beyond.
IRC 2704. Arguably the most talked about issue in 2016 was the issuance of the controversial proposed IRC Section 2704 regulations designed to curb estate valuation discounts for minority interests. The valuation community was shocked over the scope of the proposed rules, which would apply to family-owned operating businesses as well as asset-holding entities that are perceived to be pushing the envelope in terms of discounts. Appraisers were also stunned over how the regs essentially redefined long-accepted definitions of fair market value, marketability, and control.
A record number of speakers, including from the AICPA, ASA and NACVA, appeared at the IRS public hearing in Washington, D.C., to fight the regs. They all agreed that the rules are so broad and convoluted that they should be withdrawn permanently or, barring that, completely revised. At the time of this writing, the IRS has made no announcement on the fate of the proposed regs. Regardless of what happens, the matter demonstrates how the valuation profession can mobilize and speak with one compelling voice over issues of great concern. Business Valuation Updates (BVU) applauds their efforts, which were also demonstrated in the collaboration over the CEIV credential.
CEIV. A groundbreaking development was the close collaboration of major valuation professional organizations (VPOs) to develop a new credential, Certified in Entity and Intangible Valuations™ (CEIV™), for professionals involved in fair value for financial reporting. For the first time, the AICPA, ASA, and RICS joined forces to bring more consistency to the profession and reduce the number of questions auditors raise about the valuations. A mandatory performance framework (MPF) has now been finalized, clearing the way for the new credential’s launch. The MPF will require professionals to better document their assumptions, which will help make auditors more comfortable with valuation estimates, especially for intangibles. This will also ease the concerns of the SEC and PCAOB, which have been critical of the valuation profession in this regard. This issue has an article with more details on the new CEIV credential.
Standards and guidance. The Appraisal Practices Board (APB) of The Appraisal Foundation adopted APB VFR Valuation Advisory No. 2: The Valuation of Customer-Related Assets. The 116-page document offers voluntary guidance on recognized valuation methods and techniques and “is not intended to be an authoritative valuation standard.” Customer-related assets can include customer lists, order or production backlog, and contractual (and non-contractual) customer relationships.
A third exposure draft was issued of proposed changes for the 2018-19 edition of the Uniform Standards of Professional Appraisal Practice. Some of the issues under consideration deal with the definition of report and communication of assignment results. There’s also a proposed revision of the definition of appraisal review, as well as splitting the existing Standard 3 into two standards.
The FASB issued three significant new accounting standards on revenue recognition, leasing, and impairment. The standard on revenue recognition is effective 2018 for calendar-year companies, with the other two kicking in shortly thereafter.
Regulatory. Aside from the Section 2704 matter, another major regulatory event occurred in 2016. In a long-awaited decision, the Department of Labor removed appraisals entirely—not just ESOP appraisals—from fiduciary treatment in its final rules designed to strengthen retirement security. The provision was part of extensive rules that require brokers and other advisers providing investment advice on retirement accounts to adhere to an ERISA-based fiduciary regimen. The proposed rule carved out just ESOP appraisals, but the final rules exempted all appraisals and fairness opinions.
In the healthcare arena, there are a few important developments worth keeping an eye on. One is accountable care organizations in the Medicare Shared Services Program. These groups do not seem to be achieving the savings that were anticipated, so this is an area to watch. Another issue is the merit-based incentive payment system, which will move a substantial amount of physician payments under the fee-for-service Medicare system to being merit-based. The Trump administration’s “repeal and replace” stance on Obamacare is not expected to affect the move to payments based on quality. Another matter that came into the spotlight during 2016 was talk about the repeal of the Stark Law. But some experts believe that it’s highly unlikely that the law will be repealed in its entirety because it generates a great deal of revenue for the government. There may be some changes to revenue-sharing rules between hospitals and physicians because the government wants them to work closer together and revenue sharing is the source of a lot of the Stark Law issues.
Legal. The January 2017 issue of BVU has a rundown of the top valuation-related court cases from 2016. They include the Delaware Chancery decision in Dell, probably the most talked about statutory fair value decision of the year, which arose out of the 2013 management buyout led by the company’s founder, Michael Dell. The court found that the deal price did not reflect fair value even though it recognized that the board and Dell himself made every effort to perform a proper sale. The court relied on a post-transaction DCF analysis for its fair value determination.
One case to keep an eye out for in 2017 is a pending Tax Court case in which an S corp valuation model is being used for the first time. The Van Vleet model (S corporation economic adjustment model) is being used in a pending U.S. Tax Court case (Cecil et al. v. Commissioner of Internal Revenue), which involves a gift of shares in a company that operates the famous Biltmore estate, which is now a tourist attraction. A much-debated issue in the valuation community is tax affecting the earnings of a pass-through entity (PTE), and there is no definitive answer. The tax-affecting issue has been argued in a number of Tax Court cases (most notably the Gross case). In all of these cases, the IRS and the Tax Court have refuted the notion that shareholder-level taxes affect a firm’s value, so the valuation conclusions in these cases were based on earnings not being tax affected. The valuation community disagrees, so a number of models have been developed that are designed to reflect the impact of shareholder taxes on value.
Global. The International Valuation Standards Council (IVSC) had a busy 2016 as it focused on the rollout of its 2017 standards (IVS 2017) and the implementation of the group’s organizational and strategic plans for the next two years. IVS 2017 is set to be issued in early 2017, and the IVSC will push for worldwide adoption. At the Standards Board meeting, Sir David Tweedie said, bluntly, that “valuation is not a profession. If valuers wish to become a profession, and continue with self-regulation, then VPOs must adopt IVS and enforce compliance—no exceptions.” IVSC and the World Association of Valuation Organizations (WAVO) strengthened their ties by signing a memorandum of cooperation (MOC) to jointly promote the importance of adopting the international valuation standards. Also, The Appraisal Foundation released a document titled “A Bridge From USPAP to IVS,” which connects the two sets of standards to help make appraisals compliant with both sets of standards. This was a significant step toward establishing a set of globally accepted ethical and professional standards for valuation.
In 2016, NACVA launched the Global Association of Certified Valuators and Analysts (GACVA) to “open its doors to the international financial consulting community and those organizations and individuals interested in obtaining, holding, and supporting” the various valuation and financial forensics credentials the group provides. GACVA is an umbrella group for international chapters, which currently include Africa, Canada, Europe, the Middle East, and Taiwan.
SpaceX Launch Brings Up Valuation Issues
The successful rocket launch last week by Elon Musk’s SpaceX brings up some interesting valuation questions about a fledgling and high-risk business. The launch was the first since the company’s last attempt resulted in its rocket blowing up on the launching pad.
Stephen Fleming (Boostphase), a venture capitalist active in the alternative space industry, says that one of the key issues for appraisers is terminal value, which most likely is zero. “Traditionally, most of these companies have failed,” he says. “There have been literally dozens of space-related startups that have simply gone bankrupt or have been acquired just for the engineering team. I have done that. So there is extraordinary volatility in terms of what the result is going to be.”
Fleming tells Michael Blake (Arpeggio Advisors), who has done appraisals of space commercialization companies, that Musk and his firm “will continue to accomplish remarkable things, but by no means is that an attainable model as yet.” However, there is optimism that this industry will eventually make a lot of money. Fleming points out that the more successful firms will target a particular market need and not try to be all things to all people.
Alternative space firms are involved in launch services, hauling cargo to space stations, satellite and rocket manufacturing, recovery of minerals on asteroids, as well as space tourism for the super-wealthy. So far, the need for valuation typically has been in a 409a context (lots of stock options are being issued), the raising of capital, and gifts or transfers.
NYSSCPA Symposium Highlights Valuation and Other Challenges of the Legal Marijuana Industry
The legal marijuana business is the fastest growing industry in the U.S., and if the momentum toward legality includes all states by 2020, U.S. retail marijuana sales could reach $35 billion. This past December, Business Valuation Update attended the Marijuana Symposium: Business, Tax and Legal Implications, sponsored by the New York State Society of CPAs. New York is one of 28 states that have legalized marijuana for medical purposes, but it is not among the eight states that have legalized recreational marijuana.
Regulatory hurdles. New York State Senators Diane Scavino and Liz Krueger talked about the regulatory hurdles legal marijuana businesses face. In her keynote address, Scavino said many problems stem from the fact that the drug remains on the federal government’s Schedule 1 status as a dangerous substance that has no accepted medical treatment use. Therefore, there is no insurance coverage for medical marijuana, banks will not open accounts for these firms, they cannot pay tax with marijuana proceeds, and they are not allowed to deduct normal business expenses. For the industry to truly thrive, marijuana must be de-scheduled, she said.
When the New York medical marijuana bill was signed into law in 2014, it created a program that was smaller and narrower than what was originally envisioned. For example, the original legislation allowed medical marijuana to be prescribed for post-traumatic stress disorder and chronic pain, but these conditions were cut in the final version due to concerns about abuse. Because the program is so narrow, it faces significant obstacles before it can sustain itself. Scavino pointed out, for instance, that there are only five licenses for up to 20 dispensaries in a state with a population of almost 20 million people. This can make access problematic, she said, particularly for patients upstate who may have to drive 400 miles to the nearest dispensary to get the brand of marijuana they need. Also, other drugs can be delivered through the mail, but federal regulations do not allow marijuana to be sent through the mail or through any private courier service.
There is also a great concern that the nominee for U.S. attorney general, U.S. Senator Jeff Sessions, who has come out heavily against marijuana legalization, for both medical and recreational use, will crack down and stifle industry growth. If he becomes the nation’s top law enforcer, it could mean the end of the “Cole Memo,” a set of guidelines the Department of Justice issued to federal prosecutors about how to enforce marijuana laws under the Controlled Substances Act.
Business owner perspective. One of five licensed operators in New York for medical marijuana is Etain Health. Hillary Peckham, one of the firm’s co-founders, told of the struggles to get the business up and running. Part of being in the marijuana industry, she says, is being an activist and promoting education. “There needs to be more awareness and involvement to better ensure operator compliance,” she says. “We’ve had several accountants tell us they don’t want to get involved in the marijuana business because they don’t think they are allowed to, so it’s a lot more difficult to find that kind of help than most people think.”
The Arkley Accounting Group is one firm that counts business owners in the cannabis industry among its clients. The firm’s owner, Todd Arkley, is a former landscaper who got into accounting after he agreed to keep the books for one of his customers. Arkley points to federal taxation problems this industry faces in terms of the inability to take tax deductions for normal business expenses. IRC Section 280E does not allow the deductions because marijuana is illegal under federal law. There have been several court cases on this issue, and the industry is now able to deduct COGS, but it is still faced with effective tax rates of 60% to 80% because of the inability to claim business expense deductions. An audience member pointed out that there is a case pending in Tax Court that argues that Section 280E should not apply to businesses that are legal under state law. The case involves Harborside Healthcare Center, the country’s largest cannabis dispensary ($30 million in sales), which is facing a $2.4 million back tax bill from the IRS.
Peckham also says it has been challenging to access banking services. “We found that state banks were more likely to work with us, but branches of national banks either would not or could not,” she says. Etain Health did what a lot of marijuana companies do and that is to split the company up into different operations, with each entity handling a specific task. This at least protects some parts of the overall operation in terms of being allowed access to banking.
Valuation angles. “In my 30 years of doing business valuation I thought I had seen everything until I got involved in this industry,” says Ron Seigneur (Seigneur Gustafson LLP), calling the appraisal of a legal marijuana firm the “ultimate challenge.” His practice is based in Colorado, one of the first states to legalize adult recreational marijuana, and he has done about 20 valuations so far. Of course, risk is a major factor, he pointed out, with company-specific risk premiums ranging from 30% to 40%. He also advised that when valuing a cannabis firm, focus on the “four L’s”: license rights, lease, location, and legislative environment.
A dearth of comparable transactional data from the market means that appraisers must rely on the income approach. Revenue projections can be especially tricky, but Seigneur uses management interviews and site visits to examine the size of the facility and the nature of the technology in use. Drawing from his experience in this industry, Seigneur is then able to estimate potential production. Using third-party resources, such as Cannabis Benchmarks, which tracks national prices, and the number of harvests (average of 5.5 per year), you can project out the revenue side.
Ground floor. “The rewards of early involvement may be quite significant,” says corporate cannabis lawyer Neil Kaufman (Kaufman & Associates), talking about accountants getting involved in this industry. Of course, this is of interest to any professional service provider, such as valuation experts. “The tide has turned,” he says, referring to the changing public opinion and the pressing fiscal needs of state governments. “There’s an inexorable march around the world towards the legalization, regulation and taxation of marijuana products,” he says. If a state can generate significant tax revenues, then this industry will not be ignored. And states that are already involved will not want to give up those revenues.
While medical marijuana will continue to be a part of the market, it will be dwarfed by the huge increase in the recreational market, Kaufman says. This has already been seen in Colorado, and it will soon happen in California. “When the California recreational market opens up, it’s expected to change the entire dynamics of the industry,” he says. In November 2016, it was reported that a shipment of marijuana was seized while on its way from California to Mexico—instead of the other way around. “That may be a harbinger of things to come.”
Amid all of the political and economic challenges, panel moderator Debra Borchardt (Forbes) asked if there was anything positive about going into this business. “We now have about 50 children who used to have 100 seizures a day and after using our product are now down to about one seizure a month,” Peckham said to an audience that burst into applause. “They’ve gone from incapacitated to all smiles.”
U.S. Goodwill Impairment Doubled in 2015: D&P Study
U.S. publicly traded companies recorded $57 billion in goodwill impairment (GWI) in 2015—more than double the impairment recorded during the prior year, according to the 2016 U.S. Goodwill Impairment Study from Duff & Phelps. The study was prepared and issued in partnership with the Financial Executives Research Foundation (FERF).
Hard-hit industries: For the second year in a row, the energy sector was the hardest-hit industry, with GWI of $18.2 billion in 2015, compared to $5.8 billion in the prior year. Energy accounted for nearly one-third of the aggregate GWI in 2015, with 56% of energy companies that carry goodwill on their balance sheets recording an impairment. The IT industry was also significantly impacted in 2015, as two of the three overall largest impairments took place in this industry and total GWI more than tripled, to $12.9 billion compared to 2014. The consumer discretionary industry and industrial sector also saw steep increases in 2015, more than doubling impairment levels of the prior year.
The study examines general and industry goodwill impairment trends through December 2015 for over 8,500 U.S. publicly traded companies. It also reports results from an annual survey of Financial Executive International (FEI) members, representing both privately owned and publicly traded companies.
Economic Update at a Glance
The U.S. economy—as indicated by GDP—grew at an annual rate of 1.9% in the fourth quarter of 2016, which is slower than the 3.5% rate reported in the third quarter of 2016. The slowing rate is due to a decline in exports and federal government spending. Imports, however, which are subtracted in the calculation of GDP, increased. For the year 2016, GDP increased 1.6% compared with 2.6% in 2015. Consumer spending rose 2.5% in the fourth quarter. Increased spending on big-ticket items drove the fourth-quarter rise in consumer spending. Spending on long-lasting or durable goods leaped nearly 11.0%. Comparatively, consumer spending rose at a rate of 3.0% in the third quarter, although both quarters suggest the economy is growing at a steady pace. Private inventory investment also helped boost GDP. Excluding inventories, GDP rose at a 0.9% rate in the fourth quarter. Total government spending rose 1.2% in the fourth quarter, marking the second consecutive quarterly increase, while state and local government spending increased following two consecutive quarters of declines. Private fixed investment, which includes residential and business spending, increased 4.2%. This marks a trend reversal after private fixed investment dropped for four straight quarters. The trade deficit widened in the fourth quarter, lowering by 1.7 percentage points.
Job growth continued on a solid pace in December, as employment rose by 156,000, but came in lower than the 170,000 initially projected. Job growth has averaged 165,000 jobs per month over the past three months, well above the 80,000-jobs-a-month pace the White House Council of Economic Advisers believes is needed to maintain a low and stable unemployment rate. For year-end 2016, job gains totaled nearly 2.2 million, a decline of more than a half a million from the previous year. The unemployment rate increased 0.1 percentage point in December, to 4.7%, while the labor-force participation rate remained unchanged, at 62.7%.
In December, the Federal Open Market Committee voted unanimously to raise its target range for the federal funds rate by 0.25%, to between 0.5% and 0.75%. This was the second increase in the federal funds rate since the 2008 financial crisis. In making its decision to raise the federal funds rate, the Federal Open Market Committee cited a change for the better in the economic environment since the election of President Trump.
Readings for consumer confidence improved in December. The Consumer Confidence Index improved 6.6 points, to 113.7, reaching its highest level since August 2001. The post-election surge in the index reflects consumer optimism in the economy, jobs, and their personal income. The survey is a leading indicator of consumer attitudes, measures of confidence toward business conditions, short-term outlook, and personal finances and jobs. The Consumer Sentiment Index rose 4.4 points in December, to 98.2, reaching its highest total since 2004.
The 4Q 2016 Wells Fargo/Gallup Small Business Index, which was reported in August, surged 12.0 points, to a reading of 80.0. This represents the highest optimism reading since January 2008 and the largest quarterly increase in a year. The report highlighted that small-business owners are more optimistic about the operating environment in 2017. The 4Q survey asked small-business owners about their priorities for the incoming president and Congress. Eighty-one percent said actions relating to the tax code, tax regulations, and tax rates for small businesses were most important. Other top priorities included the healthcare law (76.0%), government regulation of small business (70.0%), and actions that could affect oil prices or energy costs (59.0%). The report went on to note that in six key areas—financial situation, cash flow, revenues, capital spending allocation, hiring, and credit availability—the present situation dipped 5.0 points, from a reading of 29.0 in July to 24.0 points in November, while the future expectations score rose 17.0 points, from 39.0 in July to 56.0 in November.
Growth in the services sector was unchanged in December and remained at the strong growth levels established in November. The ISM reported that its Non-Manufacturing Index (NMI) stayed at 57.2%, which is a 12-month high. The December reading marked the 89th consecutive month of growth for the services sector. The majority of respondents’ comments were positive about business conditions and the overall economy, citing a very busy fourth quarter due to customers’ year-end spending boost.
The major stock indexes recorded gains in the fourth quarter and closed out 2016 with positive figures. The Dow Jones climbed 7.9% in the quarter and finished the year with a 13.4% gain. The Nasdaq Composite Index saw gains of 2.5% in the quarter and finished at 87% for the year. The Russell 2000 Index posted an 8.4% quarterly increase and finished the year up 19.5%, while the S&P 500 Index achieved a total return of 3.3% in the fourth quarter and recorded gains of 9.5% for the year. Treasury yields rose throughout the fourth quarter as a combination of anticipated higher levels of growth and inflation drove long-term yields higher. In addition, the Federal Reserve’s decision to raise interest rates in December and raise their guidance of the pace of future rate hikes drove shorter-term yields higher. The 10-year Treasury peaked at a yield of 2.6% on December 15 as yield curves steepened and Treasury yields rose, putting downward pressure on bond prices in anticipation of the future economic policies of President Trump.
Housing starts rose 11.3% in December. The 2016 growth in housing starts, the strongest since 2007, came in 5.7% higher than figures for 2015. The increase can be partly attributed to a rebound in multifamily units. Building permits authorized fell 0.2% in December but remained 0.7% above their levels from a year ago due to a rise in both single-family and multifamily permits. Existing-home sales fell 2.8% in December, halting a three-month upswing. Regardless, it was the best year for home sales in a decade. In December, homebuyers dealt with a lack of listings and quickly rising home prices as the major headwinds. Meanwhile, the surge in rates since early November ultimately caught some prospective buyers off guard and dimmed their appetite or ability to buy a home as 2016 ended.
The National Association of Realtors Confidence Index for current conditions decreased 1.0 point in December, to a reading of 62.0 points, but remained 5.0 points higher than one year ago. Builder confidence, as measured by the National Association of Home Builders/Wells Fargo Housing Market Index, increased 7.0 points in December, to 70.0. The report noted that the indicators show that the housing market will continue on an upward path into 2017.
2017 1st Quarter