“As similarity to the company to be valued decreases, the number of required comparables increases in order to minimize the risk that the results will be distorted by attributes unique to each of the guideline companies.”
How later courts described this case
- “As similarity to the company to be valued decreases, the number of required comparables increases in order to minimize the risk that the results will be distorted by attributes unique to each of the guideline companies.”
Written by the judges who cited it.
The opinion
T.C. Memo. 2002-34
UNITED STATES TAX COURT
ESTATE OF RICHIE C. HECK, DECEASED,
GARY HECK, SPECIAL ADMINISTRATOR, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 11619-99. Filed February 5, 2002.
Decedent owned 630 shares of F. Korbel & Bros.,
Inc. stock representing a 39.62-percent ownership
interest in the corporation.
Held: Fair market value of the shares determined.
Sec. 2031, I.R.C.
Richard J. Sideman, Steven M. Katz, and George I. Hoffman,
for petitioner.
Marion T. Robus, for respondent.
- 2 -
MEMORANDUM FINDINGS OF FACT AND OPINION
HALPERN, Judge: By notice of deficiency dated April 16,
1999, respondent determined a deficiency in Federal estate tax of
$5,427,983. Of the adjustments giving rise to that
determination, the only one remaining in dispute is respondent’s
increase in the value of certain shares of stock included in the
gross estate.
Unless otherwise noted, all section references are to the
Internal Revenue Code in effect at the time of decedent’s death,
and all Rule references are to the Tax Court Rules of Practice
and Procedure.
FINDINGS OF FACT
Some facts are stipulated and are so found. The stipulation
of facts, with accompanying exhibits, is incorporated herein by
this reference.
Introduction
Richie C. Heck (decedent) died on February 15, 1995 (the
date of death or the valuation date). Gary Heck (sometimes,
petitioner) is the special administrator of decedent’s estate.
At the time of the petition, petitioner resided in Santa Rosa,
California. Among the assets includable in decedent’s gross
estate are 630 shares of stock (the shares), representing
39.62 percent, of the outstanding common stock of F. Korbel &
Bros., Inc. (Korbel), a California corporation. Petitioner
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timely filed a Form 706, United States Estate (and Generation-
Skipping Transfer) Tax Return (the estate tax return) on May 15,
1996. Petitioner did not elect alternate valuation. See sec.
2032. In the estate tax return, petitioner valued the shares at
$16,380,000, or $26,000 a share. In determining a deficiency in
estate tax, respondent valued the shares at $30,177,000, or
$47,900 a share.
Organization and Operation of Korbel
Korbel was formed in 1903. Its business began in 1860, when
three Korbel brothers purchased property in Guerneville,
California, for the logging of timber. A decade later, vinifera
grapes were planted on the property, and, in 1882, the first
bottle of champagne was produced. Korbel has produced champagne
on the property, utilizing the traditional “methode
champenoise”,1 ever since.
1
Champagne or sparkling wine (although the name
“champagne”, technically, refers to sparkling wine produced in
the Champagne region of France, the terms “champagne” and
“sparkling wine” are often used interchangeably, and are so used
herein) is, in essence, wine that has been subject to a second
fermentation. Premium brands, such as Korbel, utilize the French
“methode champenoise”, pursuant to which the second fermentation
and all subsequent steps such as the removal of impurities and
the addition of flavoring components take place while the
champagne is in the bottle that is ultimately sold to the public.
That method is much more expensive and is considered far superior
to methods, such as the “Charmat process” or the “transfer
method”, pursuant to which certain steps do not take place in the
bottle.
- 4 -
The Heck family purchased control of Korbel in 1954, and, in
1976, Adolf Heck (decedent’s husband) became the sole shareholder
of the 1,900 shares of common stock outstanding. As of 1984,
Adolf and decedent each owned 950 shares. In 1984, Gary Heck
acquired 380 shares (190 each from Adolf and decedent). Also, in
1984, Adolf died, Korbel redeemed 310 of his remaining 760 shares
from his estate, and the remaining 450 shares passed in trust for
decedent’s benefit. In or around 1987, Gary Heck purchased the
450 of the shares in trust, giving him 830 shares (52.2 percent
of the 1,590 shares outstanding) and leaving decedent with the
remaining 760 shares. In 1989, decedent transferred 130 shares
in trust for the benefit of her two grandchildren. That left
decedent with 630 shares, the value of which, on the date of
death, is in dispute herein.
Primarily, Korbel produces economically priced premium
champagne. During the 3-year period ending with 1994, champagne
sales represented approximately 70 percent of Korbel’s total
sales, brandy represented approximately 27 percent of such sales,
and still wine accounted for the approximately 3-percent balance.
At the beginning of 1995, 95 percent of Korbel’s gross profits
were attributable to sales of champagne and just under 5 percent
to sales of brandy.
As of the valuation date, Korbel’s facilities were located
on 1,800 acres of land, mostly in Sonoma County. Of that
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acreage, 1,099 acres were not used in Korbel’s business
activities, and, on the valuation date, such land had a value of
$2,000 an acre.
In January 1986, Korbel elected to become an S corporation
(within the meaning of section 1361(a)(1)). That election was in
effect on the valuation date. Korbel’s financial statements and
tax returns are prepared on a calendar-year basis.
Distribution Agreement Between Korbel and Brown-Forman Corp.
In 1965, Korbel signed a marketing agreement with Jack
Daniel Distillery, Lem Motlow, Prop., Inc. (Jack Daniel),
granting Jack Daniel worldwide rights to buy, sell, and
distribute all Korbel beverage products. Thereafter, Jack Daniel
was consolidated into Brown-Forman Corp. (Brown-Forman), and, in
1987, Brown-Forman contracted to be the exclusive distributor of
Korbel products.
In 1991, Korbel and Brown-Forman entered into a new
distribution agreement (the agreement or the Brown-Forman
agreement), effective through April 30, 2003, automatically
renewable on a year-to-year basis thereafter, and cancelable on
or after May 1, 1998, upon 5 years’ written notice by either
party to the other of its intent to cancel. The agreement
granted to Brown-Forman the U.S. distribution rights for Korbel’s
champagne and brandy products, except for Korbel’s right to sell
through its on-premises wine shop. The agreement was amended in
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October 1994 to grant Brown-Forman worldwide distribution rights.
In addition to dealing with the distribution of Korbel’s
products, the agreement grants to Brown-Forman a right of first
refusal with respect to offers of Korbel’s stock by family
members. In that respect, the agreement provides:
RIGHT OF FIRST REFUSAL. In the event any member
of the Heck family desires to sell his or her shares of
stock in KORBEL to a person who is not a lineal
descendant of ADOLF L. HECK, he or she shall notify
BROWN-FORMAN, in writing, giving the name of the
prospective purchaser, a copy of the offer to purchase,
the number of shares and the price per share. BROWN-
FORMAN shall have thirty (30) days from receipt of such
notice to elect to purchase and pay for the said stock
at the price stated for cash. If BROWN-FORMAN does not
purchase such stock within said 30 day period, it may
be sold to the stated person at the stated price
without any further obligation to BROWN-FORMAN, meaning
that BROWN-FORMAN shall not have any further right to
purchase any of the KORBEL stock sold. If KORBEL has a
prospective purchaser for 50% or more of KORBEL stock
who is not a lineal descendant of ADOLF L. HECK and
BROWN-FORMAN does not exercise its prior right to
purchase said stock, then BROWN-FORMAN shall have no
further first right of refusal to buy that stock of
KORBEL at any time. * * *
Financial Performance
From 1985 through 1994, Korbel’s sales and net income were
as follows:
Year Revenues Net Income
1986 $76,955,000 $17,527,000
1987 85,582,000 25,317,000
1988 86,920,000 20,177,000
1989 79,294,000 12,728,000
1990 78,646,000 11,961,000
1991 75,677,000 7,735,000
1992 77,551,000 6,720,000
1993 78,569,000 7,179,000
1994 82,758,000 11,955,000
- 7 -
As of December 31, 1994, Korbel’s audited balance sheet
showed assets valued at $83,985,000, liabilities of $10,115,000
(current liabilities of $5,456,000 and long-term obligations of
$4,659,000), and shareholder equity of $73,870,000. Among
Korbel’s assets was a $2,209,000 interest-bearing note receivable
from KFTY Broadcasting (KFTY), a company owned by Gary Heck.
In 1994, although sales of Charmat process and transfer
method brands declined 11 percent, sales by domestic methode
champenoise producers increased by 4 percent. Korbel’s sales of
champagne increased by 6 percent in 1994. That year, although
Korbel was responsible for only 8.8 percent of total sales of
champagne in the United States, it represented 47.6 percent of
the domestic market for champagne produced by the methode
champenoise.
Respondent’s Expert
Respondent offered Herbert T. Spiro, Ph.D. (Dr. Spiro), as
an expert witness, to testify concerning the valuation of closely
held companies. Dr. Spiro is president of the American Valuation
Group, Inc. (AVG), and has directed and conducted valuation
studies of various types of business enterprises. The Court
accepted Dr. Spiro as an expert in the valuation of closely held
companies and received written reports of AVG into evidence as
Dr. Spiro’s direct testimony and his rebuttal testimony,
- 8 -
respectively. In his direct testimony, Dr. Spiro reached the
conclusion that the aggregate fair market value of the shares as
of the valuation date was $30,300,000, or $48,100 a share,
rounded.2
In reaching his conclusion, Dr. Spiro utilized both a market
approach and an income approach, the latter of which is based
upon the discounted cashflow method. He then applied to the
results under both approaches a 15-percent “liquidity discount”
and a 10-percent discount for “additional risks associated with S
corporations” including “the potential loss of S corporation
status and shareholder liability for income taxes on S
corporation income, regardless of the level of distributions.”
He reconciled the two approaches by applying a 70-percent
weighting factor to the “indicated value” of each share under the
income approach ($36,150) and a 30-percent weighting factor to
such value under the market approach ($65,209), resulting in a
2
The AVG report that constitutes Dr. Spiro’s direct
testimony is dated Apr. 26, 2000. The parties have stipulated,
and we have received into evidence, an earlier report from AVG to
respondent, dated Oct. 3, 1997, in which AVG concludes that the
fair market value of the shares on the valuation date was
$30,177,000. That value agrees with the value used by respondent
in preparing the notice of deficiency here in issue, but it is
lower than the value reached in the Apr. 26, 2000, report. On
brief, respondent asks us to find that, on the valuation date,
the fair market value of the shares was $30,177,000. We conclude
that respondent is not asking for any increased deficiency, even
though the report that constitutes Dr. Spiro’s direct testimony
finds a slightly higher valuation of the shares.
- 9 -
“weighted” share value of $44,868. He explained that “[t]he
market approach is weighted less at 30 percent due to the lack of
perfect comparables”. Lastly, he adjusted that value upward to
account for certain nonoperating assets: 1,099 acres of so-
called excess land with a stipulated value of $2,000 an acre
(total value: $2,198,000) and $5.25 million of “excess cash”.
Before making that upward adjustment, however, he applied certain
discounts. He applied a 25-percent “minority” discount and,
sequentially, the above mentioned 25-percent “liquidity” discount
to the stipulated value of the land, reducing such stipulated
value to $1,236,375, or $778 a share. He applied the additional
25-percent “minority” discount in recognition of the fact that
the land value “cannot be readily realized by the minority
shareholder.” He applied the same 25-percent minority discount
(but not the liquidity discount) to the so-called excess cash,
resulting in a value of $3,939,000, or $2,477 a share. He
derived his share value for Korbel of $48,123 ($48,100 rounded)
and total value of decedent’s 630 shares (rounded) of $30,300,000
after making the aforesaid adjustments to the value of the
nonoperating assets.
Petitioner’s Expert
Petitioner offered Mukesh Bajaj, Ph.D (Dr. Bajaj), as an
expert witness, to testify concerning the valuation of closely
held companies. Dr. Bajaj is a managing director, finance and
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damages practice, of LECG, Inc. Dr. Bajaj has experience as a
university professor of finance and business economics, he has
lectured on valuation issues, and he has performed business
valuations for purposes of litigation. The Court accepted
Dr. Bajaj as an expert in the valuation of closely held companies
and received his written reports into evidence as his direct and
rebuttal testimony, respectively. In his direct testimony,
Dr. Bajaj reached the conclusion that the aggregate fair market
value of the shares as of the valuation date was $18,707,000, or
$29,694 a share.
Dr. Bajaj rejected the market approach and relied
exclusively upon a discounted cashflow analysis. He rejected the
market approach on the ground that there were no publicly traded
companies that were comparable to Korbel.
Dr. Bajaj’s discounted cashflow analysis resulted in a net
operating asset value for Korbel of $72,041,711. To that amount
he (like Dr. Spiro) added an additional amount for nonoperating
assets: $5,517,000, consisting of $2,198,000 for the excess
land, $1,110,000 representing the proceeds from insurance
policies on decedent’s life, and $2,209,000 for the note
receivable from KFTY. He then subtracted $4,918,000 of interest-
bearing debt, resulting in a fair market value for Korbel as of
the valuation date of $72,640,711.
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Dr. Bajaj then applied a 35-percent discount to the value
derived under his discounted cashflow approach, which consisted
of a 25-percent marketability discount and an additional
10-percent discount to reflect the negative impact of Brown-
Forman’s right of first refusal and what Dr. Bajaj refers to as
“agency problems” (the inability of a purchaser of decedent’s
minority interest to influence dividend distributions, which
would be at the discretion of the controlling shareholder, Gary
Heck). Application of those discounts, totaling 35 percent,
resulted in Dr. Bajaj’s being of the opinion that the marketable
minority value of Korbel’s equity as of the valuation date was
$47,216,462, resulting in a value of $18,707,162 for decedent’s
630 shares, or $29,694 a share.
OPINION
I. Introduction
We must determine the fair market value of decedent’s 630
shares of Korbel on the valuation date. The shares were included
in decedent’s gross estate and reported on the estate tax return
at a value of $26,000 a share. Based upon the expert testimony
of Dr. Bajaj, petitioner now argues that the value of each share
on the valuation date was $29,694. We interpret petitioner’s
change in position as a concession that the estate is liable for
a portion of the deficiency, and we accept that concession. In
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determining the deficiency in estate tax, respondent valued the
shares at $47,900 a share.
Petitioner bears the burden of proof. Rule 142(a).
II. Law
Section 2001(a) imposes a tax on “the transfer of the
taxable estate of every decedent who is a citizen or resident of
the United States.” Section 2031(a) provides: “The value of the
gross estate of the decedent shall be determined by including to
the extent provided for in this part, the value at the time of
his death of all property, real or personal, tangible or
intangible, wherever situated.”
Fair market value is the standard for determining the value
of property for Federal estate tax purposes. United States v.
Cartwright, 411 U.S. 546, 550-551 (1973). Section 20.2031-1(b),
Estate Tax Regs., defines fair market value as: “the price at
which the property would change hands between a willing buyer and
a willing seller, neither being under any compulsion to buy or
sell and both having reasonable knowledge of relevant facts.”
The willing buyer and willing seller are hypothetical persons,
rather than specific individuals or entities, and their
characteristics are not necessarily the same as those of the
actual buyer or seller. Estate of Newhouse v. Commissioner, 94
T.C. 193, 218 (1990) (citing Estate of Bright v. United States,
658 F.2d 999, 1006 (5th Cir. 1981)). The hypothetical willing
- 13 -
buyer and seller are presumed to be dedicated to achieving the
maximum economic advantage, which advantage must be achieved in
the context of market conditions, the constraints of the economy,
and, assuming shares of stock are to be valued, the financial and
business experience of the subject corporation existing on the
valuation date. Estate of Newhouse v. Commissioner, supra.
In valuing shares of stock in a corporation whose shares are
not publicly traded, the factors we take into account include net
worth, prospective earning power and dividend paying capacity,
and other relevant factors, including the economic outlook for
the particular industry, the company’s position in the industry,
the company’s management, the degree of corporate control
represented by the block of stock to be valued, and the value of
publicly traded stock or securities of corporations engaged in
the same or similar lines of business. See sec. 2031(b);
sec. 20.2031-2(f)(2), Estate Tax Regs.; Rev. Rul 59-60, 1959-1
C.B. 237, 238-242.
III. Expert Opinions
A. Introduction
In this case, the parties rely heavily, if not exclusively,
on expert testimony to establish the fair market value of the
shares as of the valuation date. Indeed, respondent’s only
witness was Dr. Spiro. In addition to Dr. Bajaj, petitioner
called Gary Heck, decedent’s son and Korbel’s president and
- 14 -
chairman of the board, and David Faris, a Korbel assistant vice
president. Formerly, Mr. Faris was a partner in the tax
department of Pisenti & Brinker, C.P.A.s. In that role, he
oversaw the preparation of Korbel’s income tax returns, the
estate tax return filed on behalf of decedent’s estate, and the
valuation, for gift tax purposes, of the stock that, in 1989,
decedent transferred in trust for the benefit of her
grandchildren. Mr. Heck did not testify as to the value of
the shares, and, although Mr. Faris testified that the Pisenti &
Brinker gift tax valuation, in part, formed the basis for the
value of the shares set forth on the estate tax return, it is the
value arrived at by Dr. Bajaj, not the value on the return, that
petitioner urges us to adopt.
In deciding valuation cases, courts often look to the
opinions of expert witnesses. Nonetheless, we are not bound by
the opinion of any expert witness, and we may accept or reject
expert testimony in the exercise of our sound judgment.
Helvering v. Natl. Grocery Co., 304 U.S. 282, 295 (1938); Estate
of Newhouse v. Commissioner, supra at 217. Although we may
accept the opinion of an expert in its entirety, see Buffalo Tool
& Die Manufacturing Co. v. Commissioner, 74 T.C. 441, 452 (1980),
we may be selective in determining what portions of an expert’s
opinion, if any, to accept, Parker v. Commissioner, 86 T.C. 547,
562 (1986). Finally, because valuation necessarily involves an
- 15 -
approximation, the figure at which we arrive need not be directly
traceable to specific testimony if it is within the range of
values that may be properly derived from consideration of all the
evidence. Estate of True v. Commissioner, T.C. Memo. 2001-167
(citing Silverman v. Commissioner, 538 F.2d 927, 933 (2d Cir.
1976), affg. T.C. Memo. 1974-285).
B. Differences Between the Experts
The major difference between Drs. Bajaj and Spiro is their
disagreement as to the propriety of utilizing a market approach
(i.e., the guideline company method) in valuing the shares.
Also, although both experts utilized a discounted cashflow
approach in valuing the shares (Dr. Bajaj, exclusively;
Dr. Spiro, in part), they disagree sharply over methodology in
applying that approach. We shall analyze the arguments presented
by both experts in support of their respective positions.
IV. Propriety of Dr. Spiro’s Application of the Guideline
Company Method
A. Introduction
The guideline company method of appraisal is commonly used
in valuing shares of stock in a closely held corporation. When
appropriate, its usage is mandated by section 2031(b), which
provides that the value of unlisted shares of stock or securities
“shall be determined by taking into consideration, in addition to
all other factors, the value of stock or securities of
- 16 -
corporations engaged in the same or a similar line of business
which are listed on an exchange.” See also sec. 20.2031-2(f),
Estate Tax Regs.; Rev. Rul. 59-60, 1959-1 C.B. 237, 242.
The parties sharply dispute whether (1) the two guideline
companies chosen by Dr. Spiro, the Robert Mondavi Corp. (Mondavi)
and Canandaigua Wine Co. (Canandaigua), were comparable to Korbel
for purposes of section 2031(b), (2) Dr. Spiro actually utilized
only one company, Mondavi, as a guideline company, and (3) if so,
the use of a single guideline company is permissible. The
parties also disagree as to the propriety of the financial ratios
chosen by Dr. Spiro and his adjustments to those ratios.
Petitioner also claims, and respondent denies, that Dr. Spiro’s
30-percent weighting of the result of his market approach was
essentially arbitrary.
B. Dr. Spiro’s Guideline Companies: Mondavi and
Canandaigua
1. Dr. Spiro’s Method
Dr. Spiro first identified 1,317 companies listed under the
Standard Industrial Classification Code (SIC) 2084, wines,
brandy, and brandy spirits. Of those companies he identified
only 11 that were publicly traded, and he rejected 9 of the 11 as
potential comparables because, for the most part, they were
either too large or diverse (or both), too small, unprofitable,
or conducted business in a different manner than Korbel.
- 17 -
Dr. Spiro considered the remaining two companies, Mondavi and
Canandaigua, comparable to Korbel.
Dr. Spiro valued Korbel’s stock under the guideline company
method (as of the valuation date), by reference to the 1994
fiscal yearend price to earnings (P/E) and price to operating
cashflow (P/OCF) ratios for Mondavi and Canandaigua. For
Mondavi, those ratios, when reduced to multiples (of earnings and
OCF, respectively), were 17.51 and 9.57 and, for Canandaigua,
they were 22.09 and 14.54. Dr. Spiro based Korbel’s
corresponding multiples on Mondavi alone, but he “adjusted” them
downward, to a P/E multiple of 13 and a P/OCF multiple of 8, “to
account for Korbel’s additional risk factors” (i.e., the
differences, discussed below, between Korbel and the guideline
companies in terms of size, product mix, consumption patterns,
etc.). Those derived multiples were applied, and a mean value
was determined, which mean, $86,945, was Dr. Spiro’s valuation
(before discounting) of each share of Korbel under his market
approach.
2. Comparability
Dr. Spiro treated Mondavi and Canandaigua as comparable
(guideline) companies despite acknowledging that, in many
significant respects, they differ markedly from Korbel.
Size: In 1994, in terms of both revenue and total assets,
Canandaigua was approximately 10 times as large as Korbel.
- 18 -
Mondavi’s gross revenue for its 1994 fiscal year was more than
twice that of Korbel for its 1994 calendar year ($176,236,000
versus $82,758,000), and Mondavi’s total assets at yearend were
approximately triple those of Korbel ($244,236,000 versus
$84,043,000).
Product Lines: Although Korbel produces some brandy and an
insignificant amount of still wine, it is essentially a single
product company, producing economically priced premium champagne.
In 1992, Canandaigua’s products included table wines, dessert
wines, sparkling wines, imported beer, and distilled spirits.
Sparkling wines constituted only 3.79 percent of the firm’s total
shipments for 1993.
As of the valuation date, Korbel marketed its champagne
under two labels, Armstrong Ridge and Korbel. Canandaigua
marketed its products under many brand names including Paul
Masson, Inglenook, Manischewitz, Almaden, and Taylor California
Cellars, for wine, and Corona, for beer. Although Canandaigua
also produced and marketed six different brands of sparkling wine
and maintained a 32-percent share of the sparkling wine market
for 1994, all of its sparkling wines were produced using the less
expensive Charmat process or transfer method, whereas Korbel
utilized the methode champenoise exclusively. Canandaigua
produced for the low end of the champagne market, whereas Korbel
was the leading producer of premium champagne, controlling almost
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50 percent of the methode champenoise or high-end market and
8.8 percent of the total domestic market. For the period 1985
through 1994, the low-end and high-end champagne markets fared
differently. Sales of champagne produced by means of the Charmat
process or transfer method (the low-end market) fell steadily
between 1985 and 1994. In 1994, sales of the lower priced
domestically produced Charmat process and transfer method labels
dropped 11 percent, when compared to 1993. Canandaigua’s
sparkling wine sales reflected that trend in 1994, declining by
about 8 percent from 1993. In sharp contrast, led by Korbel’s
6-percent increase in champagne sales for 1994, 1994 sales by
domestic methode champenoise producers as a whole grew 4 percent,
when compared to 1993.
Mondavi markets premium still wine under seven different
labels, but it produces little or no sparkling wine.3
Other Factors: Dr. Spiro testified that, as of the
valuation date, compared to Mondavi and Canandaigua, Korbel was
smaller, more profitable, and growing more slowly. It also had
3
Both Drs. Bajaj and Spiro state that Mondavi does not
produce any champagne. Gary Heck testified, however, that
Mondavi produces “about 1500 cases [of champagne] that they only
sell through their wine shop, kind of like we do with still
wines.” Even if Mr. Heck is correct, the amount of champagne
produced by Mondavi is negligible in comparison with its wine
production, which, for 1994, was 4,274,000 cases. Thus, as a
practical matter, Mondavi was a producer of still wines, whereas
Korbel was a producer of high-end champagne and a small amount of
brandy.
- 20 -
substantially lower debt to asset and debt to equity ratios than
either Canandaigua or Mondavi.
Dr. Spiro summarized the totality of the differences between
Korbel and both Mondavi and Canandaigua as follows:
Whereas both comparable companies produce and/or market
many products, Korbel essentially only produces two
products, champagne and brandy. Korbel also has less
revenue and greater revenue variability during the
course of a fiscal year than the two comparables.
Korbel’s greater revenue variability results from the
nature of champagne consumption in the U.S., which is
closely linked to celebrations and parties. This
results in a seasonal sales pattern with most sales
coinciding with the holiday season between Thanksgiving
and New Year’s Eve. In contrast, wine is consumed more
steadily throughout the year, often with dinner or as a
social drink. Korbel’s lack of product diversification
and comparatively small size tend to increase investor
risk, necessitating a greater investment return. * * *
Gary Heck testified to the following significant differences
between the production and marketing of wine as opposed to
methode champenoise champagne: The second fermentation in the
bottle, which makes production of the latter more complex,
expensive, and time consuming than the production of wine; the
fact that sales of champagne do not benefit from the so-called
“French Paradox” (i.e., reports that link the moderate daily
consumption of red wine to cardiovascular health); and the fact
that champagne sales are subject to higher Federal excise taxes
than are sales of wine.
3. Dr. Spiro’s Opinion
In Dr. Spiro’s opinion, comparability is established by the
fact that both Mondavi and Canandaigua, like Korbel, produce, a
- 21 -
form of wine (“While Korbel occupies a specialized niche, it
crushes grapes, ferments the juice and bottles the product like
other producers. To argue that comparables do not exist is
incorrect.”).4
C. Rejection of Mondavi and Canandaigua as Guideline
Companies
Dr. Spiro discussed the similarities and differences between
both Mondavi and Canandaigua and Korbel, and he computed price to
earnings and price to operating cashflow multiples for both
Mondavi and Canandaigua. Nevertheless, when he applied those
multiples to Korbel, he referred only to Mondavi, and he adjusted
downward from the Mondavi figures. We fail to see how
Canandaigua influenced Dr. Spiro’s guideline analysis. It
appears to us that Dr. Spiro, himself, effectively disregarded
Canandaigua as a guideline company. Assuming that to be the
case, respondent has failed to persuade us that we should have
any confidence in Dr. Spiro’s guideline analysis. In Estate of
Hall v. Commissioner, 92 T.C. 312 (1989), the Commissioner’s
expert selected only one comparable company. The proposed
comparable, American Greetings Corp. (American Greetings), was
selected because it, along with Hallmark Cards, Inc. (Hallmark),
4
Dr. Spiro’s oral testimony echoed that view: “Sir, we
selected * * * [Mondavi and Canandaigua] as guideline companies,
as the only game in town. We did not say they were exactly like
Korbel. We say they have the same general production approach.
They have the same general customer base. They are all in the
grape processing business. In that sense they are comparable.”
- 22 -
the company subject to valuation, were the two leaders in the
greeting card industry. The Commissioner’s expert concluded that
American Greetings “was the only reasonably comparable company to
Hallmark because it had a similar product mix and capital
structure and served the same markets.” Id. at 331. We rejected
the valuation report submitted by the Commissioner’s expert in
light of his reliance on a single comparable company in employing
the market approach. In so doing, we observed that “[a]ny one
company may have unique individual characteristics that may
distort the comparison.” Id. at 340. A sample of one tells us
little about what is normal for the population in question.5
Dr. Spiro has failed to convince us of the reliability of his
guideline analysis.
Even if we were to accept that Dr. Spiro relied on both
Canandaigua and Mondavi as guideline companies, as respondent
argues, we would still reject Dr. Spiro’s use of the market
approach in this case. Respondent points out that we have
approved the use of the market approach based upon as few as two
guideline companies. See Estate of Desmond v. Commissioner, T.C.
Memo. 1999-76. But in that case, all three companies were in the
same, and not just a similar, line of business (manufacture and
5
In his rebuttal report, Dr. Bajaj states: “The superior
quality of Mondavi’s wines, its innovative packaging [a new
bottle with a flange top that prevented dripping and used a dot
of wax instead of a foil capsule as a seal] and strong
advertising coupled with its reputation as an environment-
friendly producer * * * [were attributes that] were largely
unique to * * * [Mondavi]”. (Fn. ref. omitted.) Respondent does
not challenge Dr. Bajaj on that point, which point indicates that
Mondavi may not be reflective of the norm.
- 23 -
sale of paint and coatings). Here, Mondavi and Canandaigua were,
at best, involved in similar lines of business. Under section
2031(b) and section 20.2031-2(f), Estate Tax Regs., publicly held
companies involved in similar lines of business may constitute
guideline companies, and we have so held. See, e.g., Estate of
Gallo v. Commissioner, T.C. Memo. 1985-363, where, in valuing the
stock of the largest producer of wine in the United States, we
approved the use by taxpayer’s experts of comparables consisting
of companies in the brewing, distilling, soft drink, and even
food processing industries. But, in that case, the experts used
at least 10 companies as guideline companies. See also Estate of
Hall v. Commissioner, supra at 325, where we adopted an expert
report utilizing a market approach based upon a comparison with
six somewhat similar companies. As similarity to the company to
be valued decreases, the number of required comparables increases
in order to minimize the risk that the results will be distorted
by attributes unique to each of the guideline companies. In this
case, we find that Mondavi and Canandaigua were not sufficiently
similar to Korbel to permit the use of a market approach based
upon those two companies alone.6
6
Dr. Bajaj argues that only companies that are “primarily
champagne/sparkling wine producers like Korbel” constitute
permissible guideline companies. Because no such publicly traded
company existed, Dr. Bajaj rejected the market approach. We find
Dr. Bajaj’s approach to be unduly narrow (in theory), in light of
the case law cited in the text. Nonetheless, we agree, albeit
for different reasons, that respondent improperly applied the
market approach in this case.
- 24 -
Our conclusion that Dr. Spiro improperly applied the
guideline company approach based upon Mondavi and Canandaigua
makes it unnecessary to address petitioner’s other criticisms of
Dr. Spiro’s application of that approach: The selection of
inappropriate financial ratios, the arbitrary adjustment of those
ratios, and the arbitrary nature of the weight given to the
result reached by Dr. Spiro under the market approach.
D. Conclusion
Dr. Spiro improperly applied the guideline company approach
in valuing the stock of Korbel.
V. Utilization of the Discounted Cashflow Method in Valuing the
Stock of Korbel
A. Introduction
This Court considers the discounted cashflow (DCF) method
employed by both experts to be an appropriate method for use in
valuing corporate stock. See, e.g., N. Trust Co. v.
Commissioner, 87 T.C. 349, 379 (1986). Moreover, where we have
rejected use of the market approach as unreliable, we have based
the value of a closely held corporation on the DCF approach
alone. See Estate of Jung v. Commissioner, 101 T.C. 412, 433
(1993). We, therefore, find that the DCF method utilized by both
experts in this case is an appropriate method for valuing the
stock of Korbel as of the valuation date.
- 25 -
B. Analysis of the Experts’ Application of the Discounted
Cashflow Method
1. Introduction
Recently, in Estate of True v. Commissioner, T.C. Memo.
2001-167, we described the DCF method as follows:
The discounted cash-flow method is an income
approach based on the premise that the subject
company’s market value is measured by the present value
of future economic income it expects to realize for the
benefit of its owners. This approach analyzes the
subject company’s revenue growth, expenses, and capital
structure, as well as the industry in which it
operates. The subject company’s future cash-flows are
estimated, and the present value of those cash-flows is
determined based on an appropriate risk-adjusted rate
of return.
Drs. Bajaj and Spiro are in agreement as to the elements of
the DCF valuation method: The discounted present value of
cashflow projections for Korbel over a 5-year (1995-1999) period,
plus Korbel’s residual value at the end of the fifth year (also
discounted back to present value), plus the value of nonoperating
assets, less long-term debt, and less appropriate discounts,
e.g., for lack of marketability. They disagree, however,
regarding the computation of almost every element, including
projected revenues, operating costs, capital expenditures, the
rate of return to be incorporated into the discount factor, the
nature and amount of the nonoperating assets, the amount of long-
term debt, and the nature and amount of the discounts. We find
neither of the experts totally persuasive. We accept, however,
portions of the testimony of each. We shall discuss and evaluate
- 26 -
the various elements of both experts’ DCF computations in
arriving at a value for the shares.
2. Projected Cashflows
a. Sales
In projecting post-1994 sales growth for Korbel, Dr. Bajaj
determined that there would be 2-percent sales growth for 1995,
that the growth rate would steadily increase to 4.5 percent in
1999, and that the latter rate would prevail indefinitely for
post-1999 years. Dr. Bajaj considered his forecast optimistic in
light of wine industry analysts’ predictions of a 2.9-percent
decline in champagne consumption during the 1995-1999 period.
Dr. Spiro projected a 4.5-percent sales increase for 1995,
increases of 4.0, 3.5, and 3.0 percent for 1996, 1997, and 1998,
respectively, and 3-percent annual increases thereafter. Dr.
Spiro’s forecast was primarily based upon the strong growth in
Korbel’s sales during 1994 and the first quarter of 1995.
We find Dr. Spiro’s sales growth assumptions to be the more
realistic. Projected growth for 1995 is based upon Korbel’s 1994
sales growth, and subsequent years’ growth is assumed to
gradually decrease to the 3-percent growth rate applicable to
1992-1994, which does not differ materially from the annual
compound growth rate of 3.1 percent since 1984. Dr. Bajaj’s more
modest sales growth projections for the early years are based
upon projected sales for the champagne industry as a whole, which
- 27 -
includes low-end Charmat and transfer process brands. Moreover,
we find no evidence in Korbel’s recent sales history to justify
an assumed 4.5-percent sales growth for 1999 and thereafter.
b. Operating Margin
Dr. Bajaj’s projected annual operating (pretax)7 margin
(total revenues less cost of goods sold, excise taxes,
depreciation, officers’ compensation, and selling, general, and
administrative expenses (SG&A)) for 1995 and all subsequent years
is 12 percent of sales revenues. He bases his projection upon
the 5-year simple average of operating margins for the 1990-1994
period. Dr. Spiro’s projected annual operating margin for 1995-
1999 and subsequent years is 13.3 percent of sales revenues.
Dr. Spiro computes each element of cost entering into his
projection of operating margin separately, in some cases based
upon 2-year averages, in others, based upon 5-year averages. In
computing average annual SG&A for 1990-1994, Dr. Spiro fails to
include $420,000 of promotional expenses incurred by Korbel in
1993, which Dr. Spiro attributes to the launching of a new
product (Armstrong Ridge champagne). Dr. Spiro considers that to
be a special, nonrecurring cost that, in future years, will be
borne by Brown-Forman pursuant to the Brown-Forman agreement. We
do not agree with Dr. Spiro’s treatment of the 1993 promotional
7
The parties agree that the only tax applicable to the
income of Korbel is California’s 1.5-percent income tax on
S corporations.
- 28 -
expense as a nonrecurring cost. Mr. Heck testified that new
label promotional expenditures are a recurring feature of
Korbel’s business. Although the Brown-Forman agreement relieves
Korbel of any responsibility to pay marketing or selling expenses
(“Brand Expense”) for Korbel champagne or brandy, Korbel incurred
the promotional expenses in question subsequent to the 1991
effective date of the agreement, and Mr. Heck testified that a
similar “spike” in Korbel’s promotional costs could occur at any
time. Projecting the mean annual SG&A costs for a 5-year period
that includes a year of extraordinary promotional expenses
associated with the introduction of a new label does not seem
unreasonable.
Dr. Spiro criticizes Dr. Bajaj for relying on a simple
5-year average in projecting an annual operating margin. Yet for
cost of goods sold, where Dr. Spiro uses a 2-year average to make
projections, he testified, in rebuttal: “The * * * [rate chosen
by Dr. Bajaj] appears reasonable although we once again question
the use of a simple average.” Dr. Spiro, himself, uses a 5-year
average in projecting officers’ compensation and SG&A. Korbel’s
annual operating margins for the 1990-1994 period do not show a
trend, and Dr. Spiro has failed to convince us that Dr. Bajaj’s
use of a 5-year simple average is inappropriate. At least, it
has the virtue of consistency, and for that reason, we prefer it
to Dr. Spiro’s approach, the inconsistency of which he did not
- 29 -
adequately explain. We modify Dr. Bajaj’s approach only to take
into account small amounts of other income, which he takes into
account in his rebuttal testimony. Dr. Bajaj’s projected profit
margin, based upon an unweighted arithmetic average of operating
margins from 1990-1994, and including “other income” (interest
and “Heck Cellars” revenue), is 12.3 percent. We find that to be
the proper assumed operating margin for purposes of determining
Korbel’s value on the valuation date under the DCF method.
c. Cashflow Adjustments
To determine cashflow, it is necessary to modify after-tax
income by adding back depreciation and subtracting working
capital additions and capital expenditures.
Depreciation averaged 3.8 percent of sales revenues during
the 1990-1994 period and 4.1 percent for 1993 and 1994.
Dr. Bajaj, relying on a 5-year average, projected depreciation at
3.8 percent of gross sales and Dr. Spiro, relying on a 2-year
average, projected it at 4.0 percent of gross sales. Although,
for 4 out of the 5 years, total depreciation grew as a percentage
of sales revenues, the question is whether the most recent
2 years is a better measure of the trend than the last 5 years.
Neither expert took the other head-on with respect to this point,
and, since, in general, we found Dr. Bajaj’s analysis to be more
thorough than Dr. Spiro’s, we shall rely on his 5-year average as
determinative.
- 30 -
Both Drs. Bajaj and Spiro project inventory expenditures to
remain constant at 50 percent of sales revenue. However,
Dr. Bajaj projects “other working capital” (including cash) at
5 percent of sales whereas Dr. Spiro projects noninventory
working capital at 3.5 percent of sales (in both cases, based on
historical data). Dr. Spiro justifies his lower figure by
discounting the 1993 and 1994 average working capital level
(11.7 percent) on the ground that it was largely attributable to
“excess cash”. As we discuss, infra (in connection with our
analysis of Korbel’s nonoperating assets), we do not believe
Korbel retained excess cash in 1993 and 1994. We are persuaded
that Dr. Bajaj’s projection of working capital levels is
justified based on historical performance, and we find in
accordance with his calculation.
Dr. Spiro projected annual capital expenditures by Korbel
equal to $4 million for 1995 and every year thereafter.
Dr. Bajaj projected annual capital expenditures on the assumption
that they would equal depreciation plus 30 percent of Korbel’s
annual sales increases. Dr. Bajaj projected that capital
expenditures would increase in an amount adequate to maintain
Korbel’s net fixed asset to sales ratio at 30 percent, which is
slightly below the average of such ratios for the 1990-1994
period. Each expert points to unreasonable aspects of the
other’s approach: Dr. Bajaj to the fact that Dr. Spiro’s
- 31 -
approach will eventually lead to negative net asset value,
Dr. Spiro to the fact that Dr. Bajaj’s projected increases in
capital expenditures more than double his projected sales
increases over the 1995-1999 period.
Korbel’s financial statements for the 1985-1994 period show
that, whereas depreciation increased annually, capital
expenditures (“property, plant and equipment purchased”) have
fluctuated significantly over that same period, the low of
$2,315,000 occurring in 1990 and the high of $6,142,000, in 1991.
Average annual capital expenditures for the 1990-1994 period were
$3,817,000. Therefore, we consider Dr. Spiro’s projection of $4
million in annual capital expenditures to be reasonable, and we
adopt it. Conversely, we find nothing in Korbel’s financial
history to support Dr. Bajaj’s projection of ever-increasing
annual capital expenditures.
3. Rate of Return
The DCF method involves the computation of the present value
of expected future cashflows. The present value of a cashflow
equals the cashflow multiplied by a discount factor (less than
1). The discount factor is usually expressed as the reciprocal
of 1 plus a rate of return: Discount factor (for one period) =
1/(1 + r).8 Drs. Bajaj and Spiro agree that the rate of return
8
See Brealey & Myers, Principles of Corporate Finance 16
(6th ed. 2000) (“The rate of return r is the reward that
(continued...)
- 32 -
to be used in applying the DCF method to Korbel’s cashflows is
Korbel’s “weighted average cost of capital” (WACC).9 Dr. Bajaj
computed the WACC as 14.22 percent; Dr. Spiro computed it as
16.54 percent. Their only significant disagreement is as to one
component of the WACC, the cost of equity capital.10 Dr. Bajaj
computed the cost of equity capital as 14.70 percent; Dr. Spiro
computed it as 16.71 percent.
We need not engage in an extended discussion of the
appropriate cost of equity capital since, in computing the WACC,
other things being equal, the higher the cost of equity capital
(i.e., the larger the percentage), the larger the WACC. Given
the DCF method, the larger the WACC, the lower the present value
of expected cashflows. The parties endorse the DCF method,
differing only as the value of certain variables. Since we are
8
(...continued)
investors demand for accepting delayed payment.”).
9
As expressed by Dr. Spiro:
WACC = Wd x Kd x (1-t) + We x Ke
Where:
WACC = weighted average cost of capital,
Wd = weight of debt in capital structure,
Kd = estimated pretax cost of debt,
t = income taxes at 1.5 percent,
We = weight of equity in capital structure, and
Ke = cost of equity capital.
10
Dr. Spiro defined the cost of equity capital as follows:
“[T]he rate of return required by an investor as sufficient
compensation for committing equity funding to the business.”
- 33 -
deconstructing each expert’s DCF analysis, and assembling our
own, our adopting Dr. Bajaj’s cost of equity capital cannot, in
isolation, be objectionable to respondent, since respondent has
proposed that we find a higher, 16.71-percent cost of equity
capital. Dr. Bajaj relied on the capital asset pricing model
(which takes into account exclusively systematic (or market)
risk) to compute the cost of equity capital, while Dr. Spiro
relied on the so-called buildup method (which pays attention to
the unsystematic (or individual) risk that an investor would face
in investing in Korbel). Neither expert convinced us that his
approach was significantly better (on the facts at hand) than the
other expert’s approach, and we are satisfied that 14.70 percent
(the percentage reached by Dr. Bajaj) is a reasonable figure for
Korbel’s cost of equity capital, and we so find.11 We find that
the WACC is 14.22 percent.
11
In recent cases, we have criticized the use of both the
capital asset pricing model (CAPM) and WACC as analytical tools
in valuing the stock of closely held corporations. See Furman v.
Commissioner, T.C. Memo. 1998-157. See also Estate of Maggos v.
Commissioner, T.C. Memo. 2000-129 and Estate of Hendrickson v.
Commissioner, T.C. Memo. 1999-278, which reaffirm that view,
citing Furman, and Estate of Klauss v. Commissioner, T.C. Memo.
2000-191, where we rejected an expert valuation utilizing CAPM in
favor of one utilizing the buildup method. In other recent
cases, however, we have adopted expert reports which valued
closely held corporations utilizing CAPM to derive an appropriate
cost of equity capital. See BTR Dunlop Holdings, Inc. v.
Commissioner, T.C. Memo. 1999-377; Gross v. Commissioner, T.C.
Memo. 1999-254, affd. 272 F.3d 333 (6th Cir. 2001)
- 34 -
4. Present Value Computation: Yearend Versus Mid-
Year Cashflow Convention
In computing the present value of all cashflows, Dr. Bajaj
adopted a yearend convention (cashflows discounted as of
yearend), while Dr. Spiro adopted a midyear convention (cashflows
assumed to be received at, and discounted from, midyear).
Because, under the midyear convention, the cashflow for a year is
deemed to have been received 6 months earlier, the discount
factor for the year is slightly greater (and the dollar amount of
the discount itself is slightly smaller) than if the yearend
convention is adopted. Given the same cashflow but a greater
discount factor, the present value of the cashflow is greater.
The parties agree that (1) approximately 60 percent of
Korbel’s champagne sales occur during the last quarter of the
calendar year and (2) as much as 20 percent of such sales occur
during the last week of December. Since Korbel’s revenues are
not spread evenly throughout the year, we are unconvinced that
Dr. Spiro’s use of the midyear convention results in a more
accurate valuation than Dr. Bajaj’s use of the yearend
convention. We adopt the yearend convention.
5. Increase in Korbel’s Value for Nonoperating Assets
a. Introduction
The question here is whether the value of certain
nonoperating assets should be added to the value determined under
the DCF method in determining the value of the shares.
- 35 -
b. Excess Land; Insurance Proceeds; KFTY Receivable
The parties agree, and we find, that the excess land
constitutes a nonoperating asset to be added to the present value
of Korbel’s cashflows at a value of $2,198,000 and that insurance
proceeds in the amount of $1,110,000 likewise are to be so added.
Although they differ in exactly how a receivable from KFTY in the
amount of $2,209,000 is to be taken into account, they agree that
it is to be taken into account. We agree and so find. The total
of the aforesaid nonoperating assets is $5,517,000
c. Excess Cash
Dr. Spiro considered $5,250,000 of cash held by Korbel on
December 31, 1994, to be a nonoperating asset, which he referred
to as “excess cash”. Dr. Spiro reached that conclusion by
examining historical cash levels in relation to gross revenue, in
order to determine the appropriate “normalized” cash level, which
he determined to be 6.55 percent of gross revenue. Applying that
percentage to 1994 gross revenue, Dr. Spiro concluded that Korbel
had excess cash in the amount stated. In determining the value
of the shares, he included only a portion of the excess cash to
reflect the inability of minority shareholders to force a
distribution of such cash. Dr. Bajaj concluded that there was no
excess cash, and, in his rebuttal testimony, he persuasively
explained his basis for that conclusion. We were impressed with
his interpretation of the historical data, in light of the
- 36 -
information he received (the need to retain funds for a number of
contingencies) on interviewing Mr. Heck. On the basis of his
testimony, we find that there was no nonoperating asset
consisting of excess cash.
6. Decrease in Korbel’s Value by Amount of
Long-Term Debt
Putting aside Drs. Bajaj and Spiro’s disagreement over the
treatment of the KFTY receivable, see supra p. 35, the remaining
disagreement is over whether the current portion of long-term
bank borrowings is a component of working capital or a long-term
liability. On brief, respondent states that any resulting
difference in the value of the shares is immaterial, and the
choice of treatment is “a valid choice of the appraiser”. We
shall treat such current portion as a long-term liability.
7. Discounts
a. The Expert Testimony
Dr. Bajaj determined that the shares were subject to a 25-
percent basic marketability discount. Dr. Bajaj then added an
additional 10 percent to his basic marketability discount, which
addition was attributable to both the right of first refusal
(ROFR) held by Brown-Forman and what he refers to as “agency
problems”, the fact that the shares represented a minority
interest unable to influence the majority shareholder’s control
over cash distributions. The addition of those two discounts
- 37 -
resulted in Dr. Bajaj’s determination of an overall 35-percent
discount, which he treats, in total, as a marketability discount.
Dr. Spiro determined a basic 15-percent liquidity
discount,12 increased by an additional 10 percent for risks
associated with Korbel’s status as an S corporation. Thus, Dr.
Spiro’s total liquidity discount is 25 percent, which he applies
to the values that he determined under his market and income
approaches (i.e., values exclusive of the value of nonoperating
assets). Dr. Spiro applied specific, separate discounts to
nonoperating assets: A 25-percent minority discount followed by
his overall 25-percent liquidity discount applicable to “excess
land”13 and a 25-percent minority discount applicable to “excess
cash”.
b. Marketability Versus Minority Discounts
We have recognized that there is a distinction between a
discount for lack of marketability and a discount for the
minority position of the interest to be valued. As we stated in
Estate of Andrews v. Commissioner, 79 T.C. 938, 953 (1982):
The minority shareholder discount is designed to
reflect the decreased value of shares that do not
convey control of a closely held corporation. The lack
of marketability discount, on the other hand, is
12
We interpret Dr. Bajaj’s references to a “marketability”
discount and Dr. Spiro’s references to a “liquidity” discount as
references to the same type of discount.
13
Because Dr. Spiro applies the two discounts
consecutively, the total discount is 43.75 percent: 0.25 + (0.25
x 0.75) = 0.4375.
- 38 -
designed to reflect the fact that there is no ready
market for shares in a closely held corporation.
Although there may be some overlap between these two
discounts in that lack of control may reduce
marketability, it should be borne in mind that even
controlling shares in a nonpublic corporation suffer
from lack of marketability because of the absence of a
ready private placement market and the fact that
flotation costs would have to be incurred if the
corporation were to publicly offer its stock. * * *
c. Basic Discount for Lack of Marketability
Dr. Bajaj’s 25-percent marketability discount is based upon
a number of empirical studies, his critical evaluation of those
studies, and his own multiple regression analysis of the
“explanatory variables”. Dr. Spiro, in his rebuttal testimony,
finds no fault with Dr. Bajaj’s methodology.
Dr. Spiro cites many of the same empirical studies as
suggesting that liquidity discounts can range from 10 to 45
percent. He states that the average discounts were “often in
excess of 35 percent.” Yet, Dr. Spiro concludes that the basic
liquidity discount for the shares, taking into account the ROFR,
is appropriately set at 15 percent. Dr. Spiro fails to make
clear, in either his primary or rebuttal report, the basis for
his determination that the appropriate liquidity discount is at
the low end of the acceptable range of such discounts. In his
oral testimony, he set forth his theory that there was a
specialized group of purchasers who would value the shares on
other than an investment basis (who would eye Korbel as a
possible future joint venture partner). Dr. Spiro failed to
- 39 -
quantify or explain how he adjusted his analysis to take account
of that factor. Indeed, such factor has recently been rejected
by the Court of Appeals for the Ninth Circuit, the likely venue
of any appeal in this case. Estate of Simplot v. Commissioner,
249 F.3d 1191, 1195 (9th Cir. 2001), revg. 112 T.C. 130 (1999).
We did not find Dr. Spiro’s oral testimony to be persuasive. It
did not bolster what we found to be weak analysis in his written
reports.
We found Dr. Bajaj’s analysis in support of his 25-percent
basic discount to be both thorough and convincing, and we find
that a basic discount for lack of marketability in the amount of
25 percent is appropriate.
d. Additional Discounts
(1) Discount for Lack of Control
Dr. Bajaj describes his entire 35-percent discount as a
discount for lack of marketability. We view his proposed
discount for “agency problems”, however, as a discount for
minority status (or lack of control), as it is based upon the
inability of the owner of the shares to force the majority
shareholder, Gary Heck, to make dividend distributions.
Dr. Bajaj’s discount for minority status takes into account
factors similar to what Dr. Spiro took into account in addressing
problems associated with Korbel’s S corporation status, at least
to the extent that Dr. Spiro’s discount relates to the same lack
- 40 -
of control problem.14 Thus, we view Drs. Bajaj and Spiro in
basic agreement as regards the need for a discount for lack of
control, which we view as a minority status discount.
(2) Discount for Brown-Forman’s ROFR
Both experts agree that some discount for the ROFR is
warranted. Dr. Spiro includes the ROFR as part of his basic
15-percent liquidity discount, Dr. Bajaj as part of his
additional 10-percent discount for both the ROFR and the minority
interest’s lack of control.
Dr. Bajaj views the ROFR as a much more serious impediment
to marketability than does Dr. Spiro. He argues that, because of
its ROFR, Brown-Forman is always a potential bidder for an
available block of Korbel stock. He further argues that, because
it had been the sole distributor of Korbel champagne and brandy
for a number of years, Brown-Forman knows more about Korbel than
any potential outside bidder. As a result, any other outside
bidder would have to expend a great deal of effort and money to
even approach Brown-Forman’s knowledge level concerning Korbel,
without which it may offer too little and risk losing out to
Brown-Forman, or too much and risk making a bad deal. Also,
because Brown-Forman has a special interest in retaining its sole
14
Dr. Spiro also states that, as an S corporation, Korbel
is subject to several restrictions impairing liquidity, including
restrictions on the number and type of persons that can be
shareholders. Nevertheless, he views S corporation status as a
benefit and fails to quantify the relevant advantages and
disadvantages.
- 41 -
distributor position, it will have a tendency to drive up the
price beyond what a potential buyer would be willing to pay based
upon the present value of anticipated cashflows. According to
Dr. Bajaj, both of those factors act as a significant deterrence
to would-be bidders for the shares, and, therefore, they reduce
the value of the shares.
In his rebuttal testimony, Dr. Spiro responds that Korbel is
not “such a complex organization that the costs of analyzing the
company for bidding purposes would be prohibitively high.”
Dr. Spiro argues that Dr. Bajaj’s concerns regarding Brown-
Forman’s ROFR “are more appropriately applied to * * * [complex
high-tech companies] where the ‘hidden’ value of * * *
[intellectual property] can make accurate analysis difficult and
expensive, especially for an outsider.” Dr. Spiro agrees,
however, that some discount is warranted for the ROFR and, as
noted above, has included it as part of its basic 15-percent
liquidity discount.
(3) Amount of Additional Discounts
We agree with Dr. Bajaj that an additional 10-percent
discount for Brown-Forman’s ROFR and the purchaser’s lack of
control over future dividend-liquidation policy (i.e., the
purchaser’s minority status) is warranted. We ascribe most of
that discount to the minority status issue, which both Drs. Bajaj
and Spiro agree deserves recognition. Both Drs. Bajaj and Spiro
- 42 -
also believe that the ROFR would reduce value, but disagree both
as to rationale and quantum. We are satisfied that some amount
of discount is attributable to the ROFR and that 10 percent is an
appropriate discount for both the ROFR and the purchaser’s
minority status, given Dr. Spiro’s addition of a 10-percent
discount for only Korbel’s status as an S corporation.
(4) AVG’s Discounts From the Value of Nonoperating
Assets
Dr. Bajaj applied an overall 35-percent marketability
discount to his total valuation of Korbel, which included
nonoperating assets. Dr. Spiro applied a 25-percent liquidity
discount to his valuation of Korbel, not including nonoperating
assets. As noted supra p. 37, he then applied separate
additional discounts to what he considered nonoperating assets.
We reject Dr. Spiro’s 25-percent minority discount applied to
“excess cash” on the basis of our finding that Korbel retained no
excess cash as of the valuation date. We also reject Dr. Spiro’s
43.75-percent combination minority/liquidity discount applied by
him to the excess land in favor of Dr. Bajaj’s 35-percent overall
discount applied to his total valuation of Korbel, including such
excess land. We see no reason to limit a minority discount to
particular assets of Korbel even if they are nonoperating assets
and, therefore, more readily available for distribution to
shareholders than are Korbel’s operating assets. As we observed
in Estate of Fleming v. Commissioner, T.C. Memo. 1997-484, a
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minority discount generally “reflects the minority shareholder’s
inability to compel liquidation and thereby realize a pro rata
share of the corporation’s net asset value”; i.e., the minority
shareholder’s share of total corporate net asset value.
C. Conclusion
On the basis of the foregoing application of the DCF method,
taking into account certain discounts, we find that the fair
market value of the shares as of the valuation date was
$20,269,736, or $32,174 a share. See Appendix.
VI. Conclusion
We shall redetermine a deficiency in Federal estate tax
commensurate with our finding that the value of the shares as of
the valuation date was $20,269,736.
Decision will be entered
under Rule 155.
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Appendix:
Valuation of 630 Shares of R. Korbel & Bros., Inc. as of 2/15/95
Projected Items 1994 1995 1996 1997 1998 1999
Sales $82,757,920 $86,482,026 $89,941,307 $93,089,252 $95,881,929 $98,758,386
Net Income
Pre-Tax Income 10,637,289 11,062,780 11,449,977 11,793,477 12,147,281
(@ 12.3% op. margin)
Income Taxes (@ 1.5%) (159,559) (165,942) (171,750) (176,902) (182,209)
Net Income 10,477,730 10,896,838 11,278,227 11,616,575 11,965,072
Cashflow Adjustments
+ Depreciation 3,286,317 3,417,770 3,537,391 3,643,513 3,752,819
(3.8% of sales)
(-) Working Capital Additions (2,048,258) (1,902,605) (1,731,370) (1,535,972) (1,582,051)
(55% of incremental sales)
(-) Capital Expenditures (4,000,000) (4,000,000) (4,000,000) (4,000,000) (4,000,OOO)
Yearend Cashflow 7,715,789 8,412,003 9,084,248 9,724,116 10,135,840
Discount Rate (WACC) 14.22% 14.22% 14.22% 14.22% 14.22%
Present Value Interest .8755 .7666 .6712 .5876 .5145
Factor (1/(1.1422)n)
Present Value of Cashflows 6,755,173 6,448,641 6,097,347 5,713,891 5,214,890
Total Present Value of Cashflows $30,229,942
Present Value of Reversion:
10,135,840 (1.03/.1422-.03) 47,861,436
( (1 + .1422)5)
=10,135,840 (4.722)
Present Value of Operating
Assets 78,091,378
Value of Nonoperating Assets 5,517,000
Long-Term Debt (4,918,000)
Enterprise Value of Korbel (w/o discount) 78,690,378
Enterprise Value of Korbel with 35% Discount 51,148,745
Value of 39.629% interest (630 shares) 20,269,736
Value of each share 32,174