When Is Equity Value Really Zero?

Fundamentally, value of stock, units in an LLC, or some other financial instruments such as warrants or options, in a pure sense cannot have a value of less than zero. Fair Market Value (or Fair Value) of equity to a marriage is commonly what such an asset could be sold for to a market buyer on a given date, without any encumbrances regarding the ownership. On the other hand, some states embrace that concept of “intrinsic value” or value to the individual owner, which could imply that an equity position has value to the spousal owner, even though it could not be effectively sold. Some states may value a “professional license” that was garnered during the term of marriage. Definitional standards of value should be understood before concluding equity is zero.

In the marketplace, companies go bankrupt all the time, with pure equity owners retaining stock certificates worth little more than wallpaper. In a corporate structure, equity ownership does not convey any personal obligation for excess payables, bank obligations, or other liabilities. Although these types of obligations may exist in a marriage, such as with personal guarantees to a bank for a loan, typically the extra responsibility to pay corporate commitments is a personal obligation that would not be part of the equity appraisal process. Separate these assets and liabilities ' an equity asset could be worth zero on the matrimonial balance sheet, but a personal obligation to the bank could be a personal liability of the marriage.

Another element to consider is simple market dynamics. Is there any indication that similar equity has been exchanged for positive value? Does anyone want to pay money for this equity position? Since proper appraisal technique is to compare available market metrics with the subject equity being appraised, if there is an absence of market activity (and no prospects for future cash flows inuring to the ownership position, which is another yardstick), and no one wants this equity position, we may have a case of “zero” value.

Sleeper Companies

There are occasions when reported financial conditions of a company will paint a negative picture, especially in the short run. Be careful that even if the accountant presents a balance sheet with negative equity, or if earnings are negative, you do not leap to the conclusion that equity of the company is worthless. For example, suppose you are presented with simple financial statements that look something like Figure 1 below. With book value of equity at negative $20 and a loss in operations of $5, the company in the example hardly looks like a good investment. However, consider:

• These reported financial results may be stated on cash-basis accounting principles, meaning that accruals such as accounts receivable and accounts payable are not shown. Accrued receivables could be much more than accrued payables, affecting the book value of equity.
• Fixed assets are stated with tax-basis depreciation calculations. The equipment could be worth much more than $30 considering fair market value in continued use. Similarly, recent U.S. tax rules for small businesses allow for immediate expensing of certain fixed assets below a certain level in the year they are acquired, in order to give small businesses a “tax break” on capital equipment investments. Contemplate equipment appraisals and comparison shopping on the web such as Ebay and Craigslist if there appear to be obvious items of equipment in use that could be worth more than their book value, which sometimes is “zero.”
• The accounting basis balance sheet does not typically show intangible assets, such as goodwill derived from a customer list, trained staff in place, patents, or other forms of intellectual property. These often have substantial value, particularly in service or tech-oriented businesses.
• The company may have a niche market or “go-to reputation” in the area, such as the only supplier of certain produce from Mexico, or the only connection with a foreign supplier.
• Start-up companies and companies going through a rough patch (such as recessionary conditions, 2008-2011) will often show losses, but they expect the future to be profitable.
• Depreciation expense is a non-cash item. Gross cash flow, pre-tax, to the equity holders is a positive $5. Earnings before Interest, Taxes, Depreciation and Amortization (or EBITDA) is $15. Positive cash flow is a good sign of existing value.
• Some of the Cost of Sales and Administrative Expenses could be start-up related, and include non-recurring expenses. The company may have inefficiencies that a buyer would correct.
• At times, a dead-looking company actually has substantial market value because many hypothetical buyers in the industry will buy the ownership rights anticipating economies of scale, cross-selling synergies, and other cost-cutting maneuvers. One note of caution, however: A specific buyer seeing synergies may connote investment value, a different standard beyond fair market value or fair value, which could open up a host of definitional arguments.

In short, if you have a company that presents a negative picture, do not immediately assume that equity has no value. Some amount of expert analysis should be done, even if only to confirm that the negative picture seen in the financial reports is likely to continue, and that no prudent buyer exists who would pay money in exchange for any potential future earnings or a foreseeable chance to see the company liquidated and receive proportionate remains.

Zombie Companies

In contrast to Sleeper Companies, sometimes companies are operating with staff, a customer base, and providing products/services, but simply do not make money and have bleak prospects for doing so. Most often these corporate entities exist as family-owned businesses that suffer because of fresh competition, changed economic patterns, and an eroding customer base. But they are hard to kill because owners (or family members) “earn” a living through employment, often while eating through the asset base. Few owners in this situation realize that a business that constantly loses money will have few, if any, prudent buyers of the equity.

Zombie companies should be appraised on a liquidation premise. There may be some goodwill, as in a customer list or patent, but essentially once the assets and liabilities are liquidated in a forced or orderly fashion, whatever is left over, beyond broker and legal fees, will be split among the equity owners. Value may not be zero even if the company should be liquidated! On the other hand, minority interests in Zombie Companies, even if the prospect of some residual payment after closure exists, may approach zero because the minority basis owner has no control to force immediate liquidation and the foreseeability of getting anything in return for the investment is poor.

Tip-Offs That Value Is Really Zero

There are a number of indications that equity has no value, although the existence of any one of these does not necessarily mean “zero” value. Look for these factors in combination, because zero value equity should display several of these high signs:

• The company has shown sustained losses in cash flow and has little prospects for generating future positive cash flow, even with squeezing better efficiencies in operations such as cutting salaries, firing non-contributing staff, and selling off non-productive assets.
• The bank is calling loans and notes due: the company is “in workout” so the bank will threaten liquidation to obtain what it can of amounts previously loaned. Alternatively, the lenders may be the owners (or family) themselves, and they will simply not call the loans as an independent prudent lender would have done.
• The primary real estate assets of a real estate holding company have declined so much in value that current value of these assets is far less than the carrying value on the financial balance sheet and are insufficient to cover existing liabilities. (Golf courses, as an example, are one type of real estate asset that have suffered greatly through the recession due to the erosion of discretionary earnings to the golfing customer base).
• The balance sheet accounts are realistic and show negative
  equity, and any intangible assets likely to be added would not overcome the reluctance of market buyers to invest in the company by buying equity.
• Equity owners have been subject to capital calls, which are really demands to put in additional cash because the company lacks financial resources to continue without added funds.
• Book value of fixed assets in a manufacturing or other “asset-heavy” company is near zero with high maintenance costs, and the company has no ability to buy replacement equipment or fixtures.
• There may be off-balance sheet liabilities such as leases signed by the company, unbooked lawsuit damages, a particular vulnerability to increased cost in healthcare for employees, or a lack of investment in new technology necessary to effectively compete.

Look for Calculations of Value to Hold Down Fees

One of the types of expert services appraisers and CPAs can offer is called a “calculation of value.” These are generally quick-dirty-preliminary-inexpensive forms of analysis. Unfortunately, some attorneys are requesting these limited forms of work on valuable equity properties and then trying to mediate, which can be dangerous. On the other hand, a “calculation” may be sufficient for the outside expert to provide what amounts to a feasibility study of the prudence of going further with either an appraisal or a valuation analysis (CPA term). In the right situation, if equity value is likely to be zero, allow the client to invest some funds to have the expert suggest that this is likely to be so, and alert opposing counsel and both clients that it would unwise to continue to incur additional professional fees. This process is, of course, a judgment call, but be careful of commissioning a large project that will create financial tension between you and your client. Approach the valuation issue in phases.

Conclusion

It is possible for a matrimonial attorney to be faced with a marital equity asset that in reality has zero value. However, even if the Company should be liquidated, there may be some chance residual net assets that would accrue to the equity holders, and even on a speculative level, some reasonable investor would pay something for that chance. A “Zero Value” truly means that the equity could not be sold because there is no demand for it ' buyers would not be willing to part with their funds only to see nothing coming back as a return on investment.

Given our recent economic recession, there are situations where marital equity property may, in fact, be worth zero. There should be some early indications that you, as the matrimonial attorney, ought to recognize as you undertake representation. You should craft sensible steps to address the valuation issue in phases, without spending large fees for an unappetizing opinion.'

Unfortunately, if one party claims a zero value, the other spouse has nothing to lose by taking this equity asset in their part of the division. Danger lurks, Will Robinson!

'

[IMGCAP(1)]

Rob Schlegel, ASA, MCBA, a member of this newsletter's Board of Editors, is a Principal in the Indianapolis, IN, office of Houlihan Valuation Advisors. Randy Sweeten, CPA, CFE, CVA, CFF, is a Partner with Long Chilton, LLP in McAllen, TX.

Matrimonial attorneys are often confronted with a listed equity asset that, at least according to the client, “isn't worth anything.” In the past two years, we have seen several of our valuation assignments conclude with “zero value,” which is hardly pleasing. Not only is this type of opinion stressful, it also contributes to expert and attorney fees where fee containment may be one of the underlying objectives of the clients.

So, how does the matrimonial attorney approach this dilemma? Does this equity with a claimed worthless value need to be appraised? What are the signs that an equity asset would be worth little, if anything? What can meaningful experts do ' without costing an arm and a leg of scarce marital assets ' to provide some type of assurance that suggests additional investigation would not be cost effective? Here are some tips from the expert's point of view that might be useful.

Basis of Value

Fundamentally, value of stock, units in an LLC, or some other financial instruments such as warrants or options, in a pure sense cannot have a value of less than zero. Fair Market Value (or Fair Value) of equity to a marriage is commonly what such an asset could be sold for to a market buyer on a given date, without any encumbrances regarding the ownership. On the other hand, some states embrace that concept of “intrinsic value” or value to the individual owner, which could imply that an equity position has value to the spousal owner, even though it could not be effectively sold. Some states may value a “professional license” that was garnered during the term of marriage. Definitional standards of value should be understood before concluding equity is zero.

In the marketplace, companies go bankrupt all the time, with pure equity owners retaining stock certificates worth little more than wallpaper. In a corporate structure, equity ownership does not convey any personal obligation for excess payables, bank obligations, or other liabilities. Although these types of obligations may exist in a marriage, such as with personal guarantees to a bank for a loan, typically the extra responsibility to pay corporate commitments is a personal obligation that would not be part of the equity appraisal process. Separate these assets and liabilities ' an equity asset could be worth zero on the matrimonial balance sheet, but a personal obligation to the bank could be a personal liability of the marriage.

Another element to consider is simple market dynamics. Is there any indication that similar equity has been exchanged for positive value? Does anyone want to pay money for this equity position? Since proper appraisal technique is to compare available market metrics with the subject equity being appraised, if there is an absence of market activity (and no prospects for future cash flows inuring to the ownership position, which is another yardstick), and no one wants this equity position, we may have a case of “zero” value.

Sleeper Companies

There are occasions when reported financial conditions of a company will paint a negative picture, especially in the short run. Be careful that even if the accountant presents a balance sheet with negative equity, or if earnings are negative, you do not leap to the conclusion that equity of the company is worthless. For example, suppose you are presented with simple financial statements that look something like Figure 1 below. With book value of equity at negative $20 and a loss in operations of $5, the company in the example hardly looks like a good investment. However, consider:

• These reported financial results may be stated on cash-basis accounting principles, meaning that accruals such as accounts receivable and accounts payable are not shown. Accrued receivables could be much more than accrued payables, affecting the book value of equity.
• Fixed assets are stated with tax-basis depreciation calculations. The equipment could be worth much more than $30 considering fair market value in continued use. Similarly, recent U.S. tax rules for small businesses allow for immediate expensing of certain fixed assets below a certain level in the year they are acquired, in order to give small businesses a “tax break” on capital equipment investments. Contemplate equipment appraisals and comparison shopping on the web such as Ebay and Craigslist if there appear to be obvious items of equipment in use that could be worth more than their book value, which sometimes is “zero.”
• The accounting basis balance sheet does not typically show intangible assets, such as goodwill derived from a customer list, trained staff in place, patents, or other forms of intellectual property. These often have substantial value, particularly in service or tech-oriented businesses.
• The company may have a niche market or “go-to reputation” in the area, such as the only supplier of certain produce from Mexico, or the only connection with a foreign supplier.
• Start-up companies and companies going through a rough patch (such as recessionary conditions, 2008-2011) will often show losses, but they expect the future to be profitable.
• Depreciation expense is a non-cash item. Gross cash flow, pre-tax, to the equity holders is a positive $5. Earnings before Interest, Taxes, Depreciation and Amortization (or EBITDA) is $15. Positive cash flow is a good sign of existing value.
• Some of the Cost of Sales and Administrative Expenses could be start-up related, and include non-recurring expenses. The company may have inefficiencies that a buyer would correct.
• At times, a dead-looking company actually has substantial market value because many hypothetical buyers in the industry will buy the ownership rights anticipating economies of scale, cross-selling synergies, and other cost-cutting maneuvers. One note of caution, however: A specific buyer seeing synergies may connote investment value, a different standard beyond fair market value or fair value, which could open up a host of definitional arguments.

In short, if you have a company that presents a negative picture, do not immediately assume that equity has no value. Some amount of expert analysis should be done, even if only to confirm that the negative picture seen in the financial reports is likely to continue, and that no prudent buyer exists who would pay money in exchange for any potential future earnings or a foreseeable chance to see the company liquidated and receive proportionate remains.

Zombie Companies

In contrast to Sleeper Companies, sometimes companies are operating with staff, a customer base, and providing products/services, but simply do not make money and have bleak prospects for doing so. Most often these corporate entities exist as family-owned businesses that suffer because of fresh competition, changed economic patterns, and an eroding customer base. But they are hard to kill because owners (or family members) “earn” a living through employment, often while eating through the asset base. Few owners in this situation realize that a business that constantly loses money will have few, if any, prudent buyers of the equity.

Zombie companies should be appraised on a liquidation premise. There may be some goodwill, as in a customer list or patent, but essentially once the assets and liabilities are liquidated in a forced or orderly fashion, whatever is left over, beyond broker and legal fees, will be split among the equity owners. Value may not be zero even if the company should be liquidated! On the other hand, minority interests in Zombie Companies, even if the prospect of some residual payment after closure exists, may approach zero because the minority basis owner has no control to force immediate liquidation and the foreseeability of getting anything in return for the investment is poor.

Tip-Offs That Value Is Really Zero

There are a number of indications that equity has no value, although the existence of any one of these does not necessarily mean “zero” value. Look for these factors in combination, because zero value equity should display several of these high signs:

• The company has shown sustained losses in cash flow and has little prospects for generating future positive cash flow, even with squeezing better efficiencies in operations such as cutting salaries, firing non-contributing staff, and selling off non-productive assets.
• The bank is calling loans and notes due: the company is “in workout” so the bank will threaten liquidation to obtain what it can of amounts previously loaned. Alternatively, the lenders may be the owners (or family) themselves, and they will simply not call the loans as an independent prudent lender would have done.
• The primary real estate assets of a real estate holding company have declined so much in value that current value of these assets is far less than the carrying value on the financial balance sheet and are insufficient to cover existing liabilities. (Golf courses, as an example, are one type of real estate asset that have suffered greatly through the recession due to the erosion of discretionary earnings to the golfing customer base).
• The balance sheet accounts are realistic and show negative
  equity, and any intangible assets likely to be added would not overcome the reluctance of market buyers to invest in the company by buying equity.
• Equity owners have been subject to capital calls, which are really demands to put in additional cash because the company lacks financial resources to continue without added funds.
• Book value of fixed assets in a manufacturing or other “asset-heavy” company is near zero with high maintenance costs, and the company has no ability to buy replacement equipment or fixtures.
• There may be off-balance sheet liabilities such as leases signed by the company, unbooked lawsuit damages, a particular vulnerability to increased cost in healthcare for employees, or a lack of investment in new technology necessary to effectively compete.

Look for Calculations of Value to Hold Down Fees

One of the types of expert services appraisers and CPAs can offer is called a “calculation of value.” These are generally quick-dirty-preliminary-inexpensive forms of analysis. Unfortunately, some attorneys are requesting these limited forms of work on valuable equity properties and then trying to mediate, which can be dangerous. On the other hand, a “calculation” may be sufficient for the outside expert to provide what amounts to a feasibility study of the prudence of going further with either an appraisal or a valuation analysis (CPA term). In the right situation, if equity value is likely to be zero, allow the client to invest some funds to have the expert suggest that this is likely to be so, and alert opposing counsel and both clients that it would unwise to continue to incur additional professional fees. This process is, of course, a judgment call, but be careful of commissioning a large project that will create financial tension between you and your client. Approach the valuation issue in phases.

Conclusion

It is possible for a matrimonial attorney to be faced with a marital equity asset that in reality has zero value. However, even if the Company should be liquidated, there may be some chance residual net assets that would accrue to the equity holders, and even on a speculative level, some reasonable investor would pay something for that chance. A “Zero Value” truly means that the equity could not be sold because there is no demand for it ' buyers would not be willing to part with their funds only to see nothing coming back as a return on investment.

Given our recent economic recession, there are situations where marital equity property may, in fact, be worth zero. There should be some early indications that you, as the matrimonial attorney, ought to recognize as you undertake representation. You should craft sensible steps to address the valuation issue in phases, without spending large fees for an unappetizing opinion.'

Unfortunately, if one party claims a zero value, the other spouse has nothing to lose by taking this equity asset in their part of the division. Danger lurks, Will Robinson!

'

[IMGCAP(1)]

Rob Schlegel, ASA, MCBA, a member of this newsletter's Board of Editors, is a Principal in the Indianapolis, IN, office of Houlihan Valuation Advisors. Randy Sweeten, CPA, CFE, CVA, CFF, is a Partner with Long Chilton, LLP in McAllen, TX.