The Buzz about Non-Operating Assets
By Stefanie Jedra, Manager, Advisory Services
There is a lot of buzz about a recent District Court case – James F. Kress and Julie Ann Kress v. United States of America. The buzz in the valuation community has been regarding the position of the Internal Revenue Service and the decision of the United States District Court for the Eastern District of Wisconsin on tax affecting pass-through entities. In its decision, the District Court also handled another complex valuation issue that has not been the “talk of the town.”
Non-operating assets. Do you separate them from the overall business or treat them as part of the subject interest? How does your treatment of non-operating assets change if you are valuing a non-controlling or minority interest? These issues were addressed by the appraisers and discussed in the District Court’s decision. Before discussing how the non-operating assets were addressed by each appraiser in this case and the findings of the court, a brief explanation of non-operating assets is warranted.
General Definition and Overview
Put simply, non-operating assets are assets owned by a business entity that are not necessary for the operation of the business. Further, these assets do not contribute to the economic return generated by the operations of the business. As detailed in Jim Hitchner’s book Financial Valuation1, non-operating assets can include any of the following:
- Excess cash.
- Marketable securities (if in excess of reasonable needs of the business).
- Real estate (if not used in business operations, or in some situations, if the business could operate in rented facilities).
- Private planes, entertainment or sports facilities (hunting lodge, transferrable season ticket contacts, skyboxes, etc.).
- Antiques, private collections, etc.
These are only a few examples of non-operating assets that might be seen in practice. In addition to the foregoing, we frequently see investments in other business entities. Sometimes these investments are related to the business being valued, and sometimes they are unrelated entirely. Depending on how the value of the investment is reported, the business appraiser may need to endeavor (through a completely separate business valuation) to correctly account for the value of a company’s investment in another business entity.
Although this article primarily concentrates on non-operating assets, it is also possible that a business entity has reported a non-operating liability. An example of a non-operating liability might be a line of credit or note reported on the books of the business entity, which proceeds were utilized for a purpose other than the operations of the business; or credit cards payable, where the charges were personal expenses. Again, this liability would not be contributing to the economic return generated by the operations of the business.
You may be wondering how an appraiser should handle these non-operating assets once they are identified. The simple answer, and the answer that one would give on cross examination, is “it depends.” There is no hard and fast rule. We must consider the facts and circumstances pertinent to the subject interest and the details related to the specific non-operating assets in question.
Breaking Down “It Depends”
How an appraiser addresses non-operating assets largely depends on whether the subject interest of the business entity being valued is a controlling or non-controlling interest. A non-controlling interest does not have the ability to decide whether to distribute the non-operating assets or sell them and realize their value.
If the subject interest is a controlling interest:
- The appraiser may remove the income and expenses relating to any non-operating assets, value the operations of the business (without the impact of any non-operating assets), and then add the value of any non-operating assets to determine the total enterprise value of the business. Depending on the nature of the non-operating asset, the business appraiser may need to consult a specialist with valuation expertise in the particular asset, i.e., real estate, machinery, equipment, etc.
- In Valuing a Business2, Shannon Pratt indicates that “the theory of valuing non-operating assets separately from operating assets rests in the assumption that the non-operating assets could be liquidated without impairing operations.”
- The appraiser may value the business without adjusting the operating results of the company for income, expenses and/or cash flow related to the non-operating assets, and consider the impact of the non-operating assets when addressing the cost of capital.
If an appraiser chooses to value the operations of a business entity and the non-operating assets together, it is important to consider the impact of any non-operating assets on the financial results of the business entity. The appraiser should analyze how the non-operating assets affect the income, expenses, and cash flow, as well as the associated risk.
For example, if a law firm owned a portfolio of United States Treasury bonds which was determined to be a non-operating asset, the risk associated with the non-operating asset’s cash flow would almost certainly be less than that of the cash flows generated from operating the firm. However, in practice the facts are unlikely to be this simple; hence, the advisability of consulting a specialist appraiser.
Ultimately, it is important to make sure that the discount rates match the related cash flows in your analysis. To this point, in Valuing a Business3, Shannon Pratt notes that “the most common error in the application of the income approach is using a discount or capitalization rate that is not appropriate for the definition of economic income being discounted or capitalized.”
If the subject interest is a non-controlling or minority interest:
- The appraiser may remove the income and expenses relating to any non-operating assets, value the operations of the business (without the impact of any non-operating assets), add the value of any non-operating assets, and then take a discount for lack of control to determine the value of the non-controlling subject interest.
The discount is applied to account for the fact that a non-controlling or minority shareholder cannot control the operations of the business, including, but not limited to, the use of business assets to fund non-business expenses, purchase non-business assets, and/or invest in unrelated activities.
The appraiser may apply to the operations of the business a different discount for lack of control of the non-operating assets, depending on the rights of the non-controlling shareholder as outlined in the governing documents.
- The appraiser may value the business without adjusting the operating results of the company for income, expenses and/or cash flow related to the non-operating assets, and consider the impact of the non-operating assets when addressing the cost of capital. The theory in this methodology is that a non-controlling owner would not be able to distribute these non-operating assets. Nonetheless, the non-operating assets owned by the business may alter its risk profile, and therefore, they cannot be ignored entirely.
- The appraiser may value the business without adjusting the operating results of the company for income, expenses and/or cash flow related to the non-operating assets, and decide not to consider the impact of the non-operating assets when addressing the cost of capital. The appraiser in this instance is essentially excluding the non-operating assets and taking the position that a non-controlling or minority shareholder could not direct the decisions of the business entity and therefore could not access the value of these non-operating assets.
Non-operating Assets in Kress Case
The United States District Court for the Eastern District of Wisconsin was recently faced with making a decision regarding how to handle non-operating assets. The different methodologies utilized by the business appraisers in this case highlight the complexity of the topic.
In James F. Kress and Julie Ann Kress v. United States of America, the plaintiffs sought a tax refund from the United States of America to recover an overpayment of gift taxes and interest related to their gifting of non-controlling interests in Green Bay Packaging, Inc. (“GBP”). GBP had three non-operating assets, namely, an investment in a related party, a group of life insurance policies, and two private airplanes. The investment in the third party held various investments, and cash was utilized from this investment to fund operations and pay dividends to the shareholders of GBP.
The expert for the United States of America determined the value of the operations of GBP using the income and market approaches, and then added back the non-operating assets, which were separately valued, in reaching his conclusion of the value of GBP common stock. The expert took a slight discount for lack of control of GBP’s related party investment and did not discount the other non-operating assets.
The District Court’s decision found that this expert did not properly value the non-operating assets owned by GBP, as the non-operating assets were added back at almost their full value. The decision notes that adding back the full value of non-operating assets would be more appropriate if the entire business were being valued, rather than valuing only the non-controlling interest. The decision concludes that this expert’s value of the common stock of GBP overstated the value.
The first expert for the plaintiffs considered the effect of the non-operating assets owned by GBP to the extent that those assets contributed to GBP’s overall earnings, in reaching his conclusion on the value of GBP common stock. The expert did not add the overall value of the non-operating assets,4 contending that a non-controlling shareholder could not realize the value of those assets. The expert relied solely on the market approach and when criticized, the plaintiffs hired a second expert.
The second expert for the plaintiffs utilized both the income and market approaches. This expert accounted for the value of the non-operating assets by including the income from the related party investment and the cash value of the life insurance policies, and accounted for the family’s personal use of the airplanes by adding back a percentage of the related operating costs.
Differences of Opinion
The expert for the defense separately valued the non-operating assets and added almost the entire fair market value of the non-operating assets in determining the value of GBP common stock.
Both experts for the plaintiff did not separately value the non-operating assets, but considered the effect of the non-operating assets on the financial results of GBP.
The District Court’s decision found that the first expert for the plaintiff was the “most sound” and primarily relied upon the methodologies and conclusions reached therein. This expert considered the effects of the non-operating assets in the earnings of the company and did not add back the value of the non-operating assets.
The District Court’s decision notes disagreement with the expert for the defense in part for “failure to take into consideration the minority interest in evaluating the non-operating assets.” Had the expert for the defense taken a more substantial discount, the District Court may have decided differently.
Determining how to tackle non-operating assets can be complicated, as can be seen in the District Court’s decision. All three business appraisal experts in this matter were qualified and had between 29 and 31 years of experience in business valuation, and each handled the non-operating assets differently.
The most important take away from this case is that while there may be no hard and fast rule for how to handle non-operating assets, it is of the utmost importance that the facts and circumstances pertinent to the subject interest are carefully considered in determining the methodology to be utilized.
1. Hitchner, James R. (2003) Financial Valuation Hoboken, New Jersey, John Wiley & Sons, Inc.
2. Pratt, Shannon P. (2008) Valuing a Business Fifth Edition United States of America: The McGraw-Hill Companies, Inc.
3. Pratt, Shannon P. (2008) Valuing a Business Fifth Edition United States of America: The McGraw-Hill Companies, Inc.
4. The expert did consider the value of the non-operating assets in calculating GBP’s book value under the asset approach, but he did not rely upon this approach in coming to his conclusion.