The private plaintiff alleged a number of violations by the ESOP trustee and other defendants. The plaintiff maintained the trustee participated in a prohibited transaction and breached its fiduciary duties. By the plaintiff’s calculation, the ESOP overpaid for company stock. The district court dismissed the suit and, in so doing, noted that the plaintiff “fundamentally misunderstands” the transaction and the related company valuations.

Buying shares at a discount. In late 2016, Choate Construction Co. (Choate) created an ESOP. The company hired an independent trustee as well as an independent, experienced ESOP appraisal firm, which prepared a valuation for purposes of the ESOP creation and which performed subsequent annual valuations. The trustee’s responsibility was to ensure the plan did not pay more than fair market value for company stock. The trustee had a duty to oversee the appraiser’s valuations.

The ESOP paid $198 million for 8 million shares, representing 80% of the company. The company, around this time, redeemed 2 million shares held by the selling shareholders for non-voting stock and warrants. To finance the $198 million transaction, the company made a loan of $57 million to the ESOP and the ESOP issued notes to the selling shareholders for the remainder of the acquisition cost at a 4% annual rate. The 2016 year-end annual appraisal, which came about a month after the ESOP’s formation, valued the shares at $64.8 million.

The plaintiff was a former employee of Choate, who worked for the company from April 2007 to April 2017. The plaintiff said she was “fully vested” in the ESOP. She contended the transaction was not in the best interests of the company’s employees in light of the $64.8 million valuation. The plaintiff filed suit on her own behalf and on behalf of “similarly situated current and former Choate employees.”

The gist of the plaintiff’s claims was that the trustee engaged in a prohibited, party-in-interest transaction and breached its fiduciary duties to the plan. According to the plaintiff, the $64.8 million valuation showed the trustee caused the plan to overpay for company stock. The defendants filed a motion to dismiss, to which the plaintiff did not respond in time. However, in ruling for the defendants, the court addressed the plaintiff’s claims.

The principal issue was whether the court had jurisdiction over this suit. Put differently, the plaintiff had to show she had “standing” by showing she suffered an “injury in fact” that was “fairly traceable to the challenged conduct of the defendant” and that a favorable court decision would likely remedy. The court found the plaintiff failed to show she suffered any injury as a result of the acquisition of 8 million company shares at $198 million. Further, the plaintiff failed to show she suffered “any additional or unique harm separate from the harm she alleges all members of the Choate ESOP suffered.”

According to the court, the plaintiff did not understand the contested transaction and the subsequent valuation. The court noted that, in looking at the valuations, the plaintiff apparently divided the $198 million purchase price by 8 million shares to arrive at a per-share value of $24.75. Considering the year-end appraisal that valued the company at $64.8 million, the plaintiff concluded the stock had dropped to $8.10 per share in about a month. The plaintiff then decided the initial acquisition could not have been at fair market value.

Not so, the court said. It analogized the transaction to the purchase of a house listed at a certain price. The buyer would obtain a mortgage to cover the list price. However, if the buyer subsequently found out the house was worth more than the mortgage, the buyer would have the mortgage but also equity in the house. In this scenario, the buyer bought the house at a discount, the court noted.

Here, the court said, the ESOP actually obtained the 8 million shares at a discount in that it took on $198 million in debt to obtain the stock and a valuation shortly after the transaction showed a value of $64.8 million for the stock. The shares appreciated in value by about 33%, in less than a month, the court explained. The ESOP “realized an immediate equitable benefit,” the court said. It added that the benefit had since increased even more because a year-end 2017 valuation put the value of the stock at $107.2 million.

The court concluded that the contested transaction did not injure the plaintiff. Rather, it benefited her. According to the court, the plaintiff’s own complaint contradicted the plaintiff’s allegation. The plaintiff did not meet the standing requirement. Consequently, the court dismissed the complaint.

Lee v. Argent Trust Co., 2019 U.S. Dist. LEXIS 132066 (Aug. 7, 2019)

The most visible and recognizable intangible asset for a firm is its brand. A brand contains legal protections that trigger value. But knowing how to quantify the latter in view of the former can be perplexing to even the most experienced valuation professional.  According to intellectual property valuation expert Mike Pellegrino (Pellegrino & Associates), author of BVR’s Guide on Intellectual Property Valuation, there are some fundamental, underlying legal rights that provide brands monopoly protection and, ultimately, their value.

Perpetual life

A trademark, which is a protection on a brand, slogan, or logo, is generally the most valuable type of intellectual property (“IP”) because there is no statutory life associated with a trademark. If you maintain a trademark and continue to use it in the classes for which it is registered, you will just have to go through a registration process every 10 years to maintain it. And, as long as you do that, you will have perpetual ownership of that mark for the particular goods and services to which it applies. That perpetual life gives it a very long runway of economic-value creation opportunity that you do not get with some of the other assets.

Value creation

Trademarks and brands can create value for otherwise commodity products. For example, diamonds sold by Tiffany are made of the same substance—carbon—as diamonds sold by other stores. While a Tiffany diamond may cost quite a bit more, the price it commands does not necessarily relate to the intrinsic value of the asset, but there is a brand associated with that. A trademark creates value in several ways:

·         Reduced consumer search costs. By making it easier and quicker for consumers to buy a company’s product or service, the trademark reduces customer-acquisition costs on the part of that company.

·         Increased market penetration. Thanks to its brand, a company might be able to get greater market penetration, so its market share becomes disproportionately higher than its competitor’s, even if the pricing is the same.

·         Lowered sales and marketing expenditures. Let’s say two companies have competing products that cost the same and the companies have the same market share. If one company can get its product or service into the consumer’s hands for less cost than the consumer would otherwise have to spend because of that brand, then that is a value source.

·         Reduced risk of failure. You might have a greater chance of success or a reduced risk of failure, and that has a value-creating aspect. Why? Because it changes the risk profile associated with the investment, and that will ultimately affect the discount rate.

·         Increased revenue per unit. Through incremental revenues, the “brand” company can get a higher revenue per unit for a particular product or service. Table salt is nothing more than sodium chloride, but Morton Salt, for example, gets an 18% premium at a local grocer for its product. If you did a blind taste test on Morton Salt versus your local grocery store’s brand, you would probably find that they are indistinguishable.

Value can be fleeting

A disadvantage of trademarks and brands is that they can lose value instantly, especially in today’s connected world. Social networking sites such as Twitter and Facebook can disseminate information very efficiently. The bad news is that it is not always correct information. Even more, it may impair the trademark, even though the information might be incorrect.

For example, several years ago, a law firm issued a class-action suit against Yum! Brands (which owns KFC, Pizza Hut, and Taco Bell), making such claims as Yum products did not contain meat and had filler materials in them. This made a lot of splash in the headlines and the media, and people stopped buying this brand’s products for a while. Eventually, the lawsuit was dropped because independent scientific analysis showed that the product was composed primarily of meat—in fact, 88%—and that the rest was made up of seasonings. The basis for the lawsuit was basically unfounded but it still did damage to Yum in that case, even though there was not much mention of the suit in the press. Some brands might never recover.

Quantifying value

To quantify brand value, certain items of due diligence are worth noting:

·         See who owns it. Credible due diligence on a brand starts with figuring out who owns that title. As with patents and trademarks, it must be assigned and searchable. What if you discover that a client does not own a particular mark? If they don’t, you need to ask, “Why don’t they own it? Is there impairment there or might they not even be allowed to operate under that mark?”

·         Verify the history. The history and creation are important because they might help lay the groundwork for legal strength at some point if it is ever tested in court. There is a correlation between the strength of the brand or trademark and its value. Look at the trademark’s registration and understand the status of the trademark.

·         Check for look-alikes. Make sure no one else is using a similar trademark. That search provides a reasonable expectation of freedom to operate. Not searching is expensive. If a company is told that it must move away from a brand, then it has to design a new logo, reprint everything, get a new website, etc. It is a remarkably expensive process to fix that.

Building a credible forecast

The following tips can help build a credible forecast for brand valuation:

·         Toss out the yield-capitalization method. A brand value is volatile, and you are using a one-point predictor when you use a yield capitalization method. It represents an income perpetuity. Although trademarks may have a perpetual life associated with them at a legal level, that may not be the case from an economic level.

·         Look at the economic activity surrounding the brand and its associated time series. You have to spend a fair amount of time looking at such factors as marketing expenditures, marketing effectiveness, and analysis of earned media—especially for products that do not have a lot of technical differentiation. Earned media can have a direct relationship to the economic income attributable to an asset. The establishment of relationships of all those analyses together ultimately has to come into a free cash flow forecast.

·         Be prepared for a low or indeterminate value, especially if the relationships are indeterminate. In such a case, a brand may carry little value. Business owners do not like hearing that. They may believe they have a legitimate and viable brand but cannot show any sort of economic value creation attributable to it.

·         Focus only on the economic activity attributable to the brand. Also look at its associated allocated overhead.

·         Consider the discount rate. Discount rates for brands are unobservable in the market. There is no capital asset pricing model (CAPM) for brands. Conventional discount rates used by the profession developed using CAPM are not appropriate for brand valuation.

Bottom line

Credible brand valuation is difficult, and the values are volatile. The market failure rates for branded products can be very high and the value creation can be difficult to measure. Many brands are not as valuable as their owners think. Further, many companies do not want to pay for a credible brand valuation analysis because it is expensive. It is labor-intensive and will almost always be an income-based model, which requires specific product measurement and demand forecast. Bottom line: There are no shortcuts for building a credible forecast for brand valuation.

For more on the topic, check out Mike Pellegrino’s evergreen guide on Intellectual Property Valuation.