Valuation of a venture capital company

The plaintiffs in Krapf, Jr. v. U.S., 89-2 USTC par. 9448 (U.S. Claims Court 1989), claimed an income tax charitable deduction of $260,000 for their 1976 contribution of 26,000 shares of common stock in Mechtron Industries, Inc. to the University of Delaware. The IRS claimed that this stock was worthless and disallowed the entire deduction.

Mechtron had been organized in 1971. From 1972 until the company went bankrupt in 1981, it was primarily engaged in refurbishing and assembling railroad cars. Mechtron was closely held and there were few sales of its stock throughout its existence. The most significant transactions were the following: In 1975 (before the charitable gift), there was a redemption from a key employee for $10 per share. In 1979 (after the gift), there was a redemption of the contributed stock from the University of Delaware for $.04 per share and a sale of stock to a key employee for $.04 per share. In 1980, there were sales of stock to outside investors for $1.00 per share in cash and to the company’s president for $0.15 in cash plus his forgiveness of $0.85 per share in debts owed to him by the company. (The 1979 price was equivalent to $0.40 per old share and the 1980 price to $10.00 per old share due to a 10-1 split after the gift.) Mechtron was not profitable, although its revenues had increased 40% from December 1973 through December 1976. It had negative working capital on the valuation date but its net worth was positive by a small amount and it was meeting its obligations as they came due.

The plaintiffs based their valuation principally on transactions, both before and after the valuation date, in which Mechtron stock was priced at the equivalent of $10.00 per share. Neither side offered evidence as to whether or not the redemption price paid to the University of Delaware represented fair market value. The IRS contended that stock transactions prior to the gift were not reliable evidence of value for a variety of reasons and that the post-gift transactions were irrelevant. It submitted three appraisals which concluded on the basis of comparative company and adjusted net worth analyses that the Mechtron stock was worthless on the valuation date. Plaintiffs contended that traditional methods of valuation other than actual transactions cannot be used to value start-up companies.

The court stated that the valuation process should begin with the premise that sales are the best indication of fair market value. However, the sales must be freely made at arm’s length to provide an accurate indication of value. In the absence of reliable transactions, the court must examine the financial condition of the corporation on the relevant date to determine the value.

After examining the evidence regarding the Mechtron transactions, the court concluded that those preceding the gift were not indicative of fair market value. Before examining the post-gift transactions, the court addressed the issue or relevancy. It reaffirmed the general principle that valuations must be made without reference to events which occur after the valuation date because such information would not have been available to a prospective purchaser. However, the court noted two exceptions to this general rule:

"First, post-gift date can be used in valuation when there has been no material change of circumstances or conditions in the corporation between the valuation date… (and the date of the subsequent information). Second, the post-gift evidence is indicative of date of gift value when the subsequent information could have been foreseen on the valuation date."

In this case, the court found that the first exception was satisfied by the 1979-1980 transactions because the only relevant change in Mechtron’s financial condition after the gift date was a general decline. The court focused on the 1980 transaction in which additional stock was sold to the company’s president and concluded that (after adjustments) this established a minimum stock value of $4.34 per share as of the gift date.

The court then considered the appraisals submitted by IRS. It did not accept plaintiffs’ argument that comparable publicly held companies cannot be used to value a start-up or venture capital company. However, it did acknowledge the difficulty of finding suitable comparatives for such companies and it did conclude that the comparatives selected by the IRS appraisers were not acceptable.

The adjusted net worth valuations submitted by IRS determined that Mechtron stock had no value on the gift date because the company’s liabilities exceeded the liquidation value of its assets. The court rejected these valuations because it found that Mechtron was a going concern on the gift date. Therefore, its assets should have included "intangibles such as goodwill and market share" and the total fair market value of its assets should not have been reduced by liquidation costs. On this basis, as noted above, Mechtron had a small positive net worth even without attributing any specific value to its intangible assets. This confirmed that the stock was worthless.

The court held that plaintiffs were entitled to a charitable deduction of $4.34 per share or a total of $112,840.