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Fleeting Valuations

The article discusses the challenges related to Elizabeth Warren's proposed wealth tax - specifically around business valuations - in light of the recent We Work devaluation.

The We Work IPO is a stark reminder of the fleeting valuations attributed to many businesses. We Work began preparations to IPO in August with its most recent capital raising valuation close to $47 billion in January. The company began its IPO roadshow in August floating a $20 billion valuation.

As investors peaked behind the curtain, We Work revealed a money losing business with billions in loses, piles of debt, and no path to profitability, among a host of other questionable corporate governance acts by the company’s founder and CEO. Investors digested the information quickly and the company’s value declined to $5 billion by October, per the most recent reports. That must be a record price correction for a company that size.

As a valuation professional, valuing a business that is losing billions of dollars today, but has the potential to be highly profitable in the future is not an easy task. The We Work story being perpetuated by VC’s and bankers is reminiscent of successful companies like Google and Facebook that were once money losing ventures but turned out to be incredibly valuable companies that produces billions in cash flows today. This is why investing in We Work was so enticing and the valuation skyrocketed.

The democratic presidential candidate, Elizabeth Warren, proposes a 2.0% wealth tax on estates worth $50 million or more. Many ultra-millionaires and billionaires’ wealth come from the businesses they own. As we saw with We Work, a company’s value can drop dramatically in a matter of months based on investors’ expectations around the business.

Elizabeth Warren says on her website that she will tax a person’s entire wealth including, “residences, closely held businesses (emphasis added), assets held in trust, retirement assets, assets held by minor children, and personal property with a value of $50,000 or more.” Her plan acts to capture all the wealth held by millionaires and billionaires.

Valuing “closely held businesses”, meaning a privately held business that is not publicly traded, is an intricate process that incorporates many assumptions about the future.

For someone like Jeff Bezos or Warren Buffet, their wealth is largely tied up in the publicly traded companies they own, Amazon and Berkshire Hathaway, respectively. Meaning the value of their business is known every second of the day. Their businesses are valued by investors daily, and those investors are basing their appraisal on the future expected cash flows the business will generate between now and Judgement Day. Not necessarily on past performance.

But there is no public market for shares in privately held businesses. Owners of very large, privately held businesses, don’t regularly know the value of their business. They may have an idea because they get offers from private equity firms or competitors, rely on rules-of-thumb, or see what comparable companies sell for, but that’s about it.

Because there is no publicly traded market for private businesses – hence why they are private – my job as a business appraiser exists. I am tasked with analyzing privately held businesses to opine on their fair market values. Appraisers are assigned with making assumptions about future cash flows, and discounting those back into today’s dollars. Meaning, the value (or wealth) is based on future expectations.

We all know the future never plays out as we expect. Company’s may lose large contracts or be impacted by economic forces such as a recession, severely debilitating the company. But Warren’s plan is to tax the future, based on assumptions made today.

As an example let’s put a value on your wealth by valuing your future potential income, which is similar to how we would value a business. To put it in simple terms, let’s project out all of the income you expect to earn between now and the day you retire, discount that income back into today’s dollars, and sum the annual income. The total amount is the value of all of your expected future income in today’s dollars.

Let’s say you make $100,000 a year, and anticipate your income growing 3.0% per year until you retire in 30 years. The value of your expected income, in today’s dollars, is approximately $2.2 million. Let’s assume Warren will tax you 2.0% on the total amount today. That means you owe $44,000 today, or about 44% of your income, in this example.

What happens if you get fired tomorrow? Or your company goes out of business in 2 years, and your income didn’t pan out accordingly. Well too bad, you paid taxes today on income you will never receive. Does that seem reasonable or fair?

Believe it or not, not all business owners who own a $50 million dollar business have $1,000,000 of cash to pay Warren’s annual 2.0% wealth tax. Some businesses take their income, after paying income tax, and reinvest it back into the business to expand, by buying buildings and equipment, hiring employees, making costly technology improvements, etc. This limits the amount of cash available to the owners.

For someone like Warren Buffett or Jeff Bezos, they can sell 2% of their ownership interest in the open market to alleviate this tax pain point. However, privately owned business owners don’t have that luxury. The owner can’t easily sell 2.0% of their business in the open market to satisfy the tax. They must seek alternative routes to pay the tax which can have costly ramifications such as reducing future investment in the business, like hiring.

Of course, Warren does have a plan to allow business owners to defer the wealth tax payment for five years if they don’t have the cash, but they will be charged interest. In the meantime, business owners still need to come up with the cash from somewhere to pay the tax bill when it comes due. My guess is they will limit how much they reinvest into their business to fund the wealth tax. That could impact important spending decisions like hiring, major capital purchases, or other productive asset purchases.

Full disclosure, I am not an ultra-millionaire by any means. I will probably never be one – unless I win the lottery – and I don’t care to defend ultra-millionaires. They can defend themselves.

In fact, I have a lot to gain from a Warren victory. I own a small business appraisal firm where I value privately held companies. Although it’s not entirely clear under her plan, I imagine the ultra-millionaires would want (or be required) to have their businesses appraised by a qualified appraiser like me. A plan like Warren’s would be a windfall for me. Heck, a Warren Presidency could put me on the path to ultra-millionaire status, thanks to her plan.

But Elizabeth Warren’s plan forgets one item. Wealth is fleeting. If you owned a large portion of We Work you just saw your wealth crumble before your eyes. In the meantime, if her tax was in effect, you would have paid taxes on a valuation that truly never materialized.

The reason taxing income, dividend income, and capital gains is so effective is because cash is generally received, and so you should theoretically have cash in hand to pay the tax. Wealth is completely different. Wealth is based on value, and value is based on future assumptions that may or may not materialize.

Elizabeth Warren concedes that closely held businesses are “hard to value.” She proposes the IRS to “develop new valuations rules as needed.” She gives the example of the “cutting-edge retrospective and prospective formulaic valuations methods for certain harder-to-value assets like closely held businesses.”

The “cutting-edge retrospective and prospective formulaic valuation methods” were not handed down to appraisers from the IRS but are deeply rooted in academic and empirical theories developed and tested by appraisers, analysts, and investors over the last century, if not longer. The IRS has a long history of providing guidance on valuation standards and techniques as they relate to gift and estate tax issues. No matter the changes Elizabeth Warren proposes, the fundamental basis for valuation is estimating future cash flows. The theories behind valuation transcend any rules the IRS will ever think up.

What Elizabeth Warren is missing is that the future is unknown, and a business’s value is directly derived from future expectations. This is why companies like We Work can be valued at $47 billion in January, and $5 billion in October. Investor’s expectations changed, and so did its value. How should someone be comfortable paying taxes on something so fleeting?

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