Michael Jackson and 20/20 Valuation Hindsight

A fundamental principle of valuing a business is that value is determined at a specific point in time, as discussed in our blog COVID-19: Known or Knowable? Even though valuations are prepared after-the-fact, they must only rely on information that was known or knowable at that specific time. There are numerous court cases that comment on the use of hindsight information and the reasonableness of assumptions in business valuations, with the United States Tax Court’s case against Michael Jackson’s Estate being one of the most recent high profile cases.

The King of Pop

Michael Jackson, a.k.a. the King of Pop, is regarded as one of the most significant (and controversial) artists in recent history. His signature “moonwalk” influenced generations of teenagers and adults not only in North America, but also worldwide. The King of Pop, however, died of drug overdose in his California home in 2009. And similar to Prince, whose Estate has been in dispute since his death (Refer to our blog – Prince’s Estate – through the Lens of a Valuator), Michael Jackson’s Estate has also been in dispute, largely related to valuation issues.

The IRS vs. MJ

Benjamin Franklin is credited with saying “in this world, nothing is certain except for death and taxes”. Michael Jackson is no exception. After his death, Michael Jackson’s Estate filed its tax returns, which became subject to an IRS audit. Through the investigations, the IRS alleged that the value of Michael Jackson’s estate was underreported by approximately US$1.125 billion. Not only did this imply that the Estate under-paid its taxes by approximately US$500 million, but the egregiousness led to nearly US$200 million in penalties.

Although many specific assets were believed to have under-reported values (with agreements later reached between the IRS and the Estate), we focus on Michael Jackson’s “image and likeness” asset, which the Court uses to illustrate the inappropriate use of hindsight information.

Images and Likeness – Opinions Differ

The Estate’s initial valuator determined that Michael Jackson’s image and likeness had a value at the time of death of approximately US$2,000, and this is the value that was included on the Estate’s tax return. Although that may sound absurd given the mega-fame of a star like Michael Jackson, it was carefully thought out. His popularity was heavily tied specifically to his music, but his actual image and reputation was highly controversial, given the various allegations of misconduct placed against him. The result was that Michael Jackson’s image and likeness had generated virtually no revenue in the ten years leading up to his death. Nobody was interested in paying to use Michael Jackson’s image leading up to his death, so why would that change significantly after his death?

Regardless of the rationale behind the value of US$2,000, the IRS audit took a significantly different view, finding that Michael Jackson’s image and likeness was undervalued by approximately US$435 million (approximately 217,500 times more valuable than the Estate had indicated). By the time of the trial, both parties revised their stances, with the Estate producing a figure of approximately US$3 million by a different valuator, and the IRS at approximately US$160 million.

The Court’s ultimate finding was that the image and likeness was worth approximately US$4 million, similar to the Estate’s determined value.  And although both valuators used similar valuation approaches, the assumptions and methodologies relied on by the IRS valuator were criticized by the Court, in part because of the use of hindsight and unreasonable assumptions in five key areas:

Themed Attractions and Products

The IRS valuator included value of approximately US$87 million, because it was assumed a rational investor would use Michael Jackson’s image and likeness to create attractions like amusement parks, museums, and video games. Although some of these ideas came to fruition subsequent to Michael Jackson’s death, the Court found it was not a reasonable expectation leading up to the death. Specifically, the only reasonable location for a themed attraction was Michael Jackson’s Neverland home, which at the time was viewed more as a crime scene than as an attraction.

Branded Merchandise

Additional value of approximately US$14.5 million related to the concept that the Estate could derive revenue from Michael Jackson-branded merchandise. Rather than looking at the history of Michael Jackson’s actual merchandising agreements (none of which were in place leading up to his death), the valuator analyzed merchandise sales of six other celebrities (including Elvis Presley, Jennifer Lopez, and Tony Hawk). Again, although some merchandising opportunities arose after Jackson’s death, it was not considered reasonably foreseen.

Cirque du Soleil

A further US$19 million was derived from the idea that Cirque du Soleil could produce a Michael Jackson-themed show, with the production results in the third quartile of comparable productions. However, the Court found there weren’t even any discussions of a possible Cirque du Soleil show.

Film

US$38 million was derived from the idea that a film about Michael Jackson’s 45-year career could generate significant revenue, based on other recent blockbuster hits such as 8 Mile, Ray, and Walk the Line. However, it was again not reasonably foreseen that a film would be produced. There was some interest in producing a film and plenty of raw footage to work with, but it was not considered likely to be brought to fruition.

Broadway Musical

The remaining US$3 million in value related to the potential to produce a Broadway musical. Similar to the film, twelve jukebox musicals were analyzed to determine a “reasonable” value of producing a musical about Michael Jackson. Yet again, it’s unclear whether this was a reasonably foreseen event.

Throughout the analysis, the IRS valuator regularly comments on looking to what events actually occurred following Michael Jackson’s death, in order to test the reasonableness of the projected sources of revenue. Although this can be permissible, it is a slippery slope and can lead to bias in the valuation.

Takeaways

Similar to this case, the Courts in Canada hold a general position that the use of hindsight knowledge in a valuation is not permissible. If you’re involved in litigation and trying to navigate business valuations and the use of hindsight knowledge, give the experts at Davis Martindale a call.