need answers for questions 13, 17, 19, 20, and 23?

PART 5 Business Valuations Chapter Business Valuations A valuation analyst should be able to explain and defend his or her valuation, including both the valuation analysis and conclusion. Further, this explanation and defense may often beperformed within a contrarian's environment. -G. S. Gaffenl OBJECTIVES After complering Chapter 17, you should be able to: 1. 2. 3. 4. 5. Understand the importance of business valuation in business and law. Determine the many reasons for business valuations. Appreciate why business valuations can be contentious. Understand the basic principles and techniques employed by business valuation specialists. Comprehend the complexity and rigor involved in proper business valuations. II-I.. FORENSIC AND INVESTIGA.TIVE ACCOUNTING OVERVIEW Forensic practitioners are asked to perform a variety of economic and accounting measurements for many important purposes that relate to legal rights. One of the most complex and pervasive measurements made is the business valuation. Business valuations require professionals who are knowledgeable and skilled in finance. law, and accounting. Valuations are so complex, in fact, that the majority of professionals who perform them are specialists. Nevertheless, a forensic accountant who is not a business valuation special, ist may be asked to review specific issues involved in a valuation. Thus, all forensic accountants need to 1117,001 understand the basic principles involved. Business valuation is an increasingly specialized field with a variety of guidelines, case law, and techniques affecting valuations for different purposes and continually advancing the state of the art. However, business valuation is also an "easy entry" profession with wide variances in the backgrowld, training, and experience of practitioners. 'TIle quality of a business valuation and its findings is directly related to the skill, training, and experience of the professional. Entire college courses are devoted to the issues of business valuations and even those courses do not fully cover the complexities of the topic. 111is chapter provides an overview of the most significant business valuation concepts and reviews common methods of valuing businesses. Much of this chapter is derived from [he CCH service entitled Business Valuation Guide, 2015, by George Hawkins and Michael Paschall. Specifically, the Fundamentals, The Three Valuation Approaches, Gathering Initial Information, Financial Analysis, Business Valuation Standards, and Business Valuation Reports sections appear in pan in the CCH Business Valuation Guide. The author of this chapter is indebted to Hawkins and Paschall for its usc. 111ischapter concentrates on business valuations of specific closely held businesses that are performed for specifically stated needs at a single point in rime. Most publicly traded companies have market-determined values at any given date in time. 1117,011 BUSINESS 17-3 VALUATIONS Fundamentals VALUATION AND APPRAISER ACCREDITATIONS2 Organizations Certifying Valuation Professionals Rapidly growing demand for qualified business valuators has led to the development of four national cerrificarions. Each certification was developed by one of four national accrediting organizations. which provide their own education and resting programs. Business appraisers have traditionally come from either a finance background or an accounting background. Some organizations cater marc to individuals with one or the other background. The designations by organization are as follows: Accredired senior appraiser (ASA) and accredited member (AM) awarded by rhe American Society of Appraisers (ASA) Cerrified business appraiser (CBA) awarded by The lnstiture of Business Appraisers (IBA) Certified valuation analyst (CVA) awarded by the National Association of Cerrified Valuation Analysts (NACVA) Accredited in business valuation (ABV) awarded by the American Institute of Certified Public Accountants (AlCPA) All four organizations provide excellent training for prospective business appraisers, and their certifications strive ro enhance valuation professionalism. Some of these organizations offer additional accreditations with less stringent requirements for those professionals wanting to limit their business valuation engagements to pursue litigation support engagements that relate ro business valuation. Each group offers an alTay of introductory and advanced valuation courses, along with continuing education programs, seminars, and conferences. All of the groups also work closely together in various ways to develop valuation standards and terminology. Financial Analyst Accreditation A fifth accreditation and organization is the chartered financial analyst (CFA) awarded by the Association for Investment Management and Research (AlMR), parent organization of the Institute of Chartered Financial Analysts. Although nor specifically a business valuation certification, the CFA covers valuation in depth) both of public and private companies, along with a broad-based, inclusive study of other investment subjects. Some believe the CFA is among the most prestigious of all certifications in the field of corporate fi nance and on Wall Street. ENGAGEMENT AGREEMENTS THAT CREATE SUCCESSFUL CLIENT RELATIONSHIPS3 An engagement agreement is needed in any valuation or client-related undertaking. An engagement agreement: Clearly sets forth the expectations of the business valuator and client Reduces the chance for misunderstanding and, therefore. the risk of malpractice litigation and claims against the business valuator Increases the likelihood of the valuator being paid, since it establishes a clear obligation on behalf of the client A standardized engagement agreemenr should be drafted and reviewed by an attorney to meet me needs of the valuation practice. Although attorneys draft many types of contracts, they may not be familiar with issues that are unique to business valuation. The following items should be considered in drafring an engagemenr agreement: Identify the diem Specify the interest, dare, purpose, and intended use of the valuation Define the standard of value 1117,011 17-4 FORENSIC AND INVESTIGATIVE ACCOUNTING Assign responsibility for fees and costS Price the engagement Specify responsibility for real estate and other appraisal costs Obtain a retainer Protect against the use and misuse of forecasts by clients Include indemnification language Include other terms and conditions ~ 17,021 PURPOSES FOR OBTAINING BUSINESS VALUATIONS Valuations are needed for various purposes: Tax purposes (estate tax, gift tax, charitable contributions, casualty loss, sale of securities, state tax, ad valorem tax) Divorce distributions (often referred to as marital distributions) Liquidations (partnerships, sole proprietorships, and corporations) Employee stock ownership plans (ESOPs) Lost profit analyses Mergers, reorganizations, and acquisitions Minority shareholder distributions Buy-sell agreements Bankruptcies Recapitalizations Management buyouts Allocations of purchase price (financial reporting and tax) Incentive/Restricted stock options Insurance disputes Fairness opinions Damages disputes In business valuations, a practitioner is asked to provide a valuation for a business or some other economic unit. TIle vast majority of all businesses in the United States are privately held companies in which ownership (stock, partnership, LLC, LLP, or proprietorship interests) is held by a small number of people. Ownership rights are not typically traded on any market such as the New York Stock Exchange or the American Stock Exchange. Conflicts Giving Rise to Business Valuations Many situations involving business valuations of partnerships are resolved quite amicably with departing and remaining partners agreeing on the amount that is paid for the departing partner's interest. Sometimes, the partnership's value or methodology for determining the value is spelled out in advance in the partnership agreement. Many times, however, there are difFerences of opinion about the amount that should be paid for the business interest that is being sold. Such disputes are often litigated in a legal forum in "forensic" fashion. Additionally, many business sales or dissolutions are fraught with conflict from the start. Family business dissolutions that result from divorce are often contentious. Typically, divorces involve significant conAicr already, and when the issue of valuing large commonly owned assets such as a business is involved, there are major disagreements. Even in the best of situations, however, generally the seller of the business interest wants the mosr he or she can get, and the buyer wants to pay as little as possible for the business ownership interest. To resolve such differences, business valuators are asked to provide an impartial valuation that is developed in a professional and systematic manner. Often business valuations are attacked or defended in court. 'TIle business appraiser who performs the appraisal is one expert, but the opposing side may introduce other experts to give testimony on the flaws in the report. Some expens may be brought in to look at parts of the appraisal; some may be asked to look at the entire appraisal. Thus, in some situations, expert appraisal witnesses may need extensive and broad understanding of the process and issues; in other disputes, the expert may need specialized knowledge on a narrow portion of the appraisal or specific issues regarding it. ~17,021 17-5 BUSINESS VALUATIONS General Types of Valuations Tn general, there are three types of valuations: Asset-based. 111is type of valuation is used to value asset-intensive businesses such as retail and manufacturing. The focus is on what the equipment and real estate are worth. income approach. This type of valuation is useful for service companies. The focus is on how much money a buyer can make from the business. Market approach. This type of valuation looks at what the market is paying for similar businesses and is used to value many different types of businesses. The focus is on the marketplace: what others have paid for similar companies. Although most business valuations are performed for closely held companies, publicly traded companies with estabUshed market value may have issues that require additional analysis. For example, the market price at a particular date may have been determined using financial information that was distorted or fraudulent. Additionally, investors look for firms that they believe are undervalued by the market for investment opportunities, and some business appraisals may be done in investment research situations. 17,031 STANDARDS OF VALUE4 The standard of value used in a business valuation is critical because it establishes the guidelines under which the valuation will be performed. The use of different standards may produce vastly different values for the same company; therefore, the valuator must know the standards under which he or she should proceed. In many valuation situations, statutory or case law dictates the standard of value. The following six standards of value and their common uses are explained in more detail next. Fair market value (commonly used for gift and estate tax, purchase or sale, buy-sell agreements, and divorce valuations) Fair value-l 00 percent controlling interest value (commonly used in dissenting minority shareholder valuations) Fair value-minority interest and marketable value (commonly used in dissenting minority shareholder valuations) Fair value-minority interest but nonmarketable value (commonly used in dissenting minority shareholder valuations) Investment value (sometimes used in the purchase of businesses in examining the value to a specific buyer) Intrinsic value (commonly used in equitable distribution valuations) Fair Market Value The IRS defines fair market value as the amount at which property would change hands between a willing seller and a willing buyer when neither is acting under compulsion and when both have knowledge of the relevant facts. Fair market value is usually the governing standard for gift and estate tax valuations, asset purchase or sale, di,vorce, and many other situations calling for a valuation. Fair Value Fair value is used most commonly in conjunction with dissenting minority shareholder situations. Fair value is generally a judicially determined concept of value that can vary widely in interpretation in each state. "Fair value" can be interpreted in at least three different ways: Minority shareholder'spro-rata share of the 1DO-percentcontrolling interest value. This view of fair value is perceived as favoring the minority shareholder because it affords the maximum protection to the dissenting minority shareholder and does the most damage to the remaining shareholders in the business, as well as to the business itself. Fair market value of the minority shareholder's specific shares)discounted for minority interest status only, without discounts for lack of marketability. This approach is a compromise view that tries to give some value to the shares of the dissenting minority shareholder without unfairly penalizing the business and its remaining shareholders. 1117,031 17-6 FORENSIC AND INVESTIGATIVE ACCOUNTING Fair market value of the minority shareholder's specific shares, ordinarily discounted for minority interest status and lack of marketability. This view of fair value is perceived as favoring the company at the expense of the minority shareholder, because it does not give the minority shareholder anything more (han he or she already has. Investment Value Investment value is the value to a specific buyer of a business. investment value incorporates all of the synergies and other factors that arise from a particular purchase of a business. The value may be that a business is far more attractive to a particular buyer due to various advantages that the purchase of that business brings to the buyer. Examples include a beverage distributor trying to purchase a fellow distribu~ tor [Q fill in its geographic territory or a manufacturer/wholesaler trying to purchase a retailer in order to form a completely integrated company. In order to accurately estimate investment value, a valuator must analyze and predict what the particular benefits of ownership will be to the potential purchaser. In many situations, investment value may be above fair market value. In these instances, "backward-looking" valuation techniques, such as capitalization of income method, may be of little use in arriving at an accurate value. "Forward-looking" valuation techniques, such as a discounted future income method, are likely to be more suitable. The advantage to a forward-looking valuation model is its ability to capture the anticipated competitive advantages and synergies expected by a potential buyer. Intrinsic Value Intrinsic value is the value to a specific individual. Intrinsic value commonly arises in the divorce context where the sale of a business may not be possible, however, the court still finds that the business has value to its owner or owners. Ahhough this may be an appealing concept, in reality, the ability to support a logical conclusion of value under the intrinsic value standard can be quite difficult. Size of Ownership Interest Impacts Final Value The percentage of ownership interest being valued is of crucial importance to an interest's ultimate value. The key issue is control: How much power and influence does the ownership interest have by virtue of its size and its relation- ship to the overall distribution of ownership? Can the ownership interest force the sale or liquidation of all or a parr of the company's assets? Can the ownership interest declare and pay dividends? If so, the ownership interest is able to potentially receive some value (i.e., immediate cash) from the interest. If the ownership interest does not have such power, the owner has fewer and more difficult avenues to realize immediate value for the interest. Shareholder value can be segregated along three levels of value, ranging from 100-percent control to minority interest status. The middle level is called "minority marketable" because the price-earnings multiples or capitalization rates applied to the private company's earnings are derived from the returns on public company stocks. The public company stocks are fully marketable and represent small minority interests (e.g., one share ofIBM). Business Enterprise or 100-Percent Controlling Interest Value The owner of a IOO-percent controlling interest has unilateral control of all the decisions that affect the company. This includes the sale and liquidation of the company and the declaration and payment of dividends. The 1DO-percent controlling interest value often includes a premium for control. Some data suggests that the premium may be about 30 percent to 40 percent above the value afforded to freely traded minority interests. One excellent source of control premium data is MERGERSTATll Review. Control premium data is developed by comparing the market price per share before any takeover offer has been made (a minority value) to the price later paid in the takeover (a lOO-percent controlling interest value). The increase in price represents the premium for control. ~17,03l BUSINESS VALUATIONS 17-7 In 1988, R]. Reynolds was trading at about $55 per share before any takeover rumors surfaced. The company was ultimately sold for about $110 per share, representing an Industry-specific control premium of 100 percent. Note: Discounts and premiums are discussed tater. A minority discount is the opposite of a control premium Control, But less Than 100-Percent Interest In some situations an ownership interest ofless than 100 percent may still be able to exercise a significant amount of control over a business, therefore warranting a conrrol premium adjustment to the minority, marketable value. 51-Percent Ownership Interest For example, a 51-percent ownership block in a company where the corporate bylaws and relevant state law call only for a majority vote for all corporate action has the same force and impact as a 100-percent owner. Because of the power and influence held by the 5] -percent owner under this scenario, a premium for control may be appropriate. However, clearly a 51-percent interest is not as valuable as the 1DO-percent interest on a pro-rata basis. Whereas the 1DO-percent owner has unfettered control over the company and can do as he or she wishes, a 51-percent owner still must deal with the rights and concerns of minority shareholders. This factor may limit rhe 51-percent owner from specific actions that a I DO-percent owner could do. 50-Percent to 100-Percent Ownership Interest There are situations where ownership of interests between 50 percent and 100 percent does not carryall the benefits of full, I DO-percent control of the business. For example, a greater-than-50-percent interest may not give an owner full control of the business if bylaw provisions or state laws require a greater-thanmajority vote for various corporate actions. Although a 51-percent-and-above interest is often called a "controlling interest," this may nor actually be the case if, for example, the corporate bylaws call for a twothirds majority to effect various corporate actions. In this instance, the 51-percent block may be effectively powerless if at least 34 percent of the other shares oppose the action desired by the 51-percent holder. Minority Interest: Technically less Than 50 Percent The value of a minority holder's interesr might be worrh less (and perhaps substantially less) than a prorata share of the total 1DO-percent value. The main factor influencing the value of a minority interest is the amount of control that the minority interest can exert over the corporation. Those minority interests that are limited in their power to influence corporate action are worth less than the pro-rata share of the total 1DO-percent value because rhey generally cannot force the corporation to allow the minority interest holder to realize any value from his or her interest (primarily through the payment of dividends or salaries; the implementation of business strategy and plans; or the merger, sale, or liquidation of the company). The influence of a minority interest may be limited by a combination of statute, case law, and the governing corporate documents. A minority interest does not necessarily have to be as small as one percent or less to lack the ability to influence corporate action. If the corporate bylaws caU for a supermajority voting approval of 80 percent for various corporate actions, a 79-percent interest is essentially a minority interest, because its holder cannot by himself or herself affect corporate action. "Swing Vote" Interests Conversely, there may be times when a miniscule minority interest is worth more rhan a pro-rata share of the total I DO-percent value. A small minority share may be the "swing vote" in a business. ~17,031 17-8 FORENSIC AND INVESTIGATIVE ACCOUNTING Example 17.1There are two 49-percent ownership interests and one 2-percent ownership interest. Assuming that the relative statutes and corporate bytaws call for a simple majority for approval of various corporate action, the 2-percent interest becomes much more valuable because without its vote, the 49-percent interests are powerless to direct the corporation. The 2-percent interest thus becomes extremely valuable to the 49-percent interest holders who would be witting to pay a premium (i.e., a value greater than its pro-rata share of the total100-percent value) to acquire the 2-percent interest. Analyzing the Distribution of Ownership In determining the proper discount (if any) for a minority interest, one must analyze the distribution of ownership. There may be other situations in which the dynamics of share ownership call for a smaller or larger discount for minority interest than would be considered "normal." ~ U Example 17.2 One shareholder of Public Corporation A owns a 30-percent interest, with all other shareholders owning less-than-1-percent interests. If the other minority shareholders cannot consolidate their stock for a vote, conceivably, this factor justifies a lower minority interest discount for the 30-percent block. Buy-Sell Agreements May Impact Value Another situation influencing the value of a minority interest to become equal to or greater than its prorata share of the total 100-percent value occurs when a buy-sell agreement governs the disposition of a departing or dying shareholder's interest. In this situation, a "formula" calculation of value may be required that yields a value equal to or greater than the pro-rata share of the total 1OO-percent value. Alternatively, the buy-sell agreement may specifically dictate that the departing minority shareholder be paid his or her pro-rata share of the totaliOO-percent value of the company. A Closer look at Discounts and Premiums Applied to Business Valuations The information above provides a number of reasons why premiums might be added to a valuarion, or discounts might be deducted from a valuation in response to some characteristic of the business level of ownership (e.g., controlling interest or a minority interest). However, there are many other business characteristics or personnel characteristics that may have an impact on the application of premiums or discounts in arriving at a business valuation. Some of those issues include the general lack of marketability for non-trading stocks, loss of key or critical personnel, the company's lack of diversification, restrictive agreements of the company, exposure from pending litigation, potential environmental liability, the cost of liquidation, and the risk associated with being a small company, or a non-crucial supplier. The preceding list is only a parriallist of issues that may cause a business valuation expert to adjust a value upward or downward to compensate for some characteristic that has not already been included in the calculations. Of course, the adjustments rest heavily on the valuation expert's knowledge of the facts and an understanding of the relevant issues in assigning appropriate premiums or discounts under the circumstances. It has been suggested that "discounts and premiums" are the result or "fallout" of using data in the valuation analyses that are "less-than-perfecr."5 Although the concept of premiums and discounts are intuitively logical in many valuation situations, one must be cognizant that some valuation factors can be addressed in more than one way. For example, some valuation professionals adjust for known or expected business risks by applying a discount to their base valuation, while other valuation professionals may factor known or expected risks into the discount rate used in the business valuation. One challenge facing a valuation professional is to not incorporate risk measure into both components of the valuation process, thereby double counting the risk impact. TheAICPA, in VS Section 100, suggests rhat any adjustments (discounts or premiums) should be made to the pre-adjustment value. According to the guide, examples of valuation adjustments for businesses, business ownership interest, or security include a discount for lack of marketability or liquidity and a discount for lack of control. A valuation adjustment for an intangible asset is obsolete." Given the large number of possible reasons for applying premiums and/or discounts to the base valuation of an organization, valuation professionals must carefully weigh the issues giving rise to the valuation adjustments, and they must fully understand the purpose of each valuation that is performed. ~17,031 ~ 17,041 17-9 BUSINESS VALUATIONS Flow-Through Business Valuations Flow-through or pass-through business structures can raise a variety of interesting and challenging valuation issues. It is sometimes argued that flow-through businesses, such as Subchapter "S" corporations, have a greater value than an identical corporation that is organized as a traditional "C" corporation. The primary reason for this is that C corporation earnings are taxed at applicable corporate tax rates, and then when a C corporation's after tax earnings are distributed to its stockholders as dividends, stockholders pay taxes on the dividends (distributed earnings). Some would argue that the C corporation earnings are taxed twice and the S corporation earnings are taxed only once. Using this logic, it can be argued that two corporations that are identical, except that one is a C corporation and the other is an S corporation, would cause the S corporation to be valued higher than the C corporation. The IRS and Tax Court suggest that the valuation of flow-through entities should include a premium over traditional C corporation entities. As per Tax Court decisions and the IRS,? no deduction should be made for the income tax of a passthrough entity because the taxes are passed through to the owners. Thus, using the no tax deduction approach, there can be a significant premium for flow-through entities (e.g., S corporations and LLCs). In addition, there is no definitive opinion as to whether a flow-through entity should be valued before or after taxes." A simple example to demonstrate the difference between a valuation of a C corporation and a passthrough entity follows: C Corporation Before tax income Corporate income tax After tax income Capitalization rate Value Premium Pess-thrcugh Entity $10,000 3000 $7,000 -;-15% $46.667 $10,000 ~ $10,000 715% $66,667 43% Other valuation professionals would argue that the flow-through premium should be lower than suggested by the IRS or perhaps not exist at alL Therefore, to correctly value flow-through entities, valuation professionals must address the challenge and decide what (if any) adjustment should be made for S versus C corporation entities that are otherwise identical business organizations. PURPOSE OF THE VALUATION THE VALUATION METHODS AFFECTS USED9 The purpose of the valuation impacts the standards of value employed and the valuation methods used. There are numerous reasons for private company valuations, including, but not limited to, gift and estate tax planning, dissenting minority shareholder actions, equitable distribution (divorce), employee stock ownership plans (ESOPs), asset purchases and sales, buy-sell agreements, bankruptcies, and business damages. Applicable standards, statutes, regulations, and specific case law govern several of these areas. It is crucial for the valuation expert to understand the relevant governing authority and make sure the business valuation complies with the required guidelines. Business valuators are supposed to be totally unbiased about the outcome of their valuation. Under this premise, the business valuator is supposed to seleer those methods he or she feels are most applicable and reasonable in a particular case. However, in some instances, there may be a controlling standard or case law that dictates a particular method or methods to use that may result in an estimate of value that is different from that obtained under "normal" circumstances. Fol1owing are some examples of how purposes affecr the choice of methods. Gift and Estate Tax Planning Certain IRS revenue rulings and relevant case law may contain standards that dictate the appropriate method of valuation. 1117,041 17-10 FORENSIC AND INVESTIGATIVE ACCOUNTING Revenue Ruling 59-6010 The controlling authority on gift and estate tax valuations is Revenue Ruling 59-60 and subsequent rulings. Promulgated in 1959, this revenue ruling lists eight broad factors requiring careful analysis for the valuation of closely held stocks for gift and estate tax purposes. The eight factors are as follows: 1. 2. 3. 4. 5. 6. 7. 8. The nature of the business and the history of the enterprise from its inception The economic outlook in general and for the specific industry in particular The book value of the stock and the financial condition of the business The earnings capacity of the company The dividend-paying capacity of the company Whether or not the enterprise has goodwill or other intangible value Sales of the stock and the size of the block of stock to be valued The market price of stocks of corporations engaged in the same or similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter Dissenting Minority SharehoLder Actions Owners of closely held businesses may not get along. Unlike a public corporation where disgruntled shareholders can sell rheir stock and move on, a minority shareholder in a closely held company often does not have such an option and is forced to hold his or her shares despite a conflict with other owners. Often, the only redress a minority shareholder has is to file a dissenting minority shareholder action. Generally, this type of action is governed by the laws of the state in which the company is incorporated. Although the laws vary from state to state, one recurring provision allows for dissenting minority shareholders to be paid the "fair value" of their srock upon selling their shares. Unfortunately, in many states, "fair value" is not a defined, objective term and, therefore, is subject to interpretation. Ultimately, the decision on "fair value" may rest with a business valuation or through the determination of value by state courts and applicable state law. EquitabLe Distribution (Divorce): Impact of State Statutes and Case Law Another area of business valuation in which the valuator must be aware of controlling law is in equitable distribution or divorce valuations. All states have statutory requirements applying to this area, and a valuation expert must know the ground rules before starting a valuation. Relevant Valuation Date-A Key Issue State laws vary as to how long couples must wait before they can be divorced. Some states allow an immediate divorce; others require a period of separation before the actual divorce is granted. Some states requiring a separation period before the divorce require the valuation to be the fair market value as of the date of separation. Marital Versus Separate Property and Related Appreciation Issues A business valuator must understand state guidelines as to the differences between marital and separate property. Suppose a man owns a business worth $1 million on his wedding day. Twenty-five years later, when the couple divorces, the company is worth $4 million. Many states will consider the $1 million to be separate property that was brought to the marriage. However, the $3 million in appreciation that occurred during the marriage may be considered marital property and, thus, subject to equitable distribution. Under this hypothetical situation, $1 million of the business value remains the sole property of the husband, but the $3 million of appreciated business value can be divided between the husband and wife. However, in some states, the original $1 million can also become "tainted" and turn into community property. ~17,041 BUSINESS VALUATIONS 17-11 Divorce Situation Valuations. Divorce is a highly emotional event for those involved. Since the emotions are typically negative---anxiety, anger, mistrust-it is common for one spouse to suspect the other is hiding or undervaluing significant assets in an attempt to keep them out of the divorce settlement. This suspicion often arises when a family-owned business is at stake. So determining whether one spouse has hidden assets requires that a valuation professional investigate the business's financial records and documents. The valuator then can understand the location of assets, track any significant changes in spending habits of either spouse prior to the date of separation, and look for patterns or breaks in patterns that may point to suspicious activities. Discovering hidden assets can be a painful process because the spouse involved in the business may have taken steps to cover his or her tracks in anticipation of the increased level of scrutiny. Careful investigation of the business and the industry (as well as consideration of other factors, such as the individuals involved) can often reveal the trends that witt show an investigator how and where assets have been moved." The valuation issue does nor end there, however, because there may be an issue as to whether the $2 million appreciation noted above is "active" or "passive." In some states, if the appreciation is considered to be "passive," the $1 million remains the separate property of the husband. If the appreciation is considered to be "active," the $1 million is marital property and, thus, subject to division. In general, "passive" appreciation is appreciation that happens regardless of the actions of the owners (e.g., stocks or bonds). In contrast, "active" appreciation is appreciation that is the result of the action and hard work underraken by the owners (e.g., a business). Under the passive appreciation argument, the husband's attorney will argue that, at an average historical annual inflation rate of five percent, the husband's original $1 million business value grew to $2.65 million. Given the total business value of$3 million on the date of separation, only $350,000 ($3 million less $2.65 million) of the $2 million appreciation is "active" and, thus, subject to division. The remaining $2.65 million is the separate property of the husband. The wife's attorney will argue that this inflation argument makes no sense, and the entire $2 million appreciation in the value of the business is active and, thus, subject to division. Her attorney will argue that, unlike a piece of raw land that appreciates passively over rime, a closely held business is an entity that requires constant care and attention. No owner can leave a business alone for 20 years and expect to come back to a value that has increased at the rate of inflation-the business will have been long dead. Increases in company values result from factors such as the development and production of a product superior to those of competitors (Microsoft), filling a niche in rhe market that previously had been unsatisfied (Home Depot), consolidating similar operations and achieving economies of scale (Bank of America), or providing a consistently excellent and popular product year after year (Coca-Cola). Inflation has little, if anything, to do with the rise or fall of corporate value. In fact, some studies indicate that inflation actually has a negative correlation to rhe value of a business. Indeed, much of the tremendous bull market of the '80s and '90s was arguably the result of a low-inflation environment. Lack of Case Guidance as Typical Issue A5 just evidenced, resolution of the separate/marital and acrive/passive issues is important to a valuator reaching a correct estimate of value in an equitable distribution dispute. Unfortunately, in many states these issues havenot been heavily litigared, and there is a paucity of case law for guidance. Alternatively, many court decisions .are never appealed, making a determination of judicial valuation trends and their application to a specific situation difficult to ascertain. A business valuator must work closely with the family law attorney to be sure the valuator understands the relevant standards. Professional Practices Valuations in Equitable Distributions Even if the relevant statute mandates that the measure of value for the valuarion of professional practices is "fair market value," this concept may be interpreted difFerently for equitable distributions than in an estate or dissenting minority shareholder situation. In some states, the value of a professional practice may nor be what a willing buyer would pay a willing seller for the practice. Instead, some stare equitable distribution statures direct that the value of the professional practice be measured by its worth to the owner. 1117,041 17-12 FORENSIC AND INVESTIGATIVE ACCOUNTING A husband with a lucrative law practice might not be allowed to sen the goodwill to a buyer. Under the fair market value standard, the practice may have little value; however, in an equitable distribution context, the practice may have a significant value. Again, a valuator must work closely with qualified legal advisors standard to to determine the proper valuation apply in equitable distribution cases. Personal Versus Practice Goodwill Issues A related issue to consider in the valuation of professional practices is the treatment of "personal" versus "practice" goodwill. Goodwill is that portion of practice value that is beyond the hard assets (including accounts receivable) of the practice. If a medical practice has a total value of $400,000, with $50,000 in fixed assets and $50,000 in accounts receivable, that practice is said to have a goodwill value of $300,000. Goodwill is that intangible asset that keeps existing patients coming back for treatment and attracts new patients to the practice. Goodwill includes, but is not limited to, reputation, name recognition, employees, location, years in the community, and even telephone number. Personalgoodwillis the goodwill that attaches to a particular individual or individuals. Practice goodwill, on the other hand, is the goodwill that attaches to a particular entity. In reality, the MO can be difficult to isolate and quantify. Do patients go to a particular medical practice because it is a long-standing, wellrespected practice in their community? Or do they go to see a particular physician whom they really like? If a physician left practice A and joined practice B, would practice A suffer a drop-off in business because a number of patients followed the departing doctor to practice B? Or would practice A continue to thrive as the patients continued to come to the practice with different physicians? These questions can be difficult to deal with in a valuation context. The reason it is so important to understand and be able to segregate personal versus practice goodwill is that state law may dictate whether one qualifies as a marital asset. In a situation where one or both spouses have a lucrative professional practice, this issue becomes pivotal in valuing the marital estate for an equitable distribution case. Employee Stock Ownership Plans (ESOPs) Employee stock ownership plans (ESOPs) represent another fertile field for business valuation. In genera!, ESOPs are tax-favored devices that encourage employee ownership of businesses. By giving employees an equity stake in the company, the hope is that they will work harder to improve the value of the company. Furrhermore, by allowing employees to annually add to their shares held in the ESOp, it is hoped that employees will have additional resources upon their retirement. ESOPs are encouraged by means of various tax advantages. Some of these advantages include tax deferral for the owner selling more than 30 percent of the company's srock to the ESOP and company deduction of both the interest and principal of the ESOP loan. Valuation issues arise in the ESOP context in several areas. First, if the ESOP is leveraged (i.e., if the company must borrow money to fund the ESOP), the newly created ESOP trust will be the primary source of repayment. However, the company, in effect, is the ultimate source of repayment for the loan. This debt service must be a key part of any discount cash flow forecast done as a part of the company valuation. Anomer key issue to consider in the valuation of the ESOP shares is the mandatory put option required under the Employee Retirement Income Security Act (ERISA). ERISA requires that an ESOP must provide a market for an employee's company shares upon the employee's retirement or termination of employment. This share repurchase liability of the company ensures that employees will have some degree of liquidity to their investment and will not be forced to sell their company shares in what otherwise would be an illiquid market. Indeed, the ERISA-mandated put option is why most business valuations are prepared in the ESOP context. A put option creates another issue to be considered in the valuation because it provides a degree ofliquidiry to the closely held shares that would not exist without the ESOP. Therefore, a smaller discount for lack of markerabiliry of the stock may be appropriate, given that the ESOP does create some market, albeit limited, for the shares. Asset Purchase or Sale The key issue ro consider in a valuation done in the context of a purchase or sale is the value of the subject company to the specific buyer. A specific buyer may place a value on a subject company that is substantially 'il17,041 \\Q BUSINESS VALUATIONS 17-13 different from the normal concept of fair marker value. Reasons for this difference include synergies or competitive advantages gained from the purchase of the subject company that otherwise are not present or available to the normal "willing buyer." Indeed, in the public company realm, company values are often bid to ever-higher levels as buyers seek to supplement their businesses by purchasing complementary operations, as opposed to having ro develop competing operations. This concept is discussed later in this chapter; however, the business valuator needs to be cognizanr of the buyer's perspective in a purchase or sale valuation. Buy-Sell Agreements Buy-sell agreemenrs are common in many closely held companies. A buy-sell agreement can serve several purposes, including ensuring the continuity of management and ownership, providing liquidity to deceased or withdrawing owners, and (in some cases) establishing company values for estate tax purposes. Buy-sell agreements may be drafted in several ways; however, the most common valuation provision calls for either a formula provision to calculate value or the appointment of a third-parry valuator or valuators to determine company value. Formula provisions, although usually easy to calculate, run the risk of severely over- or undervaluing the business. Many buy-sell agreements calling for formula calculations of value have been in place for many years, and the company and its industry may have undergone changes in the interim that render the company unrecognizable from the day the document was drafted. As an example, a formula buy-sell calculation at "accounting book value" for a real estate holding company may grossly understate the value of the business if the land is in an area that has experienced rapid development over the years. In addition to antiquated formulas, some buy-sell agreements may suffer from vague or ambiguous language that renders them all but unusable. A valuation professional hired to help an attorney draft a buy-sell agreement must consider these potentia! risks and pitfalls. The most efficient way to derive an accurate company value for a buy-sell agreement is to provide for a currenr valuation at the time the buysell is activated. However, the owners may want to keep the buy-sell simple and peg the price at an easily calculated figure. Some owners may be happy with the formula after enacted, but this still does not mean it is necessarily a valid indicator of the current "real world" fair market value of the shares. Another problem occurs when the buy-sell agreement value is an artificially low price to minimize the potential exposure of the shareholder's spouse in a divorce. For example, professional practice buy-sell agreements will sometimes establish a value based on accounting book value per share measures, ignoring the inclusion of any goodwill value, even though other valuation techniques clearly demonstrate the existence of goodwill value. The family law attorney will vigorously argue on behalf of the shareholder spouse that book value is all he or she can receive and that goodwill value is irrelevant. This view is not necessarily universally accepted by the courts. Whether a buy-sell value will prevail in a family law setting that is at odds with other valuation methods varies from state to state. Therefore, a valuator should address this issue with the attorney involved. Problems can arise, however, when either the buying or selling party is upset with a formula-derived value that does not accurately reflect the true value of the business. Problems also arise if the buying and selling parties cannot agree on how the buy-sell specifies that the value be calculated. All of these issues make the buy-sell agreement a potentially contentious issue for a business valuator. Bankruptcies Business valuators are often used when private companies become bankrupt. Potential valuation services include the valuation of a business to determine an allocation to creditors or as part of a proposed reorganization plan. In valuing businesses within these scenarios, the valuator must consider the value of the business from the perspective of the credirorfs). For companies that are troubled financially, the valuator may appropriately place more emphasis on the cost approach to valuation as opposed to the income or market approach. Because creditors generally have the option oflooking to collateral as a secondary source of repayment for their loan, they may possess many of the same attributes of control as the majority or 1DO-percent owner of a business. Given this power possessed by the creditors, one may appropriately value the business on a 1DO-percent control basis. Bankruptcy valuations also can view fair market value in a hypothetical vacuum. For example, the court might direct that the valuation ignore a company's crushing debt load and value it as if the company had a normal level of debt. This approach enables a court to decide how to allocate the going concern value to the various classes of creditors. ~17,041 17-14 FORENSiC AND ACCOUNTING INVESTIGATIVE Business Damages Business damages cases generally arise in a litigation context. A typical case involves a plaintiff business owner who alleges that someone or something caused a diminution in his or her private company's value. Generally, the plaintiff asks for business damages measured by the difference between what the company would have been worth with om the damages and what the company is acrually worth. Business damaO'es b disputes call for creative valuation solutions because of the difficulty of estimating the difference between a business's actual value and its hypothetical value. Common methodologies include the extrapolation of company performance from rhe before-damages period throughout the period of damages. This process may be as simple as forecasting lost revenue that resulted from the damages; however, the valuation also may require a forecast of the alleged damages' effect on the operating structure and margins of the company. Alternative valuation methods include the comparative analysis of the damaged company to companies in the same or similar industries. In any case, valuations involving business damages unavoidably involve some subjective degree of analysis and/or forecasting. A business valuator must be able to logically suppOrt his or her conclusions. This support is particularly true for valuators engaged by the plaintiff because they shoulder the burden of proof on business damages. See Chapter 10 for more information about commercial damages. Medical Practice Acquisitions by Tax-exempt Entities One field in valuation that has seen explosive growth over the past decade is medical practice acquisition by hospitals. This acquisition activity is driven by several forces, including the continued consolidation of healthcarc providers in the country, as well as continued private and public pressure to control everincreasing health care costs. In many situations, the acqulri ng hospitals are not-for-profit organizations that must follow strict federal and regulatory guidelines to preserve their tax-exempt status. Failure to follow these guidelines can generate serious tax and legal ramifications for both the selling and acquiring parties. The Three VaLuation Approaches Like the valuation of real estate, business valuation involves three basic approaches: income, market, and cost. ~ 17,051 INCOME APPROACH12 There are numerous methods within the income approach category, including capitalization of income, excess earnings, discounted future income, discounted future cash Row, and others. Capitalization of Income Method All capitalization methods estimate value by converting a company's estimated future income stream into value. This conversion is accomplished through application of an appropriate capitalization rate, which incorporates beth an investor's required rate of return for risk and a factor for future growth in income. The resulting value is ultimately based on the present worth, today, of anticipated benefits the buyer will receive in the future (in the form of income, cash flow, or dividends). An offshoot of the Gordon-Shapiro dividend 11 discount valuation model, the capitalization of an income stream is a single-period valuation approach. Discounted Future Income Method Discounted projected future income methods involve projecting the possible future income streams (e.g., earnings, cash How) on a year-by-year basis, usually for five or seven years. Future income streams are then discounred at an appropriate discount rate (required rate of return on investment for risk) required by a buyer, back (Q a present value. For the final projection year, a terminal value is determined that represents the estimated value for the sale of the company at that time. This terminal value is then discounted back (at the discount rate) ro its present value. The summation of the present value of both the income streams and the terminal value yields a fair market value estimate of the company. When an "invested capital" approach is employed, the income streams are discounted ro present value at a "weighted average cost of capital," a measure incorporating the costs of debt and equity. 111eresulting value represents the value for the total capitalization of the company, including debt and equity. From this value, the total ptesent value of debt is subtracted in order ro obtain the fair market value of equity in the company benefiting common shareholders. The value is the sum of the present values of the annual income streams and the capitalized future sale (or terminal value) of the company. ~17,051 ~ 17,061 \\ BUSINESS VALUATIONS 17-15 If a company's income or cash flow is growing at a constant rate into perpetuity, the previous method does not need to be employed because the formula is then mathematically equivalent to the results achieved by the capitalization approach discussed earlier. However, when a company is experiencing a near-term rate of growth that is above a sustainable long-term trend, or when there are cyclical or unusual near-term factors that are influencing results (and which can be reasonably predicted), this method can more reliably capture the impact of those changes on valuation than a capitalization approach. Discounted Future Cash Flow Method The discounted future cash flow method is nearly identical to the discounted future income method described earlier. The essential difference between the two methods is that the discounred future cash flow method requires the estimation and projection of a company's future cash flows. This process requires the consideration of a company's noncash charges (such as depreciation and amortization), a company's working capital needs, anticipated capital expenditures and related depreciation schedules, the retirement or assumption of debt, and other associated calls on company cash flows. After this process, the methodology and procedure are idenrical to the future earnings method. One important adjustment the valuator must make is to be sure the discount rate employed is applicable to cash flows (as opposed to earnings or some other income measure). Capitalization of Excess Earnings Method The excess earnings (formula) method is really a hybrid of the cost and income approaches because it involves the determination of the portion of the earnings that may be attributed separately to the tangible and intangible assets of a company. This method is available to estimate intangible value. This method involves the followi ng steps: 1. 2. 3. 4. Multiply the net tangible assets of the company by the rate of return such assets might reasonably be required to earn. Deduct this estimate of earnings from the total earnings to derive that portion of the earnings that might be attributed to the intangible assets. Divide the earnings attributed to intangibles by a capitalization rate for intangibles to estimate the total value attributed to the intangibles. Sum the value attributed to intangibles and the market value of the net tangible assets of the firm to estimate an overall fair market value. Michael Paschal! from Banister Financial, Inc., a business valuation firm, states, "The IRSindicates that this method should only be used as a last resort when better methods are not available. In practice, this method has a significant number of logical flaws and inconsistencies in its application. This method has been heavily criticized by the IRSand the business valuation c.ommunity and is rarely, if ever, used any more. In fact, the use of this method is usually a strong indication of an unsophisticated business appraiser who is out of touch with current valuation methodologies." MARKET APPROACH'4 Some of the numerous market approaches include the identification of comparable publicly traded companies whose securities sell on a free and open market, the examination of definitive and verifiable transaction data available on actual sales of similar privately held concerns, the existence of actual or potential markets for a security, such as buy-sell or shareholder agreements, and past transactions in the shares or other interests in the business itself. Guideline (Public Company) Method Under the guideline (public company) method, the valuator seeks to identify publicly traded companies in the same or a similar line of business as the subject private company. 1he assumption is that a private company in the same line of business as public companies is influenced by the same economic, industry, and market conditions. Therefore, one may reasonably assume that a public company's prices and multiples should be a reasonable proxy of a private company's prices. This comparison, however, is not done on a pari passu basis because there likely are numerous differences between the public comparables and the private company that the valuator must take into consideration. Some of these considerations include size differences (assets and revenues) between the public com parables and the private company, differences in 1117,061 17-16 FORENSIC AND INVESTIGATIVE ACCOUNTING accounting methods used, the degree of marketability of the public shares, the size and control features of the private shares being valued, differences in company operations, and many more. Market Data Method Another useful method under the market valuation approach is to analyze recent sales of entire companies that are in the same line of business as the subject private company. As with the public market for trades of very small minority interests (the guideline method just described), market data on what l Ou-percem controlling interests of companies are selling for can also lend insight into the value of the subject private company. As with the guideline method, however, direct application of sale multiples is probably not appropriate to the subject private company due to the considerations mentioned earlier. Detailed analysis is required by the valuator to ensure that differences between the company sale data and the subject private company are properly accounted for in the valuation estimate. Past Transactions Method A third useful method under the market valuation approach is to examine past transactions in the shares of the private company. Share liquidity is a spectrum that ranges from companies whose shares have not, do not, and are not expected to trade at all to companies whose shares trade daily by the hundreds of thousands on national, public exchanges. Some "privately held" companies do experience some trading activity among their shares. Other "public company" shares trade quite infrequently through local market makers or as noted in such publications as the "pink sheets." Some private companies may create their own "market" for the shares by offering to match up willing sellers with willing buyers. Past transactions in the shares of a company can be useful indicators of value if the trades were recent enough, were under a true arm's length relationship, and were not forced, coerced, or dictated by a prearranged formula. In using past trade data, a valuator must be careful to inquire into and analyze the circumstances surrounding each prior trade. Many times in the private company context, trades among shareholders are inuafamily transfers, distress sales by financially strapped shareholders, or forced sales dictated by a formula. Shares trading under these and similar circumstances may not meet the appropriate criteria (such as fair market value) for valuation of the subject private company's shares. ~ 17,071 COST APPROACH'5 The cost approach involves adjusting a company's assets and liabilities up or down to reflect their "fair market value." This method considers tangible and intangible assets and any contingent liabilities. Although tangible assets can be appraised and their actual balance sheet values adjusted to reflect those results accordingly, the major problem with this method is dealing with the valuation of the intangible assets, such as the company's name, reputation, trained workforce, and other factors. The cost approach is a suitable approach for valuation only in the context of a liquidation of a company. The implication of a cost approach that generates a value higher than values generated by the income or market approaches is that the company may be worth more "dead" than "alive." In other words, the economically logical course of acrion to take to maximize value would be to sell the assets of the company, payoff the liabilities, and distribute the proceeds to the shareholders. To continue to operate the business under this scenario is an inefficient and illogical use of economic resources. Book Value: Not Really a Valuation Method In accounting terms, book value is the difference between total assets and total liabilities. Alternatively, book value is known as "net worth" or "equity." Although book value may be of some use when used in conjunction with other valuation measures (such as the "price (Q book value" of public comparables), as a stand-alone measure, book value is generally of little use in valuing a business. The primary reason for its uselessness is that book value is basically an accounting convention that has little or nothing to do with the actual value of a company. Many companies may have had significant land and improvements on their balance sheet for many years. Over time, the land value remains unchanged on the company's balance sheet while the value of the improvements is depreciated to zero. If the land and improvements have appreciated over time and are in fact quite valuable, the book value significantly understates the value of the company. Similar problems arise with potential differences between actual and book values of other assets and liabilities. ~17,071 ~ 17,081 BUSINESS VALUATIONS 17-17 Adjusted Book Value (Adjusted Net Asset Value) If a cost method approach to valuation is appropriate, adjusted book value provides a much more accurate method of valuation. In its most basic sense, the adjusted book value method calls for an item-by-item adjustment of each balance sheet component (both assets and liabilities). In addition, the estimation or reservation for anticipated windfalls or liabilities is an integral part of adjusted book value. Tangible Assets Tangible assets include physical assets and liabilities that can actually be seen or touched (such as inventory and fixed assets) or can be evidenced by documentation that verifies their existence (such as investments, receivables, payables, and bank debt). Adjustment of tangible assets can take several forms. fu previously mentioned, some tangible assets (such as land or fixed assets) can be adjusted from their book value to their appraised value. Other tangible assets, such as accounts receivable, can be valued based on their estimated collecrabiliry Assets such as corporate debt can be valued based on their existing interest rate and repayment schedule, as compared to the similarly risky publicly traded debt instruments on the market. Intangible Assets Intangible assets are those assets of a company that cannot be verified in a physical sense, yet still add value to a business. Examples of intangible assets include: Name Company reputation The existence of a skilled and trained workforce Customer base Patents and trademarks As compared to tangible assets, intangible assets can be far more difficult to value for the business valuator. Challenges arise with the analysis of such issues as: What would the company be worth with a different name? What would the value be without this particular patent? Valuation techniques for intangible assets vary widely. One technique is the capitalization of estimated value derived from the intangible asset. Another is "what-if" analysis, where the company is valued as it exists today, and compared to its estimated value as if a certain intangible asset had never been associated with the business. Gathering lnitial lnforrnatlon" 111erwo most important pans of any valuation assignment are the preparation before the company interview and the focus and depth of the interview itself Every company is unique. Although corporations, partnerships, and limited liability companies (LLCs) are merely legal creations, each business is its own mix of management, people, customers, suppliers, competition, industry, regulations, and numerous other internal and external factors. These elements come together in unique ways to make the company what it has been, what it is today, and what it might become in the future. The valuator's job is to identify how these elements are present in a specific company and to discern what each implies about the risks, opportunities, and future of the business from the viewpoint of a buyer. Unlike the shareholders and management of a company, the business valuator is an outsider looking inside, albeit for a brief amount of time. Therefore, the valuator must quickly identify key risk factors and opportunities and how they impact the company's valuation. Details are important, bur a valuator also must not get lost in the minutiae and miss the big picture. The most substantial risks and opportunities facing most businesses usually come down to a handful of critical issues. TIle ability to identify