2003 Monthly Newsletters
December 2003 - Is There a "Fair Market?"

Revenue Ruling 59-60 is the legal foundation of fair market value, the standard applicable to tax-related and many other appraisals. Section 2, Paragraph 2 makes a vital point: fair market value reflects how hypothetical buyers and sellers negotiate value. The “fair market” is a theoretical legal construct necessitated by the fact that there will be no real transaction (instead, a gift or non-arms-length sale that will be subject to potential taxation). In the “fair market”, imperfections such as coercion, unequal information, special circumstances, a small number of potential buyers, and personal motivations are irrelevant. Moreover, the existence of willing buyers and sellers at fair market value is assumed. The buyer will not buy unless the benefits of the acquisition equal / exceed the purchase price. The seller will not sell unless the sale price is equal to / greater than the benefits foregone. But both are assumed to exist, and by definition they will negotiate a price equal to the benefits of ownership. 

The appraiser’s task is to simulate the fair market, replicating the behavior of the theoretical buyers and sellers. To do this we must find evidence from real markets. We then adjust for the inevitable imperfections.

Comments like “Nobody would buy at that price” or “I wouldn’t sell at that price” beg the question of fair market value. They are unsubstantiated and irrelevant personal feelings, not fair market value appraisals. In the fair market, it is axiomatic that there will be buyers and sellers at fair market value prices that reflect the appropriate benefits, risks, market conditions, case facts and circumstances.  

In a tax-free world and/or a world without disputes, the need for the theoretical fair market evaporates. All transactions would be based on whatever buyers and sellers decided, giving full consideration to case-specific imperfections and non-economic criteria such as personal feelings.  

As a business broker for twenty-three years, I have learned that there is sometimes a real difference between “fair market value” as determined by a good appraiser and the price that a seller will accept and a buyer will pay for a business. I have occasionally been surprised by a business selling that I was sure no one would want at any price. I have also occasionally been surprised by a business that I consider to be excellent and a very good buy that simply did not sell.  

In the “real world,” it is often not possible to meet the required assumptions inherent in the fair market value standard of value. It is very difficult to notify a large number of potential business buyers that a specific business is for sale without hurting the business’s operations by letting customers, employees, and competitors know it is for sale. Typically, only those individuals that are actively looking for a business to purchase in a specific locality will learn about the investment opportunity. Once an owner has decided to sell the business, typically their attitude towards the business undergoes a change. They often let some things slide and are less focused on looking for opportunities to improve the business.  

Other considerations such as selling for cash or accepting terms play a part in the “fair market”. “Fair market value” presumes a cash transaction. However, in my experience as a business broker, most small businesses sell for some cash with the seller carrying the financing. Obtaining financing to allow a cash purchase of many small businesses is very difficult, if not impossible. Small Business Administration (SBA) guaranteed loans are available, but many businesses and some buyers do not meet the stringent requirements for these loans.  

Appraising a business under the fair market value standard of value or some other standard of value is a difficult process. There is no one formula or computer program that can accurately do the job. It requires a well trained, qualified and experienced business appraiser. Each business appraisal we do requires a great deal of thought along with the typical crunching of numbers. Business appraisals are a combination of art and science.  

Valuations and other consulting services play a part in all tax, transaction, and litigation matters. For additional information or advice on a current one, please do not hesitate to call. We Value Your Business!  
November 2003 - Commodity vs. Professional Services

Our nation has become a nation of shoppers looking for the best deal possible. We are bombarded by marketing pitches of all kinds and types attempting to persuade us that the current offer is the very best deal. Shopping for a new car is a great example. Within a number of miles are often located a bunch of auto dealers selling the very same automobile; all offer a variety of attractive terms and interest rates to try to get the most business possible. If I can buy the exact same item anywhere, I will find the place that offers it at the best deal for me, be it Costco, Wal-Mart, or the general store on the corner. Shopping around is the appropriate strategy when purchasing a commodity—an item that is exactly the same no matter where purchased.  

Some items don’t fit too well in the category of a commodity. Among these items are such things as professional services. For example, if price is all that matters when getting your income tax returns prepared, you are likely to get an inferior product (and thus pay more taxes than necessary or take on additional risks) as a result of finding the cheapest instead of the best. Income tax return preparation comes in various forms of quality from Self Prepared (often using some computer program), a budget service such as H & R Block, a bookkeeping service, a staff accountant or other employee in a CPA firm, or a tax partner in a CPA firm or tax attorney. If you want and need high quality, you are likely to pay more. Hopefully, by paying a little more for the tax return preparation, you will save big bucks in taxes or at least minimize your risk of failing an audit.  

Another example would be hiring an attorney for estate planning for a large, somewhat complex estate. All licensed attorneys have been to law school and passed the bar exam. However, not all attorneys specialize in estate planning – a complex arena. You could probably get a wide variety of price quotes from licensed attorneys to handle the estate planning, however, the price from those who specialize in the field and know how to save clients big bucks would likely be on the high end. In the long run, obviously, hiring the knowledgeable attorney would save you money.  

A third and final example. If you have heart problems, would you call all the doctors in the area and look for the lowest price? Or, do you check around to find the very best cardiologist in the area? Doctors provide professional services, they have all been to medical school and they all must be licensed. However, as we all know, doctors typically specialize. In a pinch any of them could and would provide emergency services, however, for a special need you need to find a qualified specialist.  

Business appraisal and business consulting fall under the category of professional services, not a commodity. While business appraisals do not equate to the importance of your health, they usually are dealing with a whole lot of money!  

The first thing to do in selecting a professional for needed professional services is to determine that he or she has the qualifications and training needed to do the job right. Next, it is important to find out if you and the professional can work well together. Third, is the price within the range of others you are comfortable working with that are also equally qualified. Price is important, however, it should be explored only after the first two qualifications have been met.  

Valuations and other consulting services play a part in all tax, transaction, and litigation matters. For additional information or advice on a current one, please do not hesitate to call. We Value Your Business.
October 2003 - Family Business Values

The timing and magnitude of estate tax relief has become a political football, vastly complicating financial, business and succession planning. Many more family businesses and investment assets will escape estate taxation as, over time, exemption amounts rise and tax rates decline. In 2010, the unified credit will become unlimited (because tax rates will fall to zero). The next year, the system will revert to pre-reform levels and rates. That’s the way things stand now. This regime will be changed, but nobody knows when and how.  

This situation has caused many families to postpone dealing with these vital planning issues on the basis that for the next few years their estate tax exposures will decline. This is understandable, but the underlying need to plan will not go away! More importantly, estate tax relief empowers families to make major decisions about business and investment asset values, as well as their allocation among heirs, based on criteria they - not the IRS, the courts, the law, or the markets - define. This raises a host of new valuation issues because, in estate tax-exempt situations, many traditional assumptions, based on tax law and market foundations, do not automatically apply.  

In a tax-exempt estate, for example:  

There will be no IRS audit exposure (except to demonstrate that estates are tax-free); indeed, no other adverse scrutiny, except from heirs.  

The fair market value standard (value to any willing buyer and seller), will no longer necessarily apply. The family will decide what standard of value is fair, and each family may define fairness differently.  

Discounts for lack of control and lack of marketability, a key estate-tax reduction benefit, will not necessarily be relevant.  

The entire concept of what is “fair”, “reasonable” and “equitable” will be a family decision.  

Families in otherwise identical circumstances will have the power to resolve these issues based on whatever criteria they deem most important. The criteria themselves will be variable, and may include non-economic as well as economic considerations.  

This will vastly increase the potential for family disputes over valuation issues. The courts may be unable or unwilling to resolve them.  

This will create new challenges for professionals who help families plan their estates.  

It will make informed, open and full communication among family members as well as their advisors even more important.  

A Case Study  

This hypothetical situation illustrates the preceding points and reveals some of the ticking time bombs inherent in tax-exempt estate appraisals.  
A client owns a $3 million estate (assume it is below the tax threshold) consisting of $2 million of marketable securities in a family limited partnership (FLP) and a profitable, going concern business with an appraised fair market value of $1 million. The business is in a consolidating industry; it is reasonable to expect that it could be sold to a strategic (not a fair market financial) buyer for $1.5 million. The business, although viable, has volatile earnings and is somewhat leveraged. There are two heirs: a daughter who competently manages the business and is paid fair market compensation, and a son who has no desire to enter the business, is in another profession which pays him less than the daughter earns, but who has more secure earnings prospects. The daughter has a strong marriage and two children who will soon be entering college. She enjoys her career and has no desire or need to sell the business (as the buyer would not require her services; she would be out of a job she loves and for which she is well-paid). The son is a confirmed bachelor with no children.  

Among the valuation and allocation issues raised in this scenario are:  

1. Should the business be valued at fair market ($1 million) or strategic value ($1.5 million)?  

2. Since the daughter is at risk for the business in terms of her income as well as the equity (were she to receive all of it), should the son be entitled to any participation in a sale?  

3. How should the grandchildren be treated? Should the daughter receive more assets because she has higher living expenses, including college tuitions?  

4. If the daughter inherits the business, she will have to personally guarantee the bank loans. Should she receive additional assets or compensation in exchange for assuming this risk?  

5. How should the FLP interests be allocated? Who should be the general partner (after the parents are no longer around)? What about valuation discounts for limited interests?  

6. What about the disparity between the son’s and the daughter’s earning prospects? Should there be compensation to equalize them?  

7. Should the son be at risk (of both gain and loss) for the value of the business of which he is not a part?  

These are but a few of the issues raised in this relatively simple case. There are many possible answers to each issue. The key point is that the family must make these decisions based on their own criteria. Their advisors can provide information, but cannot independently determine what is “fair, reasonable and equitable”.  

A traditional fair market value appraisal of the business, although informative, may not be relevant if the family decides that strategic value should apply. And the relevance of discounts for lack of control and lack of marketability for the FLP interests is another open issue. This is in stark contrast to taxable estates, in which fair market value and the indicated discounts are routine.  

There are no easy answers! This places a higher burden of responsibility on the family as well as its advisors, including the business appraiser, to identify, think through and help resolve these controversial issues. Keen analytical skills, diplomacy, sensitivity, an open mind, and a pro-active disposition are some of the skills that successful advisors will need when advising tax-exempt estates. 

Valuations and other consulting services play a part in all tax, transaction, and litigation matters. For additional information or advice on a current one, please do not hesitate to call. We Value Your Business!  
September 2003 - Economic Outlook

Revenue Ruling 59-60 issued by the IRS outlines, among other things, eight Key Factors that need to be considered in business valuations. Among the Key Factors that need to be included in a comprehensive business appraisal report is the Economic Outlook.  

Many inexperienced appraisers either omit the Economic Outlook section from their reports or they include a “canned” version that is not case specific, that is, not tailored to the facts and circumstances of the company or company interest being appraised. Often this section, when included in reports, is included only because of the requirement but nothing in the other analyses of the company ties back in anyway to the economic analysis and outlook.  

Appraisers should identify the specific economic forces that most significantly affect the subject and explain why they do. The economic factors should be considered at the following levels: international, national, regional, state and local, however, the nature of the specific business will dictate the impact of these different levels. If you are appraising a local fast food restaurant, the international and many of the national economic factors may not be all that important. Instead, local and state factors should be the primary focus. However, if the company being appraised has units or departments in many states and does business overseas, the international and national economic outlook will be much more important.  

Business appraisers should review the historical financial statements for the business in question and determine what economic factors affect both revenue and expenses. For example, a small local manufacturer would be much more concerned about local unemployment, the availability of skilled labor, local wage rate trends, etc. and would be much less concerned about national trends. However, a larger manufacturer with plants in several states would be concerned with the larger picture.  

It is important to consider the economic trends, cycles and deviations from trends and how they affect the industry (or industries) in which the subject company operates. Will historical trends continue? Is the economy in a normal cycle? For example, during the 1990s the country experienced a long period of continual economic growth. In late 2000 or 2001, the boom came to an end and many individuals went into a panic fearing a severe recession. The country certainly experienced a recession but it now appears that a period of continual growth is recurring. This is part of the overall economic cycle – growth has never continued without interruption in the past and it is unlikely to do so.  

Interest rates have been at historical lows for some months now. However, it is unlikely that interest rates will remain low for any extended period of time. As the economy continues to grow and strengthen, interest rates will rise.  

Identification of relevant economic forces and where they are in their trends, cycles and deviations from both is not the solution to the problem. Once they are identified, how they drive value in the specific company must be analyzed and applied. Many inexperienced business appraisers fail to do this—their economic analysis (combined with the industry analysis) could be deleted without affecting the balance of their appraisal. This is incorrect. The economic analysis combined with the industry analysis should drive the income forecast and directly influence the appraiser’s risk assessment as reflected in the selection of an appropriate company specific risk premium. As the future expected income of a company determines its value, the likelihood of receiving the forecasted income stream is reflected in the discount rate selected by the appraiser. 

The strength or weakness of the company being appraised compared to its industry and the influence of the economic outlook is key to the development of both the forecast and the risk assessment.

Many times an inexperienced appraiser discusses a lukewarm economic picture and a stagnate industry and then forecasts twenty to thirty percent annual growth in company revenue. This simply does not make sense. Contrary to the evidence included in many business appraisals, the income forecast must be based on the economic and industry outlook. Occasionally a unique concept emerges that may experience unusual revenue growth and profits for a time, however, when this occurs, competition rushes in bringing things back closer to the norm. 

Business appraisals must make sense!

Valuations and other consulting services play a part in all tax, transaction, and litigation matters. For additional information or advice on a current one, please do not hesitate to call. We Value Your Business!  

August 2003 - Valuation Quotes

I have always found others’, as well as my own, perceptions of the pricing of professional services to be both interesting and complex. Part of the complexity stems from the fact that clients usually do not understand the scope of work that must be undertaken.  

It’s easy and pleasant when a client thinks they need a big, long and expensive job done, when a small and quick one will suffice. Business owners who request full appraisals to value their companies for sale are thrilled when I recommend limited calculations to establish a justifiable asking price. I do this because full appraisals are a waste of the client’s time and money; what counts is getting the negotiations started properly.  

It’s more difficult and sometimes not as pleasant when the client needs more than they first suspect, such as in tax and litigation matters where full appraisals are essential. In this case, we must educate them, but we have limited time to do so because they do not necessarily anticipate a barrage of diagnostic questions.  

Physicians are the best class of professionals that I can think of who are skilled in “differential diagnosis”. It is the hallmark of their training. Starting with a general question like “Where does it hurt?” or “How are you feeling?,” they rapidly proceed through a logical series of questions and physical examinations (that are like computer program subroutines) leading them from the symptoms presented to a diagnosis and indicated course of treatment, or to identify what further tests and procedures are necessary to confirm the diagnosis.  

Most business valuation engagements begin with an inquiry focused on the cost and time to complete them. (These questions force us to uncover the “symptoms”!) The appraiser must provide reliable and quick answers, but to do this, he or she must obtain enough information to define the scope of work, which drives the fee and schedule. This can be accomplished in a well thought-out conversation that will establish:  

  • The entity and interest to be valued  
  • The standard of value (e.g. fair market value)  
  • The level of value (control/minority, marketable/non-marketable)  
  • The valuation date  
  • The use of the appraisal (e.g. for a gift tax return)  
  • The extent of economic, industry, company and financial analysis needed  
  • The applicable approaches and methods 

None of these parameters, except the use of the appraisal and the entity (and perhaps the exact interest) to be valued, will be readily apparent to most prospective clients. We must diagnose them. At the same time, we cannot jump to inappropriate conclusions. For example, we cannot ask “is your business comparable to public companies?” That’s a conclusion which we can reach with a few well-considered questions. But time is of the essence, or we will lose the client’s interest.  

A Brief Example  

Here is a model telephone call, with the appraiser’s thoughts italicized.  

Appraiser: “How can I help you, Mrs. Smith?

Mrs. Smith: “I want to give shares of my company to my children, but retain control. Attorney Jones told me to call you. How much will an appraisal cost and when can it be completed? I am anxious to make the gifts and file my tax return.”  

This is a current-date non-marketable minority interest gift tax appraisal at fair market value. The first five parameters are established. We know what we will appraise. To determine how, we need to know about her business. So we ask:  

Appraiser: “Wonderful, we specialize in this type of work. Tell me about your business.”  

We learn, with a few prompts to keep the discussion on track, that her company is a job shop stamping out metal parts. For the past five years, sales have been $4.5 to $5 million, growing slowly. The business has always been profitable, with stable margins and little debt. There are no plans for diversification or acquisition. The company leases its real estate from an independent third party and has no excess operating assets (such as idle equipment).  

Although we will probably learn a great deal of additional detail, some of which is not relevant, we can now make several important deductions. The Company is in one line of business, which will simplify our economic and industry research. Due to the Company’s small size, we reject comparisons with public companies. We know from other job-shop valuation assignments that private comparables are too few to be reliable. So the Market Approach cannot be used due to lack of data. The company is a going concern, so we reject the liquidation premise of value. Real estate and equipment appraisals will not be necessary. We will likely use the Income Approach, probably capitalizing a typical year’s cash flow with an allowance for modest growth. We need to know more about risk factors (dependence on key people, customer concentration, etc.) but this can wait until we meet Mrs. Smith and tour her facilities.  

Assessment  

We know the scope of the engagement and can quickly quote a fee and schedule as part of our engagement letter. We accomplished our mission in a 10-minute conversation. We do not have all the supporting information, but can prepare a customized list of questions to get it at our management interview, which will also be brief and focused. We are ready to be retained and to begin work.  

Valuations and other consulting services play a part in all tax, transaction, and litigation matters. For additional information or advice on a current one, please do not hesitate to call. We Value Your Business!
July 2003 - Business & Commercial Damages 

Many business valuation techniques, principles and procedures apply in calculating and supporting business and commercial damages. There are some significant differences between typical business valuations and damages calculations. For example, most damages calculations such as for lost profits are determined on a pre-tax basis, valuations are usually determined on an after-tax basis. Lost profits are calculated on a pre-tax basis as plaintiffs are subject to both federal and state income taxes on any damage awards as ordinary income. Business valuations examine the value to a shareholder, the lost profits model looks at the economic loss value to a specific part who may or may not be a shareholder. 

Included in the broad category of business and commercial damages are categories such as personal injury, wrongful death, employment/labor issues, lost profits, loss of business value, and other commercial damages. Of these categories, typically business damages and commercial damages calculations relating to lost profits and loss of business value are often best determined by a well-trained business appraiser instead of a certified public accountant or economist. Business appraisers are well suited to the calculation and support of the measure of liability or compensatory damages.

Some of the services that a business appraiser can provide in addition to expert witness testimony include conducting preliminary evaluations and calculations for a case under consideration, reviewing opposing expert’s work product, identifying other experts, aiding in discovery, identifying and evaluating alternatives for settlement, assist in developing questions for depositions and interrogatories, review case law selected by the attorney for economic impact, and provide demonstrative exhibits.

There are three basic methods typically used by business appraisers in measuring commercial damages:

  • The "before and after" method
  • The "yardstick" method, and
  • The "projecting lost revenues" method

The "before and after" method compares a business’s revenue and profits both before and after an event. The idea is to illustrate the "but for" the alleged act or event, the business would have earned the profit it had earned in the past. This method works well when a business has an established profit record but it is based on a number of assumptions. First of all, it assumes that the past performance of the business is representative of what would likely occur in the future. It also assumes that economic and industry conditions are similar in both the before and after periods. The defendant will generally attempt to show that certain other factors such as the plaintiff’s bad management, a weaker economy, and or industry changes are responsible for the difference. This is a useful method if it is applied correctly and if it is used in the correct circumstances—a common use of this method is in business interruption cases. This method essentially is equivalent to performing a business appraisal just prior to the event and again after the event to measure the reduction in goodwill of the company; a process well suited to a good business appraiser.

The "yardstick" method involves a comparison of the company to comparable companies to see if there is a difference in the level of the plaintiff’s performance after the occurrence of an event. Comparable companies may include others in the industry or the historical results of the Subject Company. Business appraisers use comparable companies regularly in business appraisals and are well qualified to apply this method and deal with the issues related to the degree of comparability between the Subject Company and comparable companies. This method is often particularly well suited for newer companies that have little track record. It is also sometimes used as further support for the before and after method.

The "projecting lost revenues" method is used to determine the "but for" the event revenue and net profit of the company. This method must be supported so that the forecasts made are reasonable. Business appraisers regularly develop supportable forecasts in the appraisal of businesses. This experience lends itself well to the use of this method in business and commercial damages cases.

There are many types of cases that may benefit from a business appraiser’s calculations or consulting on business and commercial damages. These include such things as: breach of contract issues, business interruption claims, malpractice issues, antitrust issues, unfair competition, intellectual property, and misappropriation issues, contractual interference, fraud, securities damages, wrongful termination of employment, and many, many more.

Valuations and other consulting services play a part in all tax, transaction, and litigation matters. For additional information or advice on a current one, please do not hesitate to call. We Value Your Business!
June 2003 - Fair (Market) Value?

Is there a difference between Fair Market Value and Fair Value? In a word, yes.

Marital dissolution disputes frequently deal with the issue of whether a business interest should be worth "fair market value" or "fair value". These terms are often used interchangeably in conversation, media reports, accounting regulations, and, unfortunately, in courts of law.

These two valuation standards have specific and different meanings, which can lead to large valuation differences:

Fair Market Value applies to tax-related valuations. It is defined by Revenue Ruling 59-60, many other rulings, and much case law. It assumes hypothetical third-party buyers and sellers of the interest to be valued. It also assumes knowledgeable willing buyers and sellers neither under any compulsion to buy or sell. Fair Market Value essentially assumes that value should be the price at which a transaction would likely occur between hypothetical, willing, knowledgeable buyers and sellers neither under any compulsion to buy or sell.

Fair Value typically applies to dissenting or oppressed (minority) shareholder matters. It is defined by statute. It involves actual current shareholders transacting the interest to be valued. Often, under this standard, sellers (of minority interests) may not be either knowledgeable (they may not receive information from the controlling shareholder), willing (they may or may not want to sell—often not at the price being forced on them), or have any choice in the matter as in a squeeze out merger, etc. This standard of value typically exists to protect the rights of minority shareholders that are being treated inequitably.

There are two major differences between these standards:

Treatment of discounts for lack of control and lack of marketability. These discounts are typically applied to minority interests under the fair market value standard of value, adjusted for case facts and circumstances. Fair value may or may not allow them, depending on state statutes. Often, these discounts are not permitted under the Fair Value standard as the purpose is generally to be fair, i.e. shareholders often receive a pro rata amount of the total value. Under the Fair Market Value standard of value, a minority interest is generally worth less, often a lot less, than the percentage’s pro rata of the total value. For example, a 10% interest of a $1 million dollar business might be worth $100,000 under the Fair Value standard of value – 10% pro rata of the total. Some jurisdictions recognize a Discount for Lack of Marketability for Fair Value. (Often in size more appropriate to a controlling interest instead of a minority interest—for example 8% instead of 30% as shown in our example shown below), most agree that no Discount for Lack of Control should apply. However, under a Fair Market Value Standard a ten percent (10%) interest might be only worth $56,000 as shown below if a 20% Discount for Lack of Control and a 30% Discount for Lack of Marketability were appropriate:

FAIR MARKET VALUE EXAMPLE CHART
Consideration of specific buyers and sellers. Fair market value envisions generic "financial buyers" who bring cash to the table. Fair value can conceivably involve "strategic buyers" (or sellers) who possess unique value-enhancing characteristics.

Marital litigation is complicated by the lack of uniform federal / state statutes which stipulate whether fair market value or fair value applies. Each state, jurisdiction, and trier of fact exercises discretion. Case law is often inconsistent, and has blurred the distinction between these two standards of value. This creates the potential for confusion and debate in almost every divorce case. The adoption and enforcement of a uniform standard of value for divorce litigation would remedy that, but the implementation of such a system is highly unlikely.

The bottom line is: fair market value involves transactions with hypothetical third parties; fair value involves transactions with actual shareholders. These are fundamentally different value premises which should not be, but often are, confused.

Valuations play a part in all tax, transaction, and litigation matters.

May 2003 - Computer Valuation Programs

There are a number of business "valuation" computer software programs on the market today. I receive a flyer requesting me to consider purchasing one of these many programs on a fairly regular basis. The following is a summary of the claims for one of these programs:

Successful Business Professionals across the nation are using XYZ to analyze financial data. XYZ will allow you to identify company performance and is an excellent tool for detecting irregularities in information, and much more. To do a complete analysis, they claim you need:

• Trend Analysis
• Variance Analysis
• Ratio Analysis
• Industry Ratio Variance Analysis
• Comparison Against Healthy Company Norms

 One of the new features in XYZ is the balance sheet analyst feature. This feature will analyze twelve (12) separate balance sheet items.

• Cash
• Accounts Receivable
• Accounts Receivable Volume (turnover)
• Inventory
• Current Assets
• Current liabilities
• Working Capital
• Accounts Payable
• Fixed Assets
• Long-Term Debt
• Net Worth
• Long-Term Debt To Equity Relationship

 The program promises that the user will know:

• If current assets are too low/high or good.
• If current liabilities are too low/high or good.
• How much of current assets should (by definition) be financed by long-term debt.
• Recommendations for balance sheet unfavorable relationships.
• Balance sheet health

The program claims that it includes a new industry library with over 150 industries. (Does this mean a company must be forced into one of these industries?) The program compares the company data to the industry data it contains and makes various statements based on that data. This program advertisement did not specifically mention valuation calculations, but many of them do. Based on the information entered along with a few "risk" selections, the program generates the value of the business.

 Valuations play a part in all tax, transaction, and litigation matters.
April 2003 - Valuation “Experts” Testimony Excluded

In one of the business valuation publications I regularly receive, a recent case was cited that again reinforced the need to use qualified business valuation professionals particularly in matters that may be litigated. The referenced case is:

Lippe v. Bairnco Corp., 2003 U.S. Dist. LEXIS 1133 (S.D. N.Y. Jan. 28, 2003). Judge Chin.

KEY WORDS: Bankruptcy, Fraudulent conveyance, Daubert hearing, Discounted cash flow method, Control premium, Comparable companies method, Admissibility of expert testimony

EXPERTS: Thomas E. Dewey, Jr. and Jocelyn D. Evans (both for plaintiff)

The case is a bankruptcy proceeding. The trustees, as plaintiffs, tried to prove that the defendants (Bairnco Corporation, Keene Corporation, and the management of the companies) had engaged in a series of fraudulent conveyances among subsidiaries to protect assets from the reach of asbestos claimants. Plaintiffs offered the testimony of two experts (listed above), to try to prove that newly created subsidiaries did not pay "fair consideration" for the assets they purchased from Keene Corporation, one of the subsidiaries of Bairnco Corporation.

Defendants filed a motion to exclude the testimony of the experts. After reviewing the reports and depositions of the experts, the court ruled that the testimony of these valuation "experts" was inadmissible under the Daubert standard. Before ruling on the motion to exclude, the court thoroughly discussed the Daubert standard as it applies to experts offering business valuation testimony.

First, the testimony must be reliable. It must be based on sufficient facts or data and must be the product of reliable principles and methods properly applied. Second, the expert’s testimony must be relevant, that is, it must assist the trier of fact in determining the issue in the case by providing information and explanations, but not advocating a position.

The trial court determined that the valuation reports prepared by Thomas Dewey, an investment banker, did not have a reliable foundation. He did not use the discounted cash flow method and relied solely on the comparable companies method. He was unable to explain why he did not use a discounted cash flow analysis. Dewey did not rely on accepted business valuation principles and methods. He could not explain his analysis or how he reached many of his conclusions. Dewey also applied control premiums but was unable to provide any concrete basis for them. He also failed to consider and make adjustments for certain variables between his subject company and the comparable companies. Dewey could also not explain why he chose the comparables he chose and rejected others that appeared comparable.

The trial court also found that the report and deposition testimony of Jocelyn Evans, a finance professor, was unreliable. She applied substantial control premiums on a theoretical basis that seemed designed to support the "desired" results rather than a reliable valuation. Evans did not develop her own selection of comparable companies but instead relied on the list of comparable companies supplied by plaintiff’s attorneys. She did not analyze the companies to make sure they were truly comparable nor did she make any adjustments. Her testimony reveled that she was uncertain about the accuracy of her conclusions and analysis and she testified that this was her first valuation engagement.

The court ruled that the opinions of both Dewey and Evans were not only "shaky," but that they were so unrealistic and unreliable as to suggest bad faith, or at a minimum, to constitute as an "apples and oranges" comparison. It was apparent that both "experts" had only one goal in mind, to come up with conclusions that would support plaintiff’s positions in the case.

In addition to excluding the testimony of both experts, the court refused to allow plaintiffs to substitute a qualified valuation expert or to submit a supplemental expert report. The court stated that "plaintiffs have had a full and fair opportunity to litigate this case and defendants would be severely prejudiced if discovery and the record were reopened now." The court granted summary judgement to defendants because plaintiffs had failed to provide any "concrete evidence" in support of their fraudulent conveyance claim.

This case illustrates the importance of retaining qualified business valuation experts. It also illustrates the need for valuation experts to be fully trained in the business valuation field, to have a thorough understanding of their own report when testifying for a deposition or trial, and to avoid taking an advocate position.

Valuations play a part in all tax, transaction, and litigation matters. 
March 2003 - Personal and Professional Goodwill

One of the fastest-growing areas in business valuation is the appraisal of intangible assets; those assets which have no physical presence. These include things like patents, intellectual property, trade names and "goodwill". Goodwill is quintessentially the probability of repeat patronage. It generates earnings and cash flow above that attributable to the net tangible assets (reflected on the business balance sheet) of the business. It is built on a foundation of doing business well: satisfied customers, high quality of product and service, competitive prices, successful innovation, and such. It thus adds to the value of a business enterprise.

The following formula relates these concepts:

Value of Business

Value of Net Tangible Assets

– Value of Specifically Identified Intangible Assets

= Total Goodwill Value

Some intangible assets, like trademarks, can be valued separately. Others cannot, and form the residual of "Total Goodwill Value". Total Goodwill Value has two parts: personal and professional. Personal goodwill is attached to an individual. An example is the value of a baseball star’s services, which depend much less on the team he plays for than on his own ability, reputation, endorsement power, etc. By contrast, professional goodwill is attached to the business. An example is the McDonald’s franchise and products (such as the Big Mac), which have no relationship to specific restaurants. In this formula:

Business value is determined (probably by market comparables or multiples of earnings and cash flow).
Net tangible asset value is determined (probably by appraisals of the underlying fixed assets)
Specific intangible assets are identified and appraised.
The remainder is Total Goodwill.

How do we divide Total Goodwill into its Personal and Professional components? This problem is acute in matrimonial cases, because jurisdictions differ on whether personal goodwill is a marital asset. It may also come up in acquisitions, when the purchase price must be allocated between different types of assets. It is less important in most taxation cases, because in those situations we usually need to value the business interest in total, not distinguish between its tangible and intangible components.

Here are some things that appraisers need to think about when addressing the problem of dividing goodwill into its two parts:

The employee’s time in their profession and with their present firm influences the allocation. A newly licensed doctor joining an existing practice has no personal goodwill. An experienced one switching practices and bringing patients with her contributes significant personal goodwill. Depending on how the practice is run (e.g. do physicians share patients, and how is that done), some of her personal goodwill may become business goodwill (if patients become more loyal to the practice than to her). Conversely, some business goodwill may become personal (if she attracts patients who become loyal to her, and she then leaves the practice). Moreover, total goodwill and both of its components may grow, if she and the practice have done well. Note: this is easy to discuss in theory, but often times difficult and controversial to measure.

The nature of the service or product is important. The more personal it is, the more its goodwill is personal. My dentist of many years has developed tremendous personal goodwill with me; he is the only person I will permit to treat me. By contrast, there is no personal goodwill associated with the radiologist who examines my chest x-ray. I do not know who he or she is!

It is also important to consider in whom goodwill is "vested". I have no goodwill regarding the radiologist, but my internist certainly does! The radiologist’s goodwill is vested with my internist, not me. Referral-based businesses (like business appraisal practices) have vastly more goodwill vested with gatekeepers than with one-time clients.

How standardized versus customized is the service? A McDonald’s might have a great burger flipper, but the product is standard. There is no personal goodwill there. It is very different in a restaurant where the owner is the chef! Wolfgang Puck (the owner of Spago and many other internationally renowned restaurants, as well as a marketer of name-branded products) has done a masterful job of converting his personal goodwill to business goodwill. (You could say that his business is "really cooking"…)

Goodwill is not the same as market share. The fact that you have a monopoly does not guarantee that you have goodwill. Microsoft could be a classic example of this. On a more mundane level, if you happen to be the only person selling water in the desert, you benefit from its scarcity and charge high prices. A competitor could undercut you and destroy the scarcity value of your product.

Successful innovation creates goodwill. When Merrill Lynch introduced the first money-market account, many brokers sold the product and saw their commissions increase, but this was because of the company’s good idea. No broker could take credit for such growth. This innovation created professional goodwill. On the other hand, Christian Barnaard, the first surgeon who successfully transplanted a human heart, garnered worldwide fame (massive personal goodwill) from his success. (Trivia question: who was his patient?)

These are just some of the many factors that create goodwill. Each must be considered in terms of whether it creates personal or professional goodwill.

Valuations play a part in all tax, transaction, and litigation matters. For additional information or advice on a current one, please do not hesitate to call. We Value Your Business!

February 10, 2003 - The Role of the Third Appraiser

Increasingly, well-drafted shareholder agreements have appraisal and / or arbitration clauses to cover valuation disputes. They require that each side retain an appraiser. If their values differ by more than a given percentage, the two experts appoint a third, whose binding conclusion must be in the value range developed by the first two.

This can be workable, fair and economical, but careful planning can make it even better. Here’s how.

Require that the third appraiser have senior credentials and be experienced in the review and critique of appraisals. Dispute resolution has complexities that require great expertise. The third appraiser should have both the Certified Business Appraiser designation from the Institute of Business Appraisers (IBA) and the Accredited Senior Appraiser in Business Valuation designation from The American Society of Appraisers (ASA).

Enhance the third appraiser’s authority. This person will wear many hats besides that of technical expert: judge, arbitrator, mediator, teacher, investigator, enforcer, and psychologist. Consider expanding the mission to include getting the dispute resolved equitably and economically, not just to come up with a number. This is a big difference as, to do it right, the third appraiser needs more authority to:

Ensure that the other appraisers received equal access to information and people
Rectify inequalities in the abilities and work products of the appraisers
Identify issues that are purely for the appraisers to resolve, as opposed to those that might be legal, in the realm of other professional experts, or purely personal
Enforce schedules

Allow the third appraiser to see the other two appraisals. In some cases, the third appraiser gets only the value range and access to raw data. This is foolish, particularly if one or both appraisals are grossly defective. Review of the appraisals gives the third appraiser a huge head start and eliminates redundant work, time and cost. It also allows the third appraiser to identify and focus on the areas in which the two appraisals differ, without reinventing the wheel in areas where there is agreement.

Allow the third appraiser to analyze each appraisal and provide comments to the other two (in confidence). Each appraiser then gets the option to revise his or her report within 30 days. This quality control step allows error correction. Many times, it is all that is needed to eliminate the difference or narrow it to the point where settlement can be reached. This is far less expensive than a full third appraisal. It leverages the abilities of all three appraisers: the two original appraisers can modify their reports easily, and the third one focuses on rectifying the differences. Another benefit: the third appraiser can explain each appraiser’s position to the other in a non-confrontational way, which creates a constructive, conciliatory process of conflict resolution. The emphasis should be on building consensus, not mutual destruction.

The result of these two steps will be either agreement (in which case the third appraiser’s job is done) or two sound but different valuation conclusions. Now comes the vital step:

Jointly decide whether the next step should be more negotiation, a full third appraisal, a partial third appraisal, mediation, arbitration or litigation. If the two corrected appraisals are close, settlement by splitting the difference may be acceptable. If the two valuations are vastly different, a full appraisal may be required. By "partial appraisal", I mean a valuation that focuses solely on the areas of valuation contention. (A common example: the two appraisers are close on the value of the business as a whole, but a minority interest is to be valued, and they are far apart on the discounts. There is no need for a third appraisal of enterprise value.) The third appraiser is in excellent position to serve as mediator or arbitrator.

Allow for "resolution by synthesis". In many cases, the third appraiser will agree with one appraiser on some issues, with the other on different ones, and with neither on still others. Rather than simply requiring the third appraiser to issue a full independent opinion or to agree completely with one of the two appraisers, allow them to develop an opinion using the valid aspects of both appraisals. (Example: I might concur with the first appraiser’s value of the business and the second one’s discounts. If I develop a third opinion based on those two components that explains why I agreed with them, the process will be greatly expedited, both sides will have "won" something, and will probably feel that the outcome was more equitable.)

Appraisal mechanisms have the objective of bringing technical expertise to bear on difficult valuation problems, rather than leaving it to the courts or other less-qualified individuals to decide. Because appraising is as artistic as it is scientific, even with the best efforts of both sides, differences will often remain. Moreover, the courts have more power than do "unempowered" appraisers. A skilled, empowered third appraiser can, like Solomon, cut to the valuation essence of the dispute and deal with it to produce an equitable, sound and cost-effective result. The efficacy of the entire process will be considerably enhanced if the parties help to design it.

Valuations play a part in all tax, transaction, and litigation matters.
January 13, 2003 - Compensation in Divorce

Divorce engagements are always a very interesting part of our practice. A number of issues must be dealt with—one of the most important among them is compensation consistency. To state it simply: compensation assumptions should be the same for both the business valuation and support payment calculations.

As an example, let’s assume that we are valuing a business paying the sole owner $100,000 as opposed to fair market value ‘reasonable’ compensation of $50,000. (We consult one of several databases to obtain indications of reasonable compensation for the owner). There are two correct ways to handle this:


Value the business with fair market value ‘reasonable’ compensation of $50,000, and calculate support based on the same number. This will increase the value of the business and reduce support payments.

Value the business with actual compensation of $100,000 and calculate support on the same number. This will decrease the value of the business and increase the support payments.

It is inconsistent to value the business with $50,000 ‘reasonable’ compensation and support based on $100,000 actual compensation. This would result in a higher valuation for the business and require higher support payments as well—it would not be fair.

Valuations play a part in all strategic transactions. 
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