Regardless of the cause of action; e.g., minority oppression, estate challenge, damages action and marital dissolution, most valuation engagements prepared for litigation matters focus on financial forensics. While this is important, a credible valuation opinion requires the application of other critical due diligence procedures.
There are three approaches to valuation: asset, income and market. Many appraisers place great emphasis on the income approach, but fail to perform adequate due diligence. The market approach, often deemed inapplicable, is too frequently overlooked as a source of critical data.
The “forensic accountant” on the other hand, has a different mindset. The assignment is to apply accounting principles to financial disputes that are expected to result in litigation. This is an adversarial situation and by definition, there is an element of distrust on the part of both parties. Think of us as “financial detectives”. We are looking to put together pieces of a puzzle to tell the story of what happened to contested or misappropriated funds. We follow a twisting money trail to find these assets, often completing our assignments with incomplete, inaccurate, and invalid accounting records. These investigations are often further complicated by the ways in which the money or other assets are disbursed or transferred. An audit of records in this condition would be cost prohibitive.
With the income approach, adjustments necessary to present financial information on an economic basis are identified and recorded. Examples include reclassifying officer perquisites characterized as business expenses to compensation or dividends and adjusting rent paid to a related party to fair market value. Then, based on public market returns and the risk(s) associated with investing in the subject company, an expected return, a capitalization rate, is applied to the economic income stream to determine the company’s value, as shown below:
• Normalized economic benefit stream $1,000,000
• Capitalization rate 25%
• Value $4,000,000
Revenue Ruling 59-60
Valuation is not that simple. The stock of a closely held business is not traded in a public market. Without an established market price, it is difficult to determine its worth. For that and other reasons, this 55 year old revenue ruling remains the foundation for the approach, methods and factors to be considered in valuing a closely held company. The ruling presents eight fundamental factors to be analyzed in the performance of a business valuation. This article highlights two factors which do not get adequate consideration; the site visit and the market approach
Factor One: Nature of the business and its history since its inception –Site Visit
The subject company’s stability, growth, diversity, or lack of same are among the factors needed to form an opinion on the degree of risk. The nature of the business, its products and/or services, its operating/non-operating assets, capital structure, management, etc., all require analysis. Studying the financial records and corporate documents provide some insight. However, if the appraiser forms a conclusion based on his/her “interpretation” of these documents without an in-depth interview(s) of management, all parties in the litigation, and particularly the business owner, are exposed to unnecessary risk.
In the Estate of Frederic C. Kohler, (Kohler v. Commissioner T. C. Memo 2006-152), the estate’s appraiser valued the company stock at $47,000,000; the Internal Revenue Service’s appraiser’s value was $156,000,000. The tax court found the fair market value of the stock was as reported on the estate’s tax return. The Honorable Judge Diane Krupa, United States Tax Court, heavily criticized the IRS expert because; “Dr. Halaka’s background research on Kohler was limited. He met with Kohler management just once. Moreover, we are convinced from his report and trial testimony that Dr. Hakala did not understand Kohler’s business. He spent only 2 ½ hours meeting with management. He decided the company’s expense projections were wrong, invented his own, and did not discuss his fabricated expense structure with management to test whether it was realistic.”
Factor Two – The market price of stocks of corporations engaged in the same or similar line of business – Market Approach.
Time consuming and expensive, the market approach often does not identify sufficient comparable sales or data points for closely held businesses. Appraisers often stop there, opining that the approach cannot be relied upon in forming a valuation opinion. While this may be true, the information obtained from this approach nevertheless can provide vital insight into the subject company and its industry, critical elements to the income approach to valuation..
For example, we recently completed three valuation engagements; a shareholder buyout, a damages claim, and a marital dissolution. On an economic basis, two companies experienced losses throughout the five year review period. The third experienced losses in three of the years.
Herbert v. Kohler, Jr., et al., Petitioners v. Commissioner of Internal Revenue, Respondent
By using the market approach, we identified sales of companies with a history of operating losses. The information provided was inadequate to determine the factors considered to reach the selling price; e.g., brand, in place work force, synergies, etc. However, by using the market approach, we proved that historical losses do not necessarily result in a sale at net asset value. The listed sales provided additional industry information, e.g., margins, ratios, deal structure, etc., that were fundamental to determining the subject company’s specific risk and the applicable capitalization rate for the income approach..
A business valuation must include an understanding of the business and the industry in which it operates. Failure to complete the due diligence associated with the site visit and the market approach will result in subjective conclusions disguised to appear objective and scientific. A valuation which does not thoroughly encompass these factors places the litigant at risk because the report will not comply with standards clearly and consistently applied by the Courts.
Shelley Brown, MBA, CPA/ABV/ CFF, CVA is a Partner at Paritz and Company, P. A. She can be reached at (201) 400-1503 or Forensic_cpa@comcast.net..