So you have received the written business valuation report of the closely held business owned by your client, or your client’s spouse. You find the valuation amount on the cover letter and either like it or hate. But what are the other important elements you should look at in this mind-boggling report? Assuming the valuation has been conducted by an accredited business valuation expert, here is your checklist:
- type of report – “calculation of value” or “conclusion of value”;
- date of valuation;
- standard of value;
- assumptions and limiting conditions;
- history and nature of the business;
- normalizing adjustments to financial statements;
- estimate of value;
- reconciliation of estimates of value and value of interest appraised.
Business valuation standards provide for two types of valuations. The most comprehensive type is a business valuation resulting in a “Conclusion of Value.” A less comprehensive type is a business valuation resulting in a “Calculation of Value.” The family lawyer should understand the difference between these two types of business valuations and understand the circumstances where each type is appropriate to use.
A “Conclusion of Value” is an estimate of the value of a business, business ownership interest, security, or intangible asset, arrived at by applying accepted industry valuation procedures and using professional judgment as to the value or range of values based on those procedures.[i] A business valuation resulting in a “Conclusion of Value” generally should be obtained where the property division case is going to trial and expert testimony will be required.
A “Calculation of Value” is an estimate of the value wherein the valuation analyst and the client agrees on the specific valuation approaches and methods that the valuation analyst will use and the extent of valuation procedures the valuation analyst will perform to estimate the value of a subject interest. A “Calculation of Value” engagement does not include all of the valuation procedures required for a “Conclusion of Value” engagement. The report should state that “if a Conclusion of Value had been performed, the results might have been different.” The valuation analyst expresses the results of the “Calculation of Value” engagement as a calculated value, which may be either a single amount or range.”[ii] A “Calculation of Value” will not include the same degree of due diligence or analysis by the professional valuation analyst as a “Conclusion of Value.” However, in the family law context a “Calculation of Value” can be appropriate for negotiation, mediation, or sometimes arbitration. Further, many divorce cases have a limited budget and a “Calculation of Value” engagement generally is much less expensive than a “Conclusion of Value.” The family lawyer is also wise to inquire if the business valuator will upgrade a “Calculation of Value” to a “Conclusion of Value” for the incremental cost in the event the case does not settle outside of court.
Date of Valuation
The date of valuation is the specific point in time as of which the valuator’s opinion of value applies. In property division cases, it is extremely important to comply with the jurisdictional rules for the date at which the business is to be valued. This date varies among the states but is generally the date of separation, date of divorce, or date of trial. In North Carolina, the date of separation is generally used for property division.
The date of valuation is critically important because it determines the information the analyst may consider in performing the valuation. Business valuation standards require that the valuation analyst should consider only circumstances existing at the date of valuation and events occurring up to the date of valuation.[iii] The analyst may not consider subsequent events that were not known or not knowable at the date of valuation. In property division cases, frequently the date of valuation is many years in the past, and the analyst may not consider subsequent events. As you can imagine, this can create confusion for the parties when the value of the business has materially changed after the valuation date.
“Standard of Value” is the identification of the type of value utilized in a specific engagement. The Standard of Value for property division varies among the states and not clearly defined in many states. In North Carolina, the NC equitable distribution statutes provide guidance by instructing the judge to use the “net value of marital property and net value of divisible property.” N.C. Gen. Stat. § 50-20(c) (2014). So what is the net value of a business? The North Carolina courts generally apply the fair market standard of value for property division. The North Carolina Court of Appeals has held that:
Among the valuation approaches courts may find helpful are: (1) an earnings or market approach, which bases the value of the practice on its market value, or the price which an outside buyer would pay for it taking into account its future earning capacity; and (2) a comparable sales approach which bases the value of the practice on sales of similar businesses or practices.
Poore v. Poore, 331 S.E.2d 266 at 270 (N.C. App., 1985).
Fair Market Value is defined in The International Glossary of Business Valuation Terms, issued by the American Institute of Certified Public Accountants (AICPA), the American Society of Appraisers, the Canadian Institute of Chartered Business Valuators, the National Association of Certified Valuators and Analysts and the Institute of Business Appraisers, as:
The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.
The business valuation report should state whether the report relies on any key assumptions and limiting conditions. The report should explain the key assumptions. These assumptions can include such things as a major contract will be signed, key personnel will not leave the operations of the company, or the opposite (major contract will not be signed; key personnel will leave).
The report should state the governing professional valuation standards under which it was prepared and state the limiting conditions in accordance with those standards. The qualifications of the appraiser should also be included.
The “Conclusion of Value” report should contain a section describing the history and nature of the business. This section should discuss the following aspects of the business: products or services; operating and investment assets; capital structure; markets; management; transfer restrictions in any shareholder, operating, or partnership agreement; and expectations.
Normalization adjustments are required to adjust the historical financial statements so that they are representative of a normal condition of the business as of the business valuation date. Normalizing adjustments deserve much attention in a divorce property division case because these adjustments can greatly affect the value of the business. Failure to make normalizing adjustments can result in an inaccurate value of the business. Following are the most common normalizing adjustments made by business valuators:
Owners of small, closely held businesses take money out of the business in a variety of ways, generally to minimize taxes. The form of the business entity will have a large effect on this issue. For example, owners of closely held C corporations may bucket-out money through the payment of salaries, bonuses, and benefits to avoid the double taxation of dividends. Alternatively, members of an LCC business may pay themselves a minimal salary to avoid employment taxes and bucket-out money through distributions.
The business valuator should adjust the owners’ and officers’ salaries to market rates to normalize the financial statements. The Bureau of Labor Statistics maintains current and historical compensation statistics by occupation and region, which is useful in adjusting compensation to market rates.
A business valuation report, whether a “Conclusion of Value” or “Calculation of Value,” prepared from the business’s tax returns should normalize depreciation expense on the income statement and accumulated depreciation on the balance sheet by converting the depreciation from “Tax to GAAP (Generally Accepted Accounting Principles).”
Business owners frequently rent real estate and equipment to the business for various reasons. A business valuation report should normalize rent expense to related parties by adjusting the rent expense to the market rate for similar properties or equipment.
Business owners may direct the subject company to purchase and/or maintain certain assets that are for the quasi-personal use and benefit of the owner. These expenditures are referred to as owner or shareholder discretionary expenditures. The most common examples are luxury automobiles, private aircraft, boats, and vacation properties.
A business valuation report should normalize shareholder discretionary expenditures by adding them back to the financial statements. This adjustment will increase the earnings and the value of the subject company.
Owners of small, closely held businesses may set up pension or retirement plans for the benefit of the owners only. These plans are generally not tax deductible and are a form of an owner’s discretionary spending.
A business valuation report should normalize these owner benefits by adding them back to the financial statements. This adjustment will increase the earnings and the value of the subject company.
The purpose of the Estimate of Value section is as follows: (1) to describe the valuation methods rejected and explain why they were rejected, and (2) to describe the methods accepted and explain why they were accepted. Many methods can be used to determine the fair market value of a company. The fact pattern in the specific case of the subject business dictates which methodologies are appropriate or inappropriate.
There are three approaches to valuing a business: (1) the asset approach, (2) the income approach, and (3) the market approach. Each approach has various subdivisions referred to as valuation methods as discussed below.
The asset approach is applicable where the value of the company is comprised of the assets it holds. A prime example is a real estate holding company. Current asset appraisals used to adjust the book value of the assets are important here to have an accurate business appraisal.
The income approach is a general way of determining a value indication of a business’s assets and/or equity wherein a value is determined by converting anticipated benefits to a present value. The Capitalization of Earnings Method and the Discounted Projected Earnings method are the two most commonly used Income Approach methods. The Capitalization of Earnings Method is frequently favored for property division cases because the value is derived from the historical earnings of the subject company up to the valuation date; whereas the Discounted Projected Earnings Method is derived from the expected future performance of the subject company after the valuation date.
Capitalization of Earnings requires an estimate of an ongoing benefit stream and a capitalization rate. The capitalization rate represents the required rate of return minus the sustainable growth rate. Capitalization of Earnings effectively determines the present value of the Company’s ongoing economic benefit stream growing perpetually at a fixed rate and discounted at the required rate of return. The present value is representative of the amount a willing buyer and a willing seller would exchange for the business. The primary elements of the analysis are the subject company’s historical after-tax cash flow, the capitalization rate, and applicable discounts.
The Discounted Projected Earnings Method is similar to the Capitalization of Earnings Method, except it requires an explicit forecast of the future benefit streams and an estimate of a long-term benefit stream that is stable and sustainable. An appropriate discount rate and an estimate of long-term growth beyond the forecast period allow discrete present values to be calculated and summed for all the benefit streams to determine the entity value. The present value is representative of the amount a willing buyer and a willing seller would exchange for the business.
The Market Approach Method, sometimes referred to as the “Market Data Method” or “Guideline Company Method,” compares the subject company to similar businesses sold with known transaction data. These similar businesses are referred to as “guideline companies.” Guideline companies can be either publicly traded or private transactions. Valuation professionals may use databases of private transactions to find guideline companies for comparison to a small, closely held subject company. BIZCOMPS, IBA, Pratt’s Stat’s, and Done Deals are databases of private business sale transactions frequently used. The most commonly used version of the Guideline Company Method develops a ratio, such as the price/revenue ratio, to apply to the subject company.
The valuation report, or at least the work papers, should include the names of the databases researched, the number of comparable transactions found, and the ratios developed from those comparable transactions. The valuation report should also include the application of the ratios to the subject company to derive the value of the subject company under the market data method.
The valuation report may include discounts to the derived value of the subject company depending on the purpose of the valuation, the jurisdiction, and the standard of value applied to the valuation. In property division cases, the standard of value varies among the states, as discussed above. Fair Market Value and Fair Value are the two most common standards of value in property division. The primary difference is that Fair Market Value includes discounts and Fair Value does not. The most commonly applied discounts are the Minority Interest Discount and the Discount for Lack of Marketability.
Minority Interest Discount
Generally where the ownership interest in the subject company is 50 percent or less, a minority interest discount will be considered. A minority interest discount is a reduction to the value of the ownership interest due to a lack of control prerogatives such as declaring dividends or distributions, liquidating the company, going public, issuing or buying stock, directing management, setting management’s salaries, etc. Depending on the circumstances of the interest owned and the subject company, a minority interest discount may range from 5 to 35 percent. The valuation report should apply the minority interest discount to all valuation methods used under the asset, income, or market approaches.
Discount for Lack of Marketability
Marketability is defined in the International Glossary of Business Valuation Terms as “the ability to quickly convert property to cash at minimal cost.” A Discount for Lack of Marketability (DLOM) is “an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability.”
Given two identical business interests, a higher price will be paid by investors in the market for the business interest that can be converted to cash most rapidly, without risk of loss in value. An example is a publicly-traded stock on the New York Stock Exchange, where the owner can order the sale, and the proceeds deposited in a bank account in three days. In the alternative, a lesser price is expected for the business interest that cannot be quickly sold and converted to cash. Accordingly, a prudent buyer would want a discount for acquiring such an interest that may take months or years to sell.
Depending on the circumstances of the interest owned and the subject company, a discount for lack of marketability may range from 5 percent to 45 percent. The valuation report should apply the discount for lack of marketability to most valuation methods used under all three approaches with exceptions. The valuation report should not apply the discount for lack of marketability to the value derived from the Market Data Method where a private transaction database is used because the transactions in these databases are for privately held businesses and already reflect a discount for lack of marketability.
The valuation report may derive several different values for the subject company from the various approaches. The report should summarize these various values and reconcile the values into a single value or range of values. The valuation report should state the values used, and the weight placed on each value. Further, the valuation report should calculate the value of the ownership interest if it is less than 100 percent.
So now you have your checklist of important elements to review in that mind-boggling report. I am not implying that the other portions are not important. In fact, many of the other portions of the report can be extremely important for trial testimony or cross-examination. But what I have suggested here is the first place to begin in reviewing a written business valuation report of the closely held business owned by your client or your client’s spouse. Good Luck!
Dwight A. Ensley is a Certified Valuation Analyst and a North Carolina licensed attorney. He is the founder and principal of ValuePointe.biz, a valuation firm that performs valuations of closely held businesses across the U.S. and valuations of defined benefit pension plans for divorce cases in North Carolina. His credentials include Juris Doctor, Masters of Business Administration, Bachelors of Business Administration, and Certified Valuation Analyst.
Dwight is the author of the books Business Valuation Basics for Family Lawyers and When the Wrong Person gets the Money, The ERISA Federal Preemption Trap in Equitable Distribution. Dwight and his wife, Carolyn Woodruff, are co-authors of the children’s holiday book The Seven Nights of Santa. Dwight can be reached at firstname.lastname@example.org or 336-932-9293.
[i]International Glossary of Business Valuation Terms, as adopted in 2001 by American Institute of Certified Public Accountants, American Society of Appraisers, Canadian Institute of Chartered Business Valuators, National Association of Certified Valuators and Analysts, and The Institute of Business Appraisers.
[ii]International Glossary of Business Valuation Terms, supra
[iii] American Institute of Certified Public Accountants, Statement on Standards for Valuation Services No. 1, June 2007.