Litigation + Business Ownership
A Competent Valuation Expert
The challenge of a business valuation expert is to provide, what can often be complex and detailed, information in a cogent manner within a brief period of time. The characteristics of closely-held corporations, including the lack of a ready market for the stock, make the task of valuation a particular challenge to the lawyer”.
When an appraisal is needed
Most statutes are general; therefore, judicial precedent may be a determinative factor in what methods to value are used and are governed by the individual state. Most businesses possess Goodwill, which is beyond the value of other tangible assets owned. This is why a business appraisal expert should be retained to value an intangible that is often difficult to measure. Black’s Law Dictionary (5th Ed.) defines intangible assets as: “Such values as .”
In California, which has some of the highest number of lawsuits and divorces in the country, the Golden v. Golden (CA 1969) case established the rule that, even if the enterprise is a sole practitioner practice, the value of goodwill should be considered. This is because the property is argued to go automatically to the licensed spouse and that (s)he is not actually selling or liquidating, but continuing business. The non-operating spouse of this community property is seen as effectually withdrawing and may be entitled to fair compensation for the interest owned. This implies that goodwill must be transferable to have value. Since the spouse is simply transferring the one-half community interest, it may have greater value as the other interest holder has an already established relationship with customers. This may be referred to as “compulsion value” or the unique circumstances surrounding the valuation and distribution of business interests in a dissolution.
It is vital to contact an expert before opposing counsel retains one that is in high demand; therefore, having an expert business appraiser file on hand is highly recommended. Be sure no conflict of interest exists. Also, inquire about the percentage the expert has represented the owner versus the non-operating spouse.
A cursory evaluation can be performed in typically five hours in many circumstances, with the fee applied to a more thorough engagement, if determined to be worthwhile. This usually involves providing the expert with copies of relevant documents, such as a sufficient number of years of financial statements and tax returns; lease, employment and partnership agreements; brief business history; articles of incorporation; interest to be valued and other operational materials.
Should opposing counsel have already received an appraisal report, a professional review can assure your clients an objective opinion was provided and offer alternatives, if the conclusion is suspect. Such reviews will examine whether the business appraiser appears to have the qualifications and expertise to render an opinion. The review will also determine if the report adheres to the Uniform Standards of Professional Appraisal Practice (USPAP) standards 9 and 10 and IRS Revenue Ruling 59-60; whether the assumptions and conclusions are technically correct as well as supported and documented; whether the appropriate standard of value is applied; and if, readily available data was omitted; particularly in the Market and Income approaches, to name a few areas that can be probed for efficacy.
A common area of neglect is an absence of supporting comparative information, which produces a report that is circular in logic. A report that makes a statement similar to “I have examined the Subject against itself and it is my opinion that the factors I have determined, such as risk and earnings, produces the following value”. A statement like this is based on nothing more than opinion, if details to each of the factors considered are not well represented by independent, empirical support, such as a market and economic analysis. Otherwise, how can one know that performance, of the enterprise in question, was influenced by internal or external factors? In other words, what is typical? This tends to be the valuation’s Achilles’ heel, regardless how thick or embossed the paper is in the appraisal report.
Request the entire working file of opposing counsel’s expert and determine whether the opinion is a preliminary or final report. This is in order to see what resources and processes were used to derive the conclusions presented and to limit the “wiggle room” during deposition and trial. Many legal practitioners ask that a written report is not prepared until after a value conclusion is reached and conveyed.
Under the amended (1993) Federal Rules of Court Procedure 26(a), experts must provide written reports prior to giving trial testimony allowing more time for effective cross-examination.
Selecting an “Expert” Business Appraiser
An appraiser with strong litigation support background can provide good interrogatories to produce documents and questions to raise during deposition. This can make opposing counsel’s expert “more honest” if the deposing counsel’s expert is present during testimony and provide follow up questions to responses that are unclear or seem suspect. This can make the use of client’s time considerably more productive.
If nothing else, working closely with an expert in business valuation prior, during and following deposition may be an excellent idea. Let’s be practical. The issues surrounding the value of an ownership interest in a closely-held business tend to be relatively infrequent and unless legal counsel has a strong finance/accounting background, (s)he is likely to be providing a disservice to the client, if an impartial opinion is not obtained. It is more relevant to determine whether there is sufficient evidence (substantive data) to support the opinion held. If retaining a CPA, insure competency provisions under AICPA Rule 201 are met.
It is amazing to find how many “experts” perform only three or four formal appraisal reports annually and often claim to provide dozens and sometimes hundreds of “informal” opinions. This is often because the practitioner may be performing many financial, tax or accounting services and not solely business valuations. If the “expert’s” position is fraught with inconsistencies and/or technical errors or conflicts of interest, a motion for summary judgment may be appropriate, when it becomes clear to at least one of the parties (and occasionally both) that the opinion fails to meet the Frye Standard; is not “expert” and would not assist the trier of fact in the disputed matter.
It’s important to remember that an appraiser is an “expert” in valuing businesses, not necessarily an expert in the industry appraised. Testimony is based on experience and expertise as an appraiser. Red flag an appraisal being performed by the business’ tax preparer as issues of bias and conflict of interest will surely arise as well as the degree of appraiser competency.
Perhaps, this is why the trial judge in his decision in the landmark case of Johnston v. U.S. (1984) expressed: “This Court is disappointed in the apparent fact that the so-called experts can take such license from the witness stand. These witnesses say and conclude things which, in the Court’s view, they would not dare report in a peer reviewed format.”
In many cases, the business appraiser’s written report fails to meet Rule 26 (a)(2)(B), because it often fails to contain a list of data considered; a summary of all exhibits that will support their opinions; the report writer’s signature (not firm’s) and their qualifications and compensation.
The Supreme Court Case of Daubert v. Merrell Dow Pharmaceutical and the more recent cases of Frymire v. KPMG Peat Marwick; G.E. v. Joiner; and Kumho Tire Company v. Carmichael, have strongly influenced the rules of civil procedure and evidence and provisions governing discovery (as applied in the Federal Rules of Evidence 701 – 706); particularly, the judge’s role as gatekeeper, as it pertains to admissibility of expert testimony. The valuation expert must demonstrate the appraisal report meets applicable standards and uses appropriate methodologies; is not “advocating” a value and can be replicated. The report should also discuss why alternatives were not used or given less weight.
There’s considerable backroom discussion of selecting a “hired gun” when representing a value of a business interest. The rationale tends to be that, at best, the case may be won or, at worst, the trier of fact will take a “Solomon-like” approach. Here the difference will be split between the two disparate values.
In the landmark Buffalo Tool and Die as well as the Sirloin Stockade v. Commissioner (1980), cases the Court specifically stated that it would not compromise between two opposing values, but would instead reach a decision on the valuation reports presented.
Developing testimony around a pre-established value tends to be doomed since the opposing attorney will likely explore any biases or inconsistencies in the valuation report. This is because the factors that influence “opinion” all tend to drive the value in a single direction. Since the opposition’s expert is likely to be familiar with prescribed appraisal techniques, (s)he is in an excellent position to exploit weak areas. There are seldom instances where there aren’t both positive and negative influences in a business. It is easily challenged when they’re all pointing in one direction. The risk is that the report may become discounted leaving only one opinion to be considered.
It is unwise to believe that a retained appraiser is not expected to support the value advocated by the counsel retaining him or her. If the expert was uncomfortable with this position, they would be expected to refuse the engagement.
Selecting two business appraiser experts often only serves to cloud the most likely value, if only one appraiser is truly impartial. This is why many courts operate under Rule 706 and appoint or recommend the selection of one mutually agreed upon “neutral” expert, so no perception of alliance is present. This appears practical as fewer than 5% of cases ever go to trial. It should also apply to mediation and arbitration. It is strongly urged, for reasons more than maintaining a good working relationship, to insure that the expert’s billing accounts is current, so no allegation of influence may be made.
The criteria for selection of a qualified valuation expert, as is the case with many professionals, can often be over-simplified. The fact is there are a plethora of designations.
Some are rendered by simply completing a take home exam and stating that several business appraisals have been performed. During a recent blind study we conducted, following one completed through the Institute of Business Appraisers (IBA), a few years ago, over 60 firms offering business appraisal services were contacted concerning an estate matter of a fractional interest held in a $5 million manufacturer.
Fees, time frame and what to examine
The fees quoted to complete the work ranged from a low of $2,000 to over $12,000 with hourly rates ranging from $70 to $250! The average fee hovered between $5,000 to $7,000 with an hourly rate of $150, suggesting about 40 hours to gather information, conduct an analysis, determine and reconcile values and prepare the report. The fee for solid appraisal services is nominal compared to the dollars at risk. You’ll never know until the valuation issues are contested and litigated. While just a thought, would you want a client to have selected you based solely on fee? If the appraiser and his or her report is of he very highest quality, will there be valuations issues at all?
Sadly, hourly rates and final fees do not always beget better work products. Completion times quoted appeared to be represented as taking an average of 4 weeks. What is quoted and what is performed is not always the same, particularly during tax season.
Although requested, few appraisers provided their curriculum vitae, engagement letters or any material suggesting the degree of experience for the assignment. Additionally, only two firms suggested the need for a personal property appraiser. This is relevant as many manufacturing businesses’ value will likely lie as much in their operating assets (machinery and equipment) as they will in intangible assets, such as goodwill. Although requested, no firm provided a sample “sanitized” appraisal report, so the prospective client can get an idea of the work product being purchased. Perhaps this is why many legal practitioners are reticent to place their faith in such a questionable morass of competency.
It’s best to start gathering impressions from the moment you call. Does this office have a live person responding to your calls? How long does it take to receive a reply? What type of information do they provide? Do they offer recommendations as to the depth of the appraisal report based on the situation? Do they ask questions pertaining to the given situation? Are they being clear about the number of times designated as an expert, court appearances and performing similar assignments? Who will be performing the actual appraisal? What is their personality and would it persuasive and unflappable during deposition and trial? Can they provide references? Have they spoken or written articles concerning their industry and practices?
Unless your client has unlimited resources, not sifting through these issues can readily put you in a compromising position of hiring a business appraiser who may not assist you in successfully trying your case or working towards a settlement. This serves only to cost your client untold aggravation as well as loss of time and money. If you have found somebody with whom you’re comfortable, be sure to obtain an engagement letter, which clearly spells out the parameters of the assignment.
It is fairly typical to request a 50% retainer with the balance due prior to receipt of the final work product. In part, this is to protect the appraiser from delivering unacceptable news and not getting paid. The other is to remove any compromise of partiality due to not receiving payment.
The Appraisal Engagement
Due to the often-adversarial nature of the parties, clients should endeavor to restrict dialog with the business appraiser to issues relevant to the interest to be valued, as all discussions become discoverable during deposition and trial. An appraisal assignment begins by questions and responses between the interested party and the appraiser. The more accurate picture the appraiser has of the business, the better insight (s)he has to the issues that will need to be addressed in the actual engagement.
If these are addressed earlier on, the business appraiser can provide a reasonable quotation for performing the work and an estimate when it will be finished. Once agreed, the appraiser should provide a letter of engagement stating the scope of the appraisal (what work will be performed). It should also include the Objective of the appraisal; the date and “standard” of value as well as the interest to be appraised.
(Ex: We will determine the marital (investment) value of the 30% minority interest in the Subject “C” Corporation incident to a marital dissolution as of the date of separation, May 1, 1999.)
What is value?
The value of a business is equal to the present worth of the past earnings and/or estimated future benefits to be derived from its ownership. This is a fundamental premise of business valuation. A rational buyer normally will invest in a company only if the present value of the expected benefits of ownership is at least equal to the purchase price. Likewise, a rational seller normally will not sell if the present value of those expected benefits is more than the selling price. Generally, a sale will occur at an amount equal to the benefits of ownership.
Value is not always a single number. The valuation process is full of judgments and estimates. No one can predict with certainty the amount of benefits a company’s owner(s) will receive. Informed investors may have different opinions about the amount of those benefits. In addition, buyers may require different rates of return based on their opinions with respect to the risks of owning a particular business. The business appraiser’s task is to determine a “most likely” conclusion where a hypothetical buyer and seller will agree. What’s important to remember is “price paid” is not always synonymous with the worth of a thing.
This definition (standard) of value is critical to the process of business appraisal. It creates a considerable obligation on the business appraiser to simulate the thinking of arms length buyers and sellers when there may be no market, and, in fact, no buyers or sellers. This is why many courts use “marital” value as it implies intrinsic value or the worth to the current owner-operator as was decided in Marriage of Smith (CA 1978). In partnership dissolutions, the “fair value” standard is often used, which often does not recognize discounts for minority interests held.
The premise in each assumes that management operates in a rational manner with a goal of maximizing ownership value. Other jurisdictions maintain the fair market value standard, which is based on a hypothetical purchase or sale.
The valuation date(s) is another factor that can have a considerable impact on the conclusions drawn by the appraiser and should be clearly stated to the business appraiser as early on in the assignment as possible. Value is based on a specific point in time, the valuation date. It may be the date of a specific event: marriage (merger), separaton, filing or trial. An investor’s required rate of return and amount of available benefits usually are estimated at this point in time. Also, the estimate of value is based solely on the information that is discernible and predictable as of the valuation date. In California, for example, the valuation date is usually as close as practicable to the date of trial under Cal. Civ. Code Sec. 4800(a). According to Marriage of King (CA 1983), consideration of earnings after the date of separation as a basis for valuing a business is forbidden (Cal. Civ. Code Sec. 5118).
Factors influencing value
The IRS Revenue Ruling 59-60 is the basis for factors to be considered in conducting a professional business appraisal. This basis was upheld in the Landmark Court Case of Central Trust v. the U.S. (1962).
1.The nature of the business and history of the enterprise. (Where have they been, what have they done, who is doing it and what has been the results. This should include location(s) of the operation(s) and what impact that they ha1ve; the product/service(s) offered; market served and position; customer base; competitive strengths and weaknesses; management and work force.)
2.The economic outlook in general and condition and outlook of the specific industry. (Many do not provide or develop this item to reflect its relevancy to the enterprise valued. This begs the question how they are able to determine performance and risk comparisons. If risk is not accurately determined; how is the capitalization rate (multiple of earnings) substantiated for #4 and #5 below?!)
3.The book value and financial condition of the enterprise. (Remember, book value usually has little resemblance to market value!)
4.The company’s earnings capacity. (The “golden nugget” referred to ownership benefit often adjusted to eliminate non-operating, non-recurring and extraordinary expenses.)
5.The company’s dividend paying capacity. (Every once in a while, a closely-held enterprise particularly a holding company where this is germane.)
6.The presence of goodwill or other intangible value. (This can be very relevant depending on whether the goodwill lies with the enterprise (practice) or an individual (personal or professional) and can be well in excess of the value of all tangible assets at market value!)
7.Sales of stock and size of block to be valued. (Prior sales of a company interest, if recent and at “arm’s length” can be excellent indicators. The appraiser will need to be conversant in valuing fractional (partial) interests that may have discounts (reductions) to value due to factors such as lack of marketability and control. The substantiation must be empirical and supported, not just a stated “opinion”.)
8.Comparable sales of companies involved in “similar” or “same” industries as the enterprise valued. (A frequently abused and often misunderstood process using both public and private sales transactions. It is simplified to some extent because this approach to value for real property is well established and often used. This is largely because there’s a sufficient quantity of recent real estate sales for comparison. This is the argument for and benefit of publicly traded data as it provides more readily available financial information. The weakness is that the investor motivation is typically dissimilar to a “hands on”, owner-operator and adjustments for size differentials are subjective and often unsound. There is often a void in closely-held data except for commonly sold businesses, like restaurants and auto repair, but there are a several readily available and fairly comprehensive data bases for this information, if properly weighted. The Appraiser should express what data was considered and what was not used and why to offer a sense that what was used was the best available. Finally, the use of “rules of thumb” while common in business brokerage, should only be given cursory weight, as it tends to reflect averages and often can be significantly disparate from each other.
For example, if two businesses were in the same industry, all other things being equal, both with $100,000 in income, but the first has $2 million in revenues and the second has $1 million, they would be valued the same if the rule of thumb was 2x income.)
Appraisal formulas and considerations
Section 3.01 of IRS Revenue Ruling 59-60 states a determination of value, being a question of fact, will depend upon the circumstances in each case. No formula can be devised that will be generally applicable to the multitude of different valuation issues. Often, an appraiser will find a wide difference of opinion as to the value of a particular stock. In resolving such differences, (s)he should maintain a reasonable attitude in recognition of the fact that valuation is not an exact science. A sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgment and reasonableness must enter into the process of weighting those facts and determining their aggregate significance.
What is important is that the valuation methodology should assess both the strengths and weaknesses of each approach to value: Cost, Income and Market. The expert should avoid a detailed or elaborate explanation as neither the trier of fact nor counsels will have the time or inclination to understand. The reality is that valuation does have weaknesses due to “human factors” of selection as well as constraints of time and money that may restrict the depth of investigation. The financial information provided can always be put into question.
The market and economic data may be limited. Other errors can be the selection of only one approach to value, selection of non-comparable data (publicly traded Domino’s for a “mom & pop” corner pizza store); or simply errors in calculation. Conversely, providing a value to the nearest dollar suggests a level of precision that is easily discounted. The larger the value conclusion, the greater the rounding. (Example: $1,550,000 vs. $1,548,217).
The appraisal process
So, what exactly is an appraisal? An appraisal captures the value of both the tangible and intangible assets of what is likely to be one of the largest personal investments of time and resources of most parties. It determines the present and future rewards of owning all or part of a business interest. Tangible assets are fairly straightforward. Intangible assets can include covenants not to compete, licenses, client records and goodwill to name a few. Focus tends to be primarily on goodwill, which may be defined as “the expectancy of continued patronage by existing customers and referral of new ones as a result of name, reputation and location as well as many other variables”. When goodwill is combined with tangible assets, it is what causes a customer to visit a business for the first time and is, in part, a function of management, efficiency and market.
Value may exist due to the assemblage of these assets as a going concern regardless of profitability.
If the extraneous factors are whittled away, risk and the amount of money earned after reasonable operating expenses (cash flow) are two of the most significant variables considered in determining the value of goodwill. What tends to make a business more valuable is ease of transferability; ability of new ownership to continue or increase existing growth; and that the going concern is more a business than a “job”. It is worthwhile knowing that each business should be valued as a separate entity, and not solely compared against its own historic performance. As circumstances change, the value is likely to change, too.
In the case of a purchaser, remember they are investing in an interest (right to own and operate) the business which includes the assets, human resources, processes, product(s), when applicable, relationships and other intangibles. An agreed upon sales price may not always reflect FMV, if the parties agree to other than what an interest may be actually worth. In other words, price does not always equal worth.
What are some of the specific items should the appraiser consider?
Lease & Location
The needs of a retail store differ significantly from a national manufacturer or a professional practice. Is the lease “arm’s length”? It’s not uncommon to establish a separate entity that owns the real estate, then charge above market rents to minimize profits, thereby reducing value. What are the terms, conditions and duration of the lease? A restaurant may require a minimum of 10 years with several options to renew whereas a service station is usually for 3 years. Is the rate of the lease supportable for the age of the business and annual sales?
If a business’ rent expense is 15% of annual sales, when 7% is typical, this can cripple its ability to grow due to lower profitability. What factors act as a draw to the location? If it is a business that requires visibility, is it at a busy street corner with lots a traffic and accessibility? Is there adequate parking? Does the location offer convenience and/or savings to the customer/client? From what distance will a customer/client travel? Does the lease have a non-compete clause and is it at prevailing market rates?
Demographics & marketing
Does the type of business have products and services that will appeal to its customers? Who is presently serving this market and what is market size? Being the only nail salon in a location that is primarily light industrial would not likely make sense, whereas a deli would! Who uses this product and service and how are they being reached? What percent of the business’ budget is for market development? Does the business have a special niche or multiple products or services? Retail and professional businesses will likely need to consider some of these issues more than a manufacturer with a large customer base. Six bagel stores within a 2 block radius is not likely going to allow anyone of them to become very profitable.
A family law practice is less likely to have repeat clients as compared to a CPA, so how a business attracts and retains customers is very relevant. Also, higher start up costs for a business will usually mean lower competition.
What is the depth of management? Are there any key personnel? What is the employee turnover? What is the labor market in the area? What training, skills, education and/or licenses are required? Is capital readily available for this type of business? How long has the business been in operation and how does its sales compare for this period to its competitors? What is the number of employees compared to its sales volume based on industry norms? What are the business’ cost of goods and operational expenses compared to its industry? Are repair and maintenance expenses at industry norms, if the enterprise is equipment intensive? How does this compare to depreciation expenses and age of equipment? What is the business’ asset mix? Does it have aged receivables or is it an all cash business? Is inventory accurate and is any of it obsolete? How relevant is technology to the business? Does the equipment improve quality, reduce needed staff, have lower failure rates, etc.?
A competent appraiser realizes that a business owner may be attempting to minimize tax liabilities and therefore will make a business “appear” to be relatively unprofitable. By adjusting or “normalizing” financial statements to more accurately reflect true cash flow and market value of tangible assets of the business, the appraiser can apply many, and often more, of the considerations expressed above to determine the risk and benefit to a buyer.
What the appraiser is ultimately tasked to consider is whether there is a difference between the net tangible (adjusted book) and going concern values of an enterprise and what are they. The business’ market value of these assets is determined in the Asset Based (Cost) Approach.
Income, risk and reward
To keep things simple, remind yourself that valuation is a two-step process of determining the sustainable profit (adjusted earnings over time) and applying some level of risk associated with continued profits (multiple of earnings). Keep in mind that with smaller businesses, the “discretionary earnings” (sellers’ or owners’ cash flow) is of key consideration. Simply, this is the money that may be “pocketed” or distributed after suitable amounts are retained by the business to allow for operational stability or growth.
In the valuation process, this is part of the Income Approach, and is sometimes referred to “capitalization” of earnings. A capitalization of 50% (1/2) is equal to a multiple of 2 as an example (1 divided by ½ = 2). So if adjusted earnings were $50,000 and they were capitalized by 33.3% (1/3) (or multiple of 3), the result would be $50,000/33.3% (same as $50,000 x 3) or $150,000. The percentage or multiple represents an annual return for the amount paid in the purchase price. In other words, if I need a 33.3% rate of return and I paid $150,000, the business would have to have earnings of $50,000. What’s the relevance? If you had $100,000, you can purchase a “no risk” rate of return, such as a U.S. Treasury Bond of say, 8% or annual income of $8,000 ($100,000 x .08). If you venture into publicly traded stocks, maybe you might realize 15% annually or $15,000 return on your $100,000 investment. Remind yourself that risk and reward is market and economy driven. If there’s no demand, the price goes down and the converse tends to be true.
In these prior examples, you had no control or management in your investment other than the option of fairly readily selling (liquidating) the investment for cash.
So, in return for actually operating the investment of a closely held enterprise, which you can not typically sell, at least not readily, you’ll probably require a higher rate of return.
That rate of return is the degree of risk you believe is involved in the ownership and operation of the enterprise. This factor is at the heart of every appraisal and is typically derived by examining risks associated with investment substitutes. In other words, if you can get a higher rate of return, with lower risk and more liquidity (ability to convert into cash), why would one pay more?
We also mentioned “adjusted earnings”. When a small business deducts “depreciation” expenses, does it actually pay this amount? If the business is paying a “personal” expense for a Jaguar lease, when the vehicle does not contribute directly to the business, an adjustment is made downward on the lease expense, as a willing buyer is not likely to be interested in purchasing the Jaguar or reducing their profits by paying for the vehicle’s lease. This would increase profits and, in turn, the value of the business. More profits tend to equal higher value.
Are real property rents at market or is the business leasing from a “related party” at above market rents? Is a $15,000 owners’ compensation reasonable and adequate to operate a business with $1 million in annual sales? If the compensation is stated lower than what a comparable owner/manager would earn for similar responsibilities, then an upward adjustment to this expense would be legitimate.
Look for non “arms length” transactions, where an operating party may have a close or connected association that could influence value, such as shareholder loans. These items could reduce overall business earnings (profits), which would tend to reduce the value of a business. Each of these examples, and more, are variables that the business appraiser would examine in determining whether adjustments are made to determine what the “true” earning potential of a business may be to a hypothetical owner/seller/ buyer that has authority to make management decisions. Usually, the appraiser will request five years of income history in order to examine performance trends. The conditions and assumptions for risk and earnings and ability to support them are critical to a successfully represented value. It may also be worthwhile to determine values using the “mid-year” convention or other than year end, as these, often tax adjusted, figures may yield wholly different results depending on factors, such as seasonality and payment cycles.
While comparable sales data, used in the Market Approach, are difficult to come by for most closely-held businesses, do not readily accept an often used claim “no such data was available, so this approach was not used.” If a business is valued as a going-concern, this only leaves the Income Approach and with no further support, it becomes increasingly suspect if the appraiser performed no market and economic analysis. This is the time to raise the question.
“If part of the risk (capitalization rate) you have determined is a function of the industry and market the enterprise being valued is in, how can you represent there is no data available in which to consider the Market Approach?” In the landmark case Joyce C. Hall v. Commissioner (1989), in reaching its decision, the Court placed more weight on the word “similar” than on the word “same” (Factor #8 of IRS RR 59-60), which provides appraisers, using discretion, reasonable latitude in selecting comparable sales for comparison.
The Market Approach uses ratios to price such as earnings, revenues and assets, described as Price-to-Earnings (or P/E) ratio, as an example. If a P/E ratio was 3.0 and earnings were $50,000 then the price (or value) would be (3 x $50,000) $150,000.
Several factors for selection of “comparables” are size, growth, access to capital, financial and operating strengths. Sometimes, due to the lack of active market data this approach is discounted or given minimal weight in trial, but should not be infered that such an absence means the interest to be appraised cannot be valued.
Previously, we touched upon the issue of control and liquidity. If the interest in a closely-held business being valued is below 100% or not controlling, a discount for lack of control and marketability is not uncommon. Since one may not likely influence management decisions in the absence of control, a reduction in the value of the non-controlling interest is typically from 0% to 30%, depending on many factors, such as the size of the interest valued (percent of ownership). The sale of a closely-held businesses can be difficult. Selling a fractional interest in one tends to be more difficult, so a price reduction is likely due to the inability to convert the ownership interest readily into cash (as compared to most publicly traded stocks).
These issues as well as others, such as restriction of rights, key persons and tax implications should also be considered.
The Reconciliation of Value, to provide a final expressed conclusion, is not a proclamation nor an averaging of values from the valuation methodologies, but a demonstration of the relevancy of each method, expressing which has greater influence in the appraiser’s final opinion. Sometimes referred to as the “Delaware Block Method” all three value approaches are considered and properly weighted with those which are most theoretically sound most favored.
The Appraiser should also discuss why other methods were not as relevant. This position is expressed in Arneson v. Arneson (Wis. 1984). The appraiser should not weight an approach (or method) that is considered inappropriate as it will tend to skew the results. The Court in Endicott Johnson Corp. v. Bade (NY 1975), expressed this belief. If performed correctly, these methods often provide a cluster of values, which can be mutually supporting.
Minimizing problems early on will assure clients better service and a superior work product.
Issues that crop up are not being notified with sufficient time to produce an adequate appraisal report and lack of cooperation in producing information that can hinder assignment completion. This can also serve to backfire on the party causing the delay, if the “expert” is forced to assume certain items; then the burden is often placed on the uncooperative party to explain why such “incorrect” assumptions were made, if information could have been provided, when requested.
In context of the legal environment, statutory law (which differs from state to state), case precedent and other factors that influence value, the expert must be comfortable presenting an opinion as it pertains to a given set of circumstances that is often filled with acrimony. (S)he who provides the most unambiguous testimony supported by empirical data tends to prevail. This is a worthwhile investment in peace of mind.