Business Valuation for the Practitioner: Identifying the Common Areas of Manipulation by the Valuator
Cases are won or lost based on a business valuation. Business valuators are used in dissolution of marriage matters when a business is a part of equitable distribution, probate cases when the business is being transferred to heirs and a tax is to be paid on the transfer, and in partnership disputes when partners are interested in buying one or the other out of a business or selling a business to a third party. In those types of cases, each side retains a business valuation expert to assist with their case. Practitioners must be prepared to analyze their own expert’s work and cross-examine the opposing party’s expert. This article provides a user-friendly guide to assist practitioners in preparing their own business valuation expert for trial, and, more importantly, preparing to cross-examine the opposing party’s expert.
Qualifications of the Expert
There are numerous types of people who think themselves experts with the qualifications to value businesses. Some people who are not formally trained in business valuation try to testify about business valuation issues. Despite the lack of formal training, the court may elect to deem the person an “expert” and consider the lack of training with regard to the weight placed on the expert’s opinions. Even experts without formal training may testify about business valuation because the Rules of Evidence allow an expert to be qualified through “knowledge, skill, experience, training or education.”1 Hence, the court is not much of a gatekeeper, and many people who are not qualified to testify about business valuation nonetheless testify about business valuation. The practitioner must understand the education, training, and qualifications of the best qualified experts in order to argue that the evidence should not be given much weight because of the lack of education and training of the expert.
Business valuation is heavily dependent on accounting concepts, so at a bare minimum, a business valuator should have an accounting or finance degree. Preferably, the business valuator will also be a certified public accountant (CPA).
Business valuators are certified as accredited in business valuation (ABV) by the American Institute of Certified Public Accountants (AICPA) or certified as accredited valuation analysts (AVA) or certified valuation analysts (CVA) by the National Association of Certified Valuation Analysts (NACVA). To obtain ABV certification, the applicant must have a CPA license, relevant experience, and pass an eight-hour, comprehensive, multiple-choice exam.2 To obtain the CVA and AVA certification from NACVA, the valuator must complete, at minimum, a five-day course, a four-hour exam, and provide a case study for their exam.3 The AVA certification is for those who are not CPAs, while the CVA certification is for CPAs only. Out of these certifications, the CVA certification is considered the most prestigious certification.
The American Society of Appraisers (ASA) also provides business valuation certifications. Those certified by ASA are known as accredited members (AM), accredited senior appraisers (AS), or fellows of the American Society of Appraisers (FASA). Members must have a four-year degree, complete four three-day courses, pass exams at the end of each course, and complete two more exams. The members must also practice business valuation full-time for at least one year.4 The FASA is considered the most prestigious in terms of business valuation.
The Institute of Business Appraisers (IBA) also provides business valuation certification. Those certified by the IBA are simply known as accredited by the IBA (AIBA). The IBA certification is not considered as prestigious as the ABV, AVA, CVA, or ASA certifications.
Valuation Method Used
The business valuation expert should follow the Uniform Standards of Professional Appraisal Practice (USPAP) in completing his or her valuation. Under USPAP standards, there are three approaches to valuation: the income approach, the market approach, and the asset approach.
The income approach valuation is the discounted value of the projected future income stream to the company. A market approach valuation is a valuation based comparison of the company to other comparable companies that have been sold on the open market. An asset approach is a valuation of the assets of the company only, which is essentially a liquidation valuation of the company.5
Generally speaking, the income approach is the most frequently used method for valuation because all of the information needed to conduct the income approach is usually available in the company’s financial statements and third-party publications relating to the company’s industry.6
Most valuators agree that the market approach is the best value of the company because it involves the comparison of the subject company to actual market sales. However, it is hard to find actual market sales, so the market approach is not as frequently used as the income approach.
The asset approach is not used very often because typically a company is worth a lot more than the value of its assets in liquidation. If a company were not worth more than its assets in liquidation, then the company would generally not be operational because the owners would find more value in liquidating the company than they would in running it on a daily basis.
The Income Approach Valuation
The first calculation with the income approach valuation is to build a projected annual income stream. The capitalization rate is then developed. That capitalization rate is then applied to the income stream to derive a 100 percent valuation of the company.7 A discount for lack of marketability may also be applied. And, if less than 100 percent is being valued, a discount for lack of control may then be applied.
• Developing the Income Stream. To develop the income stream for a business, the valuator usually reviews the taxable income on five years of the business’ tax returns.8 The valuator typically averages those five years’ worth of income numbers to come up with his or her anticipated income stream for the purposes of the valuation.9 Sometimes, adjustments to the income stream are appropriate, and sometimes those adjustments are mere manipulations of the numbers.10 The practitioner should watch for adjustments made for the purposes of manipulation because any reductions in that income stream decrease the value of the company, and any increases in the income stream increase the value of the company.
Typical manipulations of the income stream include increases or decreases in the actual officers’ salaries, changes in the company’s depreciation schedules, adjustments to the rental expenses, or increases or decreases in the cost of raw materials. If any of these expenses are adjusted upward, the income stream is lowered, and the resulting value is lowered.
Salary expenses should only be adjusted when they are out of line with the market.11 To compare the salaries to the market salaries, a valuator may review salary statistics compiled by Risk Management Associates, the Bureau of Labor Statistics, or income statements of similar companies. Usually, the salary expense is viewed as a percentage of sales so a company with higher sales and a company with lower sales can be compared equally.
The depreciation of the company results in the expense on the balance sheet. The company’s depreciation schedules should only be adjusted if the valuator determines that the schedules are out of line with other similar companies in the market.12 If the depreciation is adjusted upward, the depreciation expense is higher, and the income stream is lower. A lower income stream results in a lower value of the company. On the other hand, if the depreciation expense is lower, the income stream is higher, and the valuation of the company is higher. Practitioners should watch for unsupported adjustments to the depreciation schedules as it may be for the purposes of manipulation of the value.
• Developing a Capitalization Rate. The capitalization rate is counterintuitive for the uninitiated. A higher capitalization rate renders a lower business value, while a lower capitalization rate renders a higher business value. Practitioners should be on the lookout for adjustments to the capitalization rate, which tend to raise or lower the number.13
The capitalization rate seeks to predict what rate of return an investor would require for the income stream developed above based on the riskiness of the company.14 Thus, a higher capitalization rate represents a higher rate of return demanded by an investor, and a riskier company. A lower capitalization rate represents a lower rate of return demanded by an investor, and a less risky company.
The most common approach for developing a capitalization rate is the build-up method.15 To derive this number, the valuator first adds the risk-free rate (the return on treasury bonds), plus an equity-risk premium (the riskiness of the market in general), plus a size premium (riskiness based on the size of the company), plus a company specific risk premium.16 Any additional premiums added to this build-up method tend to drive the value of the company down. The practitioner should be on the lookout for any additional premiums being added.
The risk-free rate is established based on U.S. Treasury Bonds because Treasury Bonds are considered the safest and least risky investment available. The valuator typically looks at the rate on the 20-year Treasury Bond on the same date the subject company is being valued.17 The rate on the Treasury Bond is not usually subject to manipulation.
The equity risk premium is a premium added based on the riskiness of the overall market. A higher number means the market is more risky, while a lower number means the market is less risky. The valuator typically pulls this premium from an annual publication known as the SBBI Yearbook published by Morningstar.18 This book was historically published by Ibbotson Associates, so valuators refer to the data in this yearbook as the “Ibbotson Data.” The date for the yearbook used by the valuator is the yearbook available on the date of the valuation. For example, if the valuation was as of February 1, 2004, the valuator would look at the 2003 Ibbotson yearbook along with any updates published as of February 1, 2004. For the practitioner, these Ibbotson yearbooks and updates are available at larger local libraries in the reference section.
A smaller company is considered more risky than a larger company.19 Because a smaller company is more risky, the risk premium would be higher because an investor would demand a higher rate of return for a more risky investment.20 The Ibbotson yearbook publishes risk premiums based on the size of the company relative to the overall market.21 The practitioner can check the Ibbotson yearbook in the record library reference section to make sure the proper size premium is applied.
The company-specific risk premium is added when the company is more risky in the remaining market.22 Generally, a company’s specific risk should only be added if the company is even more risky than an already riskier industry. This component of the build-up method is based on the subjective judgment of the valuator. A prudent valuator will have a ratio analysis to support this decision when the ratios of the subject company are compared to comparable companies.23 The practitioner should look for the supporting analysis and confirm that it supports the valuator’s subjective decision. A company-specific risk premium without the analysis should be criticized.
Market Approach Valuation
In general, the market approach is preferable if the valuator can find comparable sales.24 Valuators find comparable sales from databases, and the most frequently used database is the Pratts Stats database. The practitioner should review the comparable sales selected by the valuator to make sure that the companies sold were, in fact, comparable.25 If the company is just not comparable, either in terms of sales or type of business, that company should not be used to compare to the subject company. If the companies’ balance sheets are not comparable, adjustments should be made to the balance sheet.26 Examples include removing nonrecurring items, adjusting the inventory accounting methods, removing nonoperating items, removing excess cash received in the sale, removing excess liabilities assumed in the sale.27 When analyzing valuations, practitioners should 1) make sure the valuator searched for comparable sales; 2) if comparable sales were found, make sure the companies were in fact comparable; and 3) if there is something on the balance sheets of the comparable companies that would skew the purchase price, adjustments should be made.
Asset Approach Valuation
The asset approach is essentially the liquidation value where the liabilities of the company are subtracted from the assets of the company leaving a net value.28 Before subtracting the liabilities from the assets, the valuator updates the values to current values through certain adjustments.29 Typical adjustments are adjustments to change marketable securities to current market value, opposed to the book value; adjusting land to the current market value, opposed to the book value; or adjusting the value of long-term debt to account for the current interest rate, opposed to the rate on the books.30 If the asset approach is relied upon by the valuator, the practitioner should review these adjustments with a critical eye, as this is the area most apt to manipulation by the valuator.
As discussed above, the asset approach is rarely, if ever, used by a valuator. Companies generally are worth much more than the sum value of their assets; if they were not, the company would not be in business as its owners would receive more value liquidating it. Practitioners should be wary of valuators that select the asset approach, and if the asset approach is significantly lower than the market approach, they should be critical of that valuator because the valuator is selecting an approach that is likely to not be equivalent to the value of the company.
Marketability Discounts
Under all methods, the valuator will likely apply a discount for lack of marketability.31 A marketability discount is applied because, in theory, a company that is not being sold on the public market through a publicly traded exchange will not render as high of a price as a company that has a larger market.32 The development of the marketability discount is almost entirely based on the subjective judgment of the valuator.
In an attempt to objectify the marketability analysis, analysts have conducted empirical studies relating to the sale of stock with restrictions on its available market and compared the prices received for stock without restrictions.33 In most of those empirical studies, restrictions were placed on publicly traded stock limiting the available market for the stock, causing the price of the stock to go down.34 However, despite all of the empirical analysis, the range of the discounts in those empirical studies was between five and 70 percent.35 As a result, the valuator’s subjective opinion becomes much more important.
In the end, the practitioner must probe the reasons for the marketability discount chosen by the valuator to determine if it is reasonable. In the writer’s experience, marketability discounts typically range from 10 percent to 25 percent36 and discounts higher or lower than these numbers should be viewed with the critical eye. The following factors should be considered in order to gauge the marketability of a company: restrictions on stock transfers, amount of shares controlled, required holding periods for the stock, and the prospect of a public offering/idea for the business.37 If those factors restrict marketability, the discount will be higher. If they favor marketability, the discount would be lower.
Control Discounts
If the valuator is valuing less than 51 percent of the company, a valuator may apply a control discount, and decrease the value of the company.38 Conversely, if the interest being valued is 51 percent or greater, the valuator may apply a control premium, and increase the value of the company.39 The theory is that a controlling interest is worth more than a noncontrolling interest because the controlling interest can control its compensation and make decisions about the operations of the business.40 The decisions of whether to apply the control discount and how much of a discount to apply are almost entirely based on the subjective judgment of the valuator.
In an attempt to objectify the marketability analysis, analysts have conducted empirical studies relating to the sale of stock with restrictions on control of the business and compared the prices received for stock without restrictions.41 In most of those empirical studies, the value of stock went up depending on the amount of control the owner had over the business.42 After all of the empirical analysis, the range of the discounts and premiums in those empirical studies was between one and 55 percent.43 As a result, the valuator’s subjective opinion becomes much more important.
In the end, the practitioner must probe the reasons for the control discount chosen by the valuator to determine if it is reasonable. In the writer’s experience, control discounts typically range from 10 percent to 25 percent, and discounts or premiums higher or lower than these numbers should be viewed with a critical eye. The following factors should be considered to determine what control discount or control premium should be applied: ability to appoint management or change the board, ability to control compensation, ability to set business policies, ability to liquidate assets, ability to select vendors and suppliers, and the ability to sell or dissolve the company.44 If those shares control those items, the valuator would apply a higher control premium, while if the shares lack control over these items, the discount will be higher. Regardless, the valuator should have a logical explanation for choosing the control discount or premium applied, and it should relate directly to the control of the company by the interest being valued.
Conclusion
This article is intended to give a general overview of business valuation for practitioners. In general, practitioners should look critically at the valuation. Manipulation of the income stream and changes to the capitalization rate based on subjective factors should be analyzed and appropriately criticized. Unsupported marketability discounts should be criticized and analyzed. Valuators who select the asset approach in the face of substantially higher income approach and market approach valuations should be criticized. And, finally, comparables used for market approach valuations should be analyzed and criticized by the practicing lawyer.
1 Fla. Stat. §90.705 (2009); FRE 702.
2 Shannon P. Pratt, Valuing a Business: The Analysis and Appraisal of Closely Held Companies 11 (5th ed. 2007) (1981) [hereinafter,
Pratt, Valuing a Business
].
3 Id. at 11.
4 Shannon P. Pratt, The Lawyer’s Business Valuation Handbook: Understanding Financial Statements, Appraisal Reports, and Expert Testimony 21 [hereinafter
Pratt, Valuation Handbook
].
5 Id. at 85. The Lawyer’s Business Valuation Handbook also mentions an excess earnings method, a method that is very similar to the income approach, and rules of thumb, a method that values the company based on how the industry values it. These two methods are not nearly as common as the income approach, market approach, and asset approach.
6 Id. at 105.
7 Pratt, Valuing a Business
at 174.
8 The valuator could rely upon a variety of income streams to value the company including gross revenues, gross profits, net operating profits, net income before tax, net income after tax, operating cash flow, net cash flow before tax, net cash flow after tax, or net cash flow available for distribution to owners.
Pratt, Valuing a Business at 175. The typical and least controversial approach is to use the taxable income.
9 Five years of tax return numbers are the norm, but any period of time could be used by the valuator if the valuator provides a valid reason for doing so.
10 Examples of adjustments include doubtful accounts, adjustments to inventories, depreciation changes, adjusting lease payments, deferred expenses or income, and unusual gains and losses.
Pratt, Valuing a Business at 131-132.
11 Id. at 147.
12 Id. at 139.
13 Instead of applying a capitalization rate to the estimated annual income stream, some valuators will apply a discount rate to the total estimated income of the company. Under this approach, the company’s total future income is calculated and that total future income is then reduced to present value using the discount rate.
Pratt, Valuing a Business at 177-179.
14 Id. at 200.
15 The build-up method is thought to be the simplest method for developing the capitalization rate.
Pratt, Valuation Handbook at 120. A more complex method known as the capital asset pricing model follows the same approach as the build-up method while adding an additional risk factor (called the beta) for the riskiness of investing in the market as a whole. P ratt, Valuation Handbook at 122.
16 Pratt, Valuing a Business at 200; P ratt, Valuation Handbook at 120. Any premiums for size or unsystematic risk applied on top of the factors discussed above will be developed based on the valuator’s subjective interpretation. Practitioners should question any additional premiums added by the valuator and probe the subjective reasons why the valuator chose to add those premiums.
17 Pratt, Valuation Handbook at 120. The valuator may also consider the 30-day or five-year Treasury Bond, but that is not as common as the 20-year bond.
18 Id. at 207.
19 Pratt, Valuing a Business at 212.
20 Id.
21 The data is grouped in “deciles.” For larger companies, the 10th decile is divided into 10a and 10b. Some commentators believe that decile 10b is problematic (too high) and will not use it.
Pratt, Valuation Handbook at 212, quoting Roger Grabowski’s comments at valuation conferences.
22 Pratt, Valuation Handbook at 121.
23 Id. at 122.
24 Pratt, Valuing a Business at 262. “The use of comparable publicly held corporations as a guide to valuation, as a practical matter, may be the most important and appropriate technique for valuing a privately held operating business.”
25 For a good discussion of the intricacies of the market approach, the practitioner can review
Pratt, Valuation Handbook at 145-163, and
Pratt, Valuing a Business at 265-305.
26 Pratt, Valuing a Business at 262-274.
27 Id. at 288.
28 Pratt, Valuation Handbook at 168.
29 Id. at 169-171.
30 Id. at 171.
31 There is some debate among practitioners as to whether any discounts for lack of marketability should be applied if no sale will actually take place, such as in the dissolution of marriage context. Head v. Head, 1998 WL 257217 (LA. App. 2d Cir. 1998); Kapp v. Kapp, 2005 Ohio App. LEXIS 6144 (Ohio App. 2005); Hanson v. Hanson, 86 P.3d 94 (Ore. Ct. App. 2004).
32 Pratt, Valuing a Business at 416.
33 Id. at 419-420.
34 Id. at 419-431.
35 Pratt, Valuation Handbook at 419-431.
36 Id. at 217. One of the studies, The Management Planning Study, set the average discounts based on the revenues of a company: a 32.9 percent discount for under $10 million; a 30.8 percent discount for $10 million to $30 million; a 25.2 percent discount for $30 million to $50 million; and 19.4 percent discount for $50 million to $100 million; and a 14.9 percent discount for revenues over $100 million.
Pratt, Valuation Handbook, citing Z. Christopher Mercer, Quantifying Marketability Discounts
(1997).
37 Pratt, Valuation Handbook at 205-206.
38 Pratt, Valuing a Business at 398. There is some debate among practitioners as to whether any discounts for lack of control should be applied when the business is a family business or controlled by the parties in the litigation. Brown v. Brown, 348 N.J. Super. 466 (N.J. Super. 2002). Hanson v. Hanson, 2005 Alas. LEXIS 166 (Alaska 2005); Baltrusis v. Baltrusis, 113 Wash. App. 1037 (Wash. Ct. App. 2002).
39 Pratt, Valuing a Business at 386-387.
40 Id. at 385.
41 Id. at 388-393.
42 Id. If a control premium is applied, the value would increase between one to 55 percent and if a discount applied, the value would decrease between one to 55 percent.
43 Pratt, Valuation Handbook at 391, Exh. 15-5.
44 Id. at 385.
Richard Dellinger is a partner with Lowndes, Drosdick, Doster, Kantor & Reed, P.A., in Orlando. Mr. Dellinger’s general litigation practice includes partnership disputes, domestic relations, trade secret theft, wrongful death, commercial litigation, and federal criminal defense. Mr. Dellinger holds his undergraduate and law degrees from the University of North Carolina. The author thanks Thomas Behon for his assistance in preparing this article.
This column is submitted on behalf of the Business Law Section, Michael J. Higer, chair, and Melanie E. Damian and Peter F. Valori, editors.
