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I am representing the plaintiff in a shareholder dissolution case in New York City. Each of the litigants hired their own business valuation experts, and these experts both used Fair Value as the standard of value. However, the values they concluded were more than 30% apart. Why is this, and what is the next step my client and I should take?
These are two questions, lets address each one separately.
I learned at a relatively early stage of my business valuation education that two reasonable and credentialed experts can sometimes come to different conclusions. However, the acceptable margin between such conclusions is generally defined as 10 to 15%. When two reports differ by a margin greater than 15%, it is often necessary to scrutinize more closely each expert’s procedure. Some follow-up questions I might ask are:
- Did both experts use the same valuation methods?
- Did both experts apply discounts and premiums in the same way, to arrive at its ultimate value?
- Did both experts value the business on the same date?
- Did both experts weigh the valuation methods similarly?
- Did both experts utilize the same underlying financial records, and make similar normalization adjustments and assumptions?
- Are there any math errors within the reports?
This is just a sample to help direct your review of these reports. Other lines of inquiry may be necessary, depending on the subject company involved, and the interest being valued.
With regards to what steps you and your client might take to address this issue, I suggest procuring a rebuttal report. Rebuttal reports assist the trier of fact in identifying the differences between two materially opposing valuation conclusions. I specifically find the detailed reconciliation aspect of this tool to be effective in quickly and clearly communicating the differences between two expert reports. A rebuttal will provide a detailed analysis of each procedural aspect of the reports and will do much to help you and others make a determination of reliability.
I am a matrimonial attorney and represent the defendant in a divorce case. The defendant’s husband has an accounting and tax practice that he operates from a house he personally owns. The house is located in a commercial part of town and is used exclusively by the practice. There are no other tenants. The court appointed a neutral expert to value the practice. That expert considered the asset, income, and market approaches.
The asset approach did not provide any meaningful value, even after adjusting for accounts receivable and accounts payable.
The income approach also did not provide a value, because once the net income was adjusted for reasonable compensation and fair market rent, there were no significant remaining profits.
Therefore, the expert relied exclusively on the market approach. The market approach indicated that accounting practices sell for 1 to 1.5 times gross sales. The expert used an average of 1.25 times and multiplied it by the last year’s gross sales to arrive at the value of the plaintiff’s business.
Does this seem reasonable?
Despite the size of the practice, you question has a number of layers to consider.
It’s not unusual that a small professional practice generates modest normalized net income, after adjusting for reasonable owner’s compensation and fair market rent to a related party. For such businesses, the income approach is seldom a proxy for valuation.
And I generally wouldn’t expect the asset approach to provide a reliable proxy either, because most professional practice owners distribute the cash from the business by year-end. Cash is frequently the most significant tangible asset of the business.
So, the neutral expert is likely correct in relying on the market approach. Still, where this approach is used, it may be necessary to consider the following:
- Does the sales multiple used represent a cash equivalent value? Under the fair market (or fair) value standard, the price must be a cash or cash equivalent. If you would go into the details of the market data, you may find that the sales price is paid over 3 to 5 years. As such, the multiple used has an implied interest factor, which must be removed to determine a cash equivalent value.
- Has there been a proper comparison of the financial attributes of the subject company to the respondents in the database? Did the expert consider size, location, profitability, year of sale – to name a few? Often sales multiples decrease as the size of the business increases, and more profitable businesses yield a higher sales multiple than less profitable businesses. These factors must be considered.
- Did the expert consider possible adjustments to the valuation multiple for items in the balance sheet that are not included in the multiple to determine an equity value? For instance, when the DealStats Database is used, the equity value is computed by adjusting for cash, accounts receivable, and total liabilities to arrive at an equity value.
This answer may be more than you bargained for, but I think these points will be helpful.
I just received a valuation report from my adversary. Though I’m an attorney, I’m very familiar with the general structure of valuation reports and consider myself to be decently fluent in their language. The report I received is very brief; the “boilerplate” language that valuation experts commonly use is particularly curtailed. Having read it for a third time, I realized the expert titled the report as a “Calculation Engagement”. I’m not familiar with that specific phrasing. Does it have any significance, or am I just being paranoid?
No, you’re not paranoid. Calculation and valuation engagements are very different.
If this matter goes to trial, you may find it useful to obtain a copy of the AICPA Valuation Standards. The Appendix has a glossary that defines the valuation engagement as:
An engagement to estimate value in which a valuation analyst determines an estimate of the value of a subject interest by performing appropriate valuation procedures, as outlined in the AICPA Statement on Standards for Valuation Services, and is free to apply the valuation approaches and methods he or she deems appropriate in the circumstances. The valuation analyst expresses the results of the valuation engagement as a conclusion of value, which may be either a single amount or a range.
Conversely, the calculation engagement is described as:
An engagement to estimate value wherein the valuation analyst and the client agree on the specific valuation approaches and valuation 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 engagement generally does not include all of the valuation procedures required for a valuation engagement. If a valuation engagement had been performed, the results might have been different. The valuation analyst expresses the results of the calculation engagement as a calculated value, which may be either a single amount or a range. (1)
Personally, I have never seen a calculation engagement used in litigation. Calculation engagements are most commonly used for management planning purposes. My advice is to review the report again, focusing specifically on the expert’s approaches and procedures. You may find these sections useful in developing your cross-examination strategy.
- American Institute of Certified Public Accountants. 2015. Appendix C of Statements on Standards for Valuation Services. New York: CCH Incorporated.
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