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If I had to do all over again I would have placed an empty pickle jar besides my desk and throw in a dollar every time a business owner proclaimed his/her business would be nothing without them.  At times, I feel the same way. But, my education and experience tells me otherwise.  That being said, if the business owner or another individual disproportionately accounts for the business’s success, it’s important to consider whether the risk of losing such a “key person” warrants an adjustment to the company’s value.   What’s a key person discount? A key person discount may be appropriate if a single owner or employee who would be difficult to replace is responsible for much of the company’s profitability and continued viability, especially when none of the company’s management team members are qualified to assume the key person’s responsibilities. The discount — usually a specific dollar amount or percentage — is taken to reflect the actual or potential departure of a key person. Instead of taking a separate, discrete discount at the entity level, some experts incorporate a key person discount into their valuation methodology. For example, under the income approach, a valuation expert might adjust the discount rate, capitalization rate or projected cash flows to reflect key person risks. Alternatively, an expert who uses the market approach might adjust the pricing multiples to reflect this risk. When are key person risks relevant? Owning a small business isn’t enough to justify a key person discount. These adjustments are […]

Looking At The Fraud Triangle & Beyond Occupational fraud continues to wreak havoc on businesses, with annual business losses reported to exceed 5% of revenues.  Fraud experts have long suggested that the presence of three conditions, known as the “fraud triangle,” greatly increases the likelihood that an organization will be defrauded. The classic fraud triangle, as conceived by criminologist Donald Cressey, consists of Pressure, Rationalization and Opportunity.  The following provides a short description of each. Pressure A perpetrator experiences some type of pressure that motivates the fraud. Pressure can come from within the organization – for example, pressure to meet aggressive earnings or revenue growth targets. Alternatively, the pressure could be personal, such as the need to maintain a high standard of living or pay off debt from credit cards, medical bills or gambling. Rationalization Perpetrators often mentally justify their fraudulent conduct. They might tell themselves that they’ll pay back the money before anyone misses it, or reason that: They’re underpaid and deserve the stolen funds, Their employers can afford the financial loss, They’ll lose everything (or someone) if they don’t commit fraud, “Everybody” does it, or No other solution or help is available for their problems. Most employees who commit fraud are first-time offenders who don’t view themselves as criminals but as honest people caught up by circumstances beyond their control. By rationalizing, perpetrators overcome ethical barriers that generally guide their conduct. Opportunity Without opportunity, even motivated and rationalizing would-be perpetrators can’t commit fraud. Occupational thieves exploit perceived opportunities […]

  Discussing hidden cash and unreported income is always a popular topic for both commercial litigators and family law attorneys.  Currently, we are working on a number of business valuation engagements that have developed into “full blown” forensic accounting and fraud exercises.  Since these issues are currently on my mind, I thought a quick review of some of these issues and techniques would be of interest. Hunt For Hidden Cash Contrary to conventional thinking, forensic accountants don’t automaitclly assume that every closely-held business owner hides cash.  Arguably, some business are more susceptible than others. However, when red flags appear, further due diligence is often required. Experts (as well as IRS investigators) typically rely on certain forensic accounting techniques to prove that cash is missing and to estimate how much income the business owner isn’t reporting. These methods include: Bank deposits. This method involves reconstructing income. In this instance we analyze the spouse’s bank deposits, canceled checks and currency transactions, accounting for cash payments made from undeposited currency receipts, as well as nonincome sources of cash. Nonincome cash sources might be loans, gifts, inheritances or insurance proceeds. Source and funds application. Here, the business owner’s personal sources and uses of cash are analyzed. This approach can be effective in determining where the owner’s income and other funds came from, and how they eventually were used. If the owner is spending more money than he or she is taking in, the excess represents unreported income. Net worth. An unsubstantiated increase in a […]

  Make no mistake about it: Analyzing and understanding the subject company’s financial statements is paramount when opining to value. However, when you start “peeling the onion” other factors play an important role.  This is why you can value two similar businesses simultaneously and arrive at different values. These other factors are commonly referred to as “key value drivers”. Key value drivers can range from a business’s culture, tangible assets, and/or intellectual property. The following provides just a few that should be considered beyond a company’s financial composition. Customers & Competitors Dependency on a few or limited customers will almost always make a business vulnerable.  In other words, a diversified customer base is almost always preferable.  A customer base that extends across several geographic regions or market sectors may add even greater value than one would expect.  This is not just a valuation expert speaking, but a sentiment shared by many sophisticated buyers. An industry by itself can also be a value driver – particularly if the sector is expanding rapidly. Business analysts are often attracted to startups in a young, hot industry – rather than one solely dependent upon organic growth. Keep in mind that you can’t use industry as your sole determinant of value.  Value and the valuation process acknowledges when a company distinguishes itself from the herd.  For example, does the subject company have a unique intellectual property or unusually efficient supply chain? Internal assets Favorable internal factors may also drive a company’s value. Although these factors […]

  As the business valuation discipline matures, judges, attorneys and other people who rely on appraisal conclusions are becoming more comfortable with the income approach. But how does a business’s perceived risk translate into a reasonable discount rate? This is one of the most subjective — and contentious — aspects of valuing a business. Breaking down the income approach Under the income approach, value is a function of a company’s expected economic benefits and its risk relative to other investment types. Valuators typically gauge expected economic benefits in terms of net cash flow. They measure risk by the company’s cost of capital, which is the expected rate of return investors require to invest in the subject company. Riskier businesses have lower values as a result of lower projected income, higher discount rates — or a combination of these. The two most common methods that fall under the income approach are the capitalization of earnings and discounted cash flow methods. Discounting future cash flow The key to both of these methods is converting expected cash flows (or other economic benefits) to present value. This requires the valuator to use a discount rate that reflects the time value of money and the degree of risk associated with an investment in the business. Put another way, the discount rate reflects the risk associated with achieving the expected cash flows. When valuing a company’s equity, valuators may estimate expected cash flows to equity investors and use the cost of equity as the discount rate. […]

  The hiring of a joint business valuation expert can often be useful. This strategy assumes that the parties will openly share information and act in good faith. But it may not be realistic in all situations, including contentious divorces and shareholder disputes. Sharing fees and information When using a joint valuation expert, the parties will only be satisfied by the outcome if there’s a mutual perception of fairness. Perceived fairness is enhanced when: • Both parties have a say in the interviewing and selection of the credentialed expert, • The expert and both parties have full access to relevant information, such as tax returns, financial statements, responses to questionnaires and notes from site visits, • The expert’s communications between the parties are shared, and • Both parties contribute to the expert’s costs. The expert should explain upfront that the valuation will be performed in an objective, unbiased manner. If either party suspects that a joint valuation expert is biased, dissatisfaction may ensue, possibly leading to appeals and additional fees. Potential upsides When the conditions are right, using a joint expert can benefit both sides. The benefits extend beyond just saving money and streamlining the valuation process. A joint expert also helps minimize disruptions to business operations from site visits, information requests and management interviews. Additionally, parties that share a valuation expert prove that they can trust each other, improving the chances of effectively working together in the future. For example, buyers and sellers who share an expert to conduct […]

Without a site visit it can be difficult for a valuation expert to gather all of the information needed to fully understand a business’s operations. This article provides insight on how these steps facilitate the valuation process and discusses a recent valuation engagement in which our request for a site visit was rejected.

Noncompete agreements can help businesses retain valuable employees, safeguard inside information and prevent unfair competition. But though they’re designed to protect companies, they can also put them at risk if they’re not properly structured and maintained. This article explains how valuators help ensure noncompete agreements are valued appropriately and are fair to all parties.

  I was recently retained to prepare a valuation report for a shareholder dispute. Our office prepared a draft report utilizing the fair value standard, which is the standard to be used in New York State for such cases. Counsel invited both experts to a meeting hoping to settle the case without the need of costly litigation. The opposing expert came armed with a plethora of schedules and worksheets computing the minority shareholders interest – but to the surprise to all, the experts opinion was developed under the fair market value standard. The terms “fair value” and “fair market value” are sometimes used interchangeably. To a business valuation professional, however, they have very different meanings. Adding to the confusion, “fair value” may be statutorily defined for shareholder litigation (NYS) and divorce purposes (NJ) – and that definition may vary depending on the case’s venue. Moreover, fair value means something entirely different when it’s used for financial reporting purposes. (See “Fair value under GAAP.”) Ultimately, an expert’s conclusion can differ significantly, depending on which standard of value is appropriate. Fair market value Fair market value is probably the most widely recognized valuation standard. It’s commonly used to value businesses or business interests for sale and tax purposes. The IRS defines fair market value in Revenue Ruling 59-60 as “[T]he price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under […]

  Information presented on a company’s financial statements may not always be meaningful from a valuation perspective – even if it follows U.S. Generally Accepted Accounting Principles (GAAP). Whether financial information is obtained from business income tax returns or audited financial records, valuation experts often make adjustments to get a clearer picture of a company’s financial position, market risk and ability to generate cash flow in the future. In some instances these adjustments may be due to some nefarious actions of the business owner.  In other instances they may just be due to elections in accounting methodology or procedures.uing a business interest. Although these adjustments vary from case to case, many of them fall into one or more of the following types when valuing a business interest. Nonstandard accounting practices, Extraordinary or nonrecurring items, Hidden assets or liabilities, and/or Discretionary spending. The following is a condensed review of these common adjustments. 1. Nonstandard accounting practices A valuation expert may estimate value by using pricing multiples derived from comparable private and public transactions (under the market approach) and discount rates derived from returns on public company stocks (under the income approach). Thus, if the subject company deviates from how other companies in its industry typically report transactions, the valuator may need to make adjustments. Certain financial reporting practices may require adjustment, if the subject company’s methods differ from industry norms. Examples include differences in inventory, depreciation or revenue recognition methods. For example, if a company uses the last-in, first-out method (LIFO) […]