Litigation Valuation REPORT. Developing a theory of damages? Read the contract! Recession troubles linger How distressed businesses are valued

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1 July/August 2012 & Litigation Valuation REPORT Developing a theory of damages? Read the contract! Recession troubles linger How distressed businesses are valued 10 questions to help you evaluate a valuation report Early fraud detection: How the SEC uses data mining Anti-Money Laundering Bankruptcy and Insolvency Business Valuations and Consulting Electronic Discovery Forensic Accounting Litigation Consulting Marital Dissolution New Business Ventures Restructuring, Monitoring, Receivership and Fiduciary Miami New York Baltimore Boca Raton Boulder Fort Lauderdale Orlando Valhalla India An Independent Member of Baker Tilly International

2 Developing a theory of damages? Read the contract! In Allstate Sweeping, LLC v. City and County of Denver, a federal court allowed most of a damages expert s testimony regarding lost profits, finding that weaknesses in the expert s methods and assumptions went to the weight of his testimony rather than its admissibility. But the court wouldn t allow the expert to testify regarding the residual value of the plaintiff s business relationship with the defendant. That element of damages conflicted with the terms of the parties contract, which contained a nonassignment clause. A sweeping arrangement In 2006, the plaintiff, Allstate Sweeping, LLC (Allstate), entered into a contract with the City of Denver to provide pressure washing services at Denver International Airport. The contract covered a 27-month term, with two one-year options to renew. About a year later, following disputes between Allstate and airport supervisors, the city terminated the contract. Allstate sued the city and other defendants for wrongful termination, seeking lost profits and other damages. Allstate s damages expert estimated its lost profits to be just over $4.6 million. A Daubert challenge The defendants brought a Daubert challenge, moving to exclude the expert s testimony. The expert used a discounted cash flow analysis to calculate Allstate s lost profits. He estimated that Allstate would have earned the full contract amount of $1.2 million over the initial term, or $44,444 per month on average. He also opined that, at the end of the initial term, Allstate would have started earning just under $180,000 per month, reflecting an expansion of job tasks comparable to that enjoyed by Allstate s successor. Other assumptions the expert made in calculating Allstate s damages included: u A 6% growth rate, u Variable expenses of 42.48%, u A 15% discount rate, u A 60-month business relationship, and u A residual or terminal value of $808,270 at the end of the 60-month period. The defendants challenged the expert s methodology and argued that his data was unreliable for a couple 2

3 of reasons. First, he didn t examine Allstate s tax returns, audited financial statements or profits from equipment sales. Second, Allstate s books didn t separate income and expenses by contract. The court disagreed, finding that the expert used reliable methods and sufficiently reliable data, including Allstate s contract with the city; financial statements, including income statements and balance sheets; and ledger books showing expenses. The court invited the defendants to bring out any weaknesses in the expert s methods or data in cross-examination. The defendants also took issue with the expert s assumptions regarding growth and discount rates, variable expenses, monthly income, and the expected duration of the business relationship. The court acknowledged that there were significant deficiencies in the expert s assumptions and conclusions, but these deficiencies went to the weight of the expert s testimony rather than its admissibility. Contract terms prevail The court did, however, grant the defendant s motion to exclude the expert s testimony regarding the residual value of Allstate s contract with the city. The residual value was based on the expert s assumption that, if the contract hadn t been terminated, Allstate could have sold its relationship with the city to another business for approximately $808,000. The court found this portion of the expert s opinion to be unreliable and, therefore, inadmissible, because it contradicted the contract s nonassignment clause. That clause prohibited Allstate from assigning its contractual rights without the city s prior written consent. Critical provisions In cases involving breach or wrongful termination of a contract, it s critical for lawyers and their damages experts to consider the contract s provisions when developing their theory of damages. In some cases, damages that might otherwise be recoverable are limited by the contract s terms. u Recession troubles linger How distressed businesses are valued Although there are signs that it s waning, the great recession continues to challenge businesses nationwide. Some are still slipping into bankruptcy, while others are sticking to tight budgets to stay afloat. Struggling companies that remain in the game may be prime targets for a takeover. But if you re on the lookout for an acquisition, make sure you do your homework. Looking for signs Distress sales and auctions may offer bargains, but don t let rock bottom prices cloud your business judgment. Acquisition due diligence is very important. That s why bringing in an appraiser who can accurately assess and benchmark financial health against industry norms is a must. Financial statement trends such as recurring net losses and declining or erratic sales growth are symptoms of a company in trouble. Others include missing financial records, fully extended lines of credit and denials for credit extensions. In addition, a business in trouble may be operating in the red and using fire sales of fixed assets to generate cash. 3

4 distressed businesses have higher discount rates and receive downward adjustments to pricing multiples. Valuators might select guideline companies based on similar financial performance or a proximate transaction date to avoid using deals that occurred during better economic times. When valuators address these companies, they can modify their appraisal approach to avoid over- or undervaluing a distressed business. Understanding value When buying a distressed company, liquidation value may be more important than going-concern value especially if the seller is under duress to exit the business. If liquidation value is the floor for purchasing a distressed business, strategic value is the ceiling. Strategic (or investment) value is the value to a particular buyer based on individual investment requirements and expectations. For example, a competitor can afford to pay extra for buyer-specific synergies and economies of scale. Financial distress creates specific valuation challenges. First, it s unlikely that a distressed business s historic financial performance will offer insight to its future performance. Future cash flow is important, because it determines business value under the income and market approaches. If turnaround plans exist and seem reasonable, valuators may use these estimates to forecast future cash flow. If not, they might work with management to project future cash flow based on expected demand, not past performance. Financial distress adds an element of risk, which lowers value. So, compared with healthy companies, Finally, liquidation value plays an increasingly important role in valuing distressed companies. Here, valuators consider what the business would receive at an auction and then subtract outstanding debt obligations. If the company is worth more in liquidation than as a going-concern business, it s probably time to close shop. Looking to acquire Despite the difficulties that the recession has created for many businesses, it has opened up many opportunities for buyers looking to acquire a suitable company at the right price. If you re in the market for a good deal, make sure you perform adequate due diligence before signing on the bottom line. u 3 metrics for evaluating asking price Three financial metrics can help buyers evaluate whether asking prices make sense: 1. Accounting payback period. This tool estimates how long an investment will take to recoup its initial cost. 2. Breakeven point. Breakeven predicts how many units a machine must generate to cover its incremental costs. If sales volume exceeds breakeven, an investment will generate profits. 3. Net present value. Here the analyst converts an investment s projected cash flows to present values using an appropriate risk-adjusted discount rate. If net present value is greater than zero, an investment makes sense. 4

5 10 questions to help you evaluate a valuation report Not all business valuation reports are created equal. So it s critical that attorneys scrutinize information prepared by valuation experts both their own and their opponents for signs of weakness or susceptibility to challenge in court. Here are 10 questions you should ask when reviewing a report. 1. What are the expert s qualifications? Does the expert possess business valuation credentials, such as Accredited Senior Appraiser (ASA), Certified Valuation Analyst (CVA) or the American Institute of CPAs Accredited in Business Valuation (CPA/ABV) designation? Although these credentials aren t required for an individual to serve as an expert witness, they carry a great deal of weight with the courts. Courts often find experts with relevant industry experience to be more persuasive. 2. Which standards were followed? The report should explain which valuation standards were used and why. This depends in part on the expert s credentials. Standards used by ASAs, for example, generally conform to Uniform Standards of Professional Appraisal Practice (USPAP). CVAs are subject to standards established by the National Association of CVAs (NACVA), while CPAs must follow the AICPA s Statement on Standards for Valuation Services (SSVS). Other credentialing organizations have established their own standards or adopted or modified another organization s standards. Failure to articulate the reasoning behind the selection (or rejection) of specific valuation methods may make the report vulnerable to attack. You must become familiar with any applicable standards to ensure that the expert follows them appropriately. Courts, for example, may reject an expert s report prepared in accordance with USPAP if it fails to contain a signed USPAP certification. And SSVS allows CPAs to perform limited scope analyses, called calculation engagements, which generally aren t suitable in a litigation context. Some experts are credentialed by more than one organization. Here, it s important for the valuation report to discuss the choice of valuation standards particularly if there are any conflicts between them. 3. Which approaches and methods were used? Business valuation methods generally fall under one of three approaches: 1) income, 2) market, and 3) asset. Depending on the type of business being valued and the circumstances, a valuator may apply one, two or all three approaches. In some cases, valuators use a 5

6 weighted average of several approaches; in others, they rely on one approach but calculate value under one or more other approaches as a backup. The valuation report should discuss all three approaches and explain why certain approaches were weighted more heavily than others or why they weren t used. It should discuss the expert s selection of specific methods within each approach. Failure to articulate the reasoning behind the selection (or rejection) may make the report vulnerable to attack. a clear picture of the company s potential cash flow and earnings in the hands of a hypothetical buyer. 6. Are calculations reasonable? When using DCF or other income-based methods, the expert s calculation of the appropriate discount or capitalization rate can have a huge impact on the valuation conclusion. Typically, these rates fall within a certain acceptable range. A rate that falls outside the norm absent an explanation as to why it s appropriate may be a red flag indicating the expert has manipulated discount or capitalization rates to achieve a desired result. 7. Are market multiples adjusted? The market approach often involves the use of market multiples, such as price-to-earnings, derived from comparable public companies or from guideline transactions involving comparable companies. The valuator should adjust those multiples to reflect differences between the subject company and comparable companies in terms of size, risk, industry and other factors. 4. Are projected earnings or cash flow consistent? The discounted cash flow (DCF) method and other income-based valuation methods often rely on the client s projections. There s nothing inherently wrong with this but, if the company s projected earnings are inconsistent with its track record, a good valuation report will recognize this fact and explain why the company s financial performance is expected to be different in the future. 5. Does it consider owner compensation? When valuing a controlling interest in a closely held business, the report should address owner compensation. It s not unusual for owner-employees to receive above-market or below-market compensation, for various business and tax reasons. In such cases, the valuator will normalize the compensation to develop 8. Are valuation discounts within the acceptable range? Like discount and capitalization rates, valuation discounts (for lack of marketability or control, for instance) should fall within a reasonable range. A valuation report that fails to consider discounts or uses discounts that are unusually high or low may be suspect. 9. Is the expert independent? A valuation report prepared by an investment banker or an advisor who has a financial stake in the outcome may fall under suspicion. Although they may serve as experts, such parties have a conflict of interest that the court will note when weighing their testimony. It s preferable to engage independent experts to testify on critical valuation issues. 10. Is the report recycled? Clients may push to reuse previously prepared valuation reports to save money. This is usually a bad idea. Business value can fluctuate dramatically, even in a short time. 6

7 Plus, value often depends on the purpose of the valuation: The value of a business for purposes of divorce may be different from its value for a merger or acquisition. Unless the previous report valued the same business interest for the same purpose, it may be vulnerable to challenge if reused in connection with litigation. Be prepared These are just a few of the many questions you should ask when reviewing a valuation report. Careful examination of this critical document can reveal flaws or weaknesses in a valuation expert s testimony either yours or the opposition s. u Early fraud detection: How the SEC uses data mining The most effective strategy for combating fraud is a combination of prevention and early detection. Once a fraud has been completed, the chances of fully recovering losses are relatively low around 16%, according to a survey by the Association of Certified Fraud Examiners. Increasingly, organizations are turning to risk analytics, such as data mining, to uncover fraudulent activity. The power of technology Data mining harnesses the power of technology to sift through massive amounts of information to reveal trends. One reason fraud is difficult to detect is that individual transactions often appear to be legitimate. Data mining makes it possible to examine large volumes of data to uncover relationships, patterns and trends that may signal fraudulent activity. The Securities and Exchange Commission (SEC) has had great success using data mining to detect fraudulent hedge fund activity. Under an initiative it calls Aberrational Performance Inquiry (API), the SEC uses proprietary risk analytics to examine hedge fund returns and identify performance that appears inconsistent with a fund s investment strategy or other benchmarks. Once the SEC flags a firm that s generating abnormally high returns, it investigates the firm s activities more closely. API in action Recently, API has led to fraud charges against several hedge funds and individuals. In one case, the SEC s complaint alleged that a fund s former portfolio manager schemed with brokers to inflate the fund s reported monthly returns and net asset value by manipulating its supposedly independent valuation process. In another case, the SEC charged a hedge fund firm and its sole managing director with engaging in a pattern of deceptive conduct. Among other things, they materially overstated a fund s performance, gave investors the false impression that the fund s returns were consistently positive and minimally volatile, and inflated the firm s assets. According to SEC personnel, The extraordinary returns reported by these advisers and portfolio managers were, in most cases, too good to be true. In other cases, outlier returns were a telltale sign that something else was amiss. Robert Khuzami, Director of the SEC s Division of Enforcement, commented that this approach especially in the absence of a tip or complaint minimizes both the number of victims and the amount of loss while increasing the chance of recovering the funds and charging the perpetrators. No substitute Data mining can be an effective fraud detection tool in a variety of contexts particularly when used in connection with traditional fraud detection methods. Although no substitute for a thorough investigation, it can point you in the right direction by identifying suspicious patterns. This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use VLBja12 7

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