Divorce Business Valuations Why Business Appraisers Values Differ

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1 Divorce Business Valuations Why Business Appraisers Values Differ By Don Bays, CPA/ABV, CVA, CFF (480) ~ DonB@hhcpa.com When a business is jointly owned by a divorcing couple, it is not uncommon for either the husband or wife, or both, to engage a qualified business appraiser to value the ownership interest of the business. As you might expect, it is not unusual for two appraisers to arrive at different values for the ownership interest being appraised. Ethically, the appraisers cannot be advocates for their clients positions as far as the value to be determined for the business. Rather, the appraiser must perform the appraisal in a manner that he or she believes is fair to both divorcing parties. Unfortunately, I have read the appraisal reports of opposing experts who lean in the direction of favoring their client s wishes regarding business value. The good news is that, although these hired guns are available, they are few and far between. The majority of the business appraisers against whom I ve testified in the court room have the highest integrity when it comes to their valuation reports. When I have been retained as an expert witness in a marital business valuation matter, I have arrived at values of business interests to be divided between husband and wife that, more often than not, are different than the values determined by the opposing experts. Whether one expert s value conclusion is selected by the court over the other depends on how persuasive the experts reports and testimony are to a judge or jury. Appraisal Report Differences Made Simple In the courtroom, I have found that there are some common areas of appraisers valuation reports that give rise to the differences in value on which they will testify. The main differences in values determined by two opposing appraisal experts always seem to occur in: a) the valuation approach and method used to value the business; b) the stream of net income or cash flows to be valued under an income approach; c) the capitalization rate applied to the net income or cash flows to be valued; d) the use of discounts from the calculated value; and e) the use of the Fair Market Value standard of value. I will usually prepare a schedule that emphasizes the above-mentioned differences and depicts therefore, why my calculation of business value differs from that of the opposing expert. The schedule seems to be

2 easily understood by the judge and jury, causes focus on the main areas of differences between appraisers, and shortens the appraisers testimony time. Consideration of Approaches and Methods Three of the common approaches to business valuation are: a) asset-based; b) market; and, c) income. Within these three approaches are various methods to arriving at a value for a business. A detailed discussion of all the processes and procedures used in these three approaches will not be made here. I will limit my discussion to some of the more significant aspects of each approach. The Income Approach Capitalization of Earnings Method - Under an income approach a Capitalization of Earnings method might be chosen. Under this method, the appraiser is required to determine an average net income number that a hypothetical buyer could expect to earn from the business in the first year in which he or she takes over the married couple s business. The appraiser arrives at this average net income number by reviewing the historical income statements of the targeted business usually for a period of five years. The five years of income statements are set forth on a spreadsheet. Adjustments to the Income Statements - The appraiser then makes adjustments to each of the five years income statements presented to eliminate unusual or non-recurring expenses that a hypothetical buyer of the entire business would not expect to encounter in the first year of assuming control of the business. Also, if there are discretionary expenses such as charitable contributions, the appraiser will remove these expenses form the income statements as well. One of the most common and, significant, discretionary expenses to be adjusted is excess compensation paid to the owner/manager of the targeted business. In my experience, this has been one of the greatest areas of difference between the average net income that I calculate versus that of the opposing expert. Another significant difference is taking a straight versus weighted average of the adjusted net income for the five years presented. Capitalization Rate - The capitalization rate 1 to be applied to the foregoing average net income can be another major area of difference between appraisers reports. Appraisers may have different ideas of what is to be considered in arriving at the capitalization rate. For example, differing considerations may be given to such factors as: a) the risk free rate; b) equity risk premium; c) size premium; and, d) specific company risk premium going into the derivation of the capitalization rate. 1 Capitalization Rate any divisor (usually expressed as a percentage) used to convert anticipated economic benefits of a single period into value; from the American Institute of CPAs Statement on Standards for Valuation Services, No. 1, page 42.

3 Discounts - Under the standard of Fair Market Value, the appraiser must take into consideration how much of a discount to offset against the calculated value under an income method. This discount is referred to as a Discount for Lack of Marketability (DLOM) 2. Depending on the percentage of ownership interest being valued and the unique facts and circumstances relating to the business to be valued, this percentage can range from 10 to 25%. If both testifying appraisers are using the standard of Fair Market Value, this discount can result in a major difference in values. If husband and wife s ownership interest in a particular business to be valued is at, or less than, 50%, another discount, Discount for Lack of Control (DLOC), 3 must be considered under the standard of Fair Market Value. This discount can also range from another 10 to 25%. The ranges of DLOM or DLOC taken by the appraisers are supported by several studies reported in leading valuation textbooks on which the appraisers typically rely. Asset-Based Approach Under an Adjusted Net Assets or Adjusted Book Value method, the appraiser determines the fair market value of the tangible and intangible assets of the business and deducts the fair market value of the debts of the business from this number in arriving at a value. If the business has real estate or a great amount of equipment recorded on its balance sheet, the appraiser should consider asking for real estate and equipment appraisal reports in order to properly report these fixed assets at fair market value under this method. If the opposing appraisers start with the same balance sheet and have the same real estate and equipment appraisal reports, this method generally can be one of least controversy between the appraisers opinions. Discounts would also be considered using this method under the standard of Fair Market Value. Market Approach Under a Direct Market Transactions method, the appraiser will access transaction databases that provide the details of companies, similar to the targeted business, that have recently sold across the US. The appraiser will attempt to locate enough companies similar in size of revenues and operations as the targeted company and determine an average multiple of selling prices to various criteria such as revenues, net earnings, or Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) of the sold businesses. The average is then applied to the revenues (or net earnings, or EBITDA) of the targeted business to obtain a preliminary indication of value of the targeted business using the guideline 2 Discount for Lack of Marketability an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability; Ibid, page Discount for Lack of Control an amount or percentage deducted from the pro rata share of value of 100% of an equity interest in a business to reflect the absence of some or all of the powers of control; Ibid, page 43.

4 transactions found in the databases. The transactions can usually be broken out as to whether they were asset or stock sales. Under this market approach method, Direct Market Transactions, differences in appraisers reports can arise from the comparable companies being too unlike the target company as to revenues generated, year in which the sale of the business occurred, and whether the sale was an asset or stock sale; also, whether the sale was to a strategic buyer. A discount for Lack of Marketability is typically not taken under this method since the transacted prices are already assumed to have this discount applied. Most Popular Valuation Method Capitalization of Earnings - In my experience, the most popular method chosen by valuation experts in arriving at value in divorce business valuations is the aforementioned Capitalization of Earnings method. However, some appraisals might require the use of an asset-based approach if the business has been sustaining losses over the five-year period mentioned above that is, the business has no net income to value. Averaging or Weighting of Methods One final difference between appraisers business valuation reports can also occur when one appraiser uses a weighting of all three approaches to valuation: asset-based, market and income, rather than selecting a single approach and method as the indicator of value as the opposing appraiser did. Fair Market Value v. Fair Value Some business appraisers will prepare their valuation reports to reflect not only a value under the standard of Fair Market Value, but under a standard of value to which they refer, for divorce litigation purposes, as Fair Value 4. To understand what Fair Value means to a divorce business valuation, we must understand the definition of Fair Market Value first. Fair Market Value is defined as: the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. 5 The concept of Fair Market Value means also that consideration must be given for a DLOM when valuing a controlling interest in a business; and, also a DLOC if a noncontrolling interest is being valued. 4 Fair Value as used here is different than the concept of Fair Value used by various states in setting forth the value of a business interest in oppressed shareholder/owner litigation. 5 Ibid, page 44.

5 Appraisers using the concept of Fair Value for a divorce business valuation simply mean Fair Market Value without any discounts (DLOC and DLOM) taken. Some appraisers will include values under both Fair Value and Fair Market Value, leaving it up to the trier-of-fact to decide which is most fair to the divorcing parties. Conclusion These are some of the nuances that cause major differences in qualified business appraisers valuation reports. In the end it is hoped that differences will become so non-significant that extensive courtroom testimony by the appraisers is not necessary or, required at all. Don Bays, CPA/ABV, CVA, CFF, is a Director of Henry & Horne, LLP s Business Valuation & Litigation Support Services. He has over 39 years of experience in public and private accounting and has testified as an expert witness on numerous civil cases. He can be reached at (480) or DonB@hhcpa.com. Tempe Scottsdale Casa Grande 2055 E. Warner Road 7098 E. Cochise 1115 E. Cottonwood Suite 101 Suite 100 Suite 100 Tempe, AZ Scottsdale, AZ Casa Grande, AZ (480) (480) (520)