ATTORNEY S GUIDE TO CROSS-EXAMINING OR DEFENDING THE FINANCIAL OR BUSINESS VALUATION EXPERT. by Clay Gill June 6, 2013

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1 ATTORNEY S GUIDE TO CROSS-EXAMINING OR DEFENDING THE FINANCIAL OR BUSINESS VALUATION EXPERT by Clay Gill June 6, 2013 A. Challenging the Financial or Business Valuation Expert. 1. Attacking the expert s credentials. What are the expert s credentials? Typically, an expert attempting to calculate a business s value will have a business valuation certification. There are a variety of recognized business valuation certifications, such as: (a) the Accredited in Business Valuation (ABV), issued by the American Institute of CPAs; (b) the Certified Valuation Analyst (CVA) and the Accredited Valuation Analyst (AVA), issued by the National Association of Certified Valuation Analysts; (c) the Accredited by the Institute of Business Appraisers (AIBA), the Certified Business Appraiser (CBA), and the Master Certified Business Appraiser (MCBA), issued by the Institute of Business Appraisers; and (d) the Accredited Member (AM) and Accredited Senior Appraiser (ASA), issued by the American Society of Appraisers. Each certification has different requirements and each certification requires the applicant to pass a written exam before obtaining the certification. Additionally, the ABV and CVA are limited to those individuals who are certified public accountants (CPAs). Economists, accountants, and business valuation experts are typically used to calculate lost profit damages. These experts must have the requisite experience in calculating discount rates in accordance with generally accepted methodologies. It is very unusual to attack an opposing expert s credentials, and such attacks are usually limited to those situations where the other side uses an in-house expert, such as a controller or chief financial officer, to calculate a business valuation or a lost profit calculation. But be aware of the different certification requirements in those situations where you have dueling opposing experts, as that may help your expert appear more experienced and reliable than the opposing party s expert. Also remember that just because an expert has the proper credentials for calculating a business valuation or lost profit damages does not make them an expert in all areas. For example, if the expert is relying on a survey to prove consumer demand, what credentials does the expert have to make sure the survey was performed in accordance with acceptable survey methodologies and statistical methodologies if the expert is attempting to draw conclusions from the results of the survey? 2. What is the expert trying to calculate? The second thing you need to determine is, what is the expert trying to calculate? For example, are they calculating lost profits, are they calculating a loss to the business, are they attempting to value the business or a portion of the business, or are they attempting to determine what an owner is owed pursuant to a buy sell agreement or some other type of buy back arrangement? Client:

2 Some financial experts use different methodologies depending on what they are trying to calculate. As a subset to this question, you need to determine if the expert is attempting to calculate something in accordance with acceptable appraisal practices, e.g., fair value or fair market value, or are they attempting to calculate something in accordance with the terms used in a contract, e.g., a contractually mandated buy back formula? When challenging a business valuation expert, you need to pin down the opposing expert on the details of what they are trying to calculate and the methodology they used in coming up with their value. For example, some financial experts believe that minority discounts are appropriate when calculating fair market value, but not when calculating fair value. Identifying the purpose of the expert s calculation helps you determine whether the expert has used acceptable methodology in performing their calculation. Additionally, if the expert is valuing something in accordance with the terms of a contract that vary from generally accepted appraisal practices or methodologies, have the expert identify those variances from generally accepted appraisal practices. This is especially important if the parties have different interpretations of a contractually mandated buy back formula, as the court must assess the reasonableness of the different interpretations when resolving any ambiguity in the buy back formula. 3. Attacking the methodology. Once you have identified the purpose of the opposing expert s assignment, the next step is identifying the methodology used by the expert. For example, if the opposing expert is attempting to value the business, has the expert utilized an asset based approach, an income based approach, a market approach, and appropriately weighed each in coming to a conclusion of value? If not, why not? When conducting discovery about an opposing expert, you will want to identify those parts of the expert s opinion that deviate from generally acceptable methodologies (for possible Daubert challenges) and those methodologies that are different from your expert s methodology or other acceptable methodologies that could have been used by the expert (so you can refine your arguments to the court or jury about why your expert s methodology is more appropriate for the case). When evaluating the methodology employed by the expert, determine if the use is consistent with the manner in which the expert has performed their calculation. For instance, if the expert has made a variety of assumptions, rather than relying upon factual data relating to the company itself or its competitors, has the expert utilized a higher discount rate than they would have otherwise if they was basing their opinion on pure factual data, or alternatively, has the expert presented range of damage scenarios? 4. What facts has the expert relied upon? The fourth thing you need to determine is, what are the critical facts the expert has relied upon? This typically requires a careful examination of the expert s report and supporting schedules. The purpose of identifying the facts the expert is relying upon is to determine the strength of the foundation supporting the expert s ultimate opinions. This could include things such as financial Client:

3 statements. If the financial statement is simply an internal financial statement, as opposed to an audited financial statement, has the expert done any independent analysis to determine the reliability or accuracy of the internal financial statement? Likewise, if the expert is relying upon a projection or forecast, what has the expert done to verify the reliability or accuracy of the projection or forecast, or is there anything else that supports the reliability of the projection or forecast, such as the results of a comparable company? If the expert has tested the reliability of the data supporting their ultimate opinions, what special education, training, or experience does the expert have to testify about the reliability of the data supporting their opinions? It is also important to identify facts that the expert has not incorporated into their analysis. Are there prior business valuations with which the expert disagrees? If so, why does the expert disagree with the conclusions of the prior business valuation? Will the expert concede that there are facts inconsistent with their ultimate opinions, and, if so, how has the expert reconciled those adverse facts (e.g., applying a higher discount rate, adjusting future projections, performing alternative damage scenarios, etc.) 5. What assumptions has the expert relied upon? The fifth thing you need to determine is, what assumptions has the expert made in performing their calculation? Have the expert differentiate between facts they are relying upon and the assumptions they are making. One of the biggest assumptions experts often make that can lead to a critical difference in business valuation is a weighted average cost of capital ( WACC ). If the expert is assuming a WACC that is materially different from the company s historical operations, what support does the expert have for using that WACC? Financial experts often must project revenues and expenses that a company would incur in the future. You must get a clear understanding of how the expert developed their projections of such future revenues and expenses, and how the expert assessed the risk or likelihood of the company achieving those results in the projected future dates. Typically, experts will apply a discount rate that appropriately reflects the probability of the company achieving the projected revenues and expenses. Special consideration should be given to any calculation of lost profits or valuations of an unproven business venture. For example, if surveys are used to prove consumer demand for products and services of the company, were the surveys conducted in accordance with acceptable standards? Were the surveys conducted in a manner that allows the expert to draw statistically valid inferences from the information? Are there facts that are inconsistent with the expert s calculation of lost profits or on-going business valuation for an unproven business venture, e.g., low barriers to entry or other failed ventures in similar markets or industries? Another critical assumption that any financial or business valuation expert must make is the date of the valuation. Typically, business appraisers are prohibited from using 20/20 hindsight when performing a business valuation; thus, the date of the valuation is critical in a business appraisal. But is 20/20 hindsight appropriate when calculating the lost profits of a business enterprise? In determining a business valuation, the appraiser is typically trying to determine what someone was willing to pay on a certain date. But in calculating lost profits, the expert is trying to determine the losses caused by a breach of contract or some other wrongful conduct. Thus, one Client:

4 can make a pretty compelling argument that 20/20 hindsight is appropriate when calculating lost profits for a defined period of time as opposed to valuing a business as of a certain date. A great way to cross-examine an opposing expert is to point out those assumptions made by the expert that vary or contradict the facts of the case. 6. Identifying the information considered by the expert. The most useful tool you can obtain for purposes of cross-examining the opposing expert is the material they have considered (not relied upon) in formulating their opinions. Your goal is to: (a) identify information that is in the possession of the opposing expert that is inconsistent with the expert s ultimate opinions or critical assumptions; (b) identify those facts that were not considered by the expert that are inconsistent with the expert s ultimate opinion or critical assumptions, e.g., the failure to consider certain deposition testimony or the failure to consider prior valuation reports; and (c) anything indicating that the expert was predisposed to a particular opinion before they performed their analysis. The things that you will typically find in a financial or business valuation expert s files should include: Prior valuation reports Financial statements (balance sheets, income statements, and statements of cash flows) Projections and forecasts Details of accounting ledgers or chart of accounts Notes from discussions with management and opposing counsel Deposition transcripts Published statistics from governmental agencies or trade organizations Published information regarding applicable industries Information regarding comparable companies Excerpts from treatises relied upon to support the methodology used Independent studies, surveys, or sampling conducted by the expert or at the direction of the expert Things you will want to get in an electronic format include: (a) financial records, so you can drill down to the general ledger if necessary; and (b) the spreadsheets prepared by the expert, so that you can evaluate the accuracy of the expert s calculation and determine the significance of any change to the inputs in the expert s calculation, e.g., the significance of any increase in the discount rate to the opposing expert s calculation of damages. 7. Identifying similar engagements. Has the expert performed similar valuations or calculations in the past? If so, any prior appraisal reports, expert witness reports, deposition transcripts, or trial transcripts may provide useful information for cross-examination, such as: (a) using different methodology to complete the same or a similar assignment; or (b) applying significantly different discount rates for a similar Client:

5 business enterprise. The things you will want to try and obtain from any opposing expert include: Prior appraisal reports for companies in similar industries Any expert reports published for prior similar engagements Prior depositions or trial testimony that was transcribed 8. Identifying any relevant treatises or trade journals. Are there any treatises or trade journal articles that the expert has relied upon? Have the expert identify those treatises or trade journals that they believe support the methodology they used to formulate their opinions. Also, ask the opposing expert if there are treatises, trade journals, or peer review reports that criticize the methodology used by the expert or that advocate for the use of a different methodology than that used by the opposing expert. During the discovery process, have the opposing expert tell you why they chose the methodology they did rather than other forms of acceptable methodologies. Are there any treatises or trade journal articles that the expert has written? Focus on treatises or trade journal articles that discuss the matters in dispute, e.g., calculating the appropriate discount rate, determining the appropriate weighted average cost of capital, formulas used to make certain calculations. 9. Daubert challenges. In Daubert v. Merrell Dow Pharmaceuticals, Inc., the United States Supreme Court held that Rule 702 of the Federal Rules of Evidence requires that the trial judge must ensure that any and all scientific testimony or evidence admitted is not only relevant, but reliable. 509 U.S. 579, 589 (1993). To assist trial courts in making that determination, the Court proposed a list of questions and considerations which it said were not a definitive checklist or test. Id. at 593. The questions and considerations the Court suggested included whether the expert s theory or technique can or has been tested, whether it has been subject to peer review or publication, and the known or potential rate of error. Id. at While Daubert dealt with the admissibility of expert testimony of a scientific nature, the Supreme Court subsequently held in Kumho Tire that the gatekeeping function prescribed in Daubert applies to all expert testimony. Kumho Tire Co. v. Carmichael, 526 U.S. 137, 141 (1999). In Kumho Tire, the Court stated that the test of reliability is flexible, and Daubert s list of specific factors neither necessarily nor exclusively applies to all experts or in every case. Id. The end result of Daubert and Kumho Tire is that the trial court is vested with discretion in admitting or excluding expert testimony. Whether a court will grant or deny a Daubert challenge to a financial or business valuation expert depends on your ability to prove the unreliability of the expert s opinions. The trial court is more likely to grant a Daubert challenge if the expert s opinions are based on novel or unproven methodologies. In other circumstances, where the expert s opinion is based upon multiple speculative assumptions, the district court will ultimately have to decide whether the expert s opinions should be excluded outright or admitted subject to cross-examination Client:

6 For a more extensive discussion on specific instances when a court has granted or denied a Daubert challenge to a financial expert and a legal discussion on acceptable methodologies for proving business valuations and lost profit damages, see Proving Lost Profits After Daubert: Five Questions Every Court Should Ask Before Admitting Expert Testimony, by Robert M. Lloyd, 41 U. Rich. L. Rev. 379 (2007); Daubert and Lost-Profits Testimony, by Stewart I. Edelstein, 41-SEP JTLATRIAL 31 (Sept. 2005); Forensic Economics -- Valuation of Businesses and Business Losses, by Philip Eden, Norman H. Leonard, Ph.D., David Mishkin, Ph.D., and Jerald H. Udinsky, Ph.D., 16 AM. JUR. Proof of Facts 2d 253 (originally published in 1978, database updated April 2013). B. Defending the Financial or Business Valuation Expert. The best way to prepare your expert is by putting him or her through the cross-examination process before they issue their written report. 1. Defining the role of the expert. When you hire an expert, you should clearly define what you are asking them to do without making any request that they achieve any particular result. For example, your engagement letter with your expert should state that you are hiring the expert to assist in determining the value of your client s interest in the business as of the date of her termination of employment from the company. The next step should be a meeting with your expert to give them an overview of the case and explore various ways to prove up any damages according to acceptable methodologies. 2. Educating your expert about the facts of the case. Make sure your expert understands your theory of the case. Do not expect your financial expert or valuation expert to have specialized knowledge about your client s industry. One of the critical aspects of your job is to educate the expert about your client s business, the industry at large, and past, present, and future competitors. You will also need to ensure that all your expert s opinions and critical assumptions are consistent with the facts of the case and are otherwise consistent with Rule 703, i.e., of a type reasonably relied upon by experts in the particular field in forming opinions or inferences upon the subject. 3. Methodology supporting your expert s opinions. You will need to ensure that your expert has used acceptable methodology. If there are two or more acceptable methodologies, have your expert prepared to explain why their methodology is more appropriate than the other acceptable methodologies. If your expert is using a newly adopted methodology or a methodology they have developed themselves, are there any peer reviewed articles that support or refute the use of such methodology? If there are peer review articles that refute the methodology, should you have your expert utilize another generally accepted methodology as a sanity check or to avoid a Daubert challenge? Do you need to have other experts to lay a foundation for the reliability of the data relied upon by your damages expert, i.e., a marketing survey expert or an industry expert? Client:

7 4. Consistency with prior engagements. Do your due diligence on your expert and make sure that their methodology and calculations of things like discount rates is consistent with their prior engagements. It is far better to find the warts yourself than have opposing counsel pull them out during a deposition after your client has incurred a significant expense in developing your expert s opinions. 5. Do your expert s opinions comport with common sense? Jurors prefer simple arguments. Is your expert s opinion consistent with common sense? For example, if the company raised money during the relevant period of time from third-party investors, is the expert s opinion regarding valuation consistent with what others actually paid for an ownership interest in the company? If not, can you provide a simple compelling argument why your expert s valuation is more reliable than what others actually paid? Is the discount rate utilized by the expert consistent with the business being valued, e.g., a higher discount rate for an unproven business venture? Are the critical inputs supporting your expert s opinions based more on facts than assumptions? The more assumptions your expert has to make, the more speculative their opinion becomes and the less likely it will be accepted by a court or jury. 6. The presentation of the report. Many lawyers agonize over how the expert s report should be presented. The expert s report should be treated like a deposition. It is not an opportunity to win the case. It is an opportunity to lose the case. If you do not disclose your expert s opinions and the basis and reasons for their opinions in the manner required by the judge, the judge may exclude your expert from testifying at trial. Thus, playing hide the ball is a dangerous game when it comes to expert witnesses. Typically, the best type of report is an outline of the expert s anticipated direct examination testimony. Additionally, expert witnesses who are savvy at defending their opinions usually create binders of all of the data and other information that support their opinions, so that these documents can easily be referenced at deposition or trial if necessary. Another critical aspect of trial preparation is to ensure that all of the documents that your expert will utilize at trial during their direct examination are timely marked as trial exhibits and produced along with their report. Note that Federal Rule of Civil Procedure 26(a)(2)(B)(iii) requires that the following be included in the expert s written report: any exhibits that will be used to summarize or support [her opinions]. Idaho Rule of Civil Procedure 26(b)(4) similarly provides that the following may be obtained by interrogatory or deposition prior to trial: any exhibits to be used as a summary of or support for the opinions. If you are the plaintiff, remember that the law requires you to prove your client s damages to a degree of reasonable certainty, and this usually requires that your expert s opinions be based on definite, certain and reasonable data. So make sure that before your expert issues their report, you verify the reliability of the data supporting their opinions Client:

8 CONCLUSION The best technique for attacking an opposing party s business valuation expert or lost profit expert is to point out the weaknesses in the foundation of the expert s opinions, i.e., that it is based upon multiple speculative assumptions or is inconsistent with the facts of the case. While it would be great to win a Daubert challenge, most trial judges defer to the cross-examination process to weed out the weaknesses of an opposing expert s opinions. To win a Daubert challenge, you must either prove that the expert s methodology is novel and unproven, or that the data and information the expert relied upon is speculative and unreliable. When choosing a business valuation expert or lost profit damage expert, evaluate the expert s ability to teach a jury and simplify his or her analysis to a third grade level. Also have the expert utilize simplified charts and analogies that the jury can relate to when explaining the value of a business or the damage caused to a business. Last, but not least, make sure you cross examine your own expert about the methodologies they used, their qualifications to make certain assumptions or evaluations about the reliability of the information that supports their opinions, and make sure that their opinions are consistent with the facts of your case or that your expert is otherwise able to adequately explain why they disregarded a fact of your case in favor of an assumption Client: