Common Errors in Business Valuations
Business valuations are prepared by a variety of professionals, including business appraisers, brokers, financial analysts, certified public accountants, and economists. On occasion, the background of the evaluator preparing the valuation may predispose that individual to serious errors.
There are quite a few common errors made in business valuations during divorce proceedings. All of these problems can be corrected before they arise.
I: Use of a Valuation Method Not Accepted by the Courts
A. Market Value Method
A common error in the valuation of businesses is the application of the market value method to privately-held companies. Using this method, the appraiser compares the price-earnings ratio of a similar public company to the business in question.
For example, if the valued business is a cosmetic company, and publicly-held cosmetic companies are selling for 20 times earnings, then the private cosmetic business' annual earnings are multiplied by 20. If that public company trades at $50 per share, and there are 10 million shares, then the market value of that company would be $500 million. If the company's annual earnings are $100 million, as estimated by the marketplace, then the price-earnings ratio would be 500-to-100, or 5-to-1.
Using the 5-to-1 ratio, the private cosmetics company with $2 million in earnings would be valued at $10 million (five times the company's annual earnings). However, two cases, In Re Marriage of Lotz (1981) 120 Cal.App.3d 379, 174 Cal. Rptr. 618, and In Re Marriage of Hewitson (1983) 142 CaI.App.3d 874, 191 CaI.Rptr. 392, have ruled that relying solely on this ratio comparing public and privately-held businesses for valuation is an error. These cases reasoned that easily sold public companies are not comparable to private, hard-to-sell businesses with one shareholder. Additionally, a private company owner can eliminate most of the corporate profits by paying himself a large salary, whereas a public company will not arbitrarily eliminate profits by paying out hefty salaries.
B. Discounted Future Earnings Method
Another valuation method occasionally used is the "discounted future earnings method." It equates the value of a company to the present discounted value of the company's projected future earnings. For example, the evaluator may determine that the company will earn $2 million, $2.5 million, and $3 million in successive two-year periods. The current discounted value of those earnings, after adding the residual value of the business at the end of the cash flow stream, constitutes the business' value. This approach is acceptable for certain businesses, but should not be used in valuing a professional practice. As the court in Marriage of Fortier (1973) 34 CaI.App.3d 384, 109 CaI.Rptr. 915, held: "Since the philosophy of the community property system is that a community interest can be acquired only during the time of the marriage, it would then be inconsistent with that philosophy to assign to any community interest the value of post-marital efforts of either spouse." In Re Marriage of King (1983) 150 Cal.App.3d 304, 197 Cal. Rptr. 716, similarly rejected a valuation where the appraisal was "replete with references to post-separation efforts of husband."
II. Use of Valuation Methods that Do Not Include All of the Assets of the Business
There are certain accepted formulas often used in valuing a small business. An appraiser relying on a rule of thumb should keep in mind that many formulas addressing small business value don't consider all the business' valuable assets. For example, one formula used to value a retail auto parts business produces an indicated value for the fixed assets, lease, and "intangibles" of the business. However, it omits from the valuation the company's cash in hand, accounts receivable, prepaid expenses and all of its liabilities. Another method produces an indicated value for the company's lease and intangibles, but omits the fixed and current assets of the company and the business' liabilities.
Similarly, exclusive attention may be given to the calculation of goodwill if it becomes too complicated. In a recent court case, an appraiser ended up using goodwill alone as the value of the business, and inadvertently disregarded all other assets and liabilities.
III. Application of Value Multiples to the Wrong Income Stream
Certain valuation methods use income multiples to determine goodwill. To properly figure goodwill, an appraiser needs to determine whether goodwill in a given industry is based on post or pre-tax earnings. The difference could be significant. For example, a company's pre and after-tax earnings are $100,000 and $70,000, respectively. The difference in goodwill value, at five times earnings, will be $150,000. That's a 30% error between $500,000 and $350,000.
Some valuation methods use a multiple of gross revenue. This requires a guard against unintentionally using a multiple of net income, or the use of income where cash flow is required.
IV: Omission of Minority Discounts
Company A and Company B have identical sales and profits, except Company A is owned by a single stockholder and Company B is owned by five equal shareholders. A valuation of both businesses concludes that each company is worth $25 million. That puts the stock value of Company A at $25 million and Company B at $5 million per shareholder.
The valuation assigned to Company B's shareholders' stock is wrong. The value of all five stocks must be discounted because each stockholder has only a minority interest in the company. Unlike the sole Company A stockholder, a Company B shareholder can't dictate company policy or control profits. Hypothetically, assume the Company A stockholder sold his share on the condition that the new owner could not change sales policies, production methods, personnel or purchasing practices. The buyer would be a technical owner of Company A, but would not have any real control over it. Presumably, he would pay much less for the stock than if he were running the company however he chose. The new owner is simply a passive investor; if he had true control over the company, he would be an active owner.
V. Failure to Consider Unique Events
A common practice in calculating goodwill is to average the more recent years' income and expenses to get an average net income. It is usually appropriate to eliminate all atypical income and expenses for the company because the valuation's purpose is to determine the business' value outside of unusual and temporary fluctuations.
A prospective buyer would probably ignore unusual occurrences when determining a business' value, and prefer to look into the company's value in normal circumstances. Therefore, the appraiser must eliminate the effects of unusual, non-recurring income or losses from the company's financial statements. The necessary adjustments, with those events taken into consideration, should then be made by the appraiser.
VI. Failure to Adjust Goodwill to Risk Factors
Businesses that generate present and future income that exceeds the norm for that industry are found to have goodwill. One common goodwill calculation incorporates at least two steps: determining a business' excess income and assessing the likelihood of it continuing in the future. An appraiser may be valuing an accounting or legal practice using methods that are perfectly appropriate, but the result will be flawed if they are unusual circumstances in nature.
For example, a law practice is highly specialized with a unique referral source, such as asbestos litigation. At one time, this was a lucrative practice, but the chances of continued excess income in that law firm would be much lower when compared to a firm that deals in a wide range of litigation practices. A manufacturer may be very successful, and his product may be similar to others in the industry, but the success may be dependent on a patent that is about to expire. A retail store may be very successful, but the neighborhood may be full of people who work at the nearby General Motors plant, which has just announced it is about to close. A local hardware store may be thriving, but a hardware chain may be building a massive store nearby.
Furthermore, the closing of a General Motors plant is not needed to affect the valuation of the retail store. One must at least consider that the success of the retail business may depend on the General Motors plant. Thus, the risk factor for the retail business must consider the risk factor of that General Motors plant.
VII. Omission of Certain Assets or Liabilities
Certain assets and liabilities are easily overlooked because of their nature. One such asset is "work in progress," which is a form of accounts receivable for services rendered where invoices have not been issued. Work in progress can form a substantial portion of the accounts receivable in some cases, such as a construction company that bills only when a significant part of the job is completed. The value of those unbilled services counts as a business asset.
The value of a lease is another notable asset. A below-market lease may be a considerable asset and should be reflected in assessing the business' value.
VIII. Overly Theoretical Analyses
Some business appraisals may be based on complex theoretical assumptions and analyses. However, a valuation by a business broker may return a much different appraisal. The business broker specializes in the real business world, and knows the market value for a business in a given industry. Complex theoretical analysis is rarely the basis for determining real world value, and should be taken with a grain of salt or a second opinion.
IX. Buy-Sell Agreements
A buy-sell agreement may form part of a firm's partnership, governing the terms of a buy-out if a partner leaves or dies, or a new partner is brought into the fold. A buy-sell agreement may also be used in a valuation during the transfer of shares in a stockholder agreement. In family law valuations, the circumstances dictate whether it is appropriate to use buy-sell agreements. In the valuation of professional practices, the courts have held that a buy-sell agreement may be considered, but will not be determinative (Marriage of Slater (1979) 100 CaI.App.3d 241, 160 CaI.Rptr. 686). A recent case, Marriage of Nichols (1994) 27 CaI.App.4th 661,33 CaI.Rptr.2d 13, concluded that it was not an abuse of discretion for the trial court to value the husband's shareholder interest in his law firm based on his firm's stock purchase agreement.
The Nichols stock purchase agreement excluded the value of accounts receivable and and work in progress, although in Marriage of Lopez (1974) 38 Cal.App.3d 93, 113 Cal. Rptr. 237, the court held that these should be included in valuing a law practice. The court in Nichols, supra, found that the purchase agreement was an appropriate valuation method in this particular case. They also recognized that the law firm in question was large and the shareholders did not share in the firm's earnings. Instead the stockholders were compensated as employees based on their own productivity and length of service in the firm. In assessing whether a buy-sell agreement should be determinative, the Nichols Court laid out the following guidelines:
- The date proximity of the buy-sell agreement to the divorce date to ensure that the agreement was not entered into contemplation of the marital dissolution;
- The existence of an independent motive for entering into the buy-sell agreement, such as the firm's desire to protect all partners from the possible effects of a partnership dissolution; and
- The similarity of the value resulting from the agreement's purchase price formula to the value produced by other approaches.
Mrs. Nichols was, however, awarded an interest in her husband's professional goodwill. The court reasoned that the stock purchase agreement did not determine the lawyer's goodwill, and that Mr. Nichols had personal goodwill regardless of his employment at the firm. The court said goodwill cannot be eliminated merely by a recital in a buy-sell agreement. "It is a community asset because husband's experience, reputation and skill, which enabled him to command this high income, were developed while he was married to wife. It directly creates excess income for husband whether he stays with his firm or strikes out on his own" Marriage of Fenton (1982) 134 Cal.App.3d 451,463, 184 CaI.Rptr. 597.
Because Nichols upheld a buy-sell agreement as to accounts receivable and work in progress, but not for goodwill, trial courts will have to examine the facts behind a buy-sell agreement on a careful case-by-case basis.
Business appraisals require close attention, both to theoretical and practical considerations. Attorneys and clients typically want a speedy, low-cost appraisal. However, that approach invites many errors, as shown above. In business valuations during family law actions, the appraiser needs to keep these possible errors in mind during the appraisal in order to avoid bigger problems.
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