5/10/2017. Tips & Traps of Business Valuation in Litigation. Julia Mast, CPA/ABV, CFE, CFF Director Forensics & Valuation Services

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1 Tips & Traps of Business Valuation in Litigation Julia Mast, CPA/ABV, CFE, CFF Director Forensics & Valuation Services 1

2 TO RECEIVE CPE CREDIT Participate in entire webinar Answer polls when they are provided If you are viewing this webinar in a group Complete group attendance form with Title & date of live webinar Your company name Your printed name, signature & address All group attendance sheets must be submitted to training@bkd.com within 24 hours of live webinar Answer polls when they are provided If all eligibility requirements are met, each participant will be ed their CPE certificates within 15 business days of live webinar AGENDA Business valuation basics Written report Kicking the tires on discounts Professional judgment 2

3 BUSINESS VALUATION BASICS Asset Approach Adjust balance sheet items to market value Assets less liabilities & debt = FMV Considered floor value for operating companies Typically used for holding companies Income Approach Cash flow divided by a capitalization rate Normalization adjs. Controlling adjs. Projected financials Discounted cash flows Historical financials Capitalization of cash flows Market Approach Multiples from market transactions applied to entity's data Various databases Transactions narrowed for comparability MVIC to Revenue Gross profit EBITDA EBIT BUSINESS VALUATION BASICS Standard of value Fair market value (willing buyer/willing seller) Fair value (willing buyer, not necessarily a willing seller) Controlling interest 51% & above Noncontrolling interest 50% & under 3

4 THE WRITTEN REPORT The report is a story does it make sense? Contains all required/necessary items Extraordinary assumptions/hypothetical conditions Approach (s) makes sense given the organization type Ownership level valued leads to Appropriate adjustments to balance sheet or income (asset & income approach) Appropriate debt to equity ratios applied (income approach) SSVS NO. 1 MINIMUM DISCLOSURES 4

5 SSVS NO. 1 MINIMUM DISCLOSURES Identity of client Valuation date Purpose Intended users of valuation Description of entity Entity s ownership structure Premise of value Standard of value Sources of information considered Appraisal procedures followed Assumptions utilized Limiting conditions Hypothetical conditions Description of appraisal process/valuation methods considered Description of appraisal process/valuation methods used Opinions & conclusions Any restrictions or other limiting conditions Conflicts of interest Subsequent events THE WRITTEN REPORT Extraordinary assumption Assumption directly related to a specific assignment, as of effective date of the assignment results, which if found to be false, could alter the appraiser s opinion or conclusions* Believed to be true, but whether or not is in fact true is uncertain Hypothetical condition Conditions that you know to be contrary to fact but you take them to be true for the purpose of the analysis* Both must be clearly & conspicuously stated* * Per Uniform Standards of Professional Appraisal Practice (USPAP) 5

6 INCOME ADJUSTMENTS: NORMALIZATION VS. CONTROL Normalization Adjustments One time or nonrecurring Gain/loss of sale of asset Lawsuit settlement Extraordinary items Natural disaster Accelerated depreciation Section 179 or special depreciation Nonoperating asset/liability income/expense Condo/airplane Nonconformance with GAAP Cash basis Control Adjustments Owner compensation to market value (increase/decrease) Market value for expenses, i.e., rent Add back of discretionary expenses What adjustments are being made to income? Do the adjustments make sense? THE WRITTEN REPORT In addition, watch out for Wrong standard of value Overreliance on management representation Advocacy language Overreliance on a single year Growth rates higher than industry forecasts Age of assets Bad debt trends Lack of access to financial information Inadequate working capital for projected growth Reflects the circumstances of a particular buyer or seller Noncredentialed valuator &/or dabbler 6

7 KICKING TIRES ON DISCOUNTS Discount for Lack of Marketability Deduction from the value to reflect relative absence of marketability* Applies to companies that are not liquid controlling & minority Restricted stock studies provide guidance Adjust for additional factors Private vs. public Distribution history/policy Restrictions on transferability Holding period *International Glossary of Business Valuation Terms Discount for Lack of Control Applies to 50% & below Theory minority-interest owner cannot affect change in the business, thus will pay less FactSet Mergerstat/BVR Control Premium Study CAUTION not always applied Value may already be on minority basis Commonly used sources? Professional judgment used? Reasoning given? Discount outside standard range? Overall effective discount make sense? PROFESSIONAL JUDGMENT Know where it is applied THROUGHOUT! Is it reasonable? Ask your friendly BV expert 7

8 WEIGHTING OF YEARS (INCOME) Period Ended December 31, December 31, December 31, December 31, December 31, Earnings Before Taxes $ 70,000 $ 170,000 $ 125,000 $ 150,000 $ 175,000 Normalization Adjustments Gain on sale of assets (40,000) Control Adjustments Executive Compensation - (30,000) (30,000) (35,000) (35,000) Adjusted Earnings Before Taxes 70, ,000 95, , ,000 Weight , ,000 95, , ,000 Weighted average earnings before taxes $ 104,000 WEIGHTING OF YEARS (INCOME) Period Ended December 31, December 31, December 31, December 31, December 31, Earnings Before Taxes $ 70,000 $ 170,000 $ 125,000 $ 150,000 $ 175,000 Normalization Adjustments Gain on sale of assets (40,000) Control Adjustments Executive Compensation - (30,000) (30,000) (35,000) (35,000) Adjusted Earnings Before Taxes 70, ,000 95, , ,000 Weight , , , , ,000 Weighted average earnings before taxes $ 114,333 8

9 WEIGHTING OF YEARS (INCOME) Period Ended December 31, December 31, December 31, December 31, December 31, Earnings Before Taxes $ 70,000 $ 170,000 $ 125,000 $ 150,000 $ 175,000 Normalization Adjustments Gain on sale of assets (40,000) Control Adjustments Executive Compensation - (30,000) (30,000) (35,000) (35,000) Adjusted Earnings Before Taxes 70, ,000 95, , ,000 Weight , ,000 Weighted average earnings before taxes $ 131,667 Can you tell how income is weighted? Is the reasoning documented? Does it make sense? WEIGHTING OF CONCLUSION Methods Considered Net Asset Value Method (Exhibit 3 ) $ 610,000 Capitalized Cash Flows Method - Invested Capital (Exhibit 4 ) 985,000 Market Transactions Method - Pratt's Stats Asset Transactions (Exhibit 6 ) 1,500,000 Indicated Value of Equity (controlling, marketable basis) (rounded) $ 1,140,000 Methods Considered Net Asset Value Method (Exhibit 3 ) $ 610,000 Capitalized Cash Flows Method - Invested Capital (Exhibit 4 ) 985,000 Market Transactions Method - Pratt's Stats Asset Transactions (Exhibit 6 ) 1,500,000 Indicated Value of Equity (controlling, marketable basis) (rounded) $ 1,243,000 0% 70% 30% 0% 50% 50% Methods Considered Net Asset Value Method (Exhibit 3 ) $ 610,000 Capitalized Cash Flows Method - Invested Capital (Exhibit 4 ) 985,000 Market Transactions Method - Pratt's Stats Asset Transactions (Exhibit 6 ) 1,500,000 Indicated Value of Equity (controlling, marketable basis) (rounded) $ 1,346,000 0% 30% 70% 9

10 COMPANY SPECIFIC RISK Equity Component of Weighted Average Cost of Capital Risk-free rate of return (1) 2.30% Common stock equity risk premium (2) 6.03% Small stock premium (3) 5.60% Industry risk-premium (4) 1.51% Company specific premium 2.00% Cost of equity (discount rate) (rounded) 17.40% Equity Component of Weighted Average Cost of Capital Risk-free rate of return (1) 2.30% Common stock equity risk premium (2) 6.03% Small stock premium (3) 5.60% Company specific premium 3.50% Cost of equity (discount rate) (rounded) 17.40% Equity Component of Weighted Average Cost of Capital Risk-free rate of return (1) 2.30% Common stock equity risk premium (2) 6.03% Small stock premium (3) 5.60% Industry risk-premium (4) 1.50% Company specific premium 1.00% Cost of equity (discount rate) (rounded) 16.40% Equity Component of Weighted Average Cost of Capital Risk-free rate of return (1) 2.30% Common stock equity risk premium (2) 6.03% Small stock premium (3) 5.60% Industry risk-premium (4) 1.50% Company specific premium 4.00% Cost of equity (discount rate) (rounded) 19.40% GROWTH RATES Growth into perpetuity Not too high not too low Industry is a good reality check 10

11 PERSONAL GOODWILL What efforts were made to consider personal & enterprise attributes? Are these efforts documented? Sensitivity analysis conducted? Importance (1-5) Existence (1-4) Multiplicative Utility Percent Personal Goodwill Attributes Lacks transferability % Specialized Knowledge % Personalized Name % Personal Reputation % Age, Health and Work Habits % % Enterprise Goodwill Attributes Number of offices % Business Location % Multiple Service Providers % Years in Business % Marketing % % % IN SUMMARY Hire well Read the story Scrutinize 11

12 QUESTIONS? BKD, LLP is registered with the National Association of State Boards of Accountancy (NASBA) as a sponsor of continuing professional education on the National Registry of CPE Sponsors. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may be submitted to the National Registry of CPE Sponsors through its website: The information contained in these slides is presented by professionals for your information only & is not to be considered as legal advice. Applying specific information to your situation requires careful consideration of facts & circumstances. Consult your BKD advisor or legal counsel before acting on any matters covered 12

13 CPE CREDIT CPE credit may be awarded upon verification of participant attendance For questions, concerns or comments regarding CPE credit, please the BKD Learning & Development Department at THANK YOU! Julia Mast