A Litigator s Guide to Business Valuation - Divorce. Frank A. Wisehart, Partner MBA, CPA, ABV, CFE, CVA, MAFF

Transcription

1 A Litigator s Guide to Business Valuation - Divorce Frank A. Wisehart, Partner MBA, CPA, ABV, CFE, CVA, MAFF

2 Table of Contents 1 How to Defend and Attack Expert Valuation Testimony 2 Principles of Business Value Standards 3 The Nuances of the Three Business Valuation Approaches 4 The Double Dip in Business Valuation RGL Forensics 2

3 1 How to Defend and Attack Expert Business Valuation Testimony RGL Forensics 3

4 Daubert Challenges to Financial Experts by PwC, May 2017 RGL Forensics 4

5 Daubert Challenges to Financial Experts by PwC, May 2017 RGL Forensics 5

6 Daubert Challenges to Financial Experts by PwC, May 2017 Reasons Cited in Successful Challenges to Experts: RGL Forensics 6

7 2 Principles of Business Value Standards RGL Forensics 7

8 The Continuum of Business Valuation Standards RGL Forensics 8

9 Fair Market Value Standard (IRS Revenue Ruling 59-60) The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. RGL Forensics 9

10 Fair Value Standard Fair Value Fair Market Value excluding lack of marketability discounts Frequently used in disadvantaged minority shareholder actions Majority shareholders should not be able to deprive minority shareholders of value through the application of significant lack of marketability discounts. To do so, would be inequitable. RGL Forensics 10

11 Standard of Value Differences Standard of Value Interpretations: Appraiser #1 - Value Without Discounts Appraiser #2 - Value With Discounts Appraisal Differences as a Percentage % Company Value $ 11,000,000 $ 10,600, % 2 Value of a 25.0% Interest 2,750,000 2,650, % 3 Discount for Lack of Marketability % % 4 Discount for Lack of Marketability - (662,500) 5 Opinion of Value of a 25.0% Interest $ 2,750,000 $ 1,987, % RGL Forensics 11

12 3 The Nuances of the Three Business Valuation Approaches RGL Forensics 12

13 Three Approaches to Value Asset Approach Asset-intensive holding companies Fair market value of the net, aggregated assets Income Approach Income producing companies worth significantly more than its hard assets Uses income and risk components Market Approach Independent observations of the value of similar companies Uses metrics to relate value to the subject RGL Forensics 13

14 Asset Approach Adjustments FMV Adjusted 2 ASSETS 3 Cash $ 825,891 $ - $ 825,891 4 Receivables, net 6,583,213-6,583,213 5 Due from shareholder 240, ,000 6 Inventories 29,545,587 7,264,000 (a) 36,809,587 7 Due from affiliate 93,690-93,690 8 Prepaids and other current assets 457, ,920 9 Assets held for sale - discontinued ops Total current assets 37,746,301 7,264,000 (a) 45,010, Property and equipment, net 9,214,591 (6,195,150) (b) 3,019, Other Assets 13 Goodwill 2,000,000-2,000, Due from shareholder 476, , Cash surrender value of life insurance 222, , Other assets 1,602,894 14,106 1,617, Total other assets 4,302,756 14,106 4,316, Total Assets $ 51,263,648 $ 1,082,956 $ 52,346,604 RGL Forensics 14

15 Income Approach 1 Investment $ 1,000,000 2 Rate of Return 11.0% 3 Solve For: Annual income????? RGL Forensics 15

16 Income Approach Solve For: Business Value??????? = $ 110, % RGL Forensics 16

17 Benefit Stream Issues Net Income (Loss) $ 2,826,426 $ 603,895 $ (490,721) $ 1,897,035 2 Plus: Fair market value of rent adjustment 998,401 1,044,901 1,093,300 1,156,441 3 Plus: Simon Insurance Agency (net income) 475, , , ,061 4 Plus/(Minus): Charlotte Car Rental (net income or loss) 50,410 32,859 (80,291) (36,578) 5 Plus/(Minus): LIFO 314, , , ,829 6 Plus: Depreciation on property and equipment 508, , , ,761 7 Less: Discontinued operations, Pontiac, GMC and Porsche - (311,062) 572,598 50,638 8 Plus: Loss on sale of property and equipment - 30, Plus: Goodwill Impairment , Plus: Amortization 2,220 2,220 2,204 1, Plus: Interest on capital and long-term obligations 57,549 59,142 66,981 70, Plus: Interest- shareholder notes 41,140 34,297 73,700 56, Plus: Bad debt expense related to affiliate receivable 365, , , Plus: Legal Fees (excess over last 5 yrs) 480, , , Plus: Country Club Dues (estimated) 22,150 22,150 18,000 16, Plus: Airplane Expenses 258, , Total Normalized Company Income $ 6,400,004 $ 4,081,496 $ 3,823,143 $ 4,555, Weighting Three-Year Weighted Average Normalized Income $ 5,197,691 RGL Forensics 17

18 Benefit Stream Issues 20 Three-year weighted average pre-tax cash flow $ 5,197, Less: Taxes (depreciation based on three-year average) 40.56% (1,663,082) 22 After tax cash flow 3,534, Less: Annual Capital Expenditures - Exhibit 5 (633,000) 24 Net free cash flow 2,901, Capitalization rate/multiple 14.50% Value of invested capital 20,011, ADD: Fair market value - classic cars (Exhibit 5a) 1,617, ADD: Nonoperating assets (Exhibit 5b) 1,010, LESS: Debt (Exhibit 5c) (1,573,911) 30 Value before Discounts 21,065, LESS: Discount for Lack of Marketability % (2,633,135) 32 Common Equity Value - 100% $ 18,431, INDICATED COMMON EQUITY VALUE OF 99% INTEREST, (rounded) $ 18,250,000 RGL Forensics 18

19 Benefit Stream Issues Facilities Capital Costs Totals 1 Dealership: 2 Nissan $ 1,600,000 $ - $ - $ - $ 1,600,000 3 Saturn 500, ,000 4 Fiat - 675, ,000 5 Chevrolet , ,000 6 BMW , ,000 7 Totals $ 2,100,000 $ 675,000 $ 575,000 $ 648,000 $ 3,998, Year Average $ 999, Year Average Facilities Capitalization Requirements based on 2014, 2015, and 2016 $ 632, Average Facilities Capitalization Requirements based on 2014, 2015, and 2016 (rounded) $ 633,000 RGL Forensics 19

20 Benefit Stream Issues Executive Compensation IRS Reasonable Compensation Job Aid Third-party surveys Capital Expenditures/Depreciation Relying on management estimates Not separating Section 179 deductions Not recognizing the long-term and short-term aspects of depreciation and capital expenditures Failing to review subject company growth (or lack of growth) factors Failure to adequately consider working capital requirements RGL Forensics 20

21 Risk Rate - The Cost of Equity 1 Factor: Build-up CAPM (a) 2 Risk-Free Rate of Return 4.0% 4.0% 3 Equity Risk Premium 5.0% 5.0% 4 Beta n/a Industry Risk Premium 1.5% n/a 6 Small Stock Risk (Size) Premium 5.6% 5.6% 7 Company Specific Premium 4.5% 1.5% 8 Cost of Equity 20.6% 17.6% (a) Capital Asset Pricing Model - CAPM RGL Forensics 21

22 Market Approach Market Multiple Method - Analyst Data Chrysler, Jeep, Dodge BMW Nissan Subaru Chevrolet Insurance / Rentals Total 1 Weighted, Normalized EBITDA $ 3,079,079 $ 621,122 $ 436,616 $ (2,518) $ 165,340 $ 257,112 $ 4,556,750 2 Times market EBTDA multiple Subtotal market multiple value 9,237,237 1,863,365 1,528,157 (7,555) 330, ,336 13,723,219 4 Adjusted for the following: 5 Cash 825,891 6 Receivables, net 6,583,213 7 Inventories, adjusted for LIFO reserve 36,809,587 8 Prepaids and other current assets 457,920 9 Due from affiliates 93, Property and equipment, net - excluding leasehold improvements 1,708, Cash surrender value of life insurance 222, Classic cars 1,617, Notes payable - floorplan (34,443,112) 14 Current portion of long-term debt (490,503) 15 Due to affiliates (22,661) 16 Reserve for chargebacks (383,159) 17 Accounts payable and accruals (5,828,161) 18 Long-term debt (1,083,408) 19 Reserve for chargebacks (278,792) 20 Net Value of Equity - 100% $ 19,512, INDICATED VALUE OF A 99% OWNERSHIP INTEREST, (rounded) $ 19,320,000 RGL Forensics 22

23 Market Approach Common Errors Not devoting enough time to this analysis Failing to find reasonable comparable companies Not understanding the underlying database methodology Not applying consistently, the metrics (i.e. three-year weighted net earnings) that were used in the income approach Failing to consider an additional metric other than revenue (thus, excluding profitability) Considering only the mean or the median RGL Forensics 23

24 Excess Earnings Approach Excess Earnings Approach Mature Business Owns Office, $200k Debt New Business Rents Office, $200k Debt Total Cash Flow to Invested Capital $ 275,000 $ 275,000 Fair Market Value of Tangible Assets $ 2,500,000 $ 100,000 Asset Specific Required Rate of Return 10.0% 10.0% Less : Required Level of Economic Income (250,000) (10,000) Excess Economic Income 25, ,000 Divided by: Direct Capitalization Rate 20.0% 25.0% Intangible Asset Value 125,000 1,060,000 Plus : Fair Market Value of Net Tangible Assets 2,500, ,000 Implied Value of Invested Capital 2,625,000 1,160,000 Less : Existing Debt (200,000) (200,000) Fair Market Value of Equity $ 2,425,000 $ 960,000 Value of Intangibles $ 125,000 $ 1,060,000 RGL Forensics 24

25 Excess Earnings Approach Rebutted by the Income Approach Mature Business New Business Income Approach Owns Office, $200k Debt Rents Office, $200k Debt Total Cash Flow to Invested Capital $ 275,000 $ 275,000 Divided by: Direct Capitalization Rate 20.0% 25.0% Value of Business Excluding Real Property 1,375,000 1,100,000 Plus : Fair Market Value of Real Property 2,500, ,000 Implied Value of Invested Capital 3,875,000 1,200,000 Less : Existing Debt (200,000) (200,000) Fair Market Value of Equity $ 3,675,000 $ 1,000,000 RGL Forensics 25

26 Reconciliation of Values Derived From Valuation Methodologies Valuation Method Exhibit # Adjusted Equity Value Weighting Weighted Value 1 Asset-Based Method - Adjusted FMV of Assets 6 $ 9,720, % $ - 2 Income Method - Capitalization of Net Cash Flows 7 18,250, % 18,250,000 3 Market Method - Market Multiple Method 8 19,320, % - 4 Market Method - Completed Transaction 9 20,660, % - 5 Market Method - Guideline Public Company 10 25,720, % - 6 Fair Market Value of a 99% Interest in Mega Auto Mall $ 18,250,000 RGL Forensics 26

27 Revenue Ruling 59-60, Sec. 7., Average of Factors Because valuations cannot be made on the basis of a prescribed formula, there is no means whereby the various applicable factors in a particular case can be assigned mathematical weights in deriving the fair market value. For this reason, no useful purpose is served by taking an average of several factors (for example, book value, capitalized earnings and capitalized dividends) and basing the valuation on the result. Such a process excludes active consideration of other pertinent factors, and the end result cannot be supported by a realistic application of the significant facts in the case except by mere chance. RGL Forensics 27

28 Beyond The Numbers Failing to visit the site Poor company descriptions Lack of understanding of the basic business operation Ignoring data relied upon in report RGL Forensics 28

29 4 Understanding the Double Dip in Business Valuation RGL Forensics 29

30 The Mathematics of the Double Dip Calculating the Value of the Business Unadjusted Salary Adjusted Salary 1 Company profit before owner compensation $ 1,400,000 $ 1,400,000 2 Owner Compensation (800,000) (400,000) 3 Profit 600,000 1,000,000 4 Valuation Multiple 6 x 6 x 5 Business Value Assigned $ 3,600,000 $ 6,000,000 Amount of Spousal Support to Award 6 Compensation for Spousal Support Purposes??? $ 800,000 $ 400,000 7 Spousal Support Award - 33% $ 266,667 $ 133,333 RGL Forensics 30

31 The Mathematics of the Double Dip Community Property Division of Assets Non-Owning Owning 8 Property Award for Business Value (Unadjusted Salary) $ - $ 3,600,000 9 Retirement Accounts 1,300,000 1,200, Value of Home 3,500, Total Distribution of Community Property $ 4,800,000 $ 4,800, Compensation for Spousal Support Purposes $ 800, Spousal Support Award - 33% $ 266,667 RGL Forensics 31

32 The Mathematics of the Double Dip Community Property Division of Assets - Double Dipped Non-Owning Owning 14 Property Award for Business (Adjusted Salary) $ - $ 6,000, Retirement Accounts 2,500, Value of Home 3,500, Total Distribution of Community Property $ 6,000,000 $ 6,000, Compensation for Spousal Support Purposes $ 800, Spousal Support Award - 33% $ 266,667 RGL Forensics 32

33 The Mathematics of the Double Dip RGL Forensics 33

34 The Mathematics of the Double Dip RGL Forensics 34

35 Differences Between Business Ownership Positions and Other Income Producing Ownership Positions Active vs. Passive Investment Passive Receives income based on the work of others Does not make decisions on business, or investment strategy Not personally liable for success or failure The most you can lose is 100% of your investment Active Directly and materially invested into the business Personally responsible for the success or failure of the business equity Pledge of post-divorce assets to cover business risks including the work of others (employees, products, compliance, etc.) You can lose everything you own RGL Forensics 35

36 Double Dip Factors to Consider Percentage of ownership control vs. minority Personal guarantees Length of business ownership Age and health of the owning spouse Number of years to liquidation Outlook for business Severing of dependency on business earnings RGL Forensics 36

37 Thank you! Frank A. Wisehart, Partner MBA, CPA, ABV, CFE, CVA, MAFF