May/June 2012
Valuation
Litigation
&
BRIEFING
Patent infringement damages
Reasonable royalties
can exceed expected profits
Helping businesses
through worst-case scenarios
Key-person discounts
estimate the value of a VIP
Medical practice valuations may
have dangerous side effects
Digging for treasure: How
to unearth hidden assets
GHP Horwath, P.C.
Member Crowe Horwath International
Accounting, Consulting, Financial Planning, Investment Advisory, and Financial Staffing Services
1670 Broadway, Suite 3000 • Denver, Colorado 80202
(303) 831-5000 • Fax (303) 831-5032 • www.GHPHorwath.com
GHP Horwath, P.C.
Member Crowe Horwath International
GHP Horwath, P.C., provides financial advisory, business valuation, and dispute resolution services to attorneys, insurance
professionals, and business owners on a regional and national basis. Our team of Certified Public Accountants, Accredited Business Valuators, Certified
Valuation Analysts, and Certified Forensic Examiners has extensive experience in the areas of civil and criminal litigation, domestic relations disputes,
business valuation, bankruptcy, fraud, and general business consulting.
Patent infringement damages
Reasonable royalties
can exceed expected profits
T
he U.S. Court of Appeals for the Federal Circuit
continues to push the boundaries of reasonable
royalty damages in patent infringement cases. In
Powell v. Home Depot, the court upheld a jury award
based on reasonable royalties that were more than
three times the plaintiff’s expected profits.
A patent with teeth
The case involved radial arm saws used in Home
Depot stores to cut lumber to order for customers.
After a series of finger amputations and other injuries
to Home Depot employees, management directed the
company’s safety personnel to fix the saws to prevent
injuries or else remove them from stores. The company decided to fix the saws, concluding that discontinuing lumber-cutting services would place it at a
competitive disadvantage.
In 2004, Powell, whose business provided installation and repair services for Home Depot’s radial arm
saws, designed a saw guard prototype. Home Depot
ordered eight production units, costing $2,000 each,
for use and testing in its stores. After the units were
installed, Powell applied for a patent.
Around the same time, unbeknownst to Powell,
Home Depot contacted another company, Industriaplex, showed it Powell’s invention and asked it to
build nearly identical saw guards for a lower price.
Home Depot eventually ordered nearly 2,000 saw
guards from Industriaplex for approximately $1,295
per unit.
Royalty pains
Powell’s patent was issued in May 2006, and he sued
Home Depot for infringement in May 2007. After
a 14-day jury trial in federal district court, the jury
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found that Home Depot had willfully infringed the
patent and awarded Powell $15 million in damages.
The court awarded enhanced damages, attorneys’
fees and prejudgment interest, bringing the total to
nearly $24 million.
The $15 million award was based on a reasonable royalty of about $7,700 per unit that Home Depot would
have paid Powell for the right to use his invention in
the United States over the patent’s life. But the evidence showed that, if Powell had successfully negotiated a deal in 2004 to build and install saw guards in
every Home Depot store, a conservative estimate of
his profits would have been $2,180 per unit.
On appeal to the Federal Circuit, Home Depot
challenged the jury’s award, arguing, among other
things, that a reasonable royalty can’t exceed Powell’s
expected profits. The court disagreed. For one thing,
a reasonable royalty is determined based on a hypothetical licensing agreement negotiation immediately
before the infringement began — in
this case, in 2006.
By that time, Home
Depot had two
years of experience with the saw
guards, reporting
no injuries in the
stores in which
they were installed.
The court also ruled
that a patentee’s
profit expectations
do not serve as a
cap on reasonable royalties. Generally, a reasonable
royalty analysis is based on the 15 Georgia-Pacific
factors. Although it’s appropriate to consider expected
profits as part of this analysis, several other factors
supported the jury’s award of a higher amount:
uHome Depot’s use of the saw guards produced
significant cost savings, including avoidance of
more than $1 million per year in injury claims.
uHome Depot enjoyed several other benefits by
using the guards, including maintaining its competitive advantage over stores that didn’t offer
lumber-cutting services and preserving sales of
follow-on items, such as nails and hinges.
uHome Depot spent about $8,500 per unit at 71
stores to replace radial saws that were incompatible with the saw guard design.
Based on these factors, the court concluded that the
jury’s award was supported by the evidence.
Value judgments
Typically, reasonable royalty damages are a fallback position used when lost profits are difficult to
measure. As the Powell case illustrates, however, by
focusing on an invention’s value to the infringer, a
reasonable royalty can sometimes be a more lucrative remedy. u
Helping businesses
through worst-case scenarios
Key-person discounts estimate the value of a VIP
I
f a business depends greatly on just one or two
people, a valuation discount may be appropriate to
reflect the risk of damage to the business should such
a key person die or otherwise leave the company. To
determine whether the discount is warranted, a valuator will examine a wide variety of factors.
What is a key person?
Some things that the valuator will look at when evaluating whether to apply a key-person discount include the:
uCompany’s relationships with customers and
suppliers,
u Nature of the business,
uKey person’s actual duties and activities, and
uQuality and depth of the company’s management
team.
After all, key people provide value in different ways,
depending on the roles they play in their businesses.
For example, a key person may drive the company’s
strategic vision or handle day-to-day management
responsibilities. He or she may offer technical expertise, an excellent reputation or an extensive network
of industry contacts.
Personal relationships are also a critical factor. If
customers and suppliers deal primarily with one key
person, they may decide to do business with another
company if that person is gone. On the other hand,
it’s easier for a business to retain customer relationships when they’re spread among several people
within the company.
A key person may also have a financial impact on
the business. In closely held businesses, for instance,
a CEO or other key person will often personally
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How is the discount determined?
Identifying risks associated with key persons is one
thing; estimating the impact of those risks on business value is quite another. Valuators generally use
one of three methods to incorporate key-person discounts into their calculations:
1.Adjust future earnings to reflect the risk of losing
a key person,
2.Adjust the discount or capitalization rate through
the specific company risk adjustment, or
3.Discount the calculated value by a certain percentage, similar to a marketability or minority interest
discount.
guarantee the company’s debts. It’s important to note
that having a key person as a large revenue generator
would likely materially affect the financial position of
the business.
Generally, companies that sell products are better
able to withstand the loss of a key person than are
service businesses. On the other hand, a productbased company that relies heavily on technology
may be at risk if a key person possesses specialized
technical knowledge.
Will other employees measure up?
One of the valuator’s most important tasks is to
evaluate the ability of others to fill a key person’s
shoes in case of death or a departure from the business. Does existing management have the knowledge,
skills and business acumen needed to fulfill the key
person’s duties? Does the company have a solid succession plan in place to smooth the transition? What
would be the total cost of hiring someone with the
same knowledge, skill and business acumen as the
key person? And would it be feasible for the company
to take out a life insurance policy on the key person?
The risk may be greater if the company would have to
bring in a replacement who’s unfamiliar with the business.
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Quantifying the discount is a challenge because,
unlike marketability and minority discounts, there’s
little empirical support for across-the-board key-person
discounts in business valuations.
One of the valuator’s most
important tasks is to evaluate the
ability of others to fill a key person’s
shoes in case of death or a departure
from the business.
Keep in mind that smaller closely held companies
are more likely to depend on one or two key people
than are larger closely held companies or public
companies — both of which are usually able to
replace key management personnel with relative
ease and, thus, minimize potential losses.
How much value?
Particularly in a sluggish economy, businesses should
be aware that losing a key person can damage the
company’s ability to deliver products or services to its
customers. In addition, if the company is fishing for a
buyer or wanting to acquire another business, the loss
of a key person will be a red flag to prospective buyers.
Make sure your clients understand how much value a
key-person discount can have in these situations. u
Medical practice valuations
may have dangerous side effects
T
he complex regulatory regime that governs health
care relationships and transactions has a big
impact on the valuation process — especially when it
comes to valuing a medical practice for sale. Concepts such as fair market value (FMV) and “commercial reasonableness” are critical to compliance with
federal regulations.
As a result, considerations of investment value or strategic value, which are common in other industries,
may be inappropriate in the health care arena. And
the stakes are high: Transactions that violate these
regulations can trigger substantial monetary penalties,
exclusion from Medicare and other federal programs,
and even criminal sanctions.
uInpatient and outpatient hospital services.
General exceptions to the Stark rules include:
uPhysician services,
uIn-office ancillary services,
uPrepaid plans,
uIntrafamily rural referrals, and
uAcademic medical centers.
Regulatory environment
Two regulations in particular have a big impact on
the valuation process: The federal antikickback regulations and the “Stark II” regulations.
The antikickback rules make it a crime to knowingly
and willfully solicit or receive bribes, kickbacks or other
items of value in exchange for referring patients for services paid for by any federal health care programs.
The Stark II rules — also known as the self-referral
rules — prohibit physicians from referring Medicare
or Medicaid patients for “designated health services”
to entities with whom they (or certain family members) have a “financial relationship,” such as ownership or investment interests. Designated health
services include:
uClinical laboratory services,
uPhysical and occupational therapy services,
uImaging services,
uOutpatient prescription drugs, and
These restrictions are intended to reduce referrals for
unnecessary services by eliminating financial incentives to refer patients. But they also create obstacles
for many legitimate transactions, such as hospital
acquisitions of medical practices, compensation
arrangements between physicians and health care
entities, and office or equipment leases.
The government may claim that a transaction or
arrangement violates antikickback or self-referral
rules if it believes there’s a disguised financial incentive to promote referrals. For example, the government might argue that a hospital has paid an inflated
price for a medical practice or paid physicians excessive compensation.
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FMV to the rescue
The best way to avoid a government challenge is to
ensure that the price and other terms of a medical practice acquisition or other transaction meet FMV standards.
Federal regulations contain various safe harbors and
exceptions that protect transactions and relationships
between health care providers — even if they’re in a
position to refer patients to each other. These provisions generally permit practice acquisitions, compensation arrangements, leases and other transactions if
they’re consistent with the FMV, their financial terms
aren’t tied to the volume or value of referrals, and
they meet certain other requirements.
In many cases, transactions must also be “commercially
reasonable” in the absence of referrals between the parties. This is significant because a transaction may meet
FMV standards yet not be commercially reasonable.
The government may claim that a
transaction or arrangement violates
antikickback or self-referral rules if it
believes there’s a disguised financial
incentive to promote referrals.
For example, physician compensation arrangements
may provide for market salaries but contain commercially unreasonable provisions, such as excessively
long employment terms or termination clauses that
make it difficult for a hospital to end the relationship.
Handle with care
Valuing a medical practice for sale is similar in many
ways to valuing other businesses. Typically, the valuator applies one or more of the income, market and
asset approaches.
But, while it’s common to consider a business’s strategic or investment value to specific potential buyers, these considerations may be inappropriate for a
medical practice. If there’s a potential for Medicare or
6
Valuation as a diagnostic tool
In health care, a business valuation provides a
significant side benefit: It serves as a powerful tool
for diagnosing potential compliance issues. As part
of the valuation process, valuators scrutinize owner
compensation, leases and other financial arrangements to determine whether they’re reasonable in
comparison to similar medical practices.
“Normalizing” the terms of these arrangements —
that is, adjusting them to better reflect market values
and industry practices — provides a more accurate
picture of a practice’s earning potential. Valuators are
well suited, therefore, to help identify arrangements
that may raise red flags for regulators.
Medicaid referrals, the appraiser must stick closely to
FMV principles, which contemplate a price based on
a hypothetical buyer and seller.
All three valuation approaches should be applied
carefully to avoid incorporating the value of referrals —
whether real or perceived. In using the income approach,
for example, the appraiser should avoid including
the value of referrals in projected earnings or cash
flow streams.
Under the asset approach, when valuing intangibles,
it’s important to allocate the purchase price, to the
extent appropriate, to identifiable intangible assets,
such as patient records or a trained workforce. In
theory, there’s nothing wrong with allocating a portion of the purchase price to goodwill, provided the
valuator can demonstrate that the goodwill has real
value to the buyer apart from referrals. In addition,
the “comparable” companies used in the market
approach may not be truly comparable to the subject
company due to differences in patient mix, location,
services provided, physician compensation and so
forth. But goodwill is a notoriously amorphous concept, so it’s possible the government will argue that it
represents a payment for referrals.
Finally, the market approach can result in inappropriate values. For instance, comparables used in the
valuation process may involve transactions in which
the purchase price reflects strategic or investment
value or the value of future referrals.
A valuation also provides an opportunity to examine terms other than the purchase price for potential
compliance problems. (See “Valuation as a diagnostic
tool” at left.)
Specialized knowledge
Industry knowledge and experience are important
when valuing any type of business, but they’re particularly important in the health care industry. Given the
potential compliance issues associated with medical
practice valuations, it’s critical to work with a valuator
who understands the health care regulatory framework and its implications for the valuation process. u
Digging for treasure: How to unearth hidden assets
The global economy, combined with electronic banking and other technological advances, has made it easier than ever
for litigants to conceal assets. Fortunately, financial experts have a number of techniques at their disposal to uncover
these assets.
Some involve tracing the flow of funds to locate hidden assets. Others involve reconstructing a person’s finances using
net worth analysis. Common tracing techniques include examining:
uBank and brokerage statements, wire transfer confirmations, canceled checks and other financial records,
uTax returns for hidden assets that may be reflected in many entries, such as wages, dividends and interest, mortgage
interest, or real estate taxes,
uCredit card, insurance, loan and employment applications, which often contain information not reported elsewhere,
uA person’s travel records for patterns that may reveal where assets were acquired or where funds are kept, and
uPublic records, including real estate records and court files.
Net worth analysis methods include:
The asset method. It takes a person’s net worth at the end of the year, subtracts his
or her net worth at the beginning of the year, and then adds known income items and
subtracts known expenses. If the result is anything other than zero, there’s income
from unknown sources.
The expenditures method. This approach looks for discrepancies between a person’s
expenditures and his or her known sources of funds, such as salaries, inheritances,
loans, gifts and cash on hand at the beginning of the year.
The bank deposits method. Here the assumption is that all money is either spent or
deposited. If net deposits plus cash expenditures exceed known sources of funds, an
undisclosed source of funds exists.
Unknown sources of funds don’t necessarily reflect illicit activities. For example, loan
proceeds and redeposits of unused cash aren’t income. But they do provide attorneys
and their financial experts with promising avenues of investigation. u
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional
advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. ©2012 VLBmj12
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THE SERVICE
The professionals of GHP Horwath are dedicated to providing expert witness testimony, business and intangible asset valuations,
and consulting services for attorneys, insurance professionals, and business owners.
Our areas of expertise include:
u
Alter Ego
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Construction Claims
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Marital Dissolution
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Bankruptcy & Corporate Recovery
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Economic Damages
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Mergers & Acquisitions
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Business Interruption/ Destruction
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Employee Stock Ownership Plans
u
P
ersonal Injury/
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Buy/Sell Agreements
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ommercial/Contract Disputes
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Discovery
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I ntellectual Property Damages,
Valuation & Licensing Consulting
THE TEAM
Lisa A. Meer,
CPA/ABV/CVA
Mark W. Pedigo,
CPA/ABV/CVA
Ms. Meer has over 24 years of experience
in providing forensic accounting, financial
and economic analysis, valuation, and
business advisory services in commercial
and shareholder litigation, bankruptcy,
marital dissolution, and transaction
matters. She regularly teaches continuing
legal education and training courses and
writes articles on economic damage,
valuation, and corporate finance
concepts, approaches, and techniques.
Mr. Pedigo has over 30 years of experience
in economic damages analysis, valuation,
strategic consulting, auditing, due diligence,
and financial analysis. Mr. Pedigo provides
consulting, valuation and expert testimony
services to Counsel on behalf
of plaintiffs and defendants involved in
commercial disputes. Further, he has
extensive experience with construction litigation and audit-related experience, and
has worked on intellectual property and
other commercial litigation cases involving
numerous other industries.
Adam H. Newman,
CPA/ABV
Mr. Newman has over 16 years of
experience providing technical valuation,
tax and consulting services for closely held
companies in a wide range of industries,
including manufacturing, real estate,
professional practices, and family limited
partnerships.
GHP Horwath, P.C.
Member Crowe Horwath International
1670 Broadway, Suite 3000 • Denver, Colorado 80202 • (303) 831-5000 • www.ghpcpa.com