The Lawyer’s Business Valuation Handbook
Understanding Financial Statements, Appraisal Reports, and Expert Testimony
By Shannon P. Pratt
TABLE OF CONTENTS
Forewords:
Tax Law Perspective – by Ronald Aucutt
Family Law Perspective – by James J. Podell
Corporate Law Perspective – by Bruce L. Silverstein
Part I: The Legal and Professional Business Environment
Chapter 1:
Defining Value in the Relevant Context: Definitions and Premises of Value
Commonly Used Definitions of Value
Fair Market Value
Fair Value
Investment Value
Intrinsic or Fundamental Value
Premises of Value
Other Terms Referring to Value
Acquisition Value
Book Value
Going-Concern Value
Enterprise Value
Liquidation Value
Strategic Value (Synergistic Value)
Transaction Value
Sources of Authority for Definition of Value
Statutory Law
Legally Binding Rules and Regulations
Contractual Definitions of Value
Non-Legally Binding Administrative Rulings
Precedential Court Decisions
Direction from the Court
Direction from the Lawyer
Use of IRS Authority in Non-Tax Situations
Opinions of Other Lawyers and Appraisers
Questions to Ask
Chapter 2:
Business Appraisal Professional Credentials and Standards
Organizations Offering Professional Accreditation
Other Organizations Offering Business Valuation Guidance
Business Valuation Professional Standards
Uniform Standards of Professional Appraisal Practice (USPAP)
Other Professional Organization Standards
Internal Review Service Authority
Chapter 3:
Admissibility and Impact of Expert Business Valuation Evidence
Supreme Court Affirms Courts’ “Gatekeeper” Role
Daubert v. Merrell Dow Pharmaceuticals
General Electric v. Joiner
Kumho Tire Company v. Carmichael
Selecting and Evaluating the Appraiser
Professional Certifications and the Case for Peer Review
The CPA as Business Appraiser
The Financial Analyst as Business Appraiser
The Broker as Business Appraiser
The Academic as Business Appraiser
The Appraisal Opinion Must Stay Within Expertise
Source Documents Must Be Those “Typically Relied Upon” by Appraisal Experts
Subjective Statements Must Be Documented
Superficial Treatment of Issues: The “Down and Dirty” Appraisal
Original and Personally Developed Appraisal Methods Create Risk
Questions to Ask
Chapter 4:
Discovery Rules for Business Valuation Evidence
Expert Witnesses: Disclosure Requirements and Written Appraisal Reports
Federal Rule of Civil Procedure 26(a)(2)
Jurisdictions That Follow and Deviate From FRCP 26(a)(2)
Requests for Production of Documents and Entry for Inspections and Interviews
Documents
Field Visit
Federal Rule of Civil Procedure 34
Limitations on the Scope of Discovery
Sanctions for Failure to Comply with Discovery Order
Subpoena for Production of Documents or Entry Upon Land in Possession or Control
of Nonparties
Subpoena of Expert’s Work Papers
Interrogatories: Timing of Service and Limitations
Interrogatories Depend Upon Written Report Requirement
Timing of Service
Limits on Number of Interrogatories That Can Be Served
Depositions: Timing of Request and Special Rules
Federal Rules of Civil Procedure 26(b)(4), 30, and 31
States That Do Not Allow Depositions of Expert Witnesses as a Matter of Course
Involving Your Own Expert in Depositions of Opposing Experts
Summary
Chapter 5:
Alternative Dispute Resolution
Alternative Dispute Resolution Act of 1998
Advantages of Arbitration Versus Litigation
Choosing Arbitrators or Mediators
Arbitrators
Mediators
Process for Selecting Arbitrators
Instructions to Arbitrators
Communications with Parties and Lawyers
Reporting an Arbitration Conclusion
Alternative Dispute Resolution in Marital Dissolution
Alternative Dispute Resolution in Federal Tax Disputes
Alternative Dispute Resolution References
Books and Publications
Professional Arbitration and Mediation Organizations
Part II: Business Valuation Approaches and Methods
Chapter 6:
Overview of Accepted Business Valuation Approaches, Methods, and Procedures
Approaches and Methods Not Totally Discrete
Hierarchy of Approaches, Methods, and Procedures
Basic Appraisal Approaches
Methods Used Within Appraisal Approaches
Summary of Business Appraisal Approaches and Methods
Business Appraisal Procedures
Invested Capital Versus Equity
Ambiguities of Business Valuation Terminology
Summary
Questions to Ask
Chapter 7:
Financial Statement Terminology Used in Business Appraisal
The Basic Financial Statements
Balance Sheet Concepts
Common Equity
Invested Capital
Capital Structure
Book Value
Book Value Per Share
Tangible Versus Total Book Value
Net Working Capital
Miscellaneous Expense Concepts
Noncash Charges
Owner’s Compensation (Including Disclosed or Hidden Perks)
Levels of Economic Income
Sales (Net Revenues)
Discretionary Earnings (also called Seller’s Discretionary Cash Flow [SDCF] and
Owner’s Cash Flow [OCF])
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)
EBIT (Earnings Before Interest and Taxes) (also called Operating Income)
Gross Cash Flow
Debt-Free Net Income (DFNI)
Debt-Free Cash Flow (DFCF)
Pretax Income
Net Income
Primary Versus Diluted Net Income Per Share
Net Cash Flow to Invested Capital
Net Cash Flow to Equity
Variables Affecting Net Cash Flow
Capital Expenditures
Changes in Net Working Capital
Changes in Debt
Cash Versus Accrual Basis Accounting
Accrual Basis Accounting
Cash Basis Accounting
Conversion from Cash to Accrual Basis
Summary
Questions to Ask
Chapter 8:
The Income Approach
The Concept of Discounting
The Concept of Capitalizing
The Basic Capitalized Cash Flow Model
The Constant Income Capitalization Model
The Income Capitalization Growth Model (Gordon Growth Model)
The Basic Discounted Cash Flow Model
The Discounted Cash Flow Model for a Limited Life Investment
The Discounted Cash Flow Model Using a “Terminal Value”
Capitalization Model Versus Market Multiples for Estimating Terminal Value
Concept and Estimation of Discount Rates
The Concept of the Discount Rate
Elements of the Discount Rate: A Risk-Free Rate and a Premium for Risk
Estimating Discount Rates for Fixed-Income Securities
Estimating Equity Discount Rates: The Build-Up Model
Estimating Equity Discount Rates: The Capital Asset Pricing Model
Concept and Estimation of Capitalization Rates
The Concept of a Capitalization Rate
Elements of the Capitalization Rate
Estimating Equity Capitalization Rates
Valuing Invested Capital Versus Valuing Equity
The Concept of Weighted Average Cost of Capital
The Basic WACC Computation Model
Derivation of Weights for WACC
Preference for Net Cash Flow in Income Approach
Net Cash Flow Is What You Get
Use of Net Cash Flow Keeps Income Approach Discrete
Questions to Ask
Invested Capital Versus Equity Basis
Discounting Versus Capitalizing
Choice or Income Variable
Questions for Discounting Method
Questions for Capitalization Method
References
Basic Income Approach References
Cost of Capital Data References
Chapter 9:
The Market Approach
Market Approach Concept and Overview
Valuing Controlling Versus Minority Interests
Valuing Total Invested Capital Versus Direct Valuation of Equity
Using Sales of Entire Companies or Publicly Traded Guideline Companies
Sources of Market Approach Data
Sales of Public Companies
Sales of Private Companies
Guideline Public Company Data
Developing Market Multiples for Valuation
Invested Capital Multiples
Equity Multiples
Time Periods for Company Financial Statement Data
Criteria for Selecting Guideline Companies
How Many Guideline Companies?
Illustration of Developing Guideline Company Market Multiples
Deciding Where Subject Company Multiples Should Fall Relative to Observed Ranges
Capitalization Rates
Multiples Selected Should Be Based on Comparative Analysis
Different Multiples May Be Higher or Lower Relative to Guideline Companies
Relative Weights to Accord Various Multiples
Illustration of Valuation by Market Approach
Variations for Smaller Companies and Professional Practice Valuations
Involvement of the Owner/Manager
Availability of Comparative Accounting Data
Prior Transactions, Offers, and Buy-Sell Agreements
Arm’s-Length Negotiations
Prior Transactions
Offers to Buy
Buy-Sell Agreements
Alternative Definition of Market Value in Some Fair Value Cases
Questions to Ask
References
Basic Market Approach References
Private Company Sale Databases
Public Company Transaction and Sale Data
Chapter 10:
The Asset-Based Approach
Basic Concept of the Asset-Based Approach
Discrete Versus Collective Revaluation
Steps in the Adjusted Net Asset Value Method
Valuation Premises for Adjusting Balance Sheet Values
Illustrative Adjusted Net Asset Value
Break-up Value
When Are Asset-Based Methods Used?
Questions to Ask
Asset-Based Approach References
Chapter 11:
Goodwill and the Excess Earnings Method
Background of the Excess Earnings Method
Basic Steps in the Excess Earnings Method
Applying the Excess Earnings Method
A “Sanity Check” for Validity of an Excess Earnings Method Value
Critique of Revenue Ruling 68-609
Use of Historical Averages Impractical
“Required Return on Tangible Assets” Ambiguous
No Definitions of “Earnings”
No Guidance for Intangibles Capitalization Rate
Common Errors in Applying the Excess Earnings Method
Undefined Earnings Stream
Unsupported Normalized Earnings Stream
Failure to Allow for Owner’s Compensation
Unsupported Net Tangible Asset Value
Unsupported or Unrealistic Required Rate of Return on Tangible Assets
Unsupported or Unrealistic Capitalization Rate for Excess Earnings
Using Rates in the Revenue Ruling 68-609 Illustration Instead of Currently
Supportable Rates
Claiming That the IRS Recommends Use of the Excess Earnings Method
Questions to Ask
Excess Earnings Method Reference
Chapter 12:
Rules of Thumb
Rules of Thumb Disclaimers
General Nature of Rules of Thumb
Rules of Thumb Not Cash-Equivalent Prices
Rule of Thumb Examples
Checking Alleged Rules of Thumb Against Actual Transactions
Court Reaction to Rules of Thumb
Questions to Ask
References and Sources
Basic Rules of Thumb References
Transaction Databases with Price/Revenue and Price/Discretionary Earnings Ratios
Chapter 13:
Discounts and Premiums
Distinguishing the Minority Factor from the Marketability Factor
Minority Versus Control
The Minority Owner’s Situation
Degrees of Minority Versus Control Ownership
Quantifying Minority or Lack of Control Discounts
Discounts for Lack of Marketability
The Concept of Marketability
Degrees of Marketability or Lack Thereof
Other Factors Affecting Discounts for Lack of Marketability
Benchmark for Marketability
Evidence Quantifying Lack of Marketability Discounts: Restricted Stock Studies
Evidence Quantifying Lack of Marketability Discounts: Pre-IPO Studies
Court Recognition of Marketability Discount Studies
Discounts for Lack of Marketability for Controlling Interests
How the Applicable Definition of Value Affects the Minority/Control and Discount for Lack of
Marketability Adjustments
Fair Market Value
Fair Value
Investment Value
How the Valuation Method Used Affects Premiums and Discounts
Income Approach
Market Approach
Asset Approach and Excess Earnings Method
Other Discounts at the Entity Level
Key Person Discount
Portfolio Discount
Trapped-in Capital Gains Discount
Litigation Risk
Environmental Risk
Other Discounts or Premiums at the Shareholder Level
Voting Versus Nonvoting Shares
Blockage
Questions to Ask
References
Basic Discount and Premiums References
References for Premium and Discount Court Cases
Widely Used Premium and Discount Data References
Chapter 14:
Reconciliation of Value Indications
Overview of the Reconciliation Process
Does the Conclusion Appraise the Right Property?
Major Considerations in the Reconciliation Process
Reconciling Divergent Results Among Business Valuation Methods
Weighting of Valuation Method Results
Explicit Weighting
Implicit Weighting
Final Value Estimate
Questions to Ask
References for Reconciliation of Value Indications
Part III: Fundamentals of Company Analysis
Chapter 15:
Financial Statement Adjustments
Reasons for Financial Statement Adjustments
Normalizing Adjustments
Nonrecurring Items
Discontinued Operations
Inventory Accounting Methods
Depreciation and Depletion Methods and Schedules
Net Operating Losses Carried Forward
Reserve and Allowance Accounts
Other Normalizing Adjustments
Control Adjustments
Reasonable Compensation
Insider Transactions
Separating Operating from Nonoperating and Excess Assets
Comparisons with Other Entities
Treatment of Nonoperating and Excess Assets
Cash Versus Accrual Accounting
Illustrative Financial Statement Adjustments
Income Statement Adjustments
Balance Sheet Adjustments
Questions to Ask
Financial Statement Adjustment References
Chapter 16:
Comparative Financial Statement Analysis
Introduction
Tools of Financial Statement Analysis
Horizontal Analysis
Trend Analysis
Vertical Analysis
Analysis of Profitability
Analysis of Liquidity
Analysis of Long-Term Solvency
Summary
Questions to Ask
Chapter 17:
Economic and Industry Analysis
National Economy – Recent Status
National Economy – Outlook
Industry – Recent Status
Industry – Outlook
Composite Company Data
Regional Information
Summary
Questions to Ask
Part IV: Valuations for Specific Purposes
Chapter 18:
Valuations for Federal Tax Matters
Fair Market Value
Fair Market Value Assumes Adequate Knowledge
Must Consider Both Buyer and Seller
Qualifications of Appraisers
Burden of Proof
Adequate Disclosures of Gifts
Access to Sites, Management, and Records
Arm’s-Length Transactions
Approaches to Value
Market Approach
Income Approach
Asset-Based Approach
Discounts
Discounts for Lack of Marketability (Minority Blocks)
Combined Minority and Lack of Marketability Discounts
Discounts for 50 Percent Interest
Discounts for Lack of Marketability (Controlling Interests)
Blockage
Key Person Discount
Nonvoting Versus Voting Stock
Trapped-in Capital Gains Taxes
Charitable Contributions
Contingent Liabilities
Subsequent Events and Information
Proximity of Financial Information to Valuation Date
Subsequent Sales
Buy-Sell Agreements
Weighting of Valuation Method Results
Pressure to Settle
Questions to Ask
References for Valuations for Federal Tax Matters
Articles and Books
Web Sites
Chapter 19:
Marital Dissolution Valuations
Standard of Value for Marital Dissolutions
Goodwill
Buy-Sell Agreements
Covenants Not to Compete
Minority Discounts
Trapped-in Capital Gains Taxes
Adequacy of Evidence
Access to Records
The Persistent Problem of “Double-Dipping”
Questions to Ask
Standard of Value
Goodwill
Buy-Sell Agreements
Covenants Not to Compete
Minority Discounts
Trapped-in Capital Gains
Double-Dipping
References for Marital Dissolution
Chapter 20:
Shareholder and Partner Disputes
“Fair Value” Standard in Most Dissent and Dissolution Suits
“Delaware Block Rule” Expanded
Discounts or Premiums Often Major Issue
Lack of “Entire Fairness” May Broaden Remedies
Fair Value Is Not Fair Market Value
States Borrow Other States’ Precedents
Timely Actions Essential
Questions to Ask
References for Shareholder and Partner Disputes
Chapter 21:
Employee Stock Ownership Plans
General Valuation Principles
Adequate Consideration
When Appraisals Are Required
Independence of Appraiser
IRS Audit Guidelines
Control Versus Minority
Lack of Marketability Discount
ESOP Financial Statement Adjustments
Repurchase Liability
Relevant Case Law
Charles S. Foltz v. U.S. News & World Report, Inc.
Las Vegas Dodge v. U.S.
Howard v. Shay
Reich v. Valley National Bank of Arizona
Gary L. Eyler v. Commissioner
William R. Davis v. Torvick, Inc.
Summary
Questions to Ask
References for ESOP Valuation
Chapter 22:
Medical Practice Valuation Issues
Physician Compensation
Definition of Compensation
Choice of Specialty
Medians, Means, and Other Stats
Fraud and Abuse
Medicare Fraud and Abuse
Stark II
Comparable Transactions
Public Transactions – Recent Transactions
Public Transactions – Selling Revenue Streams
Venture Capital Transactions
Possible Preferences for Venture Capital Stock
Capitation or Risk-Based Reimbursement
Capitation Versus Fee for Service
Need to Consider Actuarial Risk
Minding the Pennies
Failure to Anticipate Utilization Declines in Hospitalization and Ancillaries
Failure to Monitor Changes in the Medicare System That Affect Reimbursement
Other Valuation Issues
Failing to Take into Account Senior Doctor Rights or Minority Ownership
Failing to Normalize Revenue and Earnings for (Correctible) Coding Errors
Professional Goodwill Versus Practice Goodwill
Corporate Practice of Medicine
Conclusion
References for Medical Practice Valuation
Appendices
Appendix A:
Quick Review Checklist for Basic Requirements and General Report Quality
Appendix B:
Glossary of Valuation Terms
Appendix C:
Business Appraisal Professional Organizations
Appendix D:
Table of Cases
Appendix E:
General Bibliography
Index