Valuing Privately-Held Businesses for Divorce

Presented by:

W. James Lloyd, CPA/ABV, ASA, CFE

Knoxville Family Law Conference October 22, 2010

Valuing Privately Held Businesses for Divorce

Knoxville Family Law Conference November 22, 2010

Speaker Biography – W. James Lloyd

W. James (Jim) Lloyd is a shareholder and valuation services practice leader at Pershing Yoakley & Associates, P.C. Jim has valued hundreds of businesses and related intangible assets spanning a broad range of industries including healthcare, banking, manufacturing, real estate, and wholesale distribution among others. In addition to being a Certified Public Accountant, Mr. Lloyd has earned multiple professional credentials relevant to business valuation and dispute services including the Accredited in Business Valuation (ABV) credential from the American Institute of CPAs, Accredited Senior Appraiser (ASA) credential from the American Society of Appraisers, and the Certified Fraud Examiner (CFE) credential from the Association of Certified Fraud Examiners.

Jim is a frequent speaker at various national and regional conferences on valuation and litigation related topics and holds leadership roles with several professional organizations including the American Institute of CPAs and the American Society of Appraisers.

Expert testimony experience includes federal and various state and local courts and arbitration proceedings across the United States.

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Agenda

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Knoxville Family Law Conference November 22, 2010 Page 4

Agenda

What does it mean?Forensic Accounting

Assertions and/or suspicions When to do it?

Red flagsWhat to look for?

Tools and techniquesHow to find it?

Documentation and using the resultsWhat to do with it?


There are three generally recognized approaches to valuing businesses/ business interests which include:

Overview of Valuation Methods

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Market Approach

based upon transaction data

from similar businesses

Asset Approach

based upon the entity’s

underlying assets and liabilities

Income Approach

based upon the entity’s ability to

generate net cash flow for the

owner(s)


Market Approach– Guideline Public Company Method

• Uses publically-traded companies to develop metrics (e.g. price to earnings multiples) which are then used to determine value indications for the subject company

• Not applicable for many small/medium sized businesses, because of substantial differences such as: size, capital resources, product/service offerings, and geographic area)

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GPCM


Market Approach – Merger & Acquisition Method

• Relies upon transaction data from companies that have been bought/sold to develop metrics (e.g. price to sales ratios) that are used to develop value indications for the subject entity

• Often difficult to use due to substantial differences in the businesses

• Transaction data not always reliable

• Transactions must be recent and closely correlated

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M&A Method


Asset Approach – Net Asset Value Method

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NAV Method

• Assets and liabilities are adjusted to their respective current values

• Liabilities are subtracted from the assets to determine the net “equity” value of the business

• Not always appropriate for operating companies due to limitations with capturing intangible values

• Generally requires outside appraisals of the fixed assets (equipment and/or real estate)


Income Approach – Discounted Cash Flow Method

• Value is determined by computing the present value of projected future cash flows

• Therefore, …

– Future cash flows must be projected

– Discount rate must reflect the risk of the projected cash flows.

• Appropriate for growth type operating companies

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DCF Method


Income Approach – Capitalized Income Method

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CapInc Method

• Uses a single period earnings stream as a proxy for future periods

• Value indication = capitalized earnings stream

• Appropriate for mature operating companies with low/stable growth rates

• Generally not applicable for companies with high growth rates or declining profitability


Understanding The Business

A solid understanding of the business and the industry in which it operates is critical

Important considerations include:

– Value drivers – what drives business to the company?

– Competition

– Key employees

– Changing technology

– Future capital needs

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Industry Research

Benchmarking analysis– Historical operations/results – Peer groups

Site visit and personal interviews with key employees/management

Understanding the Business

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Revenue growth

Profitability

Positive cash flow

Capital requirements

Risk

Financial and Operational Analysis

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Valuation is based more on economic as opposed to tax or financial reporting rules

Key valuation factors for operating

companies include:


Balance Sheet Analysis

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Cash should be enough but not too much!

Accounts Receivable

Inventory

Fixed Assets

Accrued Expenses

Debt Obligations

collectability

consider obsolete and slow moving

“in-use” vs. resale value

sometimes aren’t recorded

use of funds and repayment terms


Income Statement Analysis

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Revenue

• Consider both volume and revenue per unit

• Items growing/ profitable vs. declining/not profitable?

Operating Expenses

• Fixed vs. variable

• Normalization adjustments

Non-operating Expenses


Therefore, the return to the business owner should be

reflective of the risk associated with the business as compared to

alternative investment choices

Risk and Discount Rates

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The discount rate should reflect the risk associated with the projected cash flows (i.e. the higher the risk

the higher the discount rate)

Discount rates represent proxy returns for alternative

investments

(assuming the cash flows are constant)

Lower discount rates higher values


Types of Discount Rates

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Equity Discount

Rate

“Build-up” method

Duff & Phelps

Capital Asset Pricing Model

Weighted Average Cost of Capital

(WACC)

Weighted average cost of equity and after-tax

cost of debt

Limitations due to assets available to

secure the debt


Valuation Adjustments

Depending upon the facts and circumstances, one or more “valuation adjustments” may be necessary to adjust the value

to the appropriate level (e.g. fair market value)

However, it’s important to understand the level of value determined before adjusting it!

Common valuation adjustments include:

•Adjustment/Discount for Lack of Control

•Adjustment/Discount for Lack of Marketability/Liquidity

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Adjustments/discounts for lack of control (DLOC) are used to adjust “control” level indications

of value (i.e. determined from control level cash flows) to minority level value indications

DLOC are generally based on benchmark data plus qualitative analysis

Note: the DLOC adjustment should be reasonable under the circumstances (e.g. would someone likely pay an implied premium for a controlling interest

in the subject company?)

Adjustments for Lack of Control

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Adjustments/discounts for lack of marketability (DLOM) are used to adjust indications of value to a cash

equivalent basis

Multiple methods available to determine benchmark discounts – several of which are controversial

Analysis generally includes both qualitative and qualitative factors

Resulting value should be reasonable under the circumstances

Adjustments for Lack of Marketability

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Reconciliation and Conclusions of Value

The indications of value determined from the various methodologies utilized

should be reconciled and weighted appropriately

The conclusion of value can be an absolute or range of values• If a range is used, it should be a reasonable range (e.g. +/- 10% to 15%)

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Enterprise vs. Personal Goodwill

Enterprise goodwill is part of the business and should be included in the entity’s

value

Personal goodwill is an individual asset and

(generally) should not be included in the entity’s value

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Separating Personal Goodwill

Personal goodwill can be separated by

normalizing compensation

and/or performing a “with and without”

analysis

Primary Reason – Avoiding the “double dip” between business value and the individual’s earnings capacity

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Separating Personal Goodwill – con’t

The earnings/cash flow used to value the business should reflect “normalized” owner’s comp based on personal efforts/duties

• Benchmark data normally available from third party resources

A “with and without” analysis compares the value of the business with and without the services of the subject individual • The difference is an indication of

value for the personal goodwill of the individual

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Standards of Value

Fair Market Value

Value to hypothetical

buyers and sellers with neither being under compulsion and both having

relevant knowledge

Investment Value

Value to specific buyers and/or

sellers

Includes anticipated synergies

Fair Value

Pro-rata share of the enterprise

value (generally excludes

discounts)

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Valuation Organizations and Credentials

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The most common business valuation organizations and credentials include:

American Institute of

CPAs

Accredited in Business

Valuation (“ABV”) credential

American Society of Appraisers

Accredited Senior Appraiser

(“ASA”) credential

Institute of Business

Appraisers

Certified Business Appraiser (“CBA”)


Levels of Valuation Services

There are basically two levels of business valuation services which include:

Valuations/Appraisals

which result in an “opinion” of value; and

Calculations

which result in an “indication” of value

and not an opinion of value

• Limited in scope• Generally not appropriate

for litigation matters

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Forensic Accounting Issues

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Fraud Defined


Fraud Triangle

INCENTIVE

RATIONALIZE

FRAUD

OPPORTUNITY

Culture or environment

enables management or

other employees to rationalize

committing fraud

Circumstances exist – ineffective or

absent control, or management ability to override controls

– that provide opportunity

Management or other employees

have an incentive or are under pressure


The Need for Forensic Accounting


When To Do It

Valuing a business/business interest in connection with a litigation/dispute matter; and: • Specific allegations of fraud have

been asserted; or• Fraud is suspected


Divorce Engagements


What To Look For


Red Flags


Standard of living is unusual relative to known financial resources

Disorganized operations

Poor internal controls – easy for management to override

Unusual and/or unsupported journal entries

Out of balance subsidiary ledgers

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Red Flags


Unusually consistent financial performance

Disconnect between cash and profitability

Financial results that are in substantial contrast to other relevant factors such as economic

conditions, peer groups, etc.

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Red Flags


How to Find It – Basic Preliminary Steps

Determine that proper predication has been established by the client

Obtain an understanding of the specific fraud suspicions or allegations by discussing the case with client/attorney and review any work already performed

Start gathering and analyzing data


Gathering and Analyzing Data

Relevant data is

generally

gathered from a

combination of

methods such

as:

Obtaining and reviewing documents - from client and/or other sources

Personal interviews

Observations

Background investigations

Public record inquiries


Reviewing Documents –Caution

Data should be gathered/analyzed with a high degree of skepticism

Falsified documents are often used in collusion with others in an effort to conceal

the fraud

Proper chain of records custody may become an issue especially if documents

have been altered or falsified


Look for unusual or unexplained trends:

Year-to-year comparisons of financial data

Benchmark comparisons

Analytical procedures can

be useful for purposes of identifying potential

problem areas

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Analytical Procedures


Data Mining


• There should be a direct relationship between income and cash

• Analyze bank activity and compare to income being reported

Profitable companies generate positive cash

flow; whereas companies with low profits should not

be generating large amounts of cash

• tracing funds generally provides a wealth of useful information, especially for small/medium sized businesses

Follow the money

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Cash is Still King


Using the Results

Depending upon the circumstances, the forensic accounting results should be

incorporated into the valuation analysis as appropriate.

Such incorporation may involve: • Normalization adjustments to the

existing financial statements • Reconstructing the financial

statements all together


Questions?

Contact Information:

W. James Lloyd, CPA/ABV, ASA, CFE

Shareholder | Valuation & Dispute Services

Pershing Yoakley & Associates, P.C.

[email protected] | 865-673-0844

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