Valuing Privately-Held Businesses for Divorce


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  • Note: discuss the importance of a site visit and interviewing management Researching the industry
  • Note: cash vs. accrual basis financials
  • Valuing Privately-Held Businesses for Divorce

    1. 1. Presented by: W. James Lloyd, CPA/ABV, ASA, CFE Knoxville Family Law Conference October 22, 2010 Valuing Privately Held Businesses for Divorce
    2. 2. Speaker Biography – W. James Lloyd <ul><li>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. </li></ul><ul><li>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. </li></ul><ul><li>Expert testimony experience includes federal and various state and local courts and arbitration proceedings across the United States. </li></ul>Page
    3. 3. Agenda Page
    4. 4. Agenda Page <ul><ul><li>What does it mean? </li></ul></ul>Forensic Accounting <ul><ul><li>Assertions and/or suspicions </li></ul></ul>When to do it? <ul><ul><li>Red flags </li></ul></ul>What to look for? <ul><ul><li>Tools and techniques </li></ul></ul>How to find it? <ul><ul><li>Documentation and using the results </li></ul></ul>What to do with it?
    5. 5. Overview of Valuation Methods There are three generally recognized approaches to valuing businesses/ business interests which include: Page <ul><ul><li>Market Approach </li></ul></ul><ul><ul><li>based upon transaction data from similar businesses </li></ul></ul><ul><ul><li>Asset Approach </li></ul></ul><ul><ul><li>based upon the entity’s underlying assets and liabilities </li></ul></ul><ul><ul><li>Income Approach </li></ul></ul><ul><ul><li>based upon the entity’s ability to generate net cash flow for the owner(s) </li></ul></ul>
    6. 6. Market Approach– Guideline Public Company Method <ul><li>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 </li></ul><ul><li>Not applicable for many small/medium sized businesses, because of substantial differences such as: size, capital resources, product/service offerings, and geographic area) </li></ul>Page <ul><ul><li>GPCM </li></ul></ul>
    7. 7. Market Approach – Merger & Acquisition Method <ul><li>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 </li></ul><ul><li>Often difficult to use due to substantial differences in the businesses </li></ul><ul><li>Transaction data not always reliable </li></ul><ul><li>Transactions must be recent and closely correlated </li></ul>Page <ul><ul><li>M&A Method </li></ul></ul>
    8. 8. Asset Approach – Net Asset Value Method <ul><li>Assets and liabilities are adjusted to their respective current values </li></ul><ul><li>Liabilities are subtracted from the assets to determine the net “equity” value of the business </li></ul><ul><li>Not always appropriate for operating companies due to limitations with capturing intangible values </li></ul><ul><li>Generally requires outside appraisals of the fixed assets (equipment and/or real estate) </li></ul>Page <ul><ul><li>NAV Method </li></ul></ul>
    9. 9. Income Approach – Discounted Cash Flow Method <ul><li>Value is determined by computing the present value of projected future cash flows </li></ul><ul><li>Therefore, … </li></ul><ul><ul><li>Future cash flows must be projected </li></ul></ul><ul><ul><li>Discount rate must reflect the risk of the projected cash flows. </li></ul></ul><ul><li>Appropriate for growth type operating companies </li></ul>Page <ul><ul><li>DCF Method </li></ul></ul>
    10. 10. Income Approach – Capitalized Income Method <ul><li>Uses a single period earnings stream as a proxy for future periods </li></ul><ul><li>Value indication = capitalized earnings stream </li></ul><ul><li>Appropriate for mature operating companies with low/stable growth rates </li></ul><ul><li>Generally not applicable for companies with high growth rates or declining profitability </li></ul>Page <ul><ul><li>CapInc Method </li></ul></ul>
    11. 11. Understanding The Business <ul><li>A solid understanding of the business and the industry in which it operates is critical </li></ul><ul><li>Important considerations include: </li></ul><ul><ul><li>Value drivers – what drives business to the company? </li></ul></ul><ul><ul><li>Competition </li></ul></ul><ul><ul><li>Key employees </li></ul></ul><ul><ul><li>Changing technology </li></ul></ul><ul><ul><li>Future capital needs </li></ul></ul>Page
    12. 12. Understanding the Business Industry Research <ul><li>Benchmarking analysis </li></ul><ul><ul><li>Historical operations/results </li></ul></ul><ul><ul><li>Peer groups </li></ul></ul>Site visit and personal interviews with key employees/management Page
    13. 13. Financial and Operational Analysis <ul><ul><li>Revenue growth </li></ul></ul><ul><ul><li>Profitability </li></ul></ul><ul><ul><li>Positive cash flow </li></ul></ul><ul><ul><li>Capital requirements </li></ul></ul><ul><ul><li>Risk </li></ul></ul>Page Valuation is based more on economic as opposed to tax or financial reporting rules Key valuation factors for operating companies include:
    14. 14. Balance Sheet Analysis Page 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
    15. 15. Income Statement Analysis Page <ul><li>Revenue </li></ul><ul><ul><li>Consider both volume and revenue per unit </li></ul></ul><ul><ul><li>Items growing/ profitable vs. declining/not profitable? </li></ul></ul><ul><li>Operating Expenses </li></ul><ul><ul><li>Fixed vs. variable </li></ul></ul><ul><ul><li>Normalization adjustments </li></ul></ul>Non-operating Expenses
    16. 16. Risk and Discount Rates <ul><ul><li>Therefore, the return to the business owner should be reflective of the risk associated with the business as compared to alternative investment choices </li></ul></ul>Page The discount rate should reflect the risk associated with the projected cash flows (i.e. the higher the risk the higher the discount rate) <ul><li>Discount rates represent proxy returns for alternative investments </li></ul>(assuming the cash flows are constant) Lower discount rates higher values
    17. 17. Types of Discount Rates Page <ul><li>Equity Discount Rate </li></ul><ul><ul><li>“ Build-up” method </li></ul></ul><ul><ul><li>Duff & Phelps </li></ul></ul><ul><ul><li>Capital Asset Pricing Model </li></ul></ul><ul><li>Weighted Average Cost of Capital (WACC) </li></ul><ul><ul><li>Weighted average cost of equity and after-tax cost of debt </li></ul></ul><ul><ul><li>Limitations due to assets available to secure the debt </li></ul></ul>
    18. 18. 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! <ul><li>Common valuation adjustments include: </li></ul><ul><li>Adjustment/Discount for Lack of Control </li></ul><ul><li>Adjustment/Discount for Lack of Marketability/Liquidity </li></ul>Page
    19. 19. Adjustments for Lack of Control 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?) Page
    20. 20. Adjustments for Lack of Marketability 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 Page
    21. 21. Reconciliation and Conclusions of Value The indications of value determined from the various methodologies utilized should be reconciled and weighted appropriately <ul><li>The conclusion of value can be an absolute or range of values </li></ul><ul><ul><li>If a range is used, it should be a reasonable range (e.g. +/- 10% to 15%) </li></ul></ul>Page
    22. 22. Enterprise vs. Personal Goodwill Page 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
    23. 23. 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 Page
    24. 24. Separating Personal Goodwill – con’t <ul><ul><li>The earnings/cash flow used to value the business should reflect “normalized” owner’s comp based on personal efforts/duties </li></ul></ul><ul><ul><li>Benchmark data normally available from third party resources </li></ul></ul><ul><li>A “with and without” analysis compares the value of the business with and without the services of the subject individual </li></ul><ul><ul><li>The difference is an indication of value for the personal goodwill of the individual </li></ul></ul>Page
    25. 25. Standards of Value Page Fair Market Value <ul><ul><li>Value to hypothetical buyers and sellers with neither being under compulsion and both having relevant knowledge </li></ul></ul>Investment Value <ul><ul><li>Value to specific buyers and/or sellers </li></ul></ul><ul><ul><li>Includes anticipated synergies </li></ul></ul>Fair Value <ul><ul><li>Pro-rata share of the enterprise value (generally excludes discounts) </li></ul></ul>
    26. 26. Valuation Organizations and Credentials Page 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”)
    27. 27. Levels of Valuation Services Page There are basically two levels of business valuation services which include: Valuations/Appraisals which result in an “opinion” of value; and <ul><li>Calculations </li></ul><ul><li>which result in an “indication” of value and not an opinion of value </li></ul><ul><ul><li>Limited in scope </li></ul></ul><ul><ul><li>Generally not appropriate for litigation matters </li></ul></ul>
    28. 28. Forensic Accounting Issues Page
    29. 29. Fraud Defined Page
    30. 30. Fraud Triangle Page 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 INCENTIVE RATIONALIZE FRAUD OPPORTUNITY
    31. 31. The Need for Forensic Accounting Page
    32. 32. When To Do It Page <ul><li>Valuing a business/business interest in connection with a litigation/dispute matter; and: </li></ul><ul><ul><li>Specific allegations of fraud have been asserted; or </li></ul></ul><ul><ul><li>Fraud is suspected </li></ul></ul>
    33. 33. Divorce Engagements Page
    34. 34. What To Look For Page
    35. 35. Red Flags Page
    36. 36. 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 Page
    37. 37. 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. Page
    38. 38. How to Find It – Basic Preliminary Steps Page 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
    39. 39. Gathering and Analyzing Data Page 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
    40. 40. Reviewing Documents – Caution Page 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
    41. 41. Analytical Procedures 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 Page
    42. 42. Data Mining Page
    43. 43. Cash is Still King <ul><ul><li>There should be a direct relationship between income and cash </li></ul></ul><ul><ul><li>Analyze bank activity and compare to income being reported </li></ul></ul>Profitable companies generate positive cash flow; whereas companies with low profits should not be generating large amounts of cash <ul><ul><li>tracing funds generally provides a wealth of useful information, especially for small/medium sized businesses </li></ul></ul>Follow the money Page
    44. 44. Using the Results Page Depending upon the circumstances, the forensic accounting results should be incorporated into the valuation analysis as appropriate. <ul><li>Such incorporation may involve: </li></ul><ul><ul><li>Normalization adjustments to the existing financial statements </li></ul></ul><ul><ul><li>Reconstructing the financial statements all together </li></ul></ul>
    45. 45. Questions? <ul><li>Contact Information: </li></ul><ul><li>W. James Lloyd, CPA/ABV, ASA, CFE </li></ul><ul><li>Shareholder | Valuation & Dispute Services </li></ul><ul><li>Pershing Yoakley & Associates, P.C. </li></ul><ul><li>[email_address] | 865-673-0844 </li></ul>Page