What Family Lawyers Need to Know About Business Valuation in Divorce - Presentation to the Memphis Bar Assoc. 2012 Family Law CLE
What Family Lawyers Need to Know About Business Valuations in DivorcePresented by:Robert Vance, CPA, ABV, CFF, CVA,CFPForensic & Valuation Services, PLC901-507-9173www.ForensicVal.comrvance@ForensicVal.com
What is the Essence of a Business Valuation? It‟s a formula – right?
What is the Essence of a Business Valuation? Estimation of two primary components 1) The future expected benefits 2) The risk related to receiving those future expected benefits A valuation measures the: Present Value of the future benefits (e.g. The Time Value of Money; a dollar today is worth more than a dollar in one year) A business is only really worth the present value of the cash flow over and above a “normal” owner compensation
What are the Standards of Value? Fair Market Value Fair Value Investment Value Intrinsic (Fundamental) Value Book Value Divorce Value?
Fair Market ValueDefinition per IRS Revenue Ruling 59-60“The price at which a property would changehands between a willing buyer and a willingseller when the former is not under anycompulsion to buy and the latter is not under anycompulsion to sell and both parties havereasonable knowledge of the relevant facts.”
Fair Market ValuePowell v. Powell11) Fair Market Value Standard as in IRS Rev. Rul. 59- 60 does not have to be strictly followed when valuing a business in a divorce2) Business owners can be held to values in personal financial statements submitted to banks3) Credentials and experience of business valuation analysts are critical1. Powell v. Powell, 124 S.W.3d 100 (Tn. Ct. App. 2003)
What are the Approaches to Valuation? Blasingame v. American Materials, Inc.2 “There are a number of acceptable methods available to determine the value of a corporation.” Blasingame recognized three of these methods [approaches]: 1) Market Value [approach], 2) Asset Value [approach], and 3) Earnings Value or Capitalization of Earnings [Income] [approach] 2. Blasingame v. American Materials, Inc., 654 S.W.2d 659, (Tenn. 1983)
What are the Approaches to Valuation? 1) Market Approach a) Expected benefit = some level of earnings (reve- nue, net income, EBITDA, gross profit, etc.) b) Expected risk and growth are measured by a market multiple (P/E, MVIC/EBITDA, etc.) c) Market multiples are obtained from public com- panies, from sales of similar companies, or prior sale of the subject company or interests in the subject company
Market Transaction Method Using The Goodwill RegistryTotal ValueGross Revenues-2010 900,000 Estimate for 2011Goodwill Registry Average Price/Rev %-General Dentistry 65.1% AverageIndicated Selling Price - Includes Equipment 585,900Adjusted Net Operating Assets 158,660 Cash, A/R, PayablesL-T Debt (213,348) 531,212Non-Operating Assets Destin Condo 450,000 Excess Cash 10,000 Residential Lot 15,000 475,000Indicated Total Value, Net of Debt 1,006,212Indicated Total Value, Net of Debt (Original) 1,006,212Total Goodwill ValueGross Revenues-2010 900,000Goodwill Registry Average GW/Gross Revenues %-General Dentistry 49.0%Indicated Goodwill Included in Selling Price 441,000* General Dentistry; Year 2010; The Health Care Group, Inc. Beware of this value as it may or may not include Goodwill and may not include all assets like cash and liabilities like A/P
What are the Approaches to Valuation? 2) Asset Approach Adjusted Net Book Value method is similar to the classic accounting formula: Assets - Liabilities = Equity or Identifiable “Hard”* Assets Adjusted to FMV – Liabilities = Value * “Hard Assets”: Cash, A/R, N/R, WIP, Patient Records, Equipment, Purchased Goodwill, etc.
Adjusted Net Asset Value Method 3/31/2011 3/31/2011 Bal. Sheet Adjustments Bal. SheetCash 98,408 98,408Accounts Receivable 63,215 (20,000) 1) 43,215Accounts Payable & Other (2,963) (2,963)Adjusted Net Operating Assets 158,660 138,660Dental Equipment (Depreciated) 50,000 150,000 2) 200,000Non-operating Assets 0 475,000 3) 475,000Total Asset Value 208,660 813,660L-T Debt (213,348) (213,348)Indicated Value, Net of Debt (4,688) 600,3121) Insurance company discount - A/R recorded at gross before discounts2) Appraisal of dental equipment by personal property appraiser3) Appraisal of other assets by personal property appraiser & real estate appraiser
What are the Approaches to Valuation? 3) Income Approach a) Expected benefit = net cash flow or other measure of: Forecasted benefits Normalized historical benefits b) Expected risk is measured by the weighted average cost of capital, capitalization rate or discount rate c) Net present value of expected benefit
Capitalization Of Earnings Capitalization RateRisk-free Rate of Return 4.5% 5 Year Average of 20 Yr Bond rateCommon Stock Equity Risk Premium 6.5% Morningstar, Ibbotson SBBI 2010 Valuation YearbookSmall Stock Risk Premium 10.5% Morningstar, Ibbotson SBBI 2010 Valuation YearbookCompany Specific Premium 6.5% Independent Analysis Net discount rate 28.0%Less Sustainable Growth 3.0% Independent AnalysisNext Year Capitalization Rate 25.0%
Capitalization Of Earnings Economic Stream Dec Dec Dec Dec Dec 2011 2010 2009 2008 2007Historic Net Income Using Sched. C as Basis 516,036 422,003 330,484 191,134 60,503Depreciation 0 17,957 33,992 69,649 119,004Mean Compensation for Independent Dentists* (211,006) (209,733) (208,468) (207,210) (205,960)Adjusted Earnings Before Deprec. and Taxes 305,030 230,227 156,008 53,573 (26,453)Weight 3 2 1 0 0Stream Weight 915,091 460,454 156,008 0 0Weighted Average 255,259Less Ongoing Depreciation/Amort. (38,000)Taxable Base 217,259Less State Income Taxes 6.5% (14,122)Sub-Total 231,381Less Federal Taxes (73,489)Sub-Total 157,892Add Back Ongoing Depreciation/Amort. 38,000Decrease/(Increase) in Working Capital (5,000)Decrease/(Increase) in Capital Expenditures (38,000)Ongoing Earning Capacity 152,892* American Dental Association, 2009 Survey of Dental Practice; 2008-2006 reported; 2011-2009calculated with trend %
Capitalization Of Earnings Indicated ValueOngoing Capacity 152,892Capitalization Rate 28.5% 1/.285 =Operating Value 536,464 3.5 MultipleNon-Operating Assets Destin Condo 450,000 Excess Cash 10,000 Residential Lot 15,000 475,000Indicated Value, Net of Debt 1,011,464Indicated Value, Net of Debt (Original) 1,099,050
How is Personal Goodwill Handled in a TennesseeDivorce? Generally 1) Fair Market Value inherently includes Goodwill when valuing with a going concern premise 2) Personal goodwill is generally not to be considered in valuation of professional practices and small, closely-held businesses primarily dependant upon the individual for success 3) Courts often use a standard other than FMV
How is Personal Goodwill Handled in a TennesseeDivorce? Hazard v. Hazard3 1) Dr. Hazard‟s practice was highly specialized and very dependent upon referrals from other physicians 2) Court rejected gross income approach to value Husband‟s medical practice 3) Goodwill in a professional practice is not a marital asset subject to equitable distribution 3. Hazard v. Hazard, 833 S.W.2d 911 (Tn. Ct. App. 1991)
How is Personal Goodwill Handled in a TennesseeDivorce? Hazard v. Hazard (cont’d) 4) Sole practitioner professional practice is to be valued using the “net tangible assets with ascertainable value.” Cites Smith v. Smith4 5) Net Asset Value a.k.a. Net Book Value 4. Smith v. Smith, 709 S.W.2d (Tn. Ct. App. 1985)
How is Enterprise/Business Goodwill Handled in aTennessee Divorce? Witt v. Witt5 1) If the professional practice or closely-held business is large and diverse enough and not solely dependent on the individual, goodwill may be considered as part of the ownership interest 2) Dr. Witt‟s clinic was found to have separate good- will that was not directly related to his professional or personal goodwill 5. Witt v. Witt, 17 TAM 15-6 (Tn. Ct. App. 1992)
How is Enterprise/Business Goodwill Handled in aTennessee Divorce? Eberting v. Eberting6 1) Orthodontia practice value at FMV by Vance at $700k; included Enterprise (not Personal) Goodwill 2) Opposing expert valued practice At $224k (net book value with no Goodwill) 3) Trial judge found value to be $500k, which was a value indicated by the owner; judge knew that any value north of $224k was including Goodwill 6. 2012 WL605512
How is Enterprise/Business Goodwill Handled in aTennessee Divorce? Eberting v. Eberting (cont’d) 4) “When asked if the amount of goodwill were subtracted from his $700,000 if the resulting value would be $270,000, Mr. Vance stated: „That‟s correct, if you went with a net asset value method, which of course is not the real value of this company.” Mr. Vance also stated: “If you were to strike the personal goodwill, this clearly has enterprise goodwill associated with it. It‟s not all personal to him.‟ ”
How is Enterprise/Business Goodwill Handled in aTennessee Divorce? Eberting v. Eberting (cont’d) 5) “Husband argues on appeal that the value assigned by Wife‟s expert, Mr. Vance, of $700,000 should not have been accepted by the Trial Court because it incorrectly included good will. We agree that “professional good will is not a marital asset which would be accounted for in making an equitable distribution of the marital estate.” Smith v. Smith, 709 S.W.2d 588, 592 (Tenn. Ct. App. 1985).”
How is Enterprise/Business Goodwill Handled in aTennessee Divorce? Eberting v. Eberting (cont’d) 6) “A trial judge, as the fact finder, is not required to check his or her common sense at the door when considering evidence. The Trial Court had before it evidence of values that Husband himself had applied to his practice, and had Husband‟s own testimony that he would be upset if he were to sell the practice and receive only the value assigned by his expert. The Trial Court found a value for the practice that was within the range of values presented by the evidence.” [emphasis added]
Multiattribute Utility Model (MUM)* Importance Existence Mult. Personal Goodwill Attributes Utility Utility Utility Percent Ability, Skill & Judgment 1 4 4 16 9.2% Lacks Transferability 2 5 0 0 0.0% Age & Health 3 5 1 5 2.9% Personal Staff 4 4 2 8 4.6% Personal Reputation 5 4 3 12 6.9% Personalized Name 6 4 3 12 6.9% Marketing & Branding 7 2 2 4 2.3% In-bound Personal Referrals 8 4 2 8 4.6% Knowledge of End User/Customer 9 2 2 4 2.3% Important Personal Nature 10 3 2 6 3.5% Total Personal Utilities 37 21 Total Personal Multiplicative Utility 75 43.4% Importance xistence E Multiplicative Enterprise Goodwill Attributes Utility Utility Utility Percent Enterprise Staff 1 4 3 12 6.9% Business Reputation 2 4 3 12 6.9% Business Name 3 5 2 10 5.8% Marketing & Branding 4 3 2 6 3.5% Business Locations 5 4 3 12 6.9% Years in Business 6 4 3 12 6.9% Systems & Organization 7 3 2 6 3.5% Out-bound Referrals 8 4 2 8 4.6% Repeating Revenue Stream 9 5 4 20 11.6% Total Enterprise Utilities 36 24Total Enterprise Multiplicative Utility 98 56.6% Total Multiplicative Utility 173 100.0%*Wood, David, BVR‟s Guide to Personal v. Enterprise Goodwill, BusinessValuation Resources, LLC, Portland OR, 2010.
How are Buy-Sell Agreements Handled in aTennessee Divorce? Harmon v. Harmon7 1) Dr. Harmon was a doc in a large medical practice 2) Buy-sell agreement contained an artificially low value formula if a doc terminated 3) Buy-sell agreement of a closely-held corporation, not signed by the non-shareholder spouse, is not binding on that spouse and is only a consideration in the valuation 7. Harmon v. Harmon, 25 TAM 15-22 (Tn. Ct. App. 2000)
How are Buy-Sell Agreements Handled in aTennessee Divorce? Inzer v. Inzer8 1) Husband owned a 24% interest in a Sonic restaurant and signed a buy/sell agreement with a low valuation method 2) Wife, not an owner, signed an agreement stating she agreed to be bound by the same terms 3) Court found that the value of the business should be determined based upon the buy/sell agreement since the wife had signed the agreement 8. Inzer v. Inzer, No. M2008-00222-COA-R3-CV July 28, 2009 (Tenn.Ct.App. 2009)
Financial Statement Adjustments 1) Adjustments for Generally Accepted Accounting Principles (“GAAP”) departures a) Year end accruals b) Accelerated depreciation c) Cash basis to accrual (inventory, accounts receivable) d) Prepaid assets e) Intangibles (work in process, medical files)
Financial Statement Adjustments 2) Adjustments for Normalization a) Personal expenses b) Owner‟s salary c) Non-operating assets d) Shareholder loans e) Nonrecurring income and expenses f) Income taxes
Discounts & Premiums 1) Discount for Lack of Control (Minority Interest) 2) Premium for Control 3) Discount for Lack of Marketability 4) Discount for Key person They depend on the interest to be valued and the techniques used to establish the value conclusion
Discounts & Premiums 1) Discount for Lack of Control (Minority Interest) Anderson v. Anderson9 “The reasons given by Warren to discount the value of the husband‟s minority interest are persuasive, and the evidence does not preponderate against discounting the value by 38.3%.” 9. Anderson v. Anderson, 2006 WL 2535393, at*4
Discounts & Premiums 3) Discount for Lack of Marketability Bertuca v. Bertuca10 “There is no indication in the record that Mr. Bertuca has any intention of selling his interest in Capital Food Services. Thus the value of the business is not affected by the lack of marketability and discounting the value for non-marketability in such a situation would be improper.” Anderson, 2006 WL 2535393, at*4. 10. Bertuca v. Bertuca, 2007 WL 3379668 (Tenn.Ct.App.).