1. business and industrial

Business Valuation Insights
Second Quarter 2015
Business Valuations and Lost Profits Analysis – Similar, Yet Also Very
Different
Page 1
By: James A. Gravitt, CPA, CBA, ABV, CFE
Business valuations and lost profits analyses employ many similar concepts. While
either may be a good choice for measuring business damages, there are important
differences in theory and application for commercial litigators and their clients to
be aware of.
It’s Official (at Least for Now) – Business Appraisers Are
NOT Fiduciaries
Page 5
By: S. Andrew McKay, Head of Investment Banking
In January, the Department of Labor reversed itself in an important matter involving
business owners and employees. And we were very glad.
Costly Mistakes that Exiting Business Owners Make
Page 6
By: Jackson Barefoot, Investment Banking Analyst
Most private business owners do not invest enough time developing an exit strategy for
the sale or transfer of their business. What are some of the pitfalls we typically encounter?
Court Case Insights
Page 9
Here are recent court cases involving business valuations and damages
measurement issues that we find of interest.
Our Value Proposition - "Real World" Valuation
We bring a special perspective to business valuation engagements via continuous
"real world" exposure to the market that is obtained through our mergers and
acquisitions practice. While we possess recognized valuation credentials, adhere
to valuation standards, and have substantial valuation experience, we believe it is
our experience in the market for buying and selling businesses that is the critical
factor grounding our valuations in reality.
www.HLinvestmentbanking.com
U
Beyond Guidance. Results.®
J.J.B. Hilliard, W.L. Lyons, LLC | Member NYSE, FINRA & SIPC
BUSINESS VALUATION INSIGHTS
Second Quarter 2015
Business Valuations and Lost Profits Analysis – Similar, Yet Also Very
Different
By James A. Gravitt, CPA, CBA, ABV, CFE
When considering the most appropriate approach (a business valuation or a lost profits analysis) to use as a
loss measure in a business damages case, an initial point of demarcation is the differing professional standards
that apply to each. These are discussed below, after which we point out additional differences between
business valuations and lost profits measurements that can affect the choice of both financial expert and
methodology in a commercial damages dispute.
1. Standards. Credentialed business appraisers (ABV, CBA, CVA, etc.) are bound by the credentialing
organizations’ professional standards for business valuations. Generally, these standards are for the work
itself (development standards) and for the report on the work (reporting standards). Although the
reporting standards generally provide an exemption for matters in controversy, there is no exemption
from the development standards.
No standardized development or reporting standards apply for a lost profits analysis per se. For CPA
business damages experts, the profession’s general professional standards1 and consulting services
standards2 apply. While the American Institute of Certified Professional Accountants (AICPA) has
published various “practice aids,” including one on calculating lost profits, the practice aids specifically
state they are providing “non-authoritative” guidance only.
Of course, any expert witness testifying in a court proceeding must be qualified to do so under the relevant
rules of evidence3. Typically, these rules contain general requirements and qualifications for the expert
and for the basis of her/his testimony.
2. The parties. A subtle distinction exists between a business valuation and a lost-profits analysis as to the
assumed parties to the transaction. For a business valuation, the International Glossary of Business
Valuation Terms4 defines fair market value as between “a hypothetical willing and able buyer and a
hypothetical willing and able seller acting at arm’s length in an open and unrestricted market, when
neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant
facts” (emphasis added). This is usually interpreted to mean that certain specific characteristics of the
1
www.aicpa.org/Research/Standards/CodeofConduct/DownloadableDocuments/
2014December15CodeOfProfessionalConduct.pdf
2
www.aicpa.org/interestareas/forensicandvaluation/resources/standards/downloadabledocuments/scss%20%20cs%20section%20100.pdf
3
For federal courts, this is Rule 702. See
www.uscourts.gov/uscourts/RulesAndPolicies/rules/2010%20Rules/Evidence.pdf, page 14.
4
www.aicpa.org/InterestAreas/ForensicAndValuation/Membership/DownloadableDocuments/
Intl%20Glossary%20of%20BV%20Terms.pdf
Page 1 of 13
BUSINESS VALUATION INSIGHTS
Second Quarter 2015
parties (such as a seller’s personal goodwill or favorable buyer synergies) and the relative bargaining
power of the litigants are ignored when performing a business valuation.
By contrast, in a business valuation, it is possible to reflect buyer and seller specific considerations. But in
those cases, the definition of value becomes “investment value” – “the value to a particular investor based
on individual investment requirements and expectations5.”
In lost profits calculations, the specific characteristics of the parties and of the transaction between them
are considered. So it is possible to factor in the unique attributes of the buyer, seller, and negotiating
circumstances on the damages measure.
3. Research. Both business valuations and business damages analyses may entail extensive research of the
factors that affect the analysis. Research may include company-specific items such as management depth
and style, as well as external factors like competition, industry trends, and the economy.
A significant difference between research performed for a business valuation versus a lost profits analysis
is in the appropriate time period for the analysis This is because a lost profits analysis may consider
unforeseen future events, such as the loss of competitor due to as a catastrophic fire, while a business
valuation may not factor such events into the analysis unless they were “known or knowable” at the
valuation date. More on this concept later.
4. Methods. Typical methods for valuing businesses fall under three basic approaches: the cost (or assetbased), income, and market approaches. While a lost profits analysis may employ methods that are
conceptually similar to the income approach to valuation, the methods “before and after,” “yardstick,”
and “but for” are unique to lost profits analyses. In addition, to the extent that a “yardstick” method for
measuring lost profits considers the undamaged results of similar companies, this method also
incorporates elements of the market approach to valuation.
Certain nuances of business valuations and lost profits calculations are unique. For example, lost profits
analyses may consider mitigating damages or damages apportionment. Business valuations may consider
minority and marketability discounts. These concepts generally do not cross over from one discipline to
the other.
5. Time periods. In a business valuation, a sale of the business between hypothetical parties is assumed
based only on what is “known or knowable” as of the valuation date. This is referred to as “ex ante”
(before the event) analysis. For example, the current low oil price environment likely would not be
factored into the valuation of an oil services company with a June 2012 “as of” date, because no one then
expected lower oil prices in the future (something we all seem to have missed).
But in a lost profits analysis, events occurring after the date of damages can be considered, despite being
unknown at the time of the injury. An example of this “ex post” consideration of events is in estimating a
royalty rate for intellectual property damages using the Georgia-Pacific factors6. The hypothetical
5
Ibid.
6
See www.ipvalue-site.com/index.php/2010/09/15/here-are-the-15-georgia-pacific-factors-considered-for-patentinfringement, based on Georgia-Pacific Corp. v. United States Plywood Corp., 318 F.Supp. 1116 (SD NY 1970).
Page 2 of 13
BUSINESS VALUATION INSIGHTS
Second Quarter 2015
licensing negotiation is assumed to occur at the instant infringement begins, yet the Federal Circuit has
approved consideration of some later events in this analysis. (This “look into the future” concept is
sometimes referred to as the “Book of Wisdom” based on a 1933 U.S. Supreme Court decision7.)
In SmithKline Diagnostics, Inc. v. Helena Laboratories, Inc.8, the Federal Circuit affirmed a 25% damages
royalty based on evidence of the later commercial success of the invention. In addition, one GeorgiaPacific factor specifically relates to the extent to which the infringer has made use of the invention and
the value of that use, all of which must occur after the date of the hypothetical negotiation.
6. Computations. While both business valuations and lost profits measurements can employ similar
concepts of future economic benefits, there are some points of departure in practice, including:
a. Pretax versus after tax: Business damages, as taxable awards, are typically determined on a pretax
basis. Business valuations typically are “after tax,” since they are based on after-tax cash flows
discounted at after-tax discount rates. A business valuation for damages could be presented on a
pretax basis by coupling pretax cash flows and an after-tax discount rate, or by “grossing up” an aftertax valuation to its pretax equivalent.
b. “Incremental” versus “full costing”: Typically, a lost profits analysis measures a loss as the difference
between the plaintiff’s incremental sales and the incremental cost to produce the sales. Business
valuations, however, consider the subject company’s full cost structure in estimating future net cash
flows (and thus value). To measure damages using a business valuation methodology, two appraisals
may be needed, one with and one without incremental sales and costs.
c. Perpetual versus limited time period: Lost profits may be measured over a finite time period,
sometimes with both past and future components. The length of the damages period is specific to the
facts of the matter. Business valuations typically assume a perpetual life for the business being valued.
The more permanent and long lasting a plaintiff’s injuries are, the more appropriate it may be to use
business valuation as the damages measure.
d. Extraordinary/non-recurring items: In a business valuation, estimates of future earning power are
based on historical results, which may be “normalized” to exclude one - time items. In a lost profits
analysis, however, these unusual/nonrecurring items themselves (mitigation expenses, temporary
storage costs, etc.) give rise to the damages the analysis is attempting to measure.
e. Net income versus net cash flow: Statutory and case law guidance in business damages cases may
focus on lost profits versus lost cash flows. Business valuations may use either benefits measure, so
long as it is matched to an appropriate discount rate. Considerations such as depreciation, capital
expenditures, and working capital can cause cash flows and accounting profits to differ substantially
from year to year.
7. Discount rate. The discount rate in a business valuation is typically based on the subject company’s cost
of capital and may include an “industry” proportion of debt and equity. The discount rate in a damages
calculation is generally case law or jurisdiction specific, and may be set by statute. The present value
7
Sinclair Refining Co. v. Jenkins Petroleum Process Co., 289 U.S. 689 (1933).
8
926 F.2d 1161 (Fed. Cir. 1991)
Page 3 of 13
BUSINESS VALUATION INSIGHTS
Second Quarter 2015
measurement date in a damages case may be the date of injury, date of the expert report, date of trial,
or anticipated date of an award. Meanwhile, the measurement date for a business valuation is usually the
date of injury. Discount rates in a lost profits analysis may also differ within the analysis of past versus
future damages.
8. Role of the expert. There should be no difference between the two types of engagements as pertains to
the expert’s possible roles. In either case, a financial expert may be engaged to testify as an expert, or to
assist the attorney in a consulting role as a non-testifying consultant. If engaged to offer an opinion on
damages, the expert’s role is to assist the fact finder (judge or jury) and to be an advocate only for his/her
opinion.
In commercial damages cases, the differences between business valuations and lost-profits analysis can be
nuanced. Either technique can apply in a given case, and both may apply in some cases. But care must be
taken to fit the appropriate methods to the facts and circumstances. Attorneys who understand the
differences will be well positioned to choose the best role for their financial expert and to work effectively
with them once an engagement approach is selected.
© 2015 J.J.B. Hilliard, W.L. Lyons, LLC. You may not reproduce or distribute any part of this newsletter without
Hilliard Lyons’ prior written consent. We believe that the information in this newsletter is reliable, but we do
not guarantee its accuracy, and it may be condensed or incomplete. This newsletter is for information purposes
only, and is not intended as financial, investment, legal, or consulting advice.
Page 4 of 13
BUSINESS VALUATION INSIGHTS
Second Quarter 2015
It’s Official (at Least for Now) – Business Appraisers Are NOT
Fiduciaries
By S. Andrew McKay, Head of Investment Banking
Business appraisal firms (including Hilliard Lyons) that perform valuations of ESOPs (employee stock
ownership plans) can exhale deeply: In late January, the U.S. Department of Labor (DOL) announced that it
will abandon its proposed the “appraiser-as-fiduciary” rule. By way of background, in 2010 the DOL issued a
proposed regulation that would impose a fiduciary obligation on business appraisers in the valuation of ESOPs.
After fierce protest from the appraisal community, the DOL withdrew its proposal in September 2011,
announcing that a new version of the regulation would be forthcoming.
Business appraisers and credentialing organizations such as the American Society of Appraisers (ASA) and the
American Institute of Certified Public Accountants (AICPA) strongly opposed the proposed regulation because:





Appraisers would need to purchase fiduciary liability insurance, driving up appraisal costs.
Higher costs could force out smaller appraiser firms and sole practitioners.
Appraisal firms may not want to take on the additional risk and avoid ESOP valuations altogether.
Higher costs would be passed on to the ESOP plans, which could discourage the creation of new ones.
Most importantly, having appraisers also act as fiduciaries when performing ESOP valuations conflicts with
their role as appraisers – to provide objective, unbiased opinions of value in a valuation assignment.
While this rule could be re-proposed at some point, the DOL’s latest retreat is certainly great news for business
appraisers. We are greatly relieved and look forward to continuing to provide valuation services to existing
and future ESOPs. This form of business ownership offers many advantages for both employees and business
owners looking to transition their ownership.
© 2015 J.J.B. Hilliard, W.L. Lyons, LLC. You may not reproduce or distribute any part of this newsletter without
Hilliard Lyons’ prior written consent. We believe that the information in this newsletter is reliable, but we do
not guarantee its accuracy, and it may be condensed or incomplete. This newsletter is for information purposes
only, and is not intended as financial, investment, legal, or consulting advice.
Page 5 of 13
BUSINESS VALUATION INSIGHTS
Second Quarter 2015
Costly Mistakes that Exiting Business Owners Make
By Jackson Barefoot, Investment Banking Analyst
Most private business owners do not invest enough time developing an exit strategy for the sale or transfer
of their business. The subject is typically delayed for both logistical and emotional reasons, including:





the significant time commitment required to support current business operations;
lack of experience and comfort with merger and acquisition (“M&A”) transactions;
uncertainty about the market value of the business;
confidence regarding post-business cash flow and ability to support a desired lifestyle; or
a sense of identity loss from retirement and disassociation with the family business.
While many business owners cope with these pressures by simply ignoring the need for exit planning, the
most successful owners consider exit strategies even before they start their businesses. For seasoned equity
holders, realizing a successful transition from the business is a top priority rather than an “unplanned potential
eventuality.” With 80-85% of the average business owner’s net worth tied up in the illiquid equity value of
their private enterprise, a hands-off approach to exit strategy poses a significant risk to an owner’s long-term
financial well-being.
A passive approach can result in a substantial decrease in shareholder value and is often manifested in the
following five most costly (and common) mistakes made by exiting business owners:
1.
Letting the Good Times Roll
Unsurprisingly, the most costly mistake made by exiting business owners is waiting too long to begin
the transition process. When asked about exit timing, business owners most frequently state that they
are either looking to exit 3-5 years from now, or wishing they had exited 1-2 years ago. By nature,
entrepreneurs are risk takers and regularly view the world through the rosy lens of future opportunities
rather than focusing on the inherent risks that exist along the way. While this philosophy may be
essential to their success as an entrepreneur, it can also lead to selling the business too late and at a
much lower valuation.
The most successful exits at the highest valuation multiples occur during periods of extraordinary
growth due to the market premiums placed on growing enterprises. As a result of this market effect,
high-growth enterprises can have a greater current value than at a later, less expansive state – even if
cash flows are lower during the growth stage! Unfortunately, many business owners begin to consider
an exit only after an expansion period has passed – or worse, with the business in decline. Owners of
high-growth organizations should always weigh the valuation premium placed on their growing
enterprise against the risk of sustaining business growth going forward.
2.
Ignoring Market Dynamics
Private M&A markets, much like their public counterparts, are affected by macroeconomic factors
outside of the business owner’s control. Even when a company is largely unaffected by the greater
economic landscape, a company’s market value will commonly rise and fall with the health of the overall
Page 6 of 13
BUSINESS VALUATION INSIGHTS
Second Quarter 2015
economy. In other words, even good companies experiencing growth in a bad economy may have less
market value than the same business in a better market.
Business owners understand these market-driven valuation principles instinctively, yet they seldom
apply them. Much like investors in publicly traded companies, business owners are more comfortable
holding onto their assets when times are good and fail to view healthy economies as a positive exit
signal. Business owners and investors who plan their exit strategies early are more likely both to
recognize a strong market as an excellent time to garner the highest transaction value and to
understand that even continued growth in the business may not overcome the loss of this valuation
premium should the overall market weaken.
3.
Penny Wise, Pound Foolish
Saving pennies at the expense of pounds by neglecting to engage professional advisors in a business
transaction process is one of the most costly mistakes made by exiting business owners. The services of
CPAs, business attorneys, and financial advisors with M&A experience help maximize transaction value
by assisting in all phases of the process. These advisors will typically cover their fees many times over
by advising business owners on the following transaction issues:
Business Attorney
 Drafts asset or stock purchase agreement documents
 Protects exiting business owners from financial liability associated with future performance of the
business
 Negotiates all final details of legal documents on behalf of the client
CPA
 Prepares proper financial statements for M&A audience
 Ensures correct adjustments to show the company’s true cash-flow-producing capabilities
 Minimizes tax exposure to exiting shareholders by advising on tax treatment of the proceeds
Investment Banker
 Identifies potential interested parties, such as:
₋ financial investors with stated industry interest or current related investments, or
₋ similar businesses with competitive or regional strategic interests
 Prepares marketing materials to convey the strengths of the business to interested parties
 Coordinates confidential competitive process and minimizes distraction from business owner and
management team
 Advises through negotiation process over valuation and terms
4.
“One Buyer Is No Buyer”
As noted, the exit planning process can be time-consuming and complex. Additionally, exit planning can
be emotional and falsely viewed as planning for the end of the business. For these and other reasons,
business owners may put off a sell-side process and simply wait until an interested party becomes more
proactive in seeking to acquire their business. This approach appears to be less complex, less timeconsuming, and seemingly just as capable of producing comparable offers to those produced through
marketing the business to a targeted group of interested parties.
Page 7 of 13
BUSINESS VALUATION INSIGHTS
Second Quarter 2015
While this approach may make sense to some, the lack of leverage resulting from one-party negotiations
undercuts these assumptions. In a non-competitive environment, a potential buyer is under no pressure
to move quickly, will often string along the business owner without making a serious proposal, and offer
a significantly lower bid with less favorable terms than would be achieved in a competitive process. A
carefully controlled M&A auction process maximizes valuation, helps ensure optimal terms, and extends
the sellers’ leverage by maintaining multiple competing bidders until a winning bid is accepted.
5.
Insufficient Delegation
Many business owners have a difficult time delegating power and authority. (That may be the very
reason they own a business!) The combination of a protective concern for the business and a history of
performing virtually every role within the company makes it difficult to entrust higher-responsibility
duties to executive management teams. Though there is some risk associated with assigning key roles
to managers with less intrinsically aligned interests, the risk of a valuable enterprise relying too heavily
on one individual is even greater.
Aside from the risk to the business in the event of a sudden loss of its key man or woman, the current
valuation is also affected by failing to develop competent successive management teams. Buyers
recognize that even if the previous owner has a stated intent to remain with the company posttransaction, his or her incentives are not as aligned with the overall business as they once were. Business
owners considering a sale in the near future should begin by asking themselves, “How capable is my
current management team of running the business in my absence?”
Managing the day-to-day operations of a business is burdensome enough and often makes the task of exit
planning seem overwhelming. Working with advisors to identify available exit options and a likely market
valuation is a great place for an owner to start crafting his or her exit plan. In addition, avoiding these costly
mistakes will place many business owners ahead of the competition when it’s time to head for the exit.
For details, visit: www.HLInvestmentBanking.com
© 2015 J.J.B. Hilliard, W.L. Lyons, LLC. You may not reproduce or distribute any part of this newsletter without
Hilliard Lyons’ prior written consent. We believe that the information in this newsletter is reliable, but we do
not guarantee its accuracy, and it may be condensed or incomplete. This newsletter is for information purposes
only, and is not intended as financial, investment, legal, or consulting advice.
Page 8 of 13
BUSINESS VALUATION INSIGHTS
Second Quarter 2015
Court Case Insights
The following case illustrates the pitfalls of inadequate “due diligence” in a lost profits case.
Russell v. Allianz Life Insurance Co. of North America, 2015 U.S. Dist. LEXIS 1946 (Jan. 8, 2015)
In this Daubert proceeding, an insurance agent sued the insurance company for breach of contract and sought
lost profits. In 2011, the insurer ended a longstanding relationship with the agent to sell its long-term care
insurance and health products. At the time of termination, the plaintiff was 70 years old. The plaintiff sued for
breach of contract, breach of the covenant of good faith and fair dealing, breach of fiduciary duty, and
“intentional interference with business relations.”
The plaintiff’s expert was a CPA who specialized in business valuation and forensic accounting. The expert
measured lost profits for 10 years after the termination date by
(1) analyzing the plaintiff’s “historical gross revenues from commissions, the related business expenses, and
resulting net profits” from 2005 to 2012;
(2) determining the plaintiff’s work life expectancy of 10 years;
(3) using data from the Insured Retirement Institute regarding sales of annuities on a national level as a
yardstick to project the plaintiff’s future annual gross commissions income; and
(4) valuing the plaintiff’s “book of business” at 1.5 times the projected gross commission income for the year
2020.
The loss of future profits was approximately $554,000, which the expert discounted to present value
($486,000) using a 2.64% discount rate, based on the 10-year Treasury bond safe rate.
The defendant filed a Daubert challenge to preclude the opinion, arguing that it erroneously assumed there
was a saleable book of business and also because it “grossly” overestimated the plaintiff’s work life
expectancy. The court examined both aspects in turn. Regarding the book of business ($152,000 of the
damages), the plaintiff’s expert stated that he used a 1.5 multiplier, based on the ratio of sales price to annual
revenues of similar sized insurance agencies. The expert stated that the multiplier could be anywhere in the
range of one to three times the agent’s projected gross commission income. Also, the expert assumed that
the plaintiff lost his entire customer list following the termination, but the plaintiff testified that after his
termination he was able to sell other carriers’ insurance products to some of the clients on the list.
The defendant contended the expert’s comparative approach was inappropriate, since the plaintiff’s annuity
book of business was “grossly dissimilar” from books of business of other insurance products that formed the
basis of the comparison. The court agreed that the expert’s opinion was “fundamentally unsupported” and
not helpful to the jury. Had the expert actually reviewed the client list, he would have known the plaintiff
continued to sell insurance to some of the clients, the court observed.
The expert based his loss analysis on a comparison to other insurers, but, when pressed to document the
comparison, he stated that he “inadvertently lost” the documentation of the specific insurance agencies he
Page 9 of 13
BUSINESS VALUATION INSIGHTS
Second Quarter 2015
used to determine the value of the plaintiff’s book of business. In the end, there was no evidence with which
the plaintiff could counter the defendant’s claim that the insurance agencies were insufficiently similar.
Regarding work life expectancy, the expert’s lost profits calculation assumed that the plaintiff would continue
to live and work for another 10 years beyond age 70, based on the plaintiff’s statements that he was in good
health, loved working as an insurance agent, and thought of the work as “retirement work.” However, this
estimate was not supported by any work life expectancy data, for example the Skoog-Ciecka work-life
expectancy study. The defendant claimed that the expert’s failure to adhere to an objective standard made
the analysis inadmissible. Once again, the court sided with the defendant, stating that the expert’s failure to
use any objective standard made the testimony inadmissible under Daubert.
Are only “trained business valuation professionals” qualified to provide evidence on the value of a business? Is
business appraisal akin to brain surgery, or is it more like driving a car? The following Delaware case seeks to
resolve this question.
In re Dole Food Co., 2014 Del. Ch. LEXIS 258 (Dec. 9, 2014)
This matter stems from a take-private merger in which the chairman and controlling shareholder of Dole Food
Co. (the defendant) purchased the remaining shares for an agreed-on $13.50-per-share price. Subsequently,
two petitioners filed a dissenting shareholder suit in the Delaware Court of Chancery contesting the adequacy
of the merger price and asking the court for a fair value appraisal.
In discovery, Dole tried to obtain from each of the petitioners valuation-related information, such as written
documents and Excel files. This information included:
(1) any internal valuations the petitioners had performed of Dole or Dole stock prior to the litigation; and
(2) any valuations the petitioners had reviewed or considered in connection with buying and selling Dole
stock and with the appraisal action.
In addition, Dole wanted to depose financial professionals in the companies.
The petitioners refused to disclose the information, initially claiming that (1) the information was irrelevant,
and (2) disclosure on valuation was premature before the expert discovery phase. Each of the petitioners also
designated a witness, but, during the actual depositions, the witnesses, on instruction of counsel, refused to
answer most of the questions Dole’s counsel posed. Dole then filed a motion to compel disclosure of this
prelitigation information addressing the value of its stock, to which the petitioners objected (while dropping
the relevance argument).
The court noted that under the state’s discovery Rule 26(b)(1), generally anything not privileged was
discoverable as long as the material was relevant. Importantly, the relevant material need not be admissible
but need only appear “reasonably calculated to lead to the discovery of admissible evidence.” The court called
this aspect “potential admissibility.”
Page 10 of 13
BUSINESS VALUATION INSIGHTS
Second Quarter 2015
In its claim that the disclosure would not lead to the discovery of admissible evidence, the petitioners argued
that the prelitigation valuations were opinions, not facts, and that valuation in an appraisal action is “purely a
matter for the experts.” Since the witnesses were not experts under Rule 702, they could give only lay opinions
under Rule 701, but their value opinions did not meet the requirements for the admission of lay opinions. In
sum, there was no basis on which any information about their opinions could be admissible at trial.
The court disagreed with these arguments, finding that the internal valuations “easily satisfy the potential
admissibility requirement.” It disagreed with the premise underlying the petitioners’ claim: that valuation was
exclusively the “province of experts.” Although valuation was a topic where expert testimony was
“appropriate” and “helpful,” the court said, valuation was not an “esoteric specialty” nor was it “a rare
discipline like nuclear physics, brain surgery, or accident reconstruction.” According to the Chancery,
“valuation resembles more closely the common skill of driving a car” in that there are professional drivers and
your average commuter. While the former have greater abilities and knowledge, the latter still are
knowledgeable enough to comment on how a fellow driver handles himself on the road. There was also irony
in the petitioners’ position, the court observed, since “the appraisal statute mandates that a lay individual
express the final conclusion of the fair value of the petitioners’ shares” (the “lay individual” being a “lawtrained judge”).
The court also observed that in this case the designated witnesses were only “technically lay witnesses” and
“were hardly unqualified.” If the petitioners believed them to be otherwise, “then perhaps they should begin
disclosing to their investors that the financial professionals who manage their funds are not qualified to do
their jobs.” Given the witnesses’ training and experience, both “likely” could qualify as experts, the court said.
But, even if they were deemed lay witnesses, their opinions would be admissible under Rule 701 because their
assessments would be helpful to “the determination of a fact in issue.”
Commenting further, the court stated that the petitioners presented an “idealized depiction of valuation as a
scientific process,” but that an important piece of evidence was the contemporaneous view of financial
professionals “who make investment decisions with real money.” Here, the petitioners’ internal
contemporaneous valuations represented “real-world” assessments by “astute” investors. How they value
the company and its stock may be “as or even more credible than the litigation-crafted opinions of valuation
experts.” For all these reasons, the Chancery found that almost all of the valuation-related information Dole
requested from the petitioners was discoverable, finding no basis on which to refuse discovery of the
information.
In Kentucky, personal goodwill in a professional practice is not a divisible marital asset (see Gaskill v. Robbins,
2009 WL 425619 (Ky.) (Feb. 19, 2009)). Can other types of businesses also have non-transferrable personal
goodwill? The following Tennessee divorce case poses this question.
McCarter v. McCarter, 2014 Tenn. App. LEXIS 778 (Dec. 1, 2014)
In this matter, the husband was a licensed auctioneer and real estate agent, and the sole shareholder of an
auction business. The husband’s expert, a CPA and experienced business appraiser, used two methods
(adjusted net book value and capitalized net cash flow) to value the business. The difference between the two
methods ($210,000 using the income method and $125,000 under the asset-based method) was goodwill, the
Page 11 of 13
BUSINESS VALUATION INSIGHTS
Second Quarter 2015
husband’s expert said – and since it was not marketable, there was no enterprise goodwill. According to the
husband’s expert, the husband was “providing a professional service. It’s not like manufacturing…. That’s the
reason we opine that all of the goodwill in excess of the adjusted net book value was personal goodwill.” The
trial court adopted the $125,000 valuation of the husband’s expert, and the ruling was appealed.
In affirming the trial court’s decision, the appeals court noted that under state law, professional goodwill was
not a marital asset. It adopted the position the husband’s expert took when he described the goodwill at play
as “professional” and called the husband, an auctioneer, “a professional.” Once characterized in this way, the
goodwill was nontransferable and, therefore, not subject to division in a divorce proceeding. The appeals
court did note that under a recent decision, some goodwill might be attributable to the business, “where the
practitioner has one or more partners or pre-established contracts that could be assumed by another
practitioner.” See Hartline v. Hartline, 2014 Tenn. App. LEXIS 7 (Jan. 13, 2014).
Tax effecting of non-tax-paying entities (such as S corporations) continues to be a contentious issue in business
valuation, as discussed in a recent bankruptcy case.
Bank of America, N.A. v. Veluchamy (In re Veluchamy), 2014 Bankr. LEXIS 5106 (Dec. 18, 2014)
The defendants in this matter were sued by Bank of America (BoA) after defaulting on their loans. BoA alleged
that the defendants carried out a scheme to move high-value assets out creditors’ reach. One disputed
transfer concerned the defendants’ sales of stock in a holding company (an S corporation). The bankruptcy
estate claimed that the defendants transferred a controlling interest in the company to their two children for
less than fair value. As a result, any creditor who seized the defendants’ stock would be unable to control the
company and its subsidiaries. The stock valuation used to effect the transfer was the subject of conflicting
expert testimony at trial. A number of valuation issues were discussed in this case; the focus here is on the
question of the appropriate tax effecting for a pass through entity (PTE) such as an S corporation.
The estate expert’s decision was to not tax effect the company’s income, explaining that the question of
assuming taxation of S corporations was a matter of debate in the valuation community and that multiple
decisions from the U.S. Tax Court have held that it is inappropriate to reduce the value of a PTE to consider
the effect of taxes on its owners. The defendants’ expert argued that not assuming taxes for a PTE was
erroneous, and that the appropriate method was to apply taxes at the rate reduced by the owners’ tax savings.
The defendants’ expert adjusted the company’s income for taxes at a 38% rate, consisting of 35% and 3%
federal and state ordinary income tax rates, respectively.
Although the court found the defendant expert’s argument persuasive, it did not adopt accept his calculation.
This is because the expert simply reduced the company’s income by the marginal tax rate of individual owners,
which was higher than the rate corporations would pay, and thus failed to reflect the savings from the
elimination of the double taxation that the owner of a PTE receives. “Purchasers of S corporations would in
fact experience a reduction in the value of the corporation’s earnings because of the need to pay personal
income taxes on those earnings, and recognizing that tax effect in valuing S corporations is appropriate,” the
court said. Ultimately, instead of correcting the defendant’s expert’s calculation, the court adopted $7.9
Page 12 of 13
BUSINESS VALUATION INSIGHTS
Second Quarter 2015
million as the company’s net cash flow. This was the midpoint between the defendant expert’s tax-affected
net cash flow ($7.3 million) and the estate expert’s non-tax affected cash flow ($8.5 million).
© 2015 J.J.B. Hilliard, W.L. Lyons, LLC. You may not reproduce or distribute any part of this newsletter without
Hilliard Lyons’ prior written consent. We believe that the information in this newsletter is reliable, but we do
not guarantee its accuracy, and it may be condensed or incomplete. This newsletter is for information purposes
only, and is not intended as financial, investment, legal, or consulting advice.
Page 13 of 13