There are countless facets of a business that owners strive to understand, including strengths and weaknesses, industry and competitors, growth prospects and historical profitability. A company’s value is not always understood, but it can be an important tool.
WHY DO YOU NEED A BUSINESS VALUATION?
There are many possible circumstances that could require an owner to understand the true value of an enterprise. Common scenarios include:
- In adding or removing an owner of the business.
- When a dispute arises between business owners.
- To comply with the terms of a shareholder, partnership or other agreement.
- As part of a marital dissolution.
- As a component of an estate plan, when a business owner wants to bequest part of the business to the next generation. A valuation is required to comply with IRS rules for filing gift tax returns and to properly plan the size and scheduling of the gifts.
- When an owner elects to retire and sell the business to the next generation. A business valuation will aid the owner in determining a price and avoid unwanted gift tax consequences.
- A business’ competitor offers to buy the owner’s interest. A valuation is the recommended way to decide if the amount offered for the business is reasonable.
- When an owner dies, a valuation must be performed to determine the value of the decedent’s interest in the business for filing the estate tax return.
- In looking to obtain financing for the business. Lenders often require a business owner to obtain a business valuation.
- In litigation, where the measure of damages may be based on the destruction of a business’ value.
WHAT IS THE VALUE OF A BUSINESS?
The first step is to determine the standard of value appropriate for the purpose of the valuation. The most common standard is fair market value, which is defined in IRS Revenue Ruling 59-60, and is the price at which property might change hands in an arm’s-length transaction between a willing buyer and a willing seller, each informed, but neither under any compulsion, both parties having reasonable knowledge of relevant facts.
Other standards of value include fair value (a legal standard that can vary from jurisdiction to jurisdiction), investment value and synergistic value. These standards typically relate to situations in which the value to specific buyers and sellers is anticipated. If there is a specific buyer or seller, the enterprise may have greater value, especially if it puts a business owner in a position where he or she can remove a competitor or grow the market share.
A valuation professional needs to gain a thorough understanding of all aspects of the business. This involves an analysis of the business, both quantitative and qualitative, its financial condition, the industry, the markets and the economies in which it operates and the outlook for the future. Based on this information, the valuator will then choose one or more methods to produce an indication of the value of the business.
There are many recognized methods for valuing a business which fall under one of the three common approaches listed below:
• Income Approach – a business’ value is based on the expected future benefits to the owner or owners, discounted back to the present using a discount rate that reflects the time value of money and the risk associated with procuring these benefits. The future benefits are typically identified in terms of cash flow or earnings. The discount rate is customarily measured by means of the build-up method or the Capital Asset Pricing Model (CAPM), both of which are based on a risk-free rate (using a rate from U.S. Treasury securities as a proxy), various levels of market risk and the specific risk of the subject business.
• Market Approach – the value of a business is based on comparisons to purchase and sale transactions for companies in the same or a similar industry and/or by comparing the subject company to either publicly traded companies in the same or a similar industry.
• Asset Approach – the value of the business will be the fair market value of the individual assets, both tangible and intangible, less the fair market value of its liabilities. This approach is typically employed as the basis for valuing an asset holding company, which often holds real property and/or marketable securities.
The indicated value using one or more of the approaches described above is not the final value, however. That value may need to be adjusted by one or more discounts, such as a discount for lack of control (for nonvoting or minority shares) or a discount for lack of marketability (to account for the time and expense it takes to sell an interest in a privately held entity), among others. In some cases it may be appropriate to increase the value by a control premium.
WHAT WILL YOUR BUSINESS VALUATION PROVIDE TO YOU?
It is important to keep in mind that business valuations are performed for specific circumstances. The value for one purpose, such as estate planning and gifting, will not be the same as the value for another purpose, such as selling your business.
The analysis and information on the industry, markets and economy contained in a detailed valuation report can have an extra benefit by providing insight that can be used by business owners in the day-to-day operations by focusing attention on the value drivers of the company. A summary valuation report will describe the most important analyses conducted and provide sufficient information for the stated purpose of the valuation performed. For some purposes, such as obtaining a preliminary value when considering selling a business, a calculation report can be provided to a business owner, encompassing a limited scope of work and agreed-upon procedures.
Our highly trained professionals have earned dozens of licenses and certifications, and have decades of experience in a wide variety of industries. These skills make us uniquely qualified to perform business valuations for your business.
Sharon Foote is a manager in Berkowitz Pollack Brant’s Forensic and Business Valuation Services practice. For more information, call 305-379-7000 or e-mail firstname.lastname@example.org.
Scott Montgomery was recently interviewed for an article about boomers who are returning to the workplace or launching new careers. The feature ran in a special section of South Florida Business Journal titled, “The Business of Aging.”
Scott shared the example of a client who is well-employed but has been purchasing rental properties for future revenue and long-term retirement options. He was one of only two professional financial planners interviewed for the article.
Click here to read the article.
John Ebenger was recently quoted in a Miami Herald article about tax tips. The article attempted to shed light on some of the recent changes to tax laws. John provided information about windfalls – especially when selling real estate. He also described how the rules for passive income have changed and the potential tax liability.
Click here to read the article.
Companies usually buy business-interruption insurance as part of a broader property-casualty insurance policy. But treating this type of coverage as an afterthought can be costly. Give thought to how your business may be impacted by a fire, flood, or in the case of South Florida, a hurricane. It’s important to pay close attention to the fine print.
I have helped companies prepare insurance claims for property destruction and business interruption that arose from on-site damages due to fires, floods, hurricanes, even the devastating tsunami that struck Japan in March 2011.
But off-site interruptions can also cripple a company, even if no on-site property damage occurs. Smart companies have business-interruption insurance with coverage triggers such as utility service stoppages, the inability to access your place of business due to physical constraints or actions by civil authorities, and disruptions affecting key suppliers and/or customers.
Consider the case of a commercial client, a manufacturer of fiberglass Jacuzzi bathtubs. The Jacuzzi manufacturer made a business-interruption insurance claim after a factory flood disabled a critical supplier. For at least 30 days, the supplier was unable to deliver a key chemical for fiberglass fabrication to the Jacuzzi manufacturer. The manufacturer responded by delaying delivery to consumers who had placed orders, and as a result, some cancelled orders. In other cases, the manufacturer lost new orders because of the inability to commit to a delivery date. The order cancellations and the lost orders became the basis of the manufacturer’s business-interruption insurance claim, which proved successful.
In other situations, you may be unable to access to your place of business for physical reasons, such as flooding or because civil authorities sometimes temporarily close public access to certain areas. Both scenarios can become a trigger for business-interruption insurance claims.
For example, after Hurricane Wilma hit South Florida in 2005, broken glass and other debris on Brickell Avenue in Miami led authorities to temporarily close public access to sections of the street, blocking employees’ ability to enter into office towers.
Utility service stoppages such as electric power outages also can serve as the basis of successful claims. A supermarket with no physical damage still may face large losses from food spoilage if the electricity goes off. Similarly, companies that rely on call-center operations or online websites to drive sales could make a successful business-interruption claim if their phone service or computer systems stopped working.
But remember, timing is everything. Insurers routinely include a waiting period or “time deductible” in their business-interruption coverage terms. Coverage for an electric power outage, for example, usually doesn’t begin until after the first 24 hours to 48 hours after the outage begins.
How much business-interruption coverage is enough? The right answer varies from company to company.
Everyone is required to use the same basic formula for calculating claims based on lost net profits. Companies should estimate potential lost net profits, not potential lost sales, in determining the dollar limits of business-interruption insurance that are best for them.
Hypothetically, if a company sells a product for $100 and spends $70 to assemble or acquire it, its business-interruption insurance will cover $30 per lost sale.
Premium levels depend on factors that include the amount or limit of insurance the company wishes to purchase, the amount of the deductible or how much risk the company is willing to accept internally, as well as the company’s history of insured losses and its exposure to hazard.
A law firm is inherently less hazardous than a chemical manufacturer that handles flammable materials. Companies with geographically diverse facilities may appear less risky to insurers than those with geographically concentrated facilities (two facilities in the Florida Keys, for example, instead of one in the Keys and one outside the Atlantic hurricane zone).
Property damage doesn’t necessarily mean a company is entitled to compensation for business interruption. Imagine a pizza parlor owner who replaces shattered windows with wooden boards due to a tornado but continues to serve customers because the business retained electrical power and telephone service. The owner can make a property-damage claim based on window damage, but it may be more difficult to prove a business-interruption claim because for all practical purposes the business operations continued.
A successful business-interruption insurance claim unfolds in four phases. It starts with a review of coverage, notification of the insurer, and the assembly of the internal recovery task force, typically staff representing operations, sales, finance, information technology and risk management.
Second, gather data to prepare damage estimates and document claims. Establish proper accounting procedures to recognize, record, categorize and track loss amounts and recovery expenses. Avoid commingling insurance-related expenses with everyday expenses.
Third, prepare and submit claims, and fourth, negotiate a recovery. Aim to collect 100 percent of a defensible claim, not 50 percent of an inflated claim. Document everything. The insurer won’t take anyone’s word for it.
Companies that experience long-term business interruptions should file a series of interim claims as losses occur, rather than waiting until a year or two after the interruption to file a single claim covering all losses.
Interrupted companies should negotiate with their insurers as they progress through the various stages of the recovery process. Claims that companies calculate unilaterally rarely get a warm reception from insurers because nobody likes surprises. The best approach is continuous collaboration. Insurers aren’t exactly partners of their commercial policyholders, of course, but treating them in that fashion can smooth the path to full recovery.
Regardless of whether a trial lawyer is representing a plaintiff or a defendant, the forensic accountant can be invaluable for those cases involving challenging financial issues or economic damages. By relying on carefully honed skills to investigate, uncover and substantiate often-complicated financial transactions, forensic accountants can scour through mountains of data to connect seemingly random events in order to identify hidden assets, uncover indicia of fraud, simplify and explain complicated concepts in a way that can be easily understood by the trier of fact, and enable you to make better case decisions.
In addition to identifying financial facts, forensic accountants can also lend their expertise to other aspects of your legal strategy. For example, they can assist you to prepare effective document requests and interrogatories during the discovery phase; they can draft specific questions helping you to better challenge opposing expert testimony during deposition; and they can serve as invaluable assets during settlement negotiations.
When working with forensic accountants, legal counsel should consider the following
Start Early. Retain a forensic professional as early as possible to help identify the accounting and financial considerations of your case, from the beginning. This will assist you to better assess the strengths and weaknesses in your case in building or altering a defendable legal strategy going forward. Moreover, by hiring a forensic accountant early on, you can maximize his/her credibility and contributions to your case while minimizing your long-term expenditures of time and money.
Share Information. Provide your forensic accountant with all relevant documents – the good and the bad – that will enable him/her to accurately analyze financial data, assess damages and identify vulnerabilities in your case. By initially retaining the forensic accountant as a non-testifying expert, the privilege between you and your client is extended to the work product of that between you, your client and the forensic accountant. While this role may ultimately transform into that of a testifying expert, until you are comfortable with this decision, the forensic accountant’s work is protected.
Share Expertise. Make sure your forensic accountant understands how his/her opinions will fit into your case. You should share with him/her the allegations in the complaint, including causation and mitigation, as well as appropriate case law that supports damages or valuations. Legal counsel should become equally knowledgeable about the forensic accountant’s work and his/her assumptions in order to present them in a manner in which a judge or trier of fact will find them easy to understand. Keep in mind that your expert should be using “provable and reasonable assumptions” that comply with admissibility requirements under Frye and Daubert. If not, the court may exclude your expert’s testimony and the data he/she presents.
A forensic accountant can supplement even the best attorney’s case by applying his/her knowledge to simplify the complex and provide fair, objective and independent expert testimony. Working in tandem with an accountant early on and with full disclosure, a forensic accountant can provide a unique perspective that can prove to be the key element in bringing about a favorable legal outcome.
Article written by Richard A. Pollack,
Richard Pollack is director in charge of the firm’s Forensic and Business Valuation Services practices. For more than 30 years he has served as a litigation consultant, expert witness, court-appointed expert, forensic accountant and forensic investigator. His team’s creative use of accounting forensics and investigations have assisted bankruptcy courts; the SEC; municipalities, school boards and government agencies; the FBI and numerous other agencies to prove or defend against allegations. As an expert witness he has testified in both federal and state courts. A frequent speaker, panel moderator and author, Pollack co-wrote Calculating Lost Profits, an AICPA practice guide about lost-profit damage analysis and professional standards in the field.