As we deal with peak hurricane season, we are reminded once again of the importance of preparing for and responding to natural disasters in order to minimize losses and ensure long-term viability. The actions a business takes during the first few days following a loss can often determine the success of its recovery and settlement of insurance claims for property damages and lost profits.
Following are seven tasks that well-prepared businesses incorporate in their continuity plans. If such a plan does not already exist, a business should still consider adopting these best practices to make the recovery process smoother and improve their chances of a complete and satisfactory recovery.
Step 1: Assess Damages. As soon as the danger has passed, business owners should conduct the following activities:
· Identify the cause and origin of the loss
· Assess structural components of the remaining facilities
· Determine the scope of physical damage
· Reach a consensus with an insurance representative on the scope of the damages
· Conduct a count of damaged and/or destroyed inventory
It is recommend that business owners record the damages they incurred via videotape as soon as possible after incurring a loss. A narrated video provides an inexpensive ounce of prevention if there are future disputes with insurers about specific damage.
Step 2: Protect and Secure the Site. Boarding up broken windows, making temporary roof repairs, covering machinery to protect against the elements and disconnecting utility services are examples of activities businesses should engage in to protect their property from further damage. In addition, consideration should be given to securing the damaged area with temporary fencing or security personnel to ensure it remains intact for subsequent investigation and calculation of losses. Retail establishments should take extra care to avoid looting. Securing the site and protecting property is typically an insurance policy requirement. Plus, it will help to expedite the business’s return to its normal operations.
Step 3: Form a Recovery Task Force. Business owners looking to get their operations up and running quickly must act fast to reestablish revenue streams from customers. The best way to accomplish this is to have a solid recovery plan carried out by a company task force made up the following key constituents:
- Employees representing the business’s damaged operations, such as an operations manager, head of manufacturing, etc.
- Personnel responsible for rebuilding, such as a facilities manager, project manager, etc.
- A representative with the construction contractor
- A risk manager or other staff member in charge of corporate insurance policies
- Key staff members who interact regularly with customers, such as sales directors or customer relations representatives
- A corporate finance or accounting liaison, who will serve as the gatekeeper to gather, track, and record the repair costs as well as distribute the necessary information to other appropriate parties
- Other consultants retained to assist in the recovery, including engineers, reconstruction experts and outside accountants and consultants
Step 4: Be Involved in Estimations of Losses. When an insured business has a covered loss, the insurance carrier will typically send out one of its adjuster to establish a “reserve”, which is an initial estimate of the loss. Rather than leaving this initial loss estimation solely in the hands of insurance adjusters or other outside consultants, business owners should involve themselves in the process. No one knows a business better than its owner(s), who have unique knowledge about the business’s operations and facilities as well as the cost of replacement equipment, building materials or temporary locations. Moreover, a business interruption estimate prepared in cooperation with a business owner is less likely to overlook important factors that might affect the ultimate amount of covered losses, such as recently awarded contracts, new customers, new products, recently implemented or soon to be implemented cost savings or efficiencies, which may affect the ultimate amount of the loss.
Step 5: Establish a Loss Accounting System. There are many ways for businesses to account for a loss, but the best method is to use a simple system that follows their normal day-to-day activities. Examples can include creating a set of charge codes related to the loss, establishing separate costs centers for each repair expense category or creating a project work order, as if the repair was a normal project. The goals should be to separate repair costs from normal operating expenses and keep them organized and easy to access.
Step 6: Run Expenses and Invoices through a Corporate Gatekeeper. Invoices for loss-related expenses should be routed to an individual in the business’s accounting department (e.g.; controller, chief accountant, etc.), who can review them for accuracy, appropriate detail and relevance to a claimed loss. The job of the Gatekeeper is to ensure that all invoices meet an insurance company’s reimbursement requirements before a business pays an invoice. If further detail is required from the vendor, it is often much easier to get the information before the invoice is paid rather than after.
Step 7: Get Help. The recovery from a loss is a traumatic and potentially significant event. For some companies, major losses threaten their very existence and a full recovery determines survival or extinction. Getting help from a professional accountant, lawyer and/or engineer who specialize in financial recovery from losses and keeps your best interests in mind can make the process less complicated. They will work with your company, insurance broker and the insurer’s representatives in the time consuming task of preparing complete and fully documented claims, allowing your personnel to concentrate on the task of serving customers, repairing facilities and returning to normal operations. In addition, their fees may be covered by an insurance policy with a “professional fee” or “claim preparation cost” endorsement.
The Forensic Accounting and Business Insurance Claims practices of Berkowitz Pollack Brant has more than three decades of experience helping Florida businesses prepare for and maximize financial recovery from insured perils.
About the Author: Daniel S. Hughes, CPA/CFF, CGMA, CVA, is a director in the Forensics and Business Valuation Services practice at Berkowitz Pollack Brant, where he works with businesses of all sizes on matters involving valuations, economic damages, lost profits and the quantification of business interruption insurance claims. He can be reached in the CPA firm’s Miami office at (305) 379-7000 or via e-mail at email@example.com.
Over the next two decades, millions of business owners will sell or transfer several trillion dollars’ worth of privately held business assets. Proper valuations of these entities using an asset approach, an income approach and/or a market approach will provide worthwhile information to both buyers and sellers. However, when using the income or market approaches to valuations, it is important to first normalize a business’ financial statements in order to estimate future expected cash flow that a potential buyer can reasonably expect to receive in return for his or her investment.
The International Glossary of Business Valuation Terms defines normalized financial statements as those “adjusted for non-operating assets and liabilities and/or for nonrecurring, noneconomic, or other unusual items to eliminate anomalies and/or facilitate comparison”. Such a normalization process requires a business’s valuation to present information on a basis similar to that of other companies in its peer group and in benchmark studies used for comparison and analysis. One of the most common normalization adjustments utilized in valuing closely held companies is officers’ and owners’ compensation.
The purpose of making a compensation adjustment is to remove any distortion of the company’s operating performance caused by compensation and/or perquisites paid to its management team. To reflect a realistic or reasonable value, the valuation professional “normalizes” the company’s cash flows to reflect what buyers can potentially expect to be available to them.
However, the U.S. Tax Court has been examining officers’ and owners’ compensation for decades because the compensation structure of smaller, privately held companies are often less structured and more flexible than that of larger and publicly traded companies. Owners may pay themselves or those related to them higher or lower salaries, or they may provide other forms of incentives and noncash compensation in order to reduce tax liabilities, improve cash flow or business value, or simply to retain cash.
For example, business owners may reallocate income and essentially misrepresent business value when they do any of the following (as well as other actions not mentioned here):
- Move income to a close family member who is in a lower tax bracket or who does not actually do any significant work for the company;
- Book deferred compensation;
- Receive income in another form, such as rent for company facilities held in a separate entity; or
- Book loans to the company, which could be considered compensation.
In the context of performing a valuation engagement, owners’ or officers’ compensation must be normalized to reflect the salary and benefits an outside third-party would be paid to fill the same position. To arrive at a normalized compensation figure, valuation analysts would commonly examine the following:
- The skill set, education, qualifications and experience of the employee;
- The employee’s duties, the nature, the scope and the time required to do them;
- The complexity, size and geographic areas serviced by the business’ operations;
- The condition of the economy and industry the business services; and
- The salaries, bonuses, benefits and/or other perquisites paid to employees doing comparable jobs in similar businesses in the same geographic region.
To determine if perquisites are at a normal level (for an outside employee), business analysts must evaluate specific items, such as (1) automobile expense allowance, (2) tuition reimbursement, (3) country club and other membership fees, and (4) insurance (health, life, or other types) and retirement benefits. If excessive, these types of expenses would need to be normalized as well. Analysts must also consider the cost to replace the current owner or officer. Locating a replacement employee could require a long and potentially expensive search as well as a costly signing bonus and/or placement agency fee.
To benchmark what a reasonable range for total compensation may be, valuators will often turn to trade associations, specialty consulting firms or other industry groups that often make this type of data readily available. Among the more popular resources are the Bureau of Labor Statistics and the RMA Annual Statement Studies. Data can also be found on the Internet, at websites such as salary.com, or in the SEC filings of publicly traded companies that may be used as reasonable comparison for the company being valued.
Compensation adjustments can have a significant impact on the value of a business, especially if the business’s value is calculated under an income or market approach using revenues and/or earnings. For that reason, normalization adjustments, such as owners’ and officers’ compensation, must be carefully considered.
About the Authors: Scott Bouchner, CMA, CVA, CFE, CIRA, is a director with Berkowitz Pollack Brant’s Forensic Accounting and Business Valuation Services practice, where he has served as a litigation consultant, expert witness, court-appointed expert and forensic investigator on a number of high-profile cases. Sharon F. Foote, ASA, CFE, is a manager in the Forensics and Business Valuation practice. For more information, call (305) 379-7000or email firstname.lastname@example.org.
Financial experts are often utilized by attorneys in commercial litigation cases. The goal is to make the injured party whole; in other words, to return the plaintiff to the financial condition the business would have been in but for the alleged acts of the defendant. Economic damage claims can be calculated by analyzing the affected business from two different perspectives – lost profits or lost business value, depending on the facts and circumstances of each case. The decision of which approach is appropriate should be decided by the damages expert and counsel early in the case, being aware that a business cannot typically recover both lost business value and lost profits.
The amount of damages under both approaches could be similar if all else is held constant. However, in reality, the damages may be significantly different due to the inherent differences in both approaches, which are discussed below.
On June 6, 2014, the Florida Supreme Court approved jury instructions for contract and business litigation that concisely presents the concepts of contract damages. Instruction 504.3, Lost Profits, explains that to recover lost profits, a claimant must prove the defendant caused the claimant’s lost profits and the amount of lost profits must be established “with reasonable certainty.” Instruction 504.4, Damages for Complete Destruction of Business, is only given in the case of a “complete destruction” of the claimant’s business. The jury is instructed that the claimant’s damages are based on the market value of the business; anything less than “complete destruction” would be compensated via the “lost profits” instruction. (Source: In re Standard Jury Instructions – Contract and Business Cases, Instruction 504.3-504.4, 116 So. 3d 284 (Fla. 2013)).
In many valuations (under the fair market value standard), the parties are the hypothetical willing buyer and willing seller as discussed in IRS Revenue Ruling 59-60; in lost profits analyses, the parties are not considered to be either hypothetical or willing. Another of the differences between a compliance-related valuation (i.e., those for tax and financial reporting purposes) and a valuation related to economic damages is that the business value in a compliance-related valuation is as of one specific date in time, whereas in a damage claim for diminution in business value, the value of the business is determined both before and after the causative act as of the dates decided by the court.
In a loss of business value calculation, only the facts known or knowable as of the valuation date are generally considered. The courts in some cases have allowed hindsight, even where there has been a loss of business value, such as when, if hindsight were not allowed, it would result in either a windfall gain or an unfair penalization of the plaintiff.
An early case, frequently cited even today, allowed hindsight and is referred to as the “Book of Wisdom” based on a 1933 U.S. Supreme Court decision in the case of Sinclair Refining Co. v. Jenkins Petroleum Process Co., 289 US 689 (1933). The decision in this case advocated the use of actual results to determine what the value of a patent should have been on the valuation date by proving the “elements of value that were there from the beginning”. The decision in Sinclair Refining effectively allowed for a valuation based on actual results after the valuation date that would supplant market value (based on forecasted data) estimated as of the valuation date since that assessment failed to accurately determine value for the undeveloped patent.
However, in a lost profits calculation, facts and events occurring after the alleged harmful actions of the defendant are considered. If the business lost earnings for a finite period of time, damages can be determined by using a lost profits approach and then adjusted for any mitigation of those damages by the plaintiff.
In the analysis of lost business value under an income approach, the discount rate utilized would typically be either the injured entity’s equity rate of return or its weighted average cost of capital (WACC), calculated using either a build-up method or the capital asset pricing model (CAPM). However, the discount rate utilized in a lost profits calculation could be one of those or others such as the plaintiff’s cost of debt, or its internal rate of return. Another option allowed by some courts is that the projected cash flows can be adjusted to account for the risk associated with them and a risk-free (or risk reduced) rate can be used.
Lost business value calculations consider all costs needed to generate the entity’s revenues and profits as compared to lost profits analyses, which typically place greater emphasis on costs associated with the lost revenues.
As is evident from the discussion above, the calculation of damages under either the lost profits approach or the loss of business value approach is complex and dependent on the facts and circumstances unique to each case, making it very important to utilize experienced, credentialed damage experts that will provide optimum assistance to counsel.
About the Author: Sharon Foote, ASA, CFE, is a member of Berkowitz Pollack Brant’s Forensic and Business Valuation Services practice. She can be reached in the firm’s Miami office at 305-379-7000 or by email at email@example.com.
Business owners may erroneously assume that the value of their companies is the same as their profits, which is calculated by subtracting expenses from total revenue. While profits certainly play a role in establishing how much an enterprise is worth, it is not the sole determinant. Other factors come into play that may enhance or dilute a business’s value, or the estimated monetary amount that a willing buyer will pay a willing seller to assume ownership of the business and all the benefits, risks and liabilities that transfer with such ownership.
A business’s value is related to the use of its financial and nonfinancial resources, as well as other non-monetary elements influencing the entity’s health and well-being in the long-term. While value may be maximized when profits are at their peak, other subjective and intangible factors play an important role in enhancing or diminishing value.
Building business value is a long-term, ongoing philosophy that business owners should adopt, preferably at inception, in order to optimize value throughout their business’s lifecycle, in both good times and bad. Selling a business at “the most opportune time” is not always possible. Therefore, business owners should have a firm understanding of the following factors typically considered in determining the value of a business:
- The nature and history of the business since its inception;
- The book value of the stock and the business’s financial position;
- The company’s earning capacity;
- Determination of whether the enterprise has goodwill or other intangible value;
- Sales of the company stock and size of the block to be valued;
- The economic outlook in general, and the condition and outlook of the company’s specific industry; and
- The market price of stocks of corporations engaged in the same or similar line of business currently having their stock actively traded in a free and open market, either on an exchange or over the counter.
The last two determinants of value are out of the business owner’s control. However, the owner has the ability to focus on improving the first five factors while remembering that those improvements must be made within the context of the uncontrollable elements. This can include managing the following:
- The company’s profit margin;
- The company’s growth and outlook;
- The quality of the business’s earnings stream (including concentration of customers or suppliers);
- The business’s ability to continue past earnings performance into the future;
- The quality of the company’s balance sheet (liquidity); and
- The capabilities of the entity’s management team, including key management characteristics and succession plans.
In general, the valuation methodologies applied to a closely held business are a function of the specific risks applicable to its earnings stream and its capital structure. Value is increased by minimizing risks, increasing growth opportunities and managing financial leverage. Common methodologies for determining value include the income approach, the market approach and the asset approach.
The Income Approach. A business’s value is based on the expected future benefits to the owner or owners, based on historical results or management’s income statement projections, which are discounted back to the present using a discount rate that reflects the time value of money and the risk associated with procuring these benefits. These future benefits are usually 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 risks of the business being valued.
The Market Approach. Businesses employing the market approach mainly focus on their income statements. They base the value of a business on comparisons to purchase and sale transactions for companies in the same or similar industry and/or by comparing the company to either publicly-traded companies in the same or similar industry and applying a multiple of revenues and/or earnings to the subject company’s revenues and/or earnings.
The Asset Approach. The asset approach to business valuations focuses on the balance sheet. The value of the subject business will be based on the current value of its individual assets, both tangible and intangible, less the current of its liabilities. This approach is typically employed as the basis for valuing an asset-holding company, such as those owning real property and/or marketable securities.
Build Value, Build the Future
Adopting strategies to manage controllable risks, be aware of uncontrollable risks, and assess opportunities will help business owners establish and maintain a strong foundation on which they can build value for an eventual sale or merger of their businesses.
About the Author: Richard A. Pollack, CPA/ABV/CFF/PFS, ASA, CBA, CFE, CAMS, CIRA, CVA, is director-in-charge of the Forensic and Business Valuation Services practice with Berkowitz Pollack Brant, where he has served as a litigation consultant, expert witness, court-appointed expert, forensic accountant and forensic investigator on a number of high-profile cases. He can be reached in the CPA firm’s Miami office at 305-379-7000 or via email at firstname.lastname@example.org.
There are many times during a business’s lifecycle when a valuation will be required to measure the entity’s realistic economic worth at the present time, historically or into the future. Examples can include situations involving litigation or a corporate dispute, a loan request, succession planning or a business purchase, sale or merger. Additionally, because a business’s value is often so closely tied with the owner’s personal wealth, a valuation can be useful in estate and gift planning, prenuptial planning, divorce litigation and in a range of other tax-related situations.
Defining a business’s value, however, is not as easy as looking at the entity’s balance sheet and income statement. Rather, a formal appraisal of the business will consider more factors and reveal far more detail than an owner can find on financial statements. As a result, the business valuation process can go a long way in helping owners make informed decisions about the enterprise’s ongoing operation and continued success.
The Valuation Process
The first step in the valuation process is to engage the expertise of experienced valuation analysts. These professionals understand all of the factors that go into undertaking a valuation, including thorough reviews and analyses of pertinent financial data and documents, management interviews and site visits, and assessments of current market and industry conditions. With this information in hand, they may employ financial models, as well as appropriate discounts and premiums, to arrive at an unbiased value for a company at a specific point in time given the potential economic value of the enterprise into the future.
Methods of Valuation
There are three fundamental approaches to arriving at the value of a business: an income approach, a market approach or an asset approach. The approach one employs will often be determined by the type of business being valued and where the business is in its lifecycle. While it is not uncommon for appraisers to employ a combination of all three approaches, business owners should have a keen knowledge of what is involved with each.
The income approach to valuation aims to measure the present value of a business’s future income and cash flow in today’s dollars. It forecasts the company’s future earnings power by considering its historic and present income, cash flow, and expenses, as well as the capital it will need to maintain operations into the future. By relying on this record of business performance as a foundation for future projections, the income approach tells individuals holding an interest in the company, what risks, returns or benefits those investors can expect in the future.
Typically, the income approach is best applied to operating businesses, where value is added to products or services from labor and intangible assets. This can include businesses in the manufacturing, retail and wholesale industries.
The market approach takes a broader look at the industry in which a business operates and compares that company’s performance to those of similar entities. Just as home sellers will look at recent sales of comparable properties to determine a fair sales price for their homes, business appraisers applying a market approach in a business valuation can look at sales of comparable businesses or guideline public companies in the same industry. By using this empirical evidence to determine benchmarks and apply industry multiples, business appraisers can arrive at an appropriate market value of the business.
The third method for valuing a business is the asset approach, which considers the fair market value of the underlying assets the business owns, minus the business’s liabilities. The appraisal begins with an assessment of the company’s balance sheet. A value is determined for each asset and liability and adjustments are made when deemed necessary. Often, this approach will require separate appraisals for equipment and real property owned by the business.
The utilization of appropriate valuation approaches should be left to the professional judgment of an experienced valuator. A qualified business appraiser is able to support his or her conclusion to correctly value a business and provide significant benefit to the client. The Forensic and Business Valuation team at Berkowitz Pollack Brant has a broad range of experience in conducting business valuations.
About the Author: Daniel S. Hughes, CPA/CFF, CGMA, CVA, is a director in the Forensics and Business Valuation Services practice at Berkowitz Pollack Brant, where he works with businesses of all sizes on matters involving valuations, economic damages, lost profits and the quantification of business interruption insurance claims. He can be reached in the CPA firm’s Miami office at (305) 379-7000 or via e-mail at email@example.com.