valuing privately-held businesses for divorce
DESCRIPTION
Knoxville Family Law ConferenceTRANSCRIPT
Presented by:
W. James Lloyd, CPA/ABV, ASA, CFE
Knoxville Family Law Conference October 22, 2010
Valuing Privately Held Businesses for Divorce
Knoxville Family Law Conference November 22, 2010
Speaker Biography – W. James Lloyd
W. James (Jim) Lloyd is a shareholder and valuation services practice leader at Pershing Yoakley & Associates, P.C. Jim has valued hundreds of businesses and related intangible assets spanning a broad range of industries including healthcare, banking, manufacturing, real estate, and wholesale distribution among others. In addition to being a Certified Public Accountant, Mr. Lloyd has earned multiple professional credentials relevant to business valuation and dispute services including the Accredited in Business Valuation (ABV) credential from the American Institute of CPAs, Accredited Senior Appraiser (ASA) credential from the American Society of Appraisers, and the Certified Fraud Examiner (CFE) credential from the Association of Certified Fraud Examiners.
Jim is a frequent speaker at various national and regional conferences on valuation and litigation related topics and holds leadership roles with several professional organizations including the American Institute of CPAs and the American Society of Appraisers.
Expert testimony experience includes federal and various state and local courts and arbitration proceedings across the United States.
Page 2
Knoxville Family Law Conference November 22, 2010
Agenda
Page 3
Knoxville Family Law Conference November 22, 2010 Page 4
Agenda
What does it mean?Forensic Accounting
Assertions and/or suspicions When to do it?
Red flagsWhat to look for?
Tools and techniquesHow to find it?
Documentation and using the resultsWhat to do with it?
Knoxville Family Law Conference November 22, 2010
There are three generally recognized approaches to valuing businesses/ business interests which include:
Overview of Valuation Methods
Page 5
Market Approach
based upon transaction data
from similar businesses
Asset Approach
based upon the entity’s
underlying assets and liabilities
Income Approach
based upon the entity’s ability to
generate net cash flow for the
owner(s)
Knoxville Family Law Conference November 22, 2010
Market Approach– Guideline Public Company Method
• Uses publically-traded companies to develop metrics (e.g. price to earnings multiples) which are then used to determine value indications for the subject company
• Not applicable for many small/medium sized businesses, because of substantial differences such as: size, capital resources, product/service offerings, and geographic area)
Page 6
GPCM
Knoxville Family Law Conference November 22, 2010
Market Approach – Merger & Acquisition Method
• Relies upon transaction data from companies that have been bought/sold to develop metrics (e.g. price to sales ratios) that are used to develop value indications for the subject entity
• Often difficult to use due to substantial differences in the businesses
• Transaction data not always reliable
• Transactions must be recent and closely correlated
Page 7
M&A Method
Knoxville Family Law Conference November 22, 2010
Asset Approach – Net Asset Value Method
Page 8
NAV Method
• Assets and liabilities are adjusted to their respective current values
• Liabilities are subtracted from the assets to determine the net “equity” value of the business
• Not always appropriate for operating companies due to limitations with capturing intangible values
• Generally requires outside appraisals of the fixed assets (equipment and/or real estate)
Knoxville Family Law Conference November 22, 2010
Income Approach – Discounted Cash Flow Method
• Value is determined by computing the present value of projected future cash flows
• Therefore, …
– Future cash flows must be projected
– Discount rate must reflect the risk of the projected cash flows.
• Appropriate for growth type operating companies
Page 9
DCF Method
Knoxville Family Law Conference November 22, 2010
Income Approach – Capitalized Income Method
Page 10
CapInc Method
• Uses a single period earnings stream as a proxy for future periods
• Value indication = capitalized earnings stream
• Appropriate for mature operating companies with low/stable growth rates
• Generally not applicable for companies with high growth rates or declining profitability
Knoxville Family Law Conference November 22, 2010
Understanding The Business
A solid understanding of the business and the industry in which it operates is critical
Important considerations include:
– Value drivers – what drives business to the company?
– Competition
– Key employees
– Changing technology
– Future capital needs
Page 11
Knoxville Family Law Conference November 22, 2010
Industry Research
Benchmarking analysis– Historical operations/results – Peer groups
Site visit and personal interviews with key employees/management
Understanding the Business
Page 12
Knoxville Family Law Conference November 22, 2010
Revenue growth
Profitability
Positive cash flow
Capital requirements
Risk
Financial and Operational Analysis
Page 13
Valuation is based more on economic as opposed to tax or financial reporting rules
Key valuation factors for operating
companies include:
Knoxville Family Law Conference November 22, 2010
Balance Sheet Analysis
Page 14
Cash should be enough but not too much!
Accounts Receivable
Inventory
Fixed Assets
Accrued Expenses
Debt Obligations
collectability
consider obsolete and slow moving
“in-use” vs. resale value
sometimes aren’t recorded
use of funds and repayment terms
Knoxville Family Law Conference November 22, 2010
Income Statement Analysis
Page 15
Revenue
• Consider both volume and revenue per unit
• Items growing/ profitable vs. declining/not profitable?
Operating Expenses
• Fixed vs. variable
• Normalization adjustments
Non-operating Expenses
Knoxville Family Law Conference November 22, 2010
Therefore, the return to the business owner should be
reflective of the risk associated with the business as compared to
alternative investment choices
Risk and Discount Rates
Page 16
The discount rate should reflect the risk associated with the projected cash flows (i.e. the higher the risk
the higher the discount rate)
Discount rates represent proxy returns for alternative
investments
(assuming the cash flows are constant)
Lower discount rates higher values
Knoxville Family Law Conference November 22, 2010
Types of Discount Rates
Page 17
Equity Discount
Rate
“Build-up” method
Duff & Phelps
Capital Asset Pricing Model
Weighted Average Cost of Capital
(WACC)
Weighted average cost of equity and after-tax
cost of debt
Limitations due to assets available to
secure the debt
Knoxville Family Law Conference November 22, 2010
Valuation Adjustments
Depending upon the facts and circumstances, one or more “valuation adjustments” may be necessary to adjust the value
to the appropriate level (e.g. fair market value)
However, it’s important to understand the level of value determined before adjusting it!
Common valuation adjustments include:
•Adjustment/Discount for Lack of Control
•Adjustment/Discount for Lack of Marketability/Liquidity
Page 18
Knoxville Family Law Conference November 22, 2010
Adjustments/discounts for lack of control (DLOC) are used to adjust “control” level indications
of value (i.e. determined from control level cash flows) to minority level value indications
DLOC are generally based on benchmark data plus qualitative analysis
Note: the DLOC adjustment should be reasonable under the circumstances (e.g. would someone likely pay an implied premium for a controlling interest
in the subject company?)
Adjustments for Lack of Control
Page 19
Knoxville Family Law Conference November 22, 2010
Adjustments/discounts for lack of marketability (DLOM) are used to adjust indications of value to a cash
equivalent basis
Multiple methods available to determine benchmark discounts – several of which are controversial
Analysis generally includes both qualitative and qualitative factors
Resulting value should be reasonable under the circumstances
Adjustments for Lack of Marketability
Page 20
Knoxville Family Law Conference November 22, 2010
Reconciliation and Conclusions of Value
The indications of value determined from the various methodologies utilized
should be reconciled and weighted appropriately
The conclusion of value can be an absolute or range of values• If a range is used, it should be a reasonable range (e.g. +/- 10% to 15%)
Page 21
Knoxville Family Law Conference November 22, 2010
Enterprise vs. Personal Goodwill
Enterprise goodwill is part of the business and should be included in the entity’s
value
Personal goodwill is an individual asset and
(generally) should not be included in the entity’s value
Page 22
Knoxville Family Law Conference November 22, 2010
Separating Personal Goodwill
Personal goodwill can be separated by
normalizing compensation
and/or performing a “with and without”
analysis
Primary Reason – Avoiding the “double dip” between business value and the individual’s earnings capacity
Page 23
Knoxville Family Law Conference November 22, 2010
Separating Personal Goodwill – con’t
The earnings/cash flow used to value the business should reflect “normalized” owner’s comp based on personal efforts/duties
• Benchmark data normally available from third party resources
A “with and without” analysis compares the value of the business with and without the services of the subject individual • The difference is an indication of
value for the personal goodwill of the individual
Page 24
Knoxville Family Law Conference November 22, 2010
Standards of Value
Fair Market Value
Value to hypothetical
buyers and sellers with neither being under compulsion and both having
relevant knowledge
Investment Value
Value to specific buyers and/or
sellers
Includes anticipated synergies
Fair Value
Pro-rata share of the enterprise
value (generally excludes
discounts)
Page 25
Knoxville Family Law Conference November 22, 2010
Valuation Organizations and Credentials
Page 26
The most common business valuation organizations and credentials include:
American Institute of
CPAs
Accredited in Business
Valuation (“ABV”) credential
American Society of Appraisers
Accredited Senior Appraiser
(“ASA”) credential
Institute of Business
Appraisers
Certified Business Appraiser (“CBA”)
Knoxville Family Law Conference November 22, 2010
Levels of Valuation Services
There are basically two levels of business valuation services which include:
Valuations/Appraisals
which result in an “opinion” of value; and
Calculations
which result in an “indication” of value
and not an opinion of value
• Limited in scope• Generally not appropriate
for litigation matters
Page 27
Knoxville Family Law Conference November 22, 2010
Forensic Accounting Issues
Page 28
Knoxville Family Law Conference November 22, 2010 Page 29
Fraud Defined
Knoxville Family Law Conference November 22, 2010 Page 30
Fraud Triangle
INCENTIVE
RATIONALIZE
FRAUD
OPPORTUNITY
Culture or environment
enables management or
other employees to rationalize
committing fraud
Circumstances exist – ineffective or
absent control, or management ability to override controls
– that provide opportunity
Management or other employees
have an incentive or are under pressure
Knoxville Family Law Conference November 22, 2010 Page 31
The Need for Forensic Accounting
Knoxville Family Law Conference November 22, 2010 Page 32
When To Do It
Valuing a business/business interest in connection with a litigation/dispute matter; and: • Specific allegations of fraud have
been asserted; or• Fraud is suspected
Knoxville Family Law Conference November 22, 2010 Page 33
Divorce Engagements
Knoxville Family Law Conference November 22, 2010 Page 34
What To Look For
Knoxville Family Law Conference November 22, 2010 Page 35
Red Flags
Knoxville Family Law Conference November 22, 2010
Standard of living is unusual relative to known financial resources
Disorganized operations
Poor internal controls – easy for management to override
Unusual and/or unsupported journal entries
Out of balance subsidiary ledgers
Page 36
Red Flags
Knoxville Family Law Conference November 22, 2010
Unusually consistent financial performance
Disconnect between cash and profitability
Financial results that are in substantial contrast to other relevant factors such as economic
conditions, peer groups, etc.
Page 37
Red Flags
Knoxville Family Law Conference November 22, 2010 Page 38
How to Find It – Basic Preliminary Steps
Determine that proper predication has been established by the client
Obtain an understanding of the specific fraud suspicions or allegations by discussing the case with client/attorney and review any work already performed
Start gathering and analyzing data
Knoxville Family Law Conference November 22, 2010 Page 39
Gathering and Analyzing Data
Relevant data is
generally
gathered from a
combination of
methods such
as:
Obtaining and reviewing documents - from client and/or other sources
Personal interviews
Observations
Background investigations
Public record inquiries
Knoxville Family Law Conference November 22, 2010 Page 40
Reviewing Documents –Caution
Data should be gathered/analyzed with a high degree of skepticism
Falsified documents are often used in collusion with others in an effort to conceal
the fraud
Proper chain of records custody may become an issue especially if documents
have been altered or falsified
Knoxville Family Law Conference November 22, 2010
Look for unusual or unexplained trends:
Year-to-year comparisons of financial data
Benchmark comparisons
Analytical procedures can
be useful for purposes of identifying potential
problem areas
Page 41
Analytical Procedures
Knoxville Family Law Conference November 22, 2010 Page 42
Data Mining
Knoxville Family Law Conference November 22, 2010
• There should be a direct relationship between income and cash
• Analyze bank activity and compare to income being reported
Profitable companies generate positive cash
flow; whereas companies with low profits should not
be generating large amounts of cash
• tracing funds generally provides a wealth of useful information, especially for small/medium sized businesses
Follow the money
Page 43
Cash is Still King
Knoxville Family Law Conference November 22, 2010 Page 44
Using the Results
Depending upon the circumstances, the forensic accounting results should be
incorporated into the valuation analysis as appropriate.
Such incorporation may involve: • Normalization adjustments to the
existing financial statements • Reconstructing the financial
statements all together
Knoxville Family Law Conference November 22, 2010
Questions?
Contact Information:
W. James Lloyd, CPA/ABV, ASA, CFE
Shareholder | Valuation & Dispute Services
Pershing Yoakley & Associates, P.C.
[email protected] | 865-673-0844
Page 45