Top Litigation Issues in Business Valuation

Transcription

1 Top Litigation Issues in Business Valuation Wednesday, April 12, 2017 Noon 1 p.m. 1 General CLE credit

2 TOP LITIGATION ISSUES IN BUSINESS VALUATION The materials and forms in this manual are published by the Oregon State Bar exclusively for the use of attorneys. Neither the Oregon State Bar nor the contributors make either express or implied warranties in regard to the use of the materials and/or forms. Each attorney must depend on his or her own knowledge of the law and expertise in the use or modification of these materials. Copyright 2017 OREGON STATE BAR SW Upper Boones Ferry Road P.O. Box Tigard, OR ii

3 TABLE OF CONTENTS Faculty v Presentation Slides iii

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5 FACULTY Paul Heidt, Morones Analytics LLC, Portland. Mr. Heidt serves as the Director of Valuation Research and provides business appraisals and lost earnings analysis, as well as general and litigation research. He has worked on business valuations for different purposes including transactions, gift and estate tax, reorganizations, marital dissolution, litigation, and succession planning. He is a member of the American Society of Appraisers and is an Accredited Senior Appraiser (ASA) in Business Valuation. Mr. Heidt previously served as managing editor for Economic Outlook Update, a quarterly economic publication used in appraisal reports and books contributing to the body of knowledge in the business valuation profession. Alina Niculita, Morones Analytics LLC, Portland. Ms. Niculita specializes in business valuation and business valuation litigation support. She has worked with businesses from many industries and of all sizes on matters including transactions, buy-sell agreements, gift and estate tax, marital dissolution, bankruptcy, reorganizations, ESOP, financing, and intangible assets and personal versus enterprise goodwill. She is a member of the CFA Institute and the American Society of Appraisers. She is a Chartered Financial Analyst (CFA) and Accredited Senior Appraiser (ASA) in Business Valuation and holds two Master of Business Administration degrees, from the Joseph M Katz Graduate School of Business at the University of Pittsburgh and the Czech Management Center in Celakovice, Czech Republic. Ms. Niculita has authored or coauthored several business valuation articles, book chapters, and books, including (with Shannon Pratt) The Lawyer s Business Valuation Handbook, 2nd edition, published by the American Bar Association. She has spoken on business valuation topics to various audiences. v

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7 Prepared by Alina Niculita, CFA, ASA, MBA Paul Heidt, ASA Morones Analytics, LLC 1: Not valuing the correct property 2: Using incorrect standards of value 3: Financial statement adjustments 4: Income approach projections inadequately supported 5: Income approach cost of capital 2 1

8 6: Use of the market approach 7: Minority versus control 8: Discounts for lack of marketability 9: Other discounts 10: Personal versus enterprise goodwill 3 Step 1: Define engagement Step 2: Gather information and make adjustments Step 3: Apply valuation approaches Step 4: Consider discounts Step 5: Conclusion and weighting of approaches Step 6: Allocate value 4 2

9 5 Define the engagement Valuation date Scope Standards of value Interest being appraised Purpose 6 3

10 Purpose of valuation Valuation for Transactions Valuation for Court Cases Valuation for Compliance Valuation for Planning Business purchase, business sale, M&A, recapitalization, LBO, MBO, ESOPs, buy back of shares, project financing, and others Bankruptcy, contractural disputes, ownership disputes, dissenting and oppressive shareholder cases, divorce cases, intellectual disputes, and others Fair value accounting, tax issues Estate planning, personal financial planning, M&A planning, and strategic planning 7 Gather initial documents Review financial trends and gain understanding of the Company In-depth management interview Circle back as needed to address issues, resolve questions, and gather additional information (forensic accounting?) 8 4

11 Financial statement adjustments Replacement compensation Non-operating assets Non-recurring events Discretionary expenses 9 Three approaches to value Income Approach Determines value by answering the questions: how much cash flow will there be and how risky is it? Market Approach Determines value by looking at what other people paid for similar types of businesses Asset Approach Determines value by figuring out what assets are worth and subtracting liabilities 10 5

12 Discounts The value of a controlling ownership interest is worth more than the value of a non-controlling interest Two main discounts Discount for lack of control Discount for lack of marketability 11 Valuing underlying assets vs. stock or partnership interest To determine the applicable valuation approaches and procedures to be performed, exactly what is to be appraised must be made clear. Much of the confusion and disagreement among appraisers and appraisal writings arises simply because it is not clear exactly what asset, property, or business interest is to be valued. [1] [1] Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 5 th Edition, Shannon P. Pratt with Alina V. Niculita, McGraw-Hill, 2008, pp

13 Definition of the specific business interest can be broken into two broad questions: Is the valuation to be a valuation of assets or a valuation of securities? In either case, exactly what assets or what securities are subject to valuation? Ambiguous and undefined terms: The value of the business Enterprise value 13 Using a different standard of value than what is called for in the engagement Assuming a standard of value is defined the same way in all jurisdictions and for all purposes 14 7

14 Fair market value.. the net amount which a willing purchaser, whether an individual or a corporation, would pay for the interest to a willing seller, neither being under any compulsion to buy nor to sell and both having reasonable knowledge of relevant facts. [1] [1] 26 CFR Fair value Definition for dissent and minority oppression cases: The value of the shares immediately before the effectuation of the corporate action to which the dissenter objects, excluding any appreciation or deprecation in anticipation of the corporate action unless exclusion would be inequitable. [1] Accounting definition: The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale. [2] [1] Revised Model Business Corporation Act, Section 13.01(3) [2] SFAS 157, Fair Value Measurements. 16 8

15 Investment value The value to a particular investor based on individual investment requirements and expectations. [1] Generally subjective value, whereas fair market value is an objective value Found frequently in business valuations for marital dissolution [1] International Glossary of Business Valuation Terms 17 Intrinsic value The amount that an investor considers, on the basis of an evaluation of available facts, to be the true or real worth of an item, usually an equity security. The value that will become the market value when other investors reach the same conclusions. [1] Generally applies to publicly traded stocks [1] W.W. Cooper and Yuri Ijini, eds. Kohler s Dictionary for Accountants, 6 th ed. (Prentice-Hall 1983) p

16 Sources of authority for definition of value Hierarchy [1] Statutory law Legally binding rules and regulations Contractual definitions of value Non-legally binding administrative rules Precedential court decisions Direction from the court Direction from the lawyer Use of IRS authority in non-tax situations Opinions of other lawyers and appraisers [1] Shannon Pratt and Alina V. Niculia, The Lawyers Business Valuation Handbook: Understanding Financial Statements, Appraisal Reports, and Expert Testimony, 2 nd edition. (Chicago: American Bar Association, 2010) p Sample questions to ask What definition of value did you use? What is the source of that definition? Why is that definition of value appropriate for this valuation assignment? 20 10

17 Overlooking appropriate adjustments Inappropriate compensation adjustment Purpose: To make adjustments to financial information to reflect how the business would perform if owned by an independent third party 21 Reasonable or replacement compensation Chief characteristic of a closely-held business is that most often its principal employees are also owners. Since compensation is tax deductible and in a C- Corp dividends are not deductible, so many owners try to maximize their compensation

18 Reasonable or replacement compensation What would a third-party pay for their services provided by the employee-owner if not the owner? Person of same age, training education & work habits Sources Next highest paid employee Various compensation studies Industry consultant Management 23 Non-operating assets Assets not needed in the ordinary course of business. Examples: Vacation homes Boats and airplanes Investments in collectibles Excess cash Adjustments are made to the balance sheet and income statement for the expenses of the asset 24 12

19 Non-recurring events Impact on the historical results of one-time occurrences Could be positive or negative Positive example: Sale of an asset Sale of part of a business Negative example: Disruption due to weather or strike Lawsuit 25 Discretionary expenses Expenses that would not normally be incurred if the business was run by a non-family member. Examples: Exotic cars Charitable contributions Non-show employees Personal expenses run through the business These expenses are added-back when the income is normalized 26 13

20 Pie in the sky projections Terminal value (usually too high) Growth beyond which the capital valued can support Extrapolation of past results 27 Actual Results Management Projections Revenues ($mil) $175 $235 $240 $210 $210 $220 $240 $245 Actual Results Management Projections EBITDA ($mil) $15 $28 $30 $35 $17 $11 $10 $

21 Sample questions to ask about income approach Did you conduct your income approach on an equity basis or an invested capital basis? Why? Did you use a discounting or capitalization method? What income variable did you choose to discount or capitalize? Why? What is the source of your projections? What procedure did you use to estimate the terminal value? Why? Explain how you calculated your equity discount rate. How did you justify your growth rate? 29 Rate that doesn t match the revenue stream Using historical rates of return for current rates Using a safe rate to discount a risky cash flow Incorrect or inadequate support for rate used Using company s overall cost of capital to value all divisions or subsidiaries 30 15

22 Market Approach The value of an investment can be determined by looking at what was paid for a similar investment Based on the economic principle of substitution A person would not pay more than they would have to pay for an equally desirable substitute 31 Market approach methods Acquisition price method Public company method Prior transactions Industry method Rules of thumb 32 16

23 Criteria for selecting guideline companies Line of business Markets served Size Comparability of earnings patterns Position in industry Capital structure Maturity of company 33 Overlooking past transactions Promoting inquires to offer status Not using comparable guideline companies Not using the public company method Being too restrictive of comparables Missing comparable guideline transactions 34 17

24 Sale Date Target Acquiror Mar-06 Tom's of Maine Colgate Palmolive Nov-06 Naked Juice Co PepsiCo Jun-08 Humm Foods General Mills Feb-10 Kettle Foods Diamond Foods May-11 Aidell's Sausage Sara Lee Jun-12 Udi's Healthy Foods Smart Balance May-13 Ella's Kitchen Hain Celestial Jan-14 Earthbound Farms WhiteWave Foods May-15 Applegate Farms Hormel Foods Aug-15 Dave's Killer Bread Flower Foods 35 September 2014 General Mills buys Annie s Paid 4x Revenues 36 18

25 Sample questions to ask about the market approach Within the market approach, what method(s) did you use? Why? How did you go about searching for comps? Were there any past transactions of the company? 37 Assuming discounted cash flow (dcf) method always produces minority/control value Assuming guideline public company method always produces a minority value Using synergistic control premiums to quantify premium for control 38 19

26 Whether to apply How much to apply 39 The concept of marketability: The ability to convert the business ownership interest (at whatever ownership level) to cash quickly, with the minimum transaction and administrative costs in so doing and with a high degree of certainty of realizing the expected amount of net proceeds. [1] [1] Shannon P. Pratt with Alina V. Niculita, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 5 th ed., p

27 Marketability versus liquidity Marketability the relative ease and promptness with which a security or commodity may be sold when desired, at a representative current price, without material concession in price merely because of the necessity of sale. [1] Liquidity the amount of time required to convert an asset into cash or pay a liability [1] [1] Shannon P. Pratt with Alina V. Niculita, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 5 th ed., p Degrees of marketability of lack thereof: Registered with the Securites and Exchange Commission (SEC) and an active trading market Registered with the SEC and fully reporting, but somewhat thin trading market A stock with contractual put rights Registered with the SEC, but not required to file Private company with an imminent public offering Private company with frequent private transactions Private company with few or no transactions Private company with interests subject to restrictions 42 21

28 Discounts for lack of marketability for controlling interests Controlling interests can not be converted to cash in three days Certain empirical studies for discounts for lack of marketability apply solely to minority interests If applicable, the discount for lack of marketability for a controlling interest must be based on the costs of preparing the company for sale (or for an IPO) and the risks and time inherent in the process 43 Often overlooked or (less likely) applied where not applicable Discount for lack of control Key person Built-in capital gains Non-homogeneous assets (portfolio) discount Voting versus non-voting interests Contingent liabilities (environmental, litigation) Blockage discount 44 22

29 Degrees of minority versus control ownership 100% control Slightly less than 100% control Less than 80% control Less than a supermajority where a supermajority is required for certain corporate actions 50% interest Swing vote minority block Enough votes to elect a director under cumulative voting High enough percentage to bring a minority oppression dissolution action 45 Sample questions to ask about discounts In the course of your appraisal process, what premium(s) or discount(s) did you apply? Please explain exactly how you arrived at the amount of the premium/discount to apply

30 Distinction between personal and enterprise goodwill Goodwill is that intangible asset that contributes to earnings as a result of a name, reputation, customer and employee loyalty, location, products, etc. Personal goodwill is that part of goodwill attributable to the individual as opposed to the entity Enterprise goodwill is that part of goodwill attributable to the entity as opposed to an individual 47 Distinction between personal and enterprise goodwill Goodwill is that intangible asset that contributes to earnings as a result of a name, reputation, customer and employee loyalty, location, products, etc. Personal goodwill is that part of goodwill attributable to the individual as opposed to the entity Enterprise goodwill is that part of goodwill attributable to the entity as opposed to an individual 48 24

31 Enterprise goodwill characteristics Written contracts with major customers or suppliers Written employment and/or non-compete agreements Advantageous location Large business with formalized organization structure Formalized production methods and business systems Not heavily dependent on personal service performed by the owner(s) Sales result from company name recognition and/or sales force 49 Personal goodwill characteristics Small entrepreneurial business highly dependent on owner s personal skills and relationships No employment and/or non-compete agreements Personal services provided by the owner(s) are an important feature in the company s products or services Sales largely dependent on owner(s) personal relationship with customers Product and/or services know-how and supplier relationships rest primarily with the owner(s) 50 25

32 Cost of Capital: Applications and Examples, 5 th Edition, by Shannon P. Pratt and Roger J. Grabowski, John Wiley and Sons, Common Errors Chapter 44. The Lawyer s Guide to the Cost of Capital: Understanding Risk and Return for Valuing Businesses and Other Investments, Shannon Pratt and Roger Grabowski, American Bar Association, Common Errors Chapter 20; Questions to Ask BV Experts Chapter 21. The Lawyer s Business Valuation Handbook: Understanding Financial Statements, Appraisal Reports, and Expert Testimony, 2 nd Edition, by Shannon Pratt and Alina V. Niculita, American Bar Association, Checklist for Reviewing a BV Report Chapter 25; Cross Examining a BV Expert Chapter 31. Business Valuation Discounts and Premiums, 2 nd Edition, Shannon P. Pratt, John Wiley and Sons, Common Errors in Applying Discounts and Premiums Chapter 23. Standards of Value: Theory and Applications, 2 nd Edition, Jay E. Fishman, Shannon P. Pratt, and William J. Morrison, John Wiley and Sons, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 5 th Edition, Shannon P. Pratt with Alina V. Niculita, McGraw-Hill, Litigation and Dispute Resolution Part VIII. 51 Questions? Alina Niculita, CFA, ASA, MBA alina@moronesanalytics.com Paul Heidt, ASA paul@moronesanalytics.com 52 26

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