November/December 2012 & Litigation Valuation REPORT Rules of thumb: Do they have a place in business valuation? When a business is being valued, consider the real estate Why financial experts should explain themselves Using regression analysis in litigation and valuation Anti-Money Laundering Bankruptcy and Insolvency Business Valuations and Consulting Electronic Discovery Forensic Accounting Litigation Consulting Marital Dissolution New Business Ventures Restructuring, Monitoring, Receivership and Fiduciary Miami New York Baltimore Boca Raton Boulder Fort Lauderdale Orlando Valhalla India www.mbafcpa.com An Independent Member of Baker Tilly International
Rules of thumb: Do they have a place in business valuation? For many types of businesses, you can find a rule of thumb for valuing it. Rules of thumb are quick, easy to understand and use, and inexpensive. However, because they re generally based on industry averages, they fail to capture the specific characteristics of a business that drive its value. Rules of thumb may offer a rough indication of value that can be used to satisfy a business owner s curiosity or to serve as a reasonableness or sanity check on results derived from other methods. But they re no substitute for a comprehensive, formal valuation. What is a rule of thumb? The International Glossary of Business Valuation Terms defines rule of thumb as a mathematical formula developed from the relationship between price and certain variables based on experience, observation, hearsay, or a combination of these; usually industry specific. Typically, rules of thumb are expressed as multiples of revenues or some form of earnings or cash flow. They may also be based on multiples of assets or units of capacity or activity. For example, one rule of thumb for valuing motels is $20,000 per room. Rules of thumb come from many sources, including business brokers, industry consultants, trade associations, publications and word of mouth. Generally, they apply to small, single-site businesses, though some industries may have them for larger organizations. In both cases, many transactions are needed to yield market-derived price multiples. The best ones are industry- and geography-specific. What are the disadvantages? A rule of thumb is a variation of the market approach to valuation. Market-based methods value a business by analyzing valuation multiples from transactions involving similar businesses and making adjustments to reflect the subject s characteristics. Key to an accurate valuation is access to information to determine whether other companies and transactions are truly comparable and to identify appropriate adjustments. The problem with rules of thumb is that they re based on average multiples derived from transactions involving companies that may or may not be comparable to the subject. And, they re often based on subjective judgment or word of mouth rather than objective sources of verifiable data. Even if a rule of thumb is derived from solid market data, it s impossible without access to details about the underlying companies and transactions to determine whether the rule has any relevance to the subject company. For example, a common rule of thumb for valuing full-service restaurants is 30% of annual gross revenues. But prices in actual transactions range from well under 20% to well over 100% of gross revenues. Why such a wide range? It s because business value is affected by a variety of factors besides revenues, such as gross profits, lease and other expenses, cash flow, 2
growth, location, competition, management strength, and risk. A rule of thumb might produce a reasonable value for a business that s near the industry average in these areas, but, for businesses that deviate from the norm, rules of thumb are unreliable indicators of value. Also, rules of thumb generally don t account for transaction terms. For example, do transactions involve cash purchases or seller financing? Are they stock sales or asset sales? In applying a rule of thumb, should you add real estate and inventory to value? Should you subtract debt? The answers to these questions can have a significant impact on value, but rules of thumb are often silent on these issues. Last, rules of thumb can be misleading if their terms aren t defined. If a business is valued at three times earnings, for example, the result can vary dramatically depending on the definition of earnings. Does it mean after-tax earnings? Earnings before interest and taxes (EBIT)? Owner s discretionary cash flow? Handle with care In situations that demand accurate valuations such as business sales, litigation or tax planning rules of thumb are no substitute for professional valuations using generally accepted methods. What s more, rules of thumb used as a major valuation method will not likely survive scrutiny in court. They may be appropriate, however, for developing a rough, preliminary indication of value or for gauging the reasonableness of a formal valuation. u Rule of thumb in action Let s look at an example of the inherent weakness of many rules of thumb: Company A and Company B are IT businesses. One rule of thumb for IT businesses is three times earnings before interest and taxes (EBIT). Companies A and B each have $500,000 in EBIT in 2012, so each would be valued at $1.5 million under the rule of thumb. Suppose, however, that Company A s EBIT was $75,000 in 2010 and $200,000 in 2011. Company B s EBIT, on the other hand, was $1 million in 2010 and $750,000 in 2011. Although the rule of thumb values the two companies equally, an informed buyer would likely place a much higher value on Company A, particularly if there s reason to believe that its pattern of rapid growth will continue in future years. When a business is being valued, consider the real estate If a client owns an office building or manufacturing facility, or any other type of real estate for that matter, it will affect the business s value. So, the issue at hand is how? Finding out will generally require the input of both a business valuator and a real estate appraiser. Assumptions and inputs Business valuators and real estate appraisers use similar methods, but there are important distinctions between the two. Although both use some combination of the income, market and asset-based approaches to valuation, the assumptions and inputs on which they rely may be different. 3
A business valuator using the income approach, for example, might calculate the present value of the business s expected future earnings or cash flows, while a real estate appraiser might determine a property s fair market rental value. A business valuator using the market approach might refer to guideline public companies that are comparable with the subject business, while a real estate appraiser might look at sales of comparable buildings or land. Link between values Whether you need a business valuator, a real estate appraiser or both depends on the extent to which the business s value is linked to the value of its underlying real estate. If a company s revenues are derived from owning or leasing real estate, for example, a real estate appraiser is likely to be the primary valuation professional. Even so, a business valuator may be needed to determine how the form of ownership affects value. In other cases, real estate is incidental to business value. Say a business owns real estate simply as an investment, or it owns its facilities but derives its revenues primarily from non-real-estate-related activities, such as producing goods or providing services. Here, a business valuator takes the lead role, and a real estate appraiser may or may not be necessary, depending on the business s real estate holdings relative to its overall value. Nevertheless, non-real-estate businesses may derive significant value from the location or characteristics of their real estate. Examples include retail stores, auto dealerships and restaurants. For these businesses, a business valuator and real estate appraiser work together to determine the best approach for incorporating real estate value into enterprise value. Splitting value If a business has significant real estate holdings, splitting its value into its business and real estate components can lead to a more meaningful value conclusion. This is particularly true when the real estate produces little or no income but has appreciated greatly in value. A failure to split the business and real estate components could result in an incorrect value. Valuing the business as a whole may not reflect the real estate s contribution to value. If a business has significant real estate holdings, splitting its value into its business and real estate components can lead to a more meaningful value conclusion. To value real estate separately, the appraiser determines a fair market rental value for the property. The business valuator removes the real estate (and the related income and expense items) from the books and estimates a hypothetical rental expense to the business, which reduces the earnings or cash flows on which the valuation is based. The resulting business value is combined with the stand-alone value of the real estate to arrive at a total enterprise value. 4
When using the guideline public company method, whether real estate should be valued separately may depend on the comparability of the guideline companies. If the subject company owns its facility but guideline companies lease theirs, it may be appropriate to treat the real estate separately. The best solution With business valuations, it s necessary to consider the value of any real estate owned by the business. To ensure a solid valuation, work with a business valuator and a qualified real estate appraiser. u Why financial experts should explain themselves recent personal injury case illustrates why it s A critical for your financial experts to provide the reasoning behind their damages calculations when they testify. In Andler v. Clear Channel Broadcasting, Inc., a federal district court excluded a financial expert s testimony regarding the plaintiff s loss of future earning capacity, finding the expert s methodology unduly speculative. But the Sixth U.S. Circuit Court of Appeals reversed and ordered a new trial on damages. Why? Because it found that the lower court had confused the concepts of lost earning capacity and lost earnings. Expert relied on national averages Before her injuries, the plaintiff worked part time at a child care center, primarily so she could be near her young children. Her injuries forced her to change jobs, and in the following years she worked full time as a manicurist and pedicurist. Based on Bureau of Labor Statistics data, the plaintiff s expert estimated what she could have earned as a full-time child care worker but for her injuries. He also estimated her postinjury annual earning capacity as a full-time manicurist and pedicurist. Interestingly, the two figures were roughly the same. The expert based his estimate of lost earning capacity approximately $230,000 on the increased likelihood that the plaintiff would miss work and exit the workforce early as a result of her injuries. The district court excluded this damages testimony as unreliable and flawed. The court said that relying on national average salaries rather than the plaintiff s actual earnings (which were significantly lower) amounted to unreasonable speculation. 5
Appeals court had its say The Sixth Circuit disagreed. The plaintiff was seeking damages for loss of earning capacity, not lost earnings. The former, the court explained, is the difference between the amount of wages the plaintiff will be capable of earning over her working life after the injury and the amount she was capable of earning over her working life before her injury. The plaintiff s historical earnings are a factor to be considered in determining future earning power, but they re not conclusive. Plaintiffs who are underemployed at the time of an accident, for example, may be entitled to damages for loss of earning capacity based on their true capabilities and potential. Plaintiffs can recover damages for loss of earning capacity even if their wages increase after an accident, provided they can show that (but for their injuries) they would have earned even more. Damages calculations that depart from actual preinjury earnings can t be unduly speculative, however. In this case, the expert s testimony involved a degree of speculation for example, he assumed that the plaintiff would shift from part-time to full-time work as her children grew older. But this speculation, the court said, wasn t unrealistic. Be prepared In Andler, the damages expert s testimony ultimately was allowed, but not before the plaintiff went through a lengthy appeal process. Although there are no guarantees, you can minimize these headaches by ensuring that your financial experts explain the rationale behind their damages calculations at the trial level. u Using regression analysis in litigation and valuation Financial experts often use regression analysis and other statistical techniques in calculating damages, determining causation and conducting business valuations. Regression analysis can be a powerful, persuasive tool. But, as the recent federal court case ATA Airlines v. Federal Express demonstrates, it can also be dangerous in the wrong hands. How it works Although the math can be complex, the concept behind regression analysis is relatively simple. It s a statistical tool for analyzing relationships between two or more variables: one that you re attempting to explain (the dependent variable) and one or more that are believed to produce or correlate with changes in the dependent variable ( independent or explanatory variables). Typically, these relationships are visually represented on a graph. Regression analysis is useful in a variety of litigation and valuation contexts. It can be used, for example, to support (or refute) the argument that an announcement in the financial press caused a public company s stock price to fall. It can also reveal potentially discriminatory relationships between employee termination or wage rates and age or gender. In business valuations, regression analysis is often used to select appropriate price multiples by 6
focusing on the connection between termination rates and age and ignoring the significance of the nondiscriminatory explanation). Getting back to the case In the ATA Airlines v. Federal Express case, a $66 million lost profits award was based entirely on a regression analysis by the plaintiff s expert. The U.S. Court of Appeals for the Seventh Circuit threw out the award on liability grounds but still took the opportunity to castigate the judge, the expert and the lawyers for both parties. identifying which factors (such as operating cash flow, book value or earnings before interest and taxes) are better predictors of price. Causation vs. correlation The distinction between causation and correlation is critical. A strong positive correlation between variables A and B doesn t necessarily mean that A causes B. It could mean that B causes A or that a third variable, C, causes both A and B. In an age discrimination case, for example, the plaintiff s expert might use regression analysis to establish unlawful discrimination by showing a positive correlation between age and termination rates. The defendant s expert might challenge this conclusion by demonstrating a stronger relationship between termination rates and a different, nondiscriminatory explanatory variable, such as computer skills. Perhaps the defendant implemented a new computer system and terminated employees who lacked the requisite technological sophistication. If regression analysis shows a statistically significant relationship between computer skills and termination rates, it would support the defendant s position that the terminations weren t age-driven, even though they had a disparate impact on older workers. This example illustrates the importance of the underlying assumptions to an accurate regression model. It also shows how faulty assumptions can produce misleading results (for example, by According to the Seventh Circuit, the expert s regression analysis was so deeply flawed that it should never have been allowed to be put before a jury. The trial judge failed to fulfill his duty to evaluate the testimony s admissibility in advance. It didn t help that neither party s lawyers understand regression analysis or they are unable to communicate their understanding in plain English. Regression analysis can reveal potentially discriminatory relationships between employee termination or wage rates and age or gender. The court also criticized the defense for offering no alternative measure of damages. It was no surprise, the court said, that the jury, presented with an unintelligible damages analysis, simply awarded the exact figure that ATA had asked for in damages. Do your homework To learn more about regression analysis, ask your financial experts before trial. There are also a number of nontechnical publications on the subject, including the Federal Judicial Center s Reference Guide on Multiple Regression. u This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. 2012 VLBnd12 7