In our family law practice, we serve as valuation and financial forensic expert witnesses. There is typically another valuation expert on “the other side.” In several recent engagements, the following topics, posed as questions here, were raised as points of contention. We present them here to help the reader, whether you are a family law attorney or a party to a divorce, understand certain valuation-related issues that may be raised in your matter.
The financial and business valuation portion of a litigation is often referred to as a “battle of the experts” because you have at least two valuation experts, one for the plaintiff and one for the defendant. Hopefully your valuation expert has both valuation expertise and industry expertise. While industry expertise is not necessary in every engagement, it can be helpful in understanding the subtleties of the business in question.
Most businesses are dependent on the climate of the national economy as well as the local economy. For businesses who have a national client base, the health of the national economy trumps any local or regional economy. However, many of the businesses we value in divorce engagements are more affected by changes in their local and regional economy. It’s important for a business appraiser to understand the difference and to be able to understand the effects of the local/regional economy on the subject business. There is also a fine balance between understanding and acknowledging the impact of that local economy without overstating it. Often some of the risks of the local economy are already reflected in the historical operating results of the business.
Many of the corporate entities involved in litigation have sophisticated governance documents that include Operating Agreements, Buy-Sell Agreements, and the like. These documents often contain provisions to value the stock or entity through the use of a formula or process. Whether or not these agreements are to be relied upon in whole or in part in a litigated matter is not always clear. In litigated matters, focus will be placed on whether the value concluded from a governance document represents fair market value, fair value, or some other standard of value.
Two common questions that arise concerning these agreements are:
These are important questions to consider when determining the appropriate weight to place on a value indication from a governance document. In divorce matters, the out-spouse is often not bound by the value indicated by the governance document since they were not a signatory to that particular agreement. It is always important to discuss this issue with your attorney.
Similar to governance documents, internal transactions are a possible valuation data point. A good appraiser will always ask if there have been prior transactions of company stock and, if so, how many have occurred, when did they occur, and at what terms did they occur? There is no magic number, but as with most statistics, more transactions closer to the date of valuation can often be considered as better indicators of value than fewer transactions further from the date of valuation.
An important consideration in internal transactions is the motivation of the buyer and seller. If there have been multiple internal transactions, appraisers have to determine the appropriateness of which transactions to possibly include and which to possibly exclude in their determination of value. Without an understanding of the motivation of the parties and of the specific facts of the transactions, it becomes trickier to include some, but exclude others. The more logical conclusion would be to include all of the transactions or exclude all of the transactions with a stated explanation.
Most business owners have to submit personal financial statements as part of any guarantee on financing. The personal financial statement includes a listing of all of the assets and liabilities of the business, typically including some value assigned to the value of the business. In divorce matters, these documents are important as yet another valuation data point.
One view of the value placed on a business in an owner’s personal financial statement is that no formal valuation process was used to determine that number; so, at best, it’s a thumb in the air, blind estimate of value. The opposing view is the individual submitting the personal financial statement is attesting to the accuracy and reliability of the financial figures contained in document under penalty of perjury. Further, some would say that the value assigned to the business has merit because the business owner is the most informed person regarding the business, its future growth opportunities, competition, and the impact of economic and industry factors on the business.
For an appraiser, it’s not a good situation to be surprised by the existence of these documents. A good business appraiser will always ask for them. The business value indicated in a personal financial statement should be viewed in light of value indications under other methodologies and sources of information. At a minimum, personal financial statements may require the expert to ask more questions or use other factors, such as the national and local economy, to explain any difference in values over time.
Normalizing adjustments are adjustments made for any unusual or non-recurring items that do not reflect normal business operations. During the due diligence interview with management, an appraiser should ask if the business has non-recurring or discretionary expenses and are personal expenses of the owner being paid by the business? Comparing the business to industry profitability data can help the appraiser understand the degree to which the business may be underperforming.
An example of how normalizing adjustments work is helpful. If a business has historically reported 2% EBITDA (earnings before interest, taxes, depreciation, and amortization) and the industry data suggests 5%, the financial expert must analyze why there is a difference between these two data points and determine if there are normalizing adjustments to be applied. Let’s use some numbers to illustrate this point. For a business with revenue of $25 million, historical profitability at 2% would suggest EBITDA of $500,000. At 5%, expected EBITDA would be $1,250,000, or an increase of $750,000. In this case, the financial expert should analyze the financial statements and the business to determine if normalization adjustments are appropriate which, when made, will reflect a more realistic figure of the expected profitability of the business without non-recurring or personal owner expenses.
There are many other issues a valuation expert faces in divorce matters; however, the issues presented here were top of mind for us because they were present in recent engagements. Valuation can be complex. Serving as an expert witness can be challenging as well. However, having an expert with valuation expertise and experience is an advantageous combination in divorce matters. In future articles, we’ll discuss other issues of importance to hopefully help you become a more knowledgeable user of valuation services. In the meantime, if you have a valuation or financial forensics issue, feel free to contact us to discuss it in confidence.
Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Third Quarter 2019.