In our family law and commercial litigation practice, we often serve as expert witnesses in auto dealership valuation disputes. We hope you never find yourself a party to a legal dispute; however, we offer the following words of wisdom based upon our experience working in these valuation-related disputes. The following topics, posed as questions, have been points of contention or common issues that have arisen in recent disputes. We present them here so that if you are ever party to a dispute, you will be a more informed user of valuation and expert witness services.
Oftentimes, the financial and business valuation portion of a litigation is 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. In the auto dealer world, you are hopefully combining valuation expertise with a highly-specialized industry. It is critical to engage an expert who is both a valuation expert and an industry expert – one who holds valuation credentials and has deep valuation knowledge and also understands and employs accepted industry-specific valuation techniques. Look with caution upon valuation experts with minimal industry experience who utilize general valuation methodologies often reserved for other industries (for example, Discounted Cash Flow (DCF) or multiples of Earnings Before Interest, Taxes and Depreciation (EBITDA)) with no discussion of Blue Sky multiples.
The auto industry, like most industries, is dependent on the climate of the national economy. Additionally, auto dealers can be dependent or affected by conditions that are unique to their local economy. The type of franchise relative to the local demographics can also have a direct impact on the success/profitability of a particular auto dealer. For example, a luxury or high-line franchise in a smaller or poorer market would not be expected to fare as well as one in a market that has a larger and wealthier demographic.
In those areas that are dependent on a local economy/industry, an understanding of that economy/industry becomes just as important as an understanding of the overall auto dealer industry and national economy. Common examples are local markets that are home to a military base, oil & gas markets in Western Texas or natural gas in Pennsylvania, or fishing industries in coastal areas. There’s 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 dealership.
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. However, the formulas contained in these agreements are not always specific to the industry and may not include accepted valuation methodology for auto dealers.
Two common questions that arise concerning these agreements are 1) has an indication of value ever been concluded using the governance document in the dealership’s history (in other words, has the dealership been valued using the methodology set out in the document)?; and 2) have there been any transactions, buy-ins or redemptions utilizing the values concluded in a governance document? These are important questions to consider when determining the appropriate weight to place on a value indication from a governance document.
Some litigation matters (such as divorce) state that the non-business party to the litigation is not bound by the value indicated by the governance document since they were not a signed party to that particular agreement. It is always important to discuss this issue with your attorney.
Similar to governance documents, another possible data point(s) in valuing an auto dealership are internal transactions. 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 owners of an auto dealership have to submit personal financial statements as part of the guarantee on the floor plan and other financing. The personal financial statement includes a listing of all of the dealer’s assets and liabilities, typically including some value assigned to the value of the dealership. In litigated matters, these documents are important as another data point to valuation.
One view of the value placed on a dealership 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 dealership 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 dealership 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.
The auto dealer industry is highly specialized and unique and should not be compared to general retail or manufacturing industries. As such, any sole comparison to general industry profitability data should be avoided.
If your appraiser solely uses the Annual Statement Studies provided by the Risk Management Association (RMA) as a source of comparison for the balance sheet and income statement of your dealership to the industry, this is problematic. RMA’s studies are organized by the North American Industry Classification System (NAICS). Typical new and used retail auto dealers would fall under NAICS #441110 or #441120. This general data does not distinguish between different franchises.
Is there better or more specialized data available? Yes, the National Automobile Dealers Association (NADA) publishes monthly Dealership Financial Profiles broken down by Average Dealerships, which would be comparable to RMA data. However, NADA drills down further, segmenting the industry into the four following categories: Domestic Dealerships, Import Dealerships, Luxury Dealerships and Mass Market Dealerships. While no single comparison is perfect, an appraiser should know to consult more specific industry profitability data when available.
Either through an income or Blue Sky approach, auto dealers are typically valued based upon expected profitability rather than the actual profitability of the business.
The difference between actual and expected profitability generally consists of normalization adjustments. Normalization 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 does the dealership have non-recurring or discretionary expenses and are personal expenses of the owner being paid by the business? Comparing the dealership to industry profitability data as discussed earlier can help the appraiser understand the degree to which the dealership may be underperforming.
An example of how normalizing adjustments work is helpful. If a dealership has historically reported 2% earnings before taxes (EBT) and the NADA 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 dealership with revenue of $25 million, historical profitability at 2% would suggest EBT of $500,000. At 5%, expected EBT would be $1,250,000, or an increase of $750,000. In this case, the financial expert should analyze the financial statements and the dealership to determine if normalization adjustments are appropriate which, when made, will reflect a more realistic figure of the expected profitability of the dealership without non-recurring or personal owner expenses. This is important because, hypothetically, a new owner could optimize the business and eliminate some of these expenses; therefore, even dealerships with a history of negative or lower earnings can receive higher Blue Sky multiples because a buyer believes they can improve the performance of the dealership. However, as noted earlier, the dealership may be affected by the local economy and other issues that cannot be fixed so the lower historical EBT may be justified.
For more information on normalizing adjustments, see our article Automobile Dealership Valuation 101.
The valuation of automobile dealerships can be complex. A deep understanding of the industry along with valuation expertise is the optimal combination for general valuation needs and certainly for valuation-related disputes. If you have a valuation issue, feel free to contact us to discuss it in confidence.
Originally published in the Value Focus: Auto Dealer Industry Newsletter, Mid-Year 2019.