In high-stakes business or divorce litigation, the client’s first call is typically to his lawyer. However once a case is filed and the preliminary groundwork has been laid, it is frequently necessary to bring in a financial expert to place a value on businesses and, in a divorce situation, to determine the income on which spousal or child support will be based. In the vast majority of family law cases in which Stout is involved, the individual litigants have little or no experience with financial experts and rely exclusively on their attorneys to contact and recommend experts. But choosing an expert is not like buying groceries, where decisions can be made by squeezing a melon or counting trans fats. Not only do experts come with all the quirks and foibles of any other person, but some financial professionals may style themselves as valuation “experts,” and even have a “valuation credential” without the experience or training necessary to develop such expertise. At a recent national conference of CPAs, Paul Beswick, deputy chief accountant for the SEC commented:
At last count, valuation professionals in the U.S. can choose among five business valuation credentials available from four different organizations, each with its own set of criteria for attainment, yet none of which is actually required to count oneself amongst the ranks of the profession...
It is not uncommon for practicing accountants to attend a seminar and obtain a business valuation credential in hopes of leveraging their existing client relationships into a new revenue stream. However, as stated by Mr. Beswick, such a credential does not guarantee that the holder is in fact amongst the ranks of the valuation profession. Further, while valuation is not unrelated to accounting, and most valuation experts have an accounting background, accounting competency is not synonymous with valuation expertise. Hiring an accountant to stand in as a family law valuation expert might be analogous to a company’s general counsel representing the owner in her divorce.
This article demonstrates through case studies of two recent encounters with opposing “experts” some common mistakes made by these individuals and the adverse impact on each case.
In this case, Stout was hired on behalf of both parties to value a dental practice that grossed annual revenues of approximately $1.0 million. The practice was solely owned and operated by the husband, who was the family’s primary provider. The wife, Mrs. Rex, suspected that Dr. Rex was underreporting revenues and/or overstating legitimate business expenses, thus artificially lowering stated income. If correct, these actions could doubly impact the divorce in both a decreased value of the practice and lower income available for support calculations. Before Stout was engaged to value the business, Mrs. Rex hired an accountant, Ms. Smith, to analyze the bank statements and cancelled checks of the practice and to recreate a profit and loss statement (“P&L”) that was not subject to Dr. Rex’s manipulations. After finishing work on her P&L, Ms. Smith offered to value the practice for the parties. Because counsel for both sides wanted an experienced neutral expert, they instead recommended Stout to value the practice and determine Dr. Rex’s income.
After reconciling the income showed by the practice’s P&L vis-à-vis the P&L compiled by Ms. Smith, Stout proceeded with the valuation. The analysis showed pre-tax income for the practice at approximately $175,000. This amount included assumed market wages for Dr. Rex of $275,000 for his labor efforts. Stout utilized the Capitalized Cash Flow Method, a form of the Income Approach, to arrive at an enterprise value of approximately $625,000, and after making adjustments for cash and debt, an equity value of $335,000. This conclusion was tested against recent transaction valuation multiples for similar practices.
During this process, Ms. Smith remained on retainer with Mrs. Rex, ostensibly to help Stout understand her work. Unbeknownst to Stout or the parties’ attorneys, however, Ms. Smith had already estimated the practice’s value at $3.0 million and communicated her “results” to Mrs. Rex. When Stout shared our results with the parties, Mrs. Rex was very upset because her expectations were for a $3.0 million value that was nearly 9 times our conclusion. Mrs. Rex then sent Stout’s valuation report to Ms. Smith, who contacted Stout to communicate what she believed to be errors. These were as follows:
Reasonableness Check – Ms. Smith could not understand how a practice that “paid” a dentist $450,000 annually ($175,000 in pre-tax income plus wages of $275,000) could be worth only $335,000.
Income Available for Spousal Support – If Dr. Rex earns $450,000 from the practice, why would his income for purposes of spousal support be any less?
Missing Assets – Ms. Smith noticed that when Stout subtracted the practice’s debt to arrive at an equity value of $335,000, there were no additions for accounts receivable or for equipment owned by the practice.
Capitalization Rate – Ms. Smith thought there was an inconsistency in the application of the capitalization rate, and inquired as to whether it had been applied to the cash balance, or the cash balance plus the accounts receivable balance.
These arguments seemed intuitive and logical to Ms. Smith and her client; however, a seasoned expert would have recognized the fallacy in each one.
In valuing a business such as a dental practice with a single owner, part of the valuation analyst’s application of the Income Approach1 is to bifurcate the earnings generated by the practice into 1) reasonable market compensation that the dentist would make if performing the same services in a practice he did not own, and 2) the residual income left over to compensate the practice’s owner for his capital investment. It is this residual income that is “capitalized” in the valuation and gives rise to business value. Ms. Smith’s simply did not understand the valuation distinction between Dr. Rex the employee and Dr. Rex the business owner.
Additionally, Ms. Smith failed to consider the negative impact to value of the practice’s $325,000 in debt. If Ms. Smith were a full-time valuation expert, she likely would have had access to information on recent transactions that would have supported the Stout conclusion and shown that her $3.0 million estimation was many times what a prudent investor would pay for such a practice.
Income Available for Spousal Support
The concept Ms. Smith raised is the classic example of a divorce “double dip” of income, where the same income dollars are counted twice: the first time, to give rise to business value; and the second, on which to base spousal support. State courts have ruled differently on the permissibility of the double dip, however, it is an issue that arises in nearly all divorces. Because Ms. Smith had never before performed a valuation for divorce purposes, she was completely unaware of its existence.
Ms. Smith noticed no separate accounting for the practice’s accounts receivable or equipment in the Stout Income Approach. She represented to her client that the Stout valuation had excluded over $375,000 in assets and once again raised Mrs. Rex’s expectations that the value should be significantly higher. While it seems logical that if debt is subtracted from value, assets should be added, there is a fundamental difference between debt and the accounts receivable and equipment Ms. Smith proposed adding to the value. Debt is typically a financing tool that allows the owner of a business to obtain capital to fund the business from an outside, non-equity investor. Accounts receivable and equipment are operating assets, meaning they are utilized directly in the operations of the practice to generate the income that was capitalized in giving rise to value. Therefore the calculated value in the Stout Income Approach already incorporated the value of these assets. On the other hand, however, the capitalized income (cash flow before interest expense in this case) did not include deductions for debt payments, and therefore the detriment to value of owing debt was required to be quantified elsewhere.
Not understanding how assets and liabilities are accounted for in a valuation is one of the most common errors we see from inexperienced professionals.
The final question raised was whether the capitalization rate had been applied to the cash balance or the combined balance of cash plus accounts receivable. The answer was neither. Ms. Smith did not realize that these rates are not applicable to cash or accounts receivable balances, but rather to ongoing cash flow generated by the business.
Case I Conclusion
Ms. Smith’s involvement in the valuation extended the divorce proceedings by several weeks; cost thousands of dollars in extra fees for herself, Stout, the mediator, and both attorneys; and further hampered the settlement process by raising client expectations to unrealistic levels. Unfortunately, this is not an uncommon scenario when an accountant who dabbles in valuation is brought into a case in an effort to save on expert fees.
In this case, Stout was engaged to value a construction subcontractor. The owner and CEO of the business controlled 100% of the company’s stock and exercised total control over the operations of the business. Stout was engaged by the non-owning spouse to perform a valuation, with the understanding that the CEO had also retained a professional to perform a valuation. The opposing “expert,” Mr. Brown, was a well-trained CPA in the construction field, but lacked valuation experience.
After receiving documents from the owner, interviewing management, and performing a detailed analysis of the company’s financial and operational prospects, Stout completed its valuation. Soon thereafter, reports were exchanged with Mr. Brown. His conclusion was dramatically lower than Stout’s, and a detailed review of his analysis revealed that the difference could be attributed to two errors. First, Mr. Brown failed to adjust his analysis for the fact that the business reported its financial statements on a cash basis rather than an accrual basis. Second, he inappropriately assumed that none of the business’s cash flow was available until the final day of each year.
Cash vs. Accrual Accounting
When valuing any asset, the valuator is concerned with the prospective return the asset will generate for the holder. Typically, this prospective return is projected in the form of cash flow, and then subsequently discounted at a rate of return incorporating commensurate risk. Because it is cash flow that is projected, rather than net income, certain adjustments are necessary to convert net income (which is reported on a company’s financial statements) to cash flow.
It is important to note that accrual-based income is recognized when it is earned, not when it is received, whereas cash-based income is recognized when the cash is actually collected and expenses are actually paid. Under an accrual-based system, to account for the timing differences between when revenue or expenses are earned/incurred and when the cash actually transacts, receivables and payables are booked (these can comprise a substantial portion of “working capital”). As a business grows, working capital typically increases and this annual change accounts for part of the ongoing difference between net income and cash flow. Therefore, when valuing a company that utilizes an accrual-based accounting convention, an adjustment is generally necessary to account for the fact that while working capital has already been incorporated into net income, it has not yet impacted the company’s cash flow.
In the instant case, the business had stable operations and reported its financial results on a cash basis. Therefore, net income in any given period excluded revenue not yet collected and expenses not yet paid, and no such “working capital adjustment” was necessary to arrive at historical cash flows. Further, the company’s projected cash flows were based upon its historical results, thus the cash flow projections were also free from the influence of ongoing working capital changes. Because Mr. Brown’s limited training had not prepared him for the subtleties of valuing a business with cash-based financial statements, he erroneously adjusted the business’s cash flows to remove working capital effects that had never existed. The result was an understatement of cash flow by the amount of his adjustment and a subsequent understatement in the value of the company.
Timing of Cash Flows and the Mid-Year Convention
When performing discounted or capitalized cash flow analyses, a business valuation expert must chose to discount future cash flows using one of two discounting conventions: the end-of-year convention or the mid-year convention. When utilizing the mid-year convention, the valuator’s fundamental assumption is that cash flows will be available to the subject interest evenly throughout the projected period. Conversely, the use of the end-of-year convention assumes that none of the projected cash flows will be available for distribution until the end of the period. Intuitively, because the recipient must wait longer to receive his investment return, an analysis assuming cash is distributed at the end of a period will yield a lower value than an analysis assuming cash is available throughout the period.
The classic example of a business that might be more appropriately treated with the end-of-year convention would be a Christmas tree farm that generates 100% of its revenues in the final month of the year. But because most businesses, even those with seasonality, generate cash throughout the year, business valuators generally view the mid-year convention as the preferred method for discounting cash flows. The mistake often made by inexperienced practitioners is the failure to understand in which instances it is appropriate to apply each of the conventions.
In the instant case, Mr. Brown chose to utilize the end-of-year convention when completing his discounted cash flow analysis. When questioned, Mr. Brown reasoned that the end-of-year convention was appropriate because the business had a history of making distributions at the end of the calendar year. While this sounds like a reasonable conclusion, it fails to account for several factors.
First, Mr. Brown did not account for the fact that the subject interest represented a 100% controlling interest in the company. When applying an income approach, the value of a company is derived from the cash flows that are available to be distributed on a forward-looking basis, not necessarily the cash flows that have been distributed historically. As such, although the husband usually chose to make an end-of-year distribution to himself historically, he possessed the ability to issue distributions on any day and at any time during the course of the year. Furthermore, Mr. Brown failed to consider the fact that the reason the company only paid the owner distributions at the end of the year was because the husband was effectively receiving his capital return throughout the year in the form of self-authorized wages in excess of market compensation.
Finally, Mr. Brown did not seem to understand that it was future distributable cash flow at issue in the valuation, not cash flow distributed in the past. He did this by acknowledging the fact that cash was accumulating in the company’s bank accounts throughout the year, but failing to account for the ability of the subject interest to distribute it. Essentially, Mr. Brown opined that the cash generated by the business was worth less because the husband let it sit in the business’s bank accounts instead of transferring it to the parties’ joint bank accounts.
Mr. Brown’s errors caused a large discrepancy between his concluded value and Stout’s. It was this discrepancy that prolonged the litigation and nearly drove the case to trial before finally settling in our client’s favor at the eleventh hour. At that point, both sets of attorneys and experts had incurred the considerable costs of preparing for trial.
Many divorcing parties look to their attorneys to guide them to true experts who can assist with the complexities of not only valuation, but also valuation in the context of divorce litigation. These cases show two real-world examples of what can result from hiring financial professionals who, while they may be experts in their respective accounting disciplines, are inexperienced in valuation. Although usually done with the best of intentions, it can be extremely counterproductive and costly to engage professionals who lack the requisite knowledge, training, and experience to prepare defensible reports and effectively advise their clients. In the rare case that a client suggests an accountant who claims to be able to perform a valuation, the attorney may be the last line of defense to look out for the client’s best interest and ensure that the expert stands out for his or her expertise and not for ineptitude.
Also a contributing author:
Jason E. Bodmer
1 The primary mechanics of the Income Approach involve projecting income into the future and discounting this income to a present value at a rate of return commensurate with the risk inherent in achieving the projected results.