Understanding business valuation for divorce litigation (part I of III)

According to PwC's 2019 "Daubert Challenges to Financial Experts" study, legal strategies to exclude expert testimony focused on three primary areas:

1. A lack of reliability of the expert's conclusions -- the expert did not use reliable data or appropriate and accepted methodology.

2. The expert's work was not relevant -- the expert went beyond the scope of their role or the testimony will not help the trier of fact.

3. The expert's qualifications -- the expert is not sufficiently credentialed or qualified to render an expert opinion on the subject matter.

Excluding overlapping prongs of attack, successful exclusion rates in the 2019 study were as follows: lack of reliability, 58%; lack of relevancy, 34%, and lack of qualifications, 8%. Understanding the reliability and relevance of the expert's business valuation work product is the key to both successful attacks and defenses of the opinion of business value rendered.

This three-part series will discuss key factors inherent in business valuation reports. The focus will be on mechanical issues and subjective decisions made by business valuation experts.

Types of Engagements -- Full and Partial Reports

Multiple credentialing authorities, the AICPA, NACVA, IBA and ASA, grant business valuation credentials. All recognize two types of reports, a "valuation engagement" (aka appraisal report) and a "calculation engagement" (aka restricted appraisal report). A full valuation engagement typically includes a written section describing the business, economic and industry conditions at the time of the valuation, and the methods considered and used in the valuation process.

A "calculation engagement" is an agreed upon procedures engagement where the business valuer and client agree on the valuation approaches and methods used and the extent of the procedures performed. A calculation engagement does not include all of the procedures required for a valuation engagement. Results from a calculation engagement can be expressed as a single number or range of value. A calculation engagement will typically exclude the written portions pertaining the business, economy, industry and methodologies used.

Cost is typically a factor in considering which type of engagement. Valuation engagements are more expensive than calculation engagements to prepare. This is due to the fact that valuation engagements must meet the reporting standards of the valuation expert's credentialing body. In a calculation engagement an agreement to forego the written portion of much of this work product is generally contained in the engagement letter. In lieu of the written portion, an oral report may be provided pertaining to the unwritten report sections.

Standards of Value

The object of a business valuation is to arrive at the cash value of the business as of the date of valuation. However, the word "value" must be defined. There are several possible definitions. Each definition can yield different values for the same interest. Therefore, it is important to understand the various standards of value commonly used in valuation.

Liquidation Value

"Liquidation value" is the net realizable cash remaining after paying all liquidation costs such as auctioneer fees, commissions, debts, etc. The underlying presumption in this approach is that the business will not continue as a going concern.

Historical Value aka Book Value

"Historical value" is expressed by the financial statements of the entity. It is commonly calculated as the net assets less all liabilities or listed as the net equity of the business. Historical or book value follows accounting basis rules. In accounting, the balance sheet lists assets at their original purchase price, not what they are worth as of the date of the financial statement. (Other than assets which are subject to adjustment to their current value. A frequent example of this mark-to-market accounting involves marketable securities which are valued as of the balance sheet date based on their current public offering price.). For example, purchased real estate five years ago is listed at the original transaction price irrespective of its current, appreciated value. Therefore, when valuing appreciating or depreciating assets, historical value does not yield an accurate measure of current value.

Investment Value

"Investment value" is the value of an investment to a particular investor or class of investors. It is based on individual investment traits and requirements. Many times these buyers purchase businesses in their industry expertise based on a required rate of return.

Synergistic Value

"Synergistic value" is the price a specific purchaser will pay for a particular business interest. For example, a business may possess a unique patent or innovation. An acquirer may have a substantial distribution network, marketing acumen, or financial leverage that the selling business does not possess. This combination levers the innovation onto a platform the seller could not achieve. As a result, this synergy increases the value of the acquired business to the acquirer.

Fair Market Value

"Fair market value" is defined by the Internal Revenue Service in Revenue Ruling 59-60 as "The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts."

Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.

This value implies the price an active "market" will pay for a given business interest. In an inactive or illiquid market, fair market value adjusts the calculated value by a lack of control and/or lack of marketability discount. The lack of control discount reflects the inability of the fractional business owner to control the underlying business. In other words, the fractional interest is less than 50%. The lack of marketability discount considers the cost and time to market a business interest to a hypothetical buyer thus reducing a business' overall value. Lack of control and lack of marketability discounts lower the pro rata business value typically by 10% to 40%.

Fair Value

"Fair value" generally means fair market value without lack of marketability discounts. This definition is common to shareholder (especially minority shareholder) disputes and buy-sell agreements. Fair value in shareholder disputes is preferred because forcing a market discount against a minority dissenting shareholder produces inequitable advantage to majority shareholders.

California Divorce Value

The appropriate standard of value for California family court is fair value. California family courts have generally held that discounts for lack of control and lack of marketability are inappropriate for determining the value of the business in the division of assets pursuant to a divorce. The California family court's fair value standard departs from the traditional definition of fair market value in aspects other than just the lack of use of discounts.

"The value of community goodwill is not necessarily the specified amount of money that a willing buyer would pay for such goodwill. In view of the exigencies that are ordinarily attendant in a marriage dissolution the amount obtainable in the marketplace might well be less than the true value of the goodwill." In re Marriage of Foster, 42 Cal. App. 3d 577, 584 (1974).

The courts have further stated that "While 'market value' and the value for marital dissolution purposes of 'professional goodwill' may be synonymous, in our view such value should be determined with considerable care and caution, since it is a unique situation in which the continuing practitioner is judicially forced to buy an intangible asset at a judicially determined value and compelled to pay a former spouse her share in tangible assets. (Civ. Code, §4800.)." In re Marriage of Lopez, 38 Cal. App. 3d 93, 110 (1974). Civil Code Section 4800(a) of the Family Law Act is satisfied when the investment value of closely held shares is determined rather than market value.

Finally, family court is an equity court. As such the standard of value has been stated as described in Code of Civil Procedure Section 1263.320(b) (relating to eminent domain): "The fair market value of property taken for which there is no relevant market is its value on the date of valuation as determined by any method of valuation that is just and equitable."

In summary, there is no clearly defined standard of value for the valuation of intangible assets (goodwill) in California family courts. As a result, the underlying quality of the data used and appropriateness of the methodology applied are two of the most important factors when judging the reliability and relevancy of expert business valuation reports. 