Business Valuation

Case Studies: Business Valuation

#1: Court-appointed Expert

Four businesses were the subject of litigation and the judge contacted Arxis to prepare the valuations.  Arxis was appointed as the court appointed experts to prepare the valuation reports.

#2:  Business Valuation, Dissenting Shareholder, Joint Report

Arxis was retained by defense counsel to prepare a joint business valuation of a business that was the subject of costly dissenting shareholder litigation.  Plaintiff’s counsel also retained an expert and the court appointed a third neutral valuation expert.  Because of our knowledge of, and prior work against, both of the other experts the engagement was marked by professional courtesy and vigorous efforts to resolve the dispute.  The result was the successful issuance of a joint report that was agreed to by all three valuation experts.

#3: Fair Buy-Out Price of Business from a Widow

Issue: What is the fair buy-out price of a widow after the untimely death of her husband?

Arxis Work: We met with the business partner of a man who had died an early and shocking death. There were several factors that made the meeting and situation that much more difficult. First, his business partner was his brother. Second, his brother had died right in front of him, his wife, and his children in a boating accident. All the nieces and nephews were present and were greatly traumatized. Third, the family was close. The two brothers had been inseparable and their respective families followed suit. The brothers were partners in a struggling personal service business that was very dependent on the skills, knowledge, and relationships of both partners. Historically, the business supplied a livable salary to each of the brothers. In short, the death of one of the partners meant the loss of half the business. There was no plan for the death of a partner – no life insurance, no shareholders agreement, and no buy-out plan. For the widow and her family, it also meant the immediate loss of income – the ability to pay bills. The estate/corporate attorney contacted Arxis with a request that I assist the parties in arriving at a fair price for the surviving brother to pay to the widow for her share of the business. By most definitions there was no value. Or, if there was value, it was minimal. However, the surviving partner knew all his brother left to his family was whatever he could pay for his share of the business. He knew the business had no value beyond the salary he earned but he wanted me to define and quantify some basis for a buyout so his sister-in-law would not feel like it was charity and also feel like the price was fair.

Result: Arxis worked off of an assumption that the standard of value was “fair value” meaning that there were no discounts for control or marketability. An analysis was done to determine how much the surviving partner could afford to pay over a period of time assuming some growth and cutting overhead. The value was agreed to and the surviving partner worked for several years to support both families. It is doubtful that the surviving family will ever fully understand the sacrifices he made to provide them a “fair” value. It was a difficult assignment for Arxis. However, it allowed us to assist a remarkable man serve his distraught and needy family.

#4: Valuation of an Earnout Provision in Acquisition

Type of Matter: Valuing a business certainly is not always straightforward.  Sometimes it requires thinking outside the box to develop an approach that works for the particular situation.  Such was the case when Arxis Financial was recently engaged in an acquisition that was about to get ugly with potential litigation.

A business owner sold their business and the negotiations involved how much would be paid after the close of the transaction and how much would be based on the future performance of the company. It is typical that such payments (earnout provisions) are put in contracts to incentivize the seller to work towards the buyer’s success. It also allows for the possibility that the seller can make some extra money on the sale than they might otherwise be paid.

For tax and litigation reasons, Arxis Financial was contacted in this particular case to value the earnout provision. The seller needed to know the fair market value of the potential earnout cash flow as of the date of sale.

Arxis Work: For the valuator, an earnout element adds to the complexity of determining and quantifying the differences between value, price, and proceeds.  In this particular case, we knew the price but the actual value of the business and proceeds of the transaction were unknown.  Potential earnout payments were based on future performance that may or may not materialize.  Also, there were questions whether the company would actually be able to meet the required payments without permanently damaging the company.

Valuing a transaction as of the close date, when there are potential additional future payments, presents great difficulty in determining the Fair Market Value of the business as of that date.  There is no real alternative to using the income approach since the cash flows are complex, uncertain, and maybe even speculative, depending on the negotiations and terms. Variations on the income approach range from a clear-cut discounted cash flow approach to complex Monte Carlo Simulation models addressing the probability that cash payments will be earned and paid out. It is also common to see probability-weighted return methodology applied within an income approach to valuing earnouts.  The additional difficulty was that actual future performance could not be considered in valuing the earnouts.  Only facts known or knowable as of the date of the sale could be considered in the valuation of the earnout.

In this case, the potential future benefit streams were probability weighted and then discounted using a discount rate that was derived from the actual transaction and then adjusted.  The adjustments included consideration of additional risk factors such as transaction risk (the risk that the relationship between seller and buyer would deteriorate and/or that the additional compensation to the seller will actually be difficult for the company to honor) and performance risk (the risk that the business simply cannot achieve growth rates that exceed those contemplated in the original deal).

Result: An opinion of value was determined and accepted. The case settled and expensive litigation was avoided.

#5: Purchase Price Allocation

Type of Matter: A competitor business purchased 100% of the outstanding stock of a successful closely-held business.  The business effect of the combination capitalized on synergies that would have been dormant had the businesses not joined forces. Shortly after the transaction was completed, the buyer’s auditors informed management that GAAP standards required an independent valuation report allocating the purchase price between tangible and intangible assets.

Background: When a business is acquired, accounting rules dictate how the transaction is to be disclosed for financial statement purposes.  FASB ASC Topic 805Business Combinations (ASC 805) is the definitive guidance on business combinations for reporting all items related to the transaction in financial statements. ASC 805 is a comprehensive guideline for establishing the principles and requirements for how an acquirer recognizes and measures identifiable assets, recognizes and measures either goodwill or gain from a bargain purchase, and the disclosures to be made in the financial statements.

Arxis Financial work: First, even though a transaction just took place, the entire business enterprise must be valued under the specific guidelines of ASC 805. This is in recognition of the concept that price, value and proceeds are potentially very different.  It is common for the enterprise valuation under ASC 805 to present a different value than the actual purchase price. This has to do with the potential for different standards of value in play during the deal than required under generally accepted accounting principles.

In this case, the buyer financed the purchase price with cash, preferred stock, notes, and assumption of debt. All those elements, particularly the preferred stock, presented complex valuation issues. Historical data was barely looked at during the transaction negotiations since the driver of the deal was the potential synergy of the combined operations. Therefore, the enterprise valuation under ASC 805 was prepared based on those projections.  An enterprise value was determined using a Discounted Cash Flow approach which was supported and consistent with the results of using the market approach (private company transactions).

Once the enterprise value was determined, an allocation to tangible asset value was made and the remainder was, of course, intangible value. ASC 805-20-25-10 requires that, “The acquirer shall recognize separately from goodwill the identifiable intangible assets acquired in a business combination. An intangible asset is identifiable if it meets either the separability criterion or the contractual-legal criterion described in the definition of identifiable.”  Extensive work was done to determine those intangible assets that met the criteria for identification and valuation, and then to apply the appropriate valuation methodology to placing a value on customer and vendor relationships, patents, trademarks, non-compete agreements, and employment agreements.

Result: A valuation report was issued (several hundred pages) and reviewed extensively by the auditors and their in-house valuation experts. The report was accepted without change and financial and tax reporting of the transaction was prepared based on the Arxis Financial valuation report.

#6: Valuation for Portion of Business Ownership to be Donated

Type of Matter: A non-control owner of a privately-held business wanted to donate a portion of her shares to a charitable organization. Time was short since there were several potential buyers approaching the business and it appeared that the business might sell pretty quickly.

Background: Depending on the size of the donation, the IRS requires a qualified appraisal of the common stock to substantiate the deduction. Large donations require that the valuation report be submitted with the tax return. The standard of value for tax valuations is “Fair Market Value.” IRS Revenue Ruling 59-60, Section 2.02 defines Fair Market Value as follows:

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.

Arxis Financial work: Two issues had to be addressed as the project developed. One was the premise of value. In most FMV valuations, the premise is “going concern” meaning that the business is assumed to continue in its present form in perpetuity. However, as the work progressed it became obvious that the business was likely to sell pretty quickly. Therefore, the valuation of the enterprise (a necessary first step) was prepared on the going concern premise and the non-control interest being donated was valued using a liquidation premise since the owner was going to be bought out and the interest would no longer exist. The practical implication of this was there were no discounts taken for lack of control and the consideration of marketability discounts was very slight. Both decisions are unusual when valuing a small minority interest in a closely-held business but perfectly appropriate given the circumstances.

The second issue was also posed by the imminent sale. There were several written letters of interest from potential buyers that included details of proposed terms and consideration. To the extent the offers are arms-length and serious they are a reasonable and even persuasive estimate of the Fair Market Value of a business. Here, because of the probability of a transaction very soon after the donation there was almost no choice but to use them to value the enterprise. The complexity arose due to IRS case law and regulations that state that personal goodwill cannot be donated. To the extent that consideration for the sale included covenants not to compete, earnouts, and compensation contracts for existing shareholders the prices considered to value the business must be allocated between personal and business goodwill. Using the assumption that the sale would take place and that the letters of interest reflected what the terms of the deal would eventually be, analysis and allocations of selling price to compensation for personal goodwill were excluded from the value conclusion.

Result: After determining the above fundamentals for the valuation of the enterprise, Arxis Financial completed the valuation on a timely basis and within budget. The report was accepted without change and financial and tax reporting of the transaction was prepared based on the Arxis Financial valuation report.

#7: Avoiding Litigation When Shareholders Leave

Type of Matter: A non-control owner/employee of a closely-held business was terminated as an employee and the other owners wanted to terminate the shareholder relationship, too. This was a matter that was wrapped in bad feelings and clearly heading for litigation to resolve the issue of how much the “out” partner was to be compensated for his/her shares.

Background: A shareholder dispute in a closely-held company is often referred to as a corporate divorce. The only real difference to the emotional difficulties of divorce cases in family court is that there are no children involved. Although, for some business owners the business might as well be called another child for all the similarities in sensitivities exposed in a dispute over the ownership and value of their “baby.”

Arxis Financial was retained by the remaining owners to place a value on the business primarily for the purpose of settling the case. Our clear instructions were to be fair to all sides, objective, and to prepare a compelling case supporting our opinion – whatever it was. It was our clients’ intent to share our report with opposing counsel in the hopes that the report and its conclusion would be persuasive enough to serve as the basis for agreement before formal litigation commenced. Unfortunately, there was no written shareholder agreement and there were several versions of what the oral agreements might have been.

Arxis Work: The financial history of the business was irregular and profitability was volatile. Consequently, historical results could not be relied upon to value the business so we asked for projections. There was no agreement among any of the partners as to what the economic future of the business would be. As a result, Arxis Financial looked pretty deeply at market transaction databases to identify similar private companies that had sold. While some were found that could serve as a means to value the company, we were dissatisfied with the persuasive nature of that evidence.

Arxis Financial had also asked for details about the buy-in transactions for current owners, as well as shareholder buy-out transactions over the history of the company. When analysis was done comparing the values in those transactions to current underlying operational metrics (sales, net income, EBITDA) a very compelling relationship was established that coincided with the multiples we found in market transactions that were obtained from independent transaction databases. Now we had a compelling story to tell.

Result: The valuation report was prepared, issued, and distributed. As a result, the valuation issues were negotiated and resolved before lawsuits were filed.

#8: The Impact of Valuation Errors on Estate Planning

Type of Matter: A large closely-held business had engaged expensive attorneys and valuation experts to facilitate a complex multi-year and phased gifting and estate plan commensurate with a large estate. The first five years into the implementation of the plan produced unusual results and the forecasted long-term results of a fully implemented gifting plan caused the board of directors to seek a second opinion.

Background: Arxis Financial was retained to prepare a current valuation and to prepare analysis of the previous reports and calculate values as of the previous dates using current assumptions. The board of directors had obtained two valuations over the five years of the plan. The company value dropped over 20% between those two valuation dates even though there had been little change in the operations. The board retained Arxis Financial to review prior valuation reports to provide affirmation of the value conclusions and the methodologies employed to arrive at the values.

Arxis Financial Work: Arxis Financial was retained to prepare a current valuation and to prepare analysis of the previous reports and calculate values as of the previous dates using current assumptions. We found several anomalies that clearly demonstrated that the company was being vastly overvalued and that the estate plan was completely overblown for the size of the business.

The valuation errors ranged from basic mistakes to subjective judgments that vastly misstated the reality of the business enterprise and the fractional interests being valued/gifted:

  • An after-tax risk rate was used to value pre-tax income. This is a common error that results in a theoretically inaccurate conclusion.
  • Risk rates (capitalization and discount) appropriate to value very large public companies were used to value the income of a comparatively tiny company.
  • The appraiser added back marketable securities held by the company as non-operating assets without asking management about the investments. Management inquiry would have prevented that mistake.
  • Discounts for lack of control and marketability for fractional interests in the business were negligible.

Result: Arxis Financial’s conclusion was that the business was overstated by more than 300%. As a result the complex gifting plan was abandoned, multiple prior gift tax returns were amended, and the estate plan was restructured to more reasonably reflect the size of the estate.

#9: Avoiding Litigation When Shareholders Leave

Type of Matter: A non-control owner/employee of a closely-held business was terminated as an employee and the other owners wanted to terminate the shareholder relationship, too. This was a matter that was wrapped in bad feelings and clearly heading for litigation to resolve the issue of how much the “out” partner was to be compensated for his/her shares.

Background: A shareholder dispute in a closely-held company is often referred to as a corporate divorce. The only real difference to the emotional difficulties of divorce cases in family court is that there are no children involved. Although, for some business owners the business might as well be called another child for all the similarities in sensitivities exposed in a dispute over the ownership and value of their “baby.”

Arxis Financial was retained by the remaining owners to place a value on the business primarily for the purpose of settling the case. Our clear instructions were to be fair to all sides, objective, and to prepare a compelling case supporting our opinion – whatever it was. It was our clients’ intent to share our report with opposing counsel in the hopes that the report and its conclusion would be persuasive enough to serve as the basis for agreement before formal litigation commenced. Unfortunately, there was no written shareholder agreement and there were several versions of what the oral agreements might have been.

Arxis Work: The financial history of the business was irregular and profitability was volatile. Consequently, historical results could not be relied upon to value the business so we asked for projections. There was no agreement among any of the partners as to what the economic future of the business would be. As a result, Arxis Financial looked pretty deeply at market transaction databases to identify similar private companies that had sold. While some were found that could serve as a means to value the company, we were dissatisfied with the persuasive nature of that evidence.

Arxis Financial had also asked for details about the buy-in transactions for current owners, as well as shareholder buy-out transactions over the history of the company. When analysis was done comparing the values in those transactions to current underlying operational metrics (sales, net income, EBITDA) a very compelling relationship was established that coincided with the multiples we found in market transactions that were obtained from independent transaction databases. Now we had a compelling story to tell.

Result: The valuation report was prepared, issued, and distributed. As a result, the valuation issues were negotiated and resolved before lawsuits were filed.

#10: Reviewing and Critiquing a Valuation Report

Type of Matter: A business valuation was prepared immediately before a complex stock transaction was finalized. That valuation report was later scrutinized in response to a claim that it was improper and erroneous.

Background: A complex stock-for-stock transaction was contemplated between owners of a closely-held business involving over 20 subsidiaries. In contemplation of that transaction, the company retained a valuation expert to place a value on a portion of the business. The transaction was consummated at the value determined by that expert. Subsequently, the valuation conclusion was challenged and Arxis was retained to evaluate the report.

Arxis Work: A copy of the complete report and all documentation that was originally supplied to the valuation expert was provided to Arxis. With that information we attempted to replicate the calculations, assumptions, and conclusions presented in the report. As a result, numerous substantial errors were identified. It was a collection of some of the most common valuation errors wrapped up in one report:

  • An invested capital risk rate (WACC) was used to value a cash flow to equity benefit stream. This, by definition, results in an incorrect conclusion.
  • The expert properly concluded that public companies were inappropriate to use as guideline companies. However, throughout the rest of the report public companies were used to project cash flow, capital expenditure levels, and working capital.
  • Public company data was used to determine the WACC rate for the subject company. This was inappropriate given the conclusion that public companies were not comparable to the subject company.
  • The expert did not consider, or adjust for, non-operating assets and non-operating income and expenses.
  • The sale of similar privately held companies (Market Approach) was not considered. This was problematic since there were hundreds of transactions in the same SIC code as the subject company available.
  • Prior transactions (several) of company stock were not considered.

Result: The report was so flawed that all parties agreed it had to be set aside and a new valuation performed. A substantial amount of money had been spent on a valuation that was flawed on every level.