The New York Court of Appeals’ Ruling on Congel v. Malfitano and Its Implications

On March 27, 2018 the New York Court of Appeals applied effective discounts and deductions amounting to 81.22%, or $3,938,928 on a 3.08% minority partnership interest in a partnership wrongful dissolution matter. The partnership, Poughkeepsie Galleria Company, owns, operates and manages a shopping mall, the Poughkeepsie Galleria Mall. We were not provided with any of the valuation reports related to the matter, and you know what they say about assuming. The standard of value utilized by the Court was going concern value, with a reduction for goodwill and discounts for a minority interest and lack of marketability.

Background

The case involves a minority partner who the court determined wrongfully dissolved their partnership. The remaining partners continued the partnership’s business. NY Partnership Law § 69(2)(c)(II) was applied to the case, which states that when a partner dissolves a partnership in contravention of the partnership agreement, and the remaining partners continue the business in the same name, the dissolving partner has “the right as against his copartners . . . to have the value of his interest in the partnership, less any damages caused to his copartners by the dissolution, ascertained and paid to him in cash . . . but in ascertaining the value of the partner’s interest the value of the goodwill of the business shall not be considered.”

In Congel v. Malfitano, the Court of Appeals applied the following deductions and discounts: 15% for goodwill, 35% for DLOM, and 66% for DLOC; resulting in effective deductions of 81.22%. No details were provided regarding how the business value (before deductions) was derived. The Plaintiffs’ valuation expert testified that the value of the Partnership included goodwill of 44%, and that a marketability discount of 35% and a minority discount of 66% applied to the matter. The Defendant’s valuation expert testified that the Partnership, a real estate holding company, did not possess goodwill, that a minority discount was not applicable when determining fair value, and that a 25% marketability discount applied to the matter.

New York Business Corporate Law §623(h)(4), which pertains to the procedure to enforce a shareholder’s right to receive payment for shares (for corporations and not partnerships), states “if the corporation fails to make such offer within such period of fifteen days, or if it makes the offer and any dissenting shareholder or shareholders fail to agree with it within the period of thirty days thereafter upon the price to be paid for their shares…The court shall determine the fair value of the shares without a jury and without referral to an appraiser or referee.  Upon application by the corporation or by any shareholder who is a party to the proceeding, the court may, in its discretion, permit pretrial disclosure, including, but not limited to, disclosure of any expert’s reports relating to the fair value of the shares whether or not intended for use at the trial in the proceeding”.

The Appellate Division relied on Anastos v. Sable for guidance on its decision. Anastos v. Sable is a Massachusetts wrongful dissolution of a partnership by a minority shareholder case. The related Company was a real estate holding company located in a jurisdiction possessing a similar regulation excluding the value of the goodwill of the business in the settlement. In the Anastos v. Sable matter, the value of the net assets of the partnership were $2,494,005, indicating utilization of a cost approach in valuing the entity. The judge applied a discount of 40% to obtain what was termed “a minority interest going concern value” for a 33.33% partnership interest, with no mention made of a deduction for goodwill.

Goodwill and Going Concern Value

Lynda J. Oswald, in her article “Goodwill and Going-Concern Value: Emerging Factors in the Just Compensation Equation”[1] sheds light on the goodwill and going concern topic. Her article originated from eminent domain proceedings and the related recovery of business losses. Oswald identifies goodwill and going concern value as closely-related, but separate, components of business value. With goodwill relating to the value which inheres in the fixed and favorable consideration of customers, rising from an established, well-known, well-conducted business that create an expectancy of earnings in excess of the normal returns on the tangible assets, and going-concern value created by such factors as avoidance of start-up costs, increased operating efficiency, and increased marketing and administration efficiencies. Goodwill reflects the existence or expectation of excess earnings, while going-concern value reflects the ability of an ongoing business to realize a higher rate of return than a newly established one. The Appellate Division decision appears to relate strongly to these concepts.

In addition to the legal foundation previous mentioned, my research on this topic identified that the SBA requires (in specified cases) going concern special purpose property appraisals be obtained from experienced and qualified appraisers.[2] Special purpose properties are limited market properties with unique physical designs, special construction materials, or layouts that restrict their utility to the specific use for which the property was built. Their appraisals allocate separate values to the individual components of the transaction including land, building, equipment and intangible assets. Paul R. Hyde, EA, MCBA, ASA, ASA, MAI has written similarly on the topic in his article “Valuing Real Property Going Concerns”[3], and Mark T. Kenney, MAI, SRPA, MRICS, MBA in his article “Shopping Mall Valuation: Is There Intangible Value to Extract?”[4] discusses the issue of intangible assets related to shopping mall real estate. If you haven’t guessed it by now, going concern special purpose property and real property going concern appraisals are a complex area of valuation, requiring real estate appraisal as well as business valuation competencies.

Implications

Without copies of the Congel v. Malfitano valuation reports, we are unable to determine with certainty whether they were going concern special purpose property or real property going concern appraisals. Based upon the history of the matter, my hypothesis is they were not. The Congel v. Malfitano decision underscores the importance of fully understanding the purpose of a valuation assignment and the applicable laws relating to the matter, as well as in seeking guidance on the appropriate appraisal for your case.

This article was intended to provide commentary on a controversial, recently decided valuation matter and does not constitute legal advice. If you have any questions or comments relating to this topic, please contact me at eonischuk@adventvalue.com.

[1] Lynda J. Oswald, Goodwill and Going-Concern Value: Emerging Factors in the Just Compensation Equation, 32 B.C.L. Rev. 283 (1991), http://lawdigitalcommons.bc.edu/bclr/vol32/iss2/1.

[2] SOP 50 10 5(H), SBA, https://www.sba.gov/sites/default/files/sops/SOP_50_10_5_H_FINAL_FINAL_CLEAN_ 5-1-15.pdf.

[3] Paul R. Hyde, EA, MCBA, ASA, ASA, MAI, Valuing Real Property Going Concerns, American Society of Appraisers, http://www.appraisers.org/docs/default-source/discipline_rp/hyde-valuing-real-property-going-concerns.pdf?sfvrsn=0.

[4] Mark T. Kenney, MAI, SRPA, MRICS, MBA, Shopping Mall Valuation: Is There Intangible Value to Extract?, American Society of Appraisers, http://www.appraisers.org/docs/default-source/discipline_rp/shopping-mall-valuation-is-there-intangible-value-to-extract-.pdf?sfvrsn=0.

Considerations in Hiring a Forensic Accountant

Hiring a forensic accountant requires due diligence. Your forensic accountant will be providing services to you during a stressful situation, during which they will be conducting an investigation and providing findings related to your matter; and possibly providing guidance to favorably structure a settlement that protects your interests, and delivering testimony that clarifies uncertainties, confirms the accuracy of your position, and succeeds in securing the proper settlement of your case. Forensic accountants impartially and objectively apply accounting, financial analysis, and investigative skills to determine facts, conduct financial investigations, and provide credible analyses and reports that may be relied upon in court, arbitration, and mediation, or by other parties to a matter. They may be called upon to deliver expert witness testimony in depositions, arbitration, mediation, and/or trial settings. This article provides guidance on the factors to consider in your selection of a forensic accountant including personal qualities, experience, credentials, costs, staffing, and resources available to assist in your hiring decision.

Identifying Forensic Accountants

Forensic accountants should possess experience in accounting and financial analysis, strong ethics, discretion, sensitivity, sound professional judgment, curiosity, effective listening, and clear communications skills. They must be able to contemplate alternatives and scrutinize fine details, while maintaining a big picture perspective. While computer forensics is a specialty of its own, a forensic accountant should possess strong, relevant computer skills, or a staff that does, and a complete understanding of how the results of their analyses were derived. Because your forensic accountant may be asking difficult questions while delving into the most highly sensitive, personal and financial details of your life, and their job is not to tell you what you want to hear, but to tell you what you need to hear, it is paramount that the professional you hire is someone whom you not only feel confident in, but are comfortable working with, feel listened to and respected by, and that is capable of understanding and looking out for your best interests.

Experience and professional credentials are two important factors to consider in hiring a forensic accountant. What is their forensic accounting experience? Is this professional familiar with the industry and its nuances, or a similar industry to yours? If not, can they readily obtain this understanding from you or other sources? Have they been deposed and/or provided expert witness testimony before? In the event that your matter proceeds to litigation, does this professional possess the qualifications and utilize the accepted methodology and reasoning to have their analyses, report, or testimony accepted by a trier of fact, mediator, or arbitrator, or will their work be rejected? Do you feel confident they possess the ability to clearly and logically articulate your case before a judge and/or jury, should that occur? Do they possess experience in assisting in structuring settlements?

Forensic accounting experience can be obtained from a variety of sources. Examples include internal audit, government examinations/investigations (ex. IRS, FBI, and SEC), as well as experience with a forensic accounting and litigation support department for a consulting or public accounting firm, a fraud department, a law firm, an insurance company, or a financial institution. A review of the forensic accountant’s resume/CV and/or LinkedIn profile will provide this information. How much experience is sufficient? There is no simple answer, and in fact, a less-experienced forensic accountant, possessing no previous similar-case bias, may ask the very questions or delve into the specific information that is the key to solving your financial puzzle!

Request a sample work product that corresponds to an engagement similar to yours, to review and understand what you can expect to receive. You may only be permitted to review this document on site, and may not obtain a copy, in order to protect the forensic accountant’s processes and work product. Do you understand the sample provided or is it confusing? Are the associated analyses and exhibits clear and logical? Be sure that the sample you review contains clearly supported conclusions.

Forensic Accounting in Litigation

In the event your case does not settle and proceeds to litigation, you will need a forensic accountant that is able to represent you. During your meeting, carefully observe your interaction with the candidate to determine if you feel confident they will be able to clearly and logically explain your case before a judge and/or jury, should that should occur. Find out if the candidate has ever been deposed and/or provided expert witness testimony. If so, did this professional possess the qualifications and utilize the accepted methodology and reasoning to have their analyses, report, or testimony accepted by a trier of fact, mediator, or arbitrator? A Daubert challenge is a hearing conducted before a judge where the validity and admissibility of expert testimony is challenged by opposing counsel. A Daubert challenge relates to the admissibility requirements in Federal Rule of Evidence 702, which state “A witness who is qualified as an expert by knowledge, skill, experience, training, or education may testify in the form of an opinion or otherwise if: a) the expert’s scientific, technical, or other specialized knowledge will help the trier of fact to understand the evidence or to determine a fact in issue; b) the testimony is based on sufficient facts or data; c) the testimony is the product of reliable principles and methods; and d) the expert has reliably applied the principles and methods to the facts of the case.” Has the candidate successfully defended a Daubert challenge, if one occurred?

The financial settlement of your case may have short and/or long-term tax repercussions that require thoughtful consideration, as you will be living with the results of this legally agreed to and binding settlement. The financial settlement process occurs at the end of your case, during a time you are emotionally exhausted and may feel ready to throw in the towel, to end your matter and move forward with your life. Other parties involved with your case may be applying pressure to end your case. This is the time you require wise advice to make an informed decision to protect your financial interests and future. A forensic accountant can provide guidance on the different settlement options available and their potential ramifications, sometimes suggesting creative ways to settle a case to the mutual satisfaction of the parties. The candidates you are considering should be able to discuss the ways they can support you at this juncture. Should your forensic accountant lack this experience, you will need to consult with an accountant who is familiar with your financial circumstances and wishes, to protect your interests during this process.

While a credentialed forensic accountant is not a guarantee of quality, it provides some level of assurance and provides legitimacy before a trier of fact, should your case proceed to trial. Some common forensic accountant professional credentials include CPA, CFE, CFF, and MAFF. More details about these credentials will appear in a future article.

Forensic Accounting Costs

After experience and professional credentials have been considered, we consider the all-important factor, cost. The Benjamin Franklin quote “The bitterness of poor quality remains long after the sweetness of low price is forgotten” applies in hiring any professional, and the hiring of a forensic accountant is no exception. While hiring a forensic accountant to represent parties jointly may save money in the short run by avoiding the duplication of forensic accounting fees by the parties, the professional will not advocate for one party over the other during the settlement process. This may or may not be in your best interest. Be sure to think this over carefully, before agreeing to joint representation, if it is applicable.

Forensic accounting deals with unknowns and a multitude of variables, with no guaranteed outcome. Typically, at the outset of a case, the final scope and cost cannot be determined with accuracy, but with an estimate generally requiring revision as the case proceeds. As the initial case work begins, it is common to discover that more work will be required than what was originally assumed, for those very reasons that only come to light as the forensic accounting work is performed. Therefore, it is important to understand what specific costs are involved in your case and what you can expect to receive for those costs. An understanding of what you might do, or not do, to keep costs down is equally important. It is critical that you provide organized information, in the format and within the requested confines, as is required by your forensic accountant, with the understanding that you are contributing to rising fees if you do not. Be prepared to communicate your anticipated budget with the prospective forensic accountant and once hired, to discuss case milestones and unanticipated hurdles openly to avoid any unpleasant surprises. This underscores the importance in hiring someone you feel comfortable working with, as you may be having difficult, uncomfortable conversations with the forensic accountant regarding fees that will be incurred to properly represent your interests.

Staffing/fees, resources and technology available will contribute to your end costs. What components of the engagement will the person you hire be performing, and what parts, if any, will be delegated to staff at different levels and billing rates? If you desire that only the person you hire works on your engagement, consider that you may be paying more for this. What qualifications do “other staff” that may be working on your engagement possess? Will staff be adequately supervised, and their work properly reviewed, to ensure that you receive an error free analysis and report? What resources and technology does the forensic accountant have access to, and how will they be utilized? Discuss the industry and other resources that might be used in your case. Is their technology up to date and compatible with yours? If their technology is not up to date or compatible with yours, additional fees may be incurred to resolve these issues. Details on the different fees relating to your engagement, and for the staff/service levels provided should be discussed and provided in writing.

This article was intended to provide guidance in the selection of a forensic accountant by discussing the personal qualities, experience, credentials, costs, staffing, and other available resources to consider during the decision making process. If you have any questions or comments relating to this topic, please contact me at eonischuk@adventvalue.com.

The Impact of the New Tax Law on Value

There has been a lot of talk about the tax law that has been signed into law and is in now in effect, mostly in terms of who benefits and what impact it will have on the economy and the Federal deficit. But the new tax law also impacts the value of businesses and may explain a good portion of the run-up in public stock prices. How? There are three basic drivers to value: Returns, Growth, and Risk. The new tax law directly impacts the first drive, returns, and indirectly impacts the second driver, growth.

Under the new tax law the corporate tax rate has been reduced from 35% to 21%. From a value perspective, this translates into higher company after tax profitability. For example, a company that reports pretax profits of $1 million will have net income (after taxes) of $790 thousand under the new tax law – up from $650 thousand under the old tax law.

How does this impact value? The following simplified computation illustrates the impact. For illustration purposes, let’s assume a required rate of return for the business (or capitalization rate), which captures risk, is 10%. That is, investors demand a 10% return on this investment based on the perceived risk in the profits continuing, given some expected growth. Under the 2017 tax rate of 35%, that implies a value of $6.5 million. But with a lower tax rate of 21% in 2018, that value goes up to $7.9 million, or a 22% increase in value resulting from lower tax rates.

 

But wait, there’s more. If tax cut proponents are to be believed, lower taxes, both personal and corporate, will spur economic growth as individuals and companies have more after tax income to spend. Increased demand increases business activity and businesses have more profits after taxes to reinvest. So let’s assume that profits grow 10% as a result of stronger economic activity. Pretax profits grow from $1 million to $1.1 million and net income (after the lower tax rates) grows from $650 thousand to $869 thousand. (see below). That implies an increase in value of 34%!

 

What about other businesses that have some sort of pass through tax status such as S-Corporations, LLCs and partnerships? While after tax profits will go up, the new tax law is not nearly so clear on how much, though it will likely not be near the reduction available to C-Corps. Consequently, increases in the value of pass through tax entities need to be considered on a case by case basis.

Valuing Personal Goodwill

We recently have been involved in a number of valuation assignments which involved the allocation of personal and enterprise goodwill.

In valuing a business, the term “goodwill” may have different meanings. In many cases, goodwill is used as a catch-all for all intangible assets of a business. However, from a valuation perspective, goodwill is, “the excess value of an enterprise beyond the value attributable to the entity’s identifiable net assets.”

In this blog article, we approach goodwill in the more general sense, referring to any and all value of a business that is not attributable to the business’s current assets (cash, accounts receivable, etc.) or its tangible assets (inventory, furniture, equipment, etc.). Overall goodwill can be further broken down to enterprise goodwill (also known as “business goodwill”) and personal (or professional) goodwill.

  • Enterprise goodwill is derived from characteristics specific to a particular business, regardless of its owner or employees working within the business.
  • Personal goodwill is value associated with a particular individual working within the organization, rather than the characteristics of the business itself.

Some of the indicators of enterprise and personal goodwill are as follows:

From a valuation standpoint, one might question why the division between personal and enterprise goodwill matters. In fact, it depends on the purpose of the valuation, in many cases goodwill (personal or enterprise) is not allocated from overall company value. The total goodwill of the business is merely incorporated as part of its total enterprise value.

For example, for a valuation prepared for gift or estate tax purpose we usually determine the company’s total value as a going concern. The resulting value often exceeds the value of the company’s tangible and monetary assets, indicating the existence of goodwill. However, the resulting goodwill is rarely further analyzed and allocated into the enterprise and personal goodwill.

Similarly, under GAAP accounting rules, goodwill on the balance sheet represents the premium for buying a business above and beyond the identifiable assets of that business. Accountants take the purchase price and subtract the fair value of company’s identifiable tangible and intangible assets. What is left, and cannot be allocated, is goodwill. For this purpose, personal goodwill is not considered a separate asset, except as it may be captured in the value of a non-compete agreement.

In other cases, like the sale of a business, the distinction between enterprise and personal goodwill could matter. One such case would be to assist in structuring a business transaction. In an acquisition, it may be beneficial to segregate out personal goodwill, since a buyer paying proceeds directly to the seller specifically for the personal goodwill (rather than as proceeds for the value of the company).

Another reason for delineating personal and enterprise goodwill pertains to the process of evaluating the total consideration to be paid by the purchaser of a business. A buyer will be willing to pay only for the portion of the intangible value of an enterprise that can be transferred upon consummation of the transaction. Based on the characteristics detailed above, this often results in only enterprise goodwill continuing with the purchaser. However, a transaction can be structured such that a portion of the personal goodwill, and its associated benefits, can transfer to the acquirer. This is often completed through the use of employment agreements.

Once the existence of personal goodwill has been identified, the next step is to calculate its value. This is generally accomplished using the “with and without” method.

The with and without method of determining personal goodwill is an income approach that attempts to value a business using two scenarios:

  • with the particular individual continuing to work in the business, and
  • without the individual’s continuing involvement.

The with and without method utilizes cash flow models to project the revenues, expenses and net cash flows that a business would expect to realize under each scenario. Under the “with” scenario, the projections usually reflect the overall assumptions and cash flow projections for the business “as is.” As a result, this scenario includes the value attributable to personal goodwill of the subject key individual.

The “without” scenario assumes that the enterprise would earn less revenue due to the loss of the subject individual. While the model may also assume that the subject company could hire a replacement for the key individual, most experts assume that it would take several years until the new individual could generate revenues and earnings comparable to those generated by the departing individual. Therefore, this scenario reflects a lesser value due to the entity’s loss of involvement by the individual.

Treasury Dept Considers Eliminating 2016 Rule on Valuation Discounts

On July 7, 2017 the Treasury Department published a notice proposing to revoke eight tax regulations (Notice 2017-38). The notice is in response to an executive order designed to reduce tax regulatory burdens issued by President Trump in April. Executive Order 13789 instructed the Treasury Secretary to review all “significant tax regulations” issued on or after Jan. 1, 2016, and submit two reports, followed promptly by actions to alleviate the burdens of regulations that meet criteria outlined in the order. Trump directed the Treasury Secretary Steven Mnuchin – in consultation with the Administrator of the Office of Information and Regulatory Affairs – to submit a 60-day interim report identifying regulations that impose an undue financial burden on U.S. taxpayers, add undue complexity to the federal tax laws, or exceed the statutory authority of the Internal Revenue Service. The order further instructs the Secretary to submit a final report to the President by Sept. 18, 2017, recommending “specific actions to mitigate the burden imposed by regulations identified in the interim report.”

The Notice reports points out that the Treasury and the IRS issued 105 temporary, proposed and final regulations between Jan. 1, 2016, through April 21, 2017. Of those, about half were minor or technical in nature and generated only minimal public comment. The Treasury treated the remaining 52 regulations as potentially significant and reexamined all of them for the purpose of compiling an interim report. Based on its review, the Treasury concluded that 8 of the regulations meet at least one of the first two criteria specified by Trump’s executive order. It intends to propose reforms to these regulations, ranging from streamlining problematic provisions in rules to full repeal of the rules in order to eliminate or reduce the burden of compliance to the regulations in a final report to President Trump.

Of interest to business owners, business appraisers and estate planners and other trusted business advisors is the Notice’s inclusion of the proposed but yet to be implemented regulations on restrictions on liquidation of an interest for estate, gift and generation- skipping transfer taxes (REG-163113-02; 81 F.R. 51413).

Section 2704(b) of the Tax Code provides that certain non-commercial restrictions on the ability to dispose of or liquidate family-controlled entities should be disregarded when determining the fair market value of an interest in the entity for estate and gift tax purposes. The proposed regulations would create an additional category of restrictions that also would be disregarded in assessing the fair market value of an interest.

Some people who commented expressed concern that the proposed regulations would eliminate or restrict common discounts, such as minority discounts and discounts for lack of marketability, which would result in increased valuations and transfer tax liability that would increase financial burdens. Commenters were also concerned that the proposed regulations would make valuations more difficult and that the proposed narrowing of existing regulatory exceptions was arbitrary and capricious. The Treasury Department is accepting public comments concerning this and the other proposed 7 regulation modifications or eliminations through August 7, 2017.

Advent has 25 years of experience preparing valuations and discount analyses for estate tax, gift tax, and charitiable contribution purposes. Contact us if we can be of service to you.

Does “4 Ways to Grow Your Business” translate to increased value? (Part 3)

In this last post on the topic of how growing your business can increase value, let’s look at the last two strategies proffered by pundits.

The second way to grow your business is to increase the transaction frequency. This strategy relates to improving customer loyalty and increasing customer retention. It is nearly always more expensive to obtain a new customer than it is to get an existing customer to do more business with you. Fred Reichheld, in his book, The Loyalty Affect states that “a 5 percent improvement in customer retention rates will yield between a 25 percent to 100 percent increase in profits across a wide range of industries.” While I’m not sure of Mr. Reichheld’s math, certainly if the marketing costs to get an existing customer to do more business with you are minimal, then all that gross profit goes right to the bottom line.

The first way to grow your business is to increase the number of customer (of the type you want). Not all customers are created equal. Analyze what customers are the most profitable, whether by market segment, product segment, or some other classification, and focus on obtaining more of these types of customers. Some even suggest reviewing your customers annually, classifying them in terms of A/B/C/D and then “firing” your D clients. The amount of time and money you spend on them can be better spent on developing more profitable relationships.

So, going back to our original discussion of value (using the simplistic model below and assuming a stable operating company), growing your business prudently by using the three revenue growth strategies we’ve discussed, will increase the value of your company. How? Increasing the expected economic benefit, whether measured in profits or cash flow, without increasing the required rate of return (or the risks of those economic benefits occurring) and robbing the future’s growth.

Value = Expected Economic Benefit* divided by (Required Rate of Return less Expected Growth)

               *Economic benefit can be some measure of income or cash flow

Let us know if we can help you discover the value of your company and assist you in identifying what drives its value.

Does “4 Ways to Grow Your Business” translate to increased value? (Part 2)

In part one of this post I presented a very simplistic value model and showed how the fourth way to grow your business, increasing the effectiveness of each process in your business, provides opportunities, though limited, in growing value. What about the third way, increasing the average sale?

How can the average transaction size be increased? Basically two ways:

First you can cross sell or up sell an existing transaction. Dell does this every day by offering upgrades, add-ons, installation, expanded support and warranty programs during the on-line shopping experience. So do the big box retailers, when they try to sell extended warranty and maintenance plans on electronics and appliances.

Second, you can raise your prices. Most business owners react to that suggestion with the response, “I’ll lose customers!” That may or not be true. And unless you know which customers you might lose and how many (or what economists call elasticity of demand), you can’t know if this is a viable strategy. For example, if your price-sensitive customers purchase the lowest margin products or services, and they’re the ones who will leave, raising your prices will increase your profit margins two ways…first by eliminating the low margin transactions, thus raising your average margin, and second, by increasing the margin on the customers who are not as price sensitive. The key is measuring whether or not the increase in margin for the remaining sales is greater than the loss of margin on the lost sales.

So how will increasing average transaction size affect value?

Let’s look at what happens to the financial performance of a business if average transaction size goes up:

  • Revenues increase
  • Gross profits increase (because of increased volume and/or better pricing)
  • Net profits increase (most operating expenses will not be affected by this strategy, so much of the benefit goes right to the bottom line.

Given such (and again assuming a stable operating company environment) you’ll increase the economic benefit (in this case profits), which grows the numerator in the value model and you’ll increase the growth rate, which decreases the denominator in the value model – both of which will increase value.

This is part two of a three part series of blog posts on this topic.

Does “4 Ways to Grow Your Business” translate to increased value? (part 1)

Many consultants talk about the 4 ways to grow your business. The 4 ways they quote are:

1. Increase the number of customers (of the type you want);
2. Increase the transaction frequency;
3. Increase the transaction value or “average sale”;
4. Increase the effectiveness of each process in your business.

But does growing your business increase its value, and if so, how do these concepts increase value? Let’s break this down into bite-sized pieces.

First, let’s talk about measuring value. Very simplistically, let’s assume that for a stable operating business, measuring value can be stated as:

Value = Expected Economic Benefit* divided by (Required Rate of Return less Expected Growth)

*Economic benefit can be some measure of income or cash flow

Mathematically, anything that increases the economic benefit, reduces the required rate of return for that economic benefit, or increases future expected growth in that benefit will increase value.

Second, what about each growth strategy’s effect on business value? Let’s start at the bottom and work up. There can be two results of growing your business the fourth way, “increasing the effectiveness of each process in your business.”

First, you reduce costs. If you reduce costs, all other things remaining equal, you improve profits, which will increase value (by growing the numerator in our simplistic value measurement model).

Second, you increase capacity; you can do more with the same resources if you are more efficient, so you can grow without increasing costs. More revenues with same costs mean more profits, again increasing value. This second result also will affect growth, which also increases value by decreasing the denominator in the formula. Of course we’re assuming here the operational risks are not increased.

One caveat here – you can only improve efficiencies so much. So while you can increase value through increased efficiencies, the increase is limited. Long term and material increases in value have to come from the other three ways to grow the business.

This is part one of a three part series of blog posts on this topic.

Reasonable Certainty in Economic Damages

The first case that required my testimony in court 18 years ago involved economic damages from a failed real estate transaction. Retained by the Plaintiffs attorney, I calculated the loss sustained as a result of the actions of the defendant. The plaintiff, using a contract sale, purchased an old independently run RV campground from the defendant. The property was on a desert road that had long since lost its high traffic due to a new highway which diverted most of the previous travelers. The contract price was quite low and the defendant was glad to “unload” the property. The plaintiff had the knowledge and experience that enabled him to convert the use of the campground from that of an independently operated destination facility to that of a membership campground, which was part of a nationwide network. Under the new use, memberships could be purchased like time-shares and then traded in a nationwide network for, perhaps, more desirable destination campgrounds. Under this new use, the property’s value rose sharply. The suit claimed that when the defendant realized how valuable the property was, given its new use, he sabotaged the transaction before all the improvements could be made and the new business could be established.

Reasonable certainty is a legal principle that states that “lost profits damages” must be proved to a reasonable degree of certainty to be awarded. The measurement of the damages has a somewhat lower standard because such measurement is an estimate. Also, part of making a case hold to the reasonable certainty standard includes demonstrating causation. It must be proved that the defendant’s behavior was the cause of the economic loss.

This case had an even more difficult challenge in that it had to be proved that the occurrence and amount of lost profits were beyond mere speculation. Since the business was not yet established at the time of the alleged breach, there was no track record for this business from which to calculate a loss. A previous court case addressed this when it had at issue that the “plaintiff had not conducted a profitable business operation for a sufficient period of time to ascertain with reasonable certainty loss of future profits.” In that case, the court stated:

“Strict application of the certainty doctrine would place a new business at a substantial disadvantage. To hold recovery is precluded as a matter of law merely because a business is newly established would encourage those contracting with such a business to breach their contracts. The law is not so deficient.”1

Given such precedent in the law, the lack of a history of earnings will not automatically deem future lost profits as speculative. But attaining “reasonable certainty” can prove to be difficult. Based on the facts and circumstances of this membership campground case and the strength of the track record and experience of the plaintiff himself, my calculation of losses met the court’s threshold of reasonable certainty. The plaintiff’s attorney proved his case and the claim of damages was awarded.

In spite of the universality of this legal principle, the courts have never really defined what constitutes “reasonable certainty,” and case law differs among jurisdictions. Each potential case is unique and other legal principles in addition to reasonable certainty apply. But reasonable certainty that damages occurred must be proved before a claim of damages will be awarded. We would welcome the opportunity to discuss your particular circumstances to see if we can assist you with an economic damages calculation.

1 Vickers v. Wichita State Univ., 619; 518 P.2d 512, 517 (Kan. 1974).

AICPA and Partners Develop New Valuation Credential

The American Institute of CPAs has partnered with the American Society of Appraisers and the Royal Institution of Chartered Surveyors on a new credential for financial professionals who provide fair value measurement services.
The AICPA, ASA and the RICS began working together on developing a single credential that offers a more consistent framework for fair value measurement. The organizations are striving to be sure financial professionals have the necessary training, qualifications, experience and expertise to perform the work. They released a proposed framework in 2016.

Financial professionals who receive the new Certified in Entity and Intangible Valuations (“CEIV”) credential would need to follow new uniform guidance on how much documentation is necesssary to support their fair value measurement results in company financial statements when they are producing valuations of entities and intangible assets such as trademarks, patents and technology, customer sales lists, and non-compete agreements.

The uniform guidance for the credential specifies the level of documentation necessary to enable investors, auditors and regulators to understand more easily how fair value measurement has been used to determine the values of businesses and intangible assets. The CEIV credential also requires regular monitoring of credential holders to make sure they’re following the new guidance.

To get the new credential, financial professionals need to meet certain eligibility requirements determined by the AICPA, ASA and the RICS, in collaboration with the Appraisal Foundation and the International Valuation Standards Council, which also helped develop the new credential. Those requirements include demonstrating competencies in valuation and fair value measurement through training and assessments, along with passing a two-part CEIV exam that will be introduced this year.

We here at Advent are always trying to proactively respond to clients’ needs and are watching the developments closely and, if necessary, will be obtaining the new credential.