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How Much is that Donated Stock Worth?

A valuation may be necessary if you’ve donated stock in a private company. Photo by Sarah Pflug from Burst

Philanthropic business owners may have made last-minute gifts of stock to charities at the end of 2020. Others plan to make donations in 2021. How much is that stock worth? Donations of publicly traded stocks are relatively easy to value, but private equity interests are typically more complicated to value.  

Deduction Requirements

Qualified charitable donations can help lower your taxable income as well as support worthwhile causes. However, not all donations are tax deductible. Individuals can deduct them only if they itemize.

In addition, charitable contributions must be made to qualified organizations. You can determine whether an organization is qualified by going to the IRS Tax Exempt Organization Search (formerly Select Check).

Depending on the amount of the donation, to claim the tax break you’ll have to:

  • File Form 8283 Section B for a donation valued at more than $5,000,
  • Obtain an independent appraisal within 60 days of the date of the gift (before or after) if the stock is valued at more than $10,000, and
  • Attach the appraisal to your tax return if the shares are deemed to be worth more than $500,000.

Fair market value (FMV) is the appropriate standard of valuation for these donations. Under IRS Revenue Ruling 59-60, FMV represents “The amount at which the property would change hands between a willing buyer and 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.”

If you put a restriction on the use of the property you donate, the FMV must reflect that restriction.

Business Valuation Report

Appraisals for donations valued at more than $10,000 must be written. Abbreviated calculations or letter formats may cost less, but they may also raise a red flag with the IRS. Moreover, valuators’ reports typically serve as their direct testimony if a return ends up in U.S. Tax Court.

According to IRS Publication 561, Determining the Value of Donated Property, qualified appraisals must include the following items:

  • Detailed descriptions of the donation, including dates of the contribution and valuation as well as terms of any agreements relating to the use, sale or other disposition of the property,
  • Statements that the appraisals were prepared for income tax purposes,
  • FMV on the date of contribution,
  • The methods used to value the business interest, such as the cost, market or income approach, and
  • Any specific data the appraiser used to determine FMV, such as comparable sales transactions.

Business valuation reports should identify the appraisers’ firms and list their qualifications, including background, experience, education and memberships in professional appraisal associations.

Always use an appraiser who has earned an appraisal designation from a recognized professional organization and who meets IRS requirements for education and experience. The IRS specifically prohibits do-it-yourself valuations by the donor, recipient or related parties.

It is important to note that you are not permitted to take a charitable deduction for business valuation or appraisal fees. In previous years, those fees may have qualified as miscellaneous deductions, subject to the 2 percent-of-adjusted-gross-income limit. However, starting in 2018, that tax break has been temporarily suspended through 2025 under the Tax Cuts and Jobs Act.

Forewarned Is Fair Warned

The IRS has cracked down on charitable contributions in recent years. The bigger your deductions, the more stringent the substantiation rules are — and the more likely the IRS is to audit them. Hire an experienced business valuation professional to help ensure your deduction survives IRS scrutiny.

Please contact the professionals at Advent Valuation Advisors if you have any questions regarding the valuation of a stock donation or other business valuation matters.

© 2021, Powered by Thomson Reuters Checkpoint 

Manufacturers More Susceptible to Fraud

Manufacturing is among the industries most susceptible to fraud, with a median fraud-related loss of $198,000, according to the 2020 Report to the Nations. Photo by Laurel and Michael Evans on Unsplash

When fraud strikes manufacturers, the effects can be devastating. The median fraud loss in the manufacturing sector, one of the industries most affected by fraud, was $198,000, according to the 2020 Report to the Nations published by the Association of Certified Fraud Examiners (ACFE). That’s significantly higher than the median fraud loss for all industries ($150,000).

Here are some other key findings from the latest biennial ACFE report:

Common Fraud Schemes

Over the years, the ACFE has identified three methods of occupational fraud:

  1. Asset misappropriation. In these schemes, dishonest employees access and misuse assets for their personal gain. For example, they might steal company funds, inflate expense reports or engage in fake billing scams.
  2. Corruption. This is abuse of business privileges enabling an employee to gain a direct or indirect benefit. Examples include bribery and manipulation of conflicts of interest.
  3. Financial statement fraud. Here, the employee intentionally causes a misstatement or omission of material information in financial reports. For example, a fraudster might record fictitious revenues, understate expenses or inflate assets.

According to the 2020 Report to the Nations, asset misappropriation occurred in roughly 86 percent of the cases. Though misappropriation schemes are the most frequent fraud technique, they resulted in the lowest median loss ($100,000). Conversely, financial statement fraud took place less frequently (in 10 percent of cases), but it had the highest median loss ($954,000).

For manufacturers, the most common fraud schemes include:

  • Corruption (50 percent),
  • Billing schemes (23 percent),
  • Theft of non-cash assets, such as inventory or fixed assets, (23 percent), and
  • Inflated expense reimbursements (20 percent).

The total adds up to more than 100 percent because incidents may involve more than one type of fraud scheme.

The median loss from corruption crimes was $200,000. This could help explain why the median fraud loss for manufacturers was higher than the overall median for all industries.

Methods of Detection

More than 40 percent of the frauds in the 2020 report were unearthed by tips. About half of those tips came from employees. But customers and suppliers can also be valuable sources of fraud tips. Other common methods of detection include internal audit (15 percent of cases) and management review (12 percent of cases).

The ACFE concludes: “When fraud is detected proactively, it tends to be detected more quickly and thus causes lower losses, while passive detection results in lengthier schemes and increased financial harm to the victim. Anti-fraud controls such as account reconciliation, internal audit departments, involved management review, and active cultivation of tips are all tools that can lead to more effective detection of occupational fraud.”

While the median duration of a fraud is 14 months, averages differ based on the type of fraud. Usually, non-cash, cash on hand, skimming and corruption fraud is caught in less than 24 months. Billing, expense reimbursement, register disbursements, check and payment tampering, payroll and financial statement frauds typically take about two years before being discovered. Naturally, the longer fraud goes undetected, the larger the financial loss.

Profile of Perpetrators

The 2020 report shows that higher-ups are responsible for larger crimes. Although owners or executives perpetrated only 20 percent of the frauds in the study, the median loss in those cases amounted to $600,000 — much higher than losses caused by managers and mid-to-lower-level employees. This is attributed mainly to wide-ranging access to funds. Similarly, frauds committed by long-time employees resulted in greater losses than ones caused by relative newcomers.

Age and gender were also among the most significant factors. More than half of the perpetrators (53 percent) were between the ages of 30 and 45, but median losses trended higher for older fraudsters. Also, males committed 70 percent of the frauds and the median loss for male perpetrators ($150,000) was almost double the median for females ($80,000).

Methods of Prevention

Manufacturers are less likely to incur fraud losses if they learn how to identify potential fraud risk and adopt an effective system of internal controls for combatting fraud.
In particular, the ACFE recommends keeping an eye out for employees who engage in one or more of the following high-risk behaviors:

  • Living beyond their means (42 percent of cases),
  • Exhibiting financial difficulties (26 percent of cases),
  • Having unusually close association with a vendor or customer (19 percent of cases),
  • Displaying excessive control issues or an unwillingness to share duties (15 percent of cases),
  • Being unusually irritable, suspicious or defensive (13 percent of cases),
  • Reflecting shrewd or unscrupulous behavior (13 percent of cases), and
  • Being recently divorced or experiencing family problems (12 percent of cases).

In 45 percent of the cases in the 2020 report, the fraudster had a record of other work misconduct issues, such as bullying, absenteeism or tardiness. Furthermore, the report stated that lack of internal controls contributed to almost one-third of frauds. Be aware that annual financial statement audits aren’t specifically designed to detect fraud. Your management team is responsible for the internal controls it employs.

Smaller firms face different challenges in preventing fraud and implementing anti-fraud controls than larger entities. The most common anti-fraud controls — external audit of financial statements and code of conduct — were evident in 56 percent and 48 percent of small businesses with fewer than 100 employees, respectively, compared to 92 percent and 91 percent for larger companies.

Fortunately, fraud prevention measures don’t necessarily require you to spend an arm and a leg. For instance, a manufacturing firm might adopt a written code of conduct, require its managers to review procedures and institute anti-fraud training for all employees. In addition, you may rely on external consultants to perform independent fraud testing, when appropriate, to address these concerns.

Final Thoughts

In the current business environment, manufacturing firms must reevaluate internal controls, policies and operating procedures, training assessments and risk identification. Since the situation remains fluid, your company should be prepared to react quickly to minimize potential losses. If you suspect suspicious activity, a forensic accountant can help evaluate the situation.

Advent Valuation Advisors has extensive and varied experience in detecting fraud. Please contact us with any questions.

© 2021, Powered by Thomson Reuters Checkpoint 

Buy-Sell Agreements Vital in the Age of COVID

A smartly crafted buy-sell agreement can spare you and your business from complications down the road. Photo by Marcelo Dias from Pexels

When a business is owned by more than one person, it’s generally advisable for the owners to enter into a contractual agreement that prescribes what will happen if an owner dies, becomes disabled, retires or otherwise leaves the company.

Some market analysts predict that the COVID-19 crisis may trigger an increase in buyouts. For example, some struggling owners may decide to throw in the towel after months of teetering on the verge of bankruptcy. Or squabbling partners may disagree about the future of the business and decide to part ways.

So, now is a good time for owners to draft or update a buy-sell agreement. Here’s a look at common valuation issues and potential pitfalls to avoid.

Valuation Considerations

“Buy-sells,” as they’re often called, may be standalone agreements or a provision within a broader agreement (such as a partners’ or shareholders’ agreement). To avoid misunderstandings and delays when redeeming a departing owner’s interest, a buy-sell should address the following key elements:

  • Appropriate standard of value (such as fair market value or fair value)
  • Definition of the standard of value
  • List of applicable valuation adjustments and discounts
  • Relevant method of quantifying valuation adjustments and discounts
  • Effective date of the valuation (for example, the year-end nearest the triggering event)
  • Buyout terms (including who will buy the interest and how payments will be made), and
  • Appraisal/redemption deadline (for example, within 30 or 90 days of the triggering event).

The buy-sell should also specify the parties’ preferred method of appraisal. Examples include a fixed price, a prescribed formula or the use of credentialed business valuation professionals.

In some cases, the owners agree to use the company’s CPA firm to perform an independent valuation of the departing owner’s interest. Other buy-sells require two outside appraisals: one for the buyer and another for the seller; the value of the departing owner’s interest is then determined by averaging the results of the two conclusions.

Potential Pitfalls

Ambiguous or outdated buy-sells can cause problems when it’s time for a buyout. For example, an agreement containing undefined valuation terminology — such as “earnings” or “value” — may be subject to different interpretations.

Likewise, the use of a prescribed formula that’s based on a simplistic industry rule of thumb might cause problems when a buyout happens several years after the agreement was executed. Industry and economic conditions may have changed, or the company’s product or service lines might have evolved.

For instance, some companies have pivoted during the COVID-19 crisis to take advantage of new market opportunities, automate certain processes, or minimize face-to-face interactions with customers.

Fixed valuation formulas that were valid before the pandemic may no longer be relevant in the new normal. This underscores the importance of creating a “living” buy-sell that’s reviewed and updated regularly to stay current.

One More Word of Caution

During a buyout, the buyer is typically either the company or the remaining owners. The seller is usually either the departing owner or the departing owner’s heirs. Because the buyer controls how financial results are reported after the seller leaves the business, the seller should be wary of the potential for financial misstatement. Financial statements often are used to value the departing owner’s interest. So, the buyer has an incentive to understate revenue and assets or overstate expenses and liabilities. These manipulations can lower the buyout price, unless adjustments are made to the company’s financial statements.

Outside Expertise

There is no one-size-fits-all buy-sell agreement. The input of a business valuation professional when drafting or updating a buy-sell can help achieve the owners’ buyout objectives and reduce disputes when and if the agreement is triggered. If you have any questions, the professionals at Advent Valuation Advisors are here to help.

For more information on buy-sell agreements, read our previous blog post here.

Lawsuit Turns on Credibility of Valuations

A shareholder dispute involving a Nassau County business was decided based on the relative merits of two experts’ valuation reports. Photo by Matthew Henry from Burst

What makes the difference between your company being valued at $30 million or $6 million?

Sometimes, it comes down to which valuation expert’s report the judge finds more credible.

That’s what the owners of Kraus USA, Inc., a Long Island business selling fine plumbing fixtures, learned earlier this year. Sergio Magarik sued his co-owners, Michael Rukhlin and Russell Levi, in 2015, seeking to dissolve the company. (Read the petition here.) The respondents elected to buy out his interest in the company, and as a result, various claims and counterclaims were discontinued, leaving but one matter to be determined by the court: the value of Magarik’s shares. 

This required a determination of the fair value of the company as of September 20, 2015, the day before the petition was filed. Kraus is an internet-based business that sells faucets, sinks, plumbing fixtures and related items, primarily through third-party retailers. Its products are manufactured in China. The company grew rapidly, from $21 million in sales in 2012 to $36 million in 2015, but had negative cash flow and a significant amount of debt. Magarik owned 24 percent of the company, Levi, 51 percent and Rukhlin, 25 percent.

The trial included testimony from the three owners, Kraus’ controller and the valuation experts for each side. Each expert prepared a valuation based on an income and a market approach to value. Magarik’s expert arrived at a value of about $30 million for Kraus, the average of his discounted cash flow income approach ($21.9 million) and guideline public company market approach ($38.8 million).

The valuation echoed projected earnings prepared months earlier by Kraus’ controller in connection with a loan application in which Kraus’ owners represented that the company was worth more than $30 million. 

The respondents’ expert estimated Kraus was worth $6.05 million, about one-fifth the amount of the other expert’s estimate. He presented an income approach based on capitalization of earnings ($6.16 million) and cash flow ($5.9 million and $6.1 million). His market approach, a “merged and acquired company method” method relying on Pratt’s Stats database (now DealStats) for comparable transactions, resulted in a range of values from $5.3 million to $6.1 million. 

Justice Vito DeStefano found that Magarik’s expert did not sufficiently account for the level of competition Kraus faced or its lack of cash flow, and that it overestimated the value of the Kraus brand, which Kraus did not actually own. 

“The court does not accept the valuations provided by petitioner’s expert … as they exceeded the true value of the business, were based on income projections that were unrealistic and optimistic and not based on appropriate comparable businesses. Moreover, the two valuations provided were vastly disparate from each other, underscoring mistaken premises and assumptions.”

“In reality,” the justice wrote, “the value of the business was never $30 million and the projections contained in the loan application were never realized.” Justice DeStefano accepted the $6.05 million valuation presented by the respondents’ expert, which he found to be “supported by the credible evidence which demonstrated a successful and growing business that was not especially liquid.” (Read the decision here.) He applied a 5 percent discount for lack of marketability – less than the 25 percent DLOM sought by the respondents. The petitioner had not applied a DLOM.

The resulting value of Magarik’s 24 percent interest was calculated to be $1,379,400. Justice DeStefano added interest of 9 percent dating back to the filing of the petition, and gave Kraus two years to make the payment, in deference to the company’s cash flow difficulties.

For more on the two valuations, you can read the parties’ post-trial memoranda here and here. The case is Sergio Magarik v. Kraus USA, Inc., Michael Rukhlin and Russell Levi, Index No. 606128-15, Nassau County Supreme Court.

The decision in Magarik underscores the importance of securing a credible, defensible business valuation. The professionals at Advent Valuation Advisors offer a full range of business valuation and litigation support services. If you have any valuation needs, the professionals at Advent are here to provide a credible valuation.

COVID Poses Challenges in Business Valuation

Determining the effects of the COVID-19 pandemic on the value of a business may involve a high degree of complexity. Photo by Sarah Pflug from Burst

Business valuation is a prophecy of the future. That is, investors typically value a business based on its ability to generate future cash flow. However, with so many uncertainties in the current marketplace, forecasting expected cash flow can be challenging.

Income Approach

Under the income approach, the value of a business interest is a function of two variables:

1. Expected economic benefits, and

2. A discount rate based on the risk of the business.

Economic benefits can take many forms, such as earnings before tax, cash flow available to equity investors and cash flow available to equity and debt investors. Likewise, discount rates can take many forms. Examples include the cost of equity or the weighted average cost of capital (WACC).

Common valuation methods falling under the income approach include:

Capitalization of earnings. Under this method, economic benefits for a representative single period are converted to present value through division by a capitalization rate. The cap rate equals the discount rate minus a long-term sustainable growth rate. This technique — sometimes referred to as the capitalized cash flow (CCF) method — is generally most appropriate for mature businesses with predictable earnings and consistent capital structures. It’s also commonly used to value real estate with a predictable stream of net operating income.

Discounted cash flow (DCF). This method derives value by discounting a series of expected cash flows. The “cash flow” at the end of the forecast period is known as the terminal (or residual) value. Terminal value is typically calculated using the market approach or the capitalization of earnings method. It represents how much the company could be sold for at the end of the forecast period, when the company’s operations have, in theory, stabilized.

DCF models are generally more flexible than the capitalization of earnings method. For example, the DCF method is well-suited for high-growth companies and those that expect to alter their capital structure over the short run.

Adjusting for COVID-19 Impact

During the pandemic, many valuation professionals are using DCF models, rather than the capitalization of earnings method, to better capture temporary changes in the marketplace. In addition to detrimental effects of the pandemic, these temporary changes may include benefits from government loans or grants. The appropriate time frame for a DCF analysis depends on how long the subject company expects its operations to be disrupted. Some experts are using two- or three-year DCF models; others prefer to use a longer time frame.

In addition, it’s important for valuators not to double-count COVID-19-related risk factors in both the company’s expected economic benefits and the discount rate.

Evaluating Inputs

A business valuation is only as reliable as the inputs on which it’s based. Business valuation professionals typically rely on management to prepare forecasts. But, in the COVID-19 era, those estimates may not necessarily be reliable. That’s because managers tend to use the prior year’s results as the starting point for forecasting the current year. Then it’s assumed that revenue, variable expenses and working capital will grow at a moderate rate, while fixed expenses will largely remain constant.

However, these simplistic models may no longer be valid in today’s volatile, evolving marketplace. Many businesses — including resorts and casinos, sports venues, schools and movie theaters — have temporarily shut down or scaled back operations during the pandemic. Others are using new methods of distribution or devising pivot strategies to stay afloat. Examples include doctors and therapists who are providing telehealth services, restaurants and retailers that are offering online ordering, delivery and curbside pick-up, and food-processing facilities that are selling directly to consumers rather than to cruise lines and high-end restaurants.

In addition, cost structures have changed for many types of businesses. For example, most white-collar workers are working from home instead of commuting to offices, people of all ages are converting from in-person to online learning, companies are eliminating nonessential travel, and some organizations have become increasingly reluctant to work with overseas suppliers. In the face of a contentious, divisive presidential election, there is also significant uncertainty about the future of federal tax laws and other government regulations.

Which changes will be temporary, and which will last beyond the COVID-19 crisis? No one has a crystal ball, but it’s likely that some changes — including work-from-home arrangements and other cost-cutting measures — will be part of the new normal. Other aspects of everyday life — such as attending sporting events, going on vacations and dining out — are expected to eventually return to normal. But it’s still unclear how long recovery will take.

So, before discounting expected earnings, it’s important to evaluate whether management’s forecasts seem reasonable. Oversimplified models and unrealistic assumptions can lead to valuation errors.

Outside Expertise

Estimating how much cash flow a business will generate is no easy task in today’s unprecedented conditions. A trained valuation professional is atop the latest trends and economic predictions and can help management create comprehensive forecasts that are supported by market evidence, rather than gut instinct and oversimplified assumptions.

The professionals at Advent Valuation Advisors stand ready to help you understand the implications of the pandemic on the value of your business. For more information, please contact us.

© 2020, Powered by Thomson Reuters Checkpoint 

First Round Goes to Insurers in COVID-19 Court Fight

More than 140 lawsuits have been filed against insurers over claims for business interruptions caused by the COVID-19 pandemic. Photo by Matthew Henry from Burst

An insurer scored a significant win in what is believed to be the first court decision involving a COVID-19-related business interruption claim. 

On July 1, 2020, 30th Circuit Judge Joyce Draganchuk in Ingham County, Michigan, dismissed a lawsuit by the owner of two restaurants in Lansing Michigan, siding with the insurer’s decision to deny a claim for business-interruption coverage because the eateries did not sustain “direct physical loss or damage.”

The decision in Gavrilides Management Company v. Michigan Insurance Co. was previously reported by the National Law Review, among others.  Gavrilides Management sought $650,000 from Michigan Insurance Co. for losses it sustained after Gov. Gretchen Whitmer issued executive orders in March that limited its two restaurants to delivery and take-out orders.

Judge Draganchuck said it is clear from the wording of the insurance policy that only direct physical loss to the properties is covered. She rejected as “simply nonsense” the plaintiff’s claim that the restaurants were damaged “because people were physically restricted from dine-in services.”

“Direct physical loss of or damage to the property has to be something with material existence, something that is tangible, something … that alters the physical integrity of the property. The complaint here does not allege any physical loss of or damage to the property,” the judge said during the July 1 video court session. “The complaint alleges a loss of business due to executive orders shutting down the restaurants for dining … in the restaurant due to the COVID-19 threat, but the complaint also states that, at no time has COVID-19 entered the Soup Spoon or the Bistro through any employee or customer.”

The judge noted that the insurance policy also has a virus and bacteria exclusion, and that loss of access to the premises due to government action is not covered. 

You can watch a recording of the virtual court appearance here.

Testing the Limits of Coverage

Business interruption insurance typically covers the loss of income that a business suffers due to the disaster-related closing of the business and the rebuilding process after a disaster. The COVID-19 pandemic is testing the limits of this coverage and its applicability to unprecedented circumstances.
Countless businesses were forced to close as a result of the COVID-19 pandemic and the ensuing emergency orders. While many businesses have been able to reopen since, often on a limited basis, the losses sustained have been steep and, in many cases, ongoing. 

Several state legislatures, including New York’s, have introduced bills that would require insurers to cover business-interruption losses stemming from COVID-19, even if the policies specifically exclude such coverage. Meanwhile, more than 140 COVID-19-related business interruption cases have been filed in federal courts nationwide, including several filed in U.S. District Court for the Southern District of New York. To read three of the complaints, click on the links below.

Broadway 104, LLC, dba Café Du Soleil, v. Axa Financial, Inc.; XL Insurance America, Inc., No. 1:20-cv-03813, SDNY

Food for Thought Caterers Corp. v. The Hartford Financial Services Group, Inc., and Sentinel Insurance Company, LTD., No. 1:20-cv-03418, SDNY

Gio Pizzeria & Bar Hospitality LLC v. Certain Underwriters at Lloyd’s, London, No. 1:20-cv-03107, SDNY

Advent Valuation Advisors provides a variety of litigation support services, including the assessment of damages from business interruption. For more information on business interruption claims, read our blog posts here and here. If you have any questions, please contact us.

Valuations in Divorce Cases Can be Tricky

Business valuations completed in connection with divorce proceedings can be especially complex. Photo by Kelly Sikkema on Unsplash

The South Carolina State Supreme Court weighed in recently on the long-simmering tension between recognized standards of business valuation and the goal of equity in dividing marital assets in divorce proceedings.

The decision In Clark v Clark (Appellate Case No. 2019-000442), addresses the division of marital assets, specifically the valuation of a minority interest in a family business. The Supreme Court reiterated a lower court’s assertion that the applicability of discounts for lack of control (DLOC) and marketability (DLOM) are to be determined on a case-by-case basis, then affirmed one part of that court’s ruling regarding discounts and reversed another.

The Family Business

George and Patricia Clark were married in 1987. During the marriage, Mr. Clark began working for the family business, Pure Country, a manufacturer of custom tapestry blankets and other items. His father founded the business and eventually transferred his 75 percent interest in it to Mr. Clark. A family court determined at the time that the transfer was a gift, and therefore the interest was not marital property. Mr. Clark purchased the remaining 25 percent of the business from his sister. In 2009, he transferred a 25 percent interest to Mrs. Clark. The related stock agreement limited any subsequent sale of that interest to other shareholders, immediate family members or the business.

In 2012, Mr. Clark filed for divorce. Both spouses hired experts to value Mrs. Clark’s interest in the business. The husband’s expert applied a DLOC and a DLOM. In support of the DLOM, she noted that the sale of interests in privately held companies require more time and resources and involve higher transaction costs than do sales of publicly traded interests. She also considered the restrictive language in the stock agreement from the 2009 transfer.

The wife’s expert applied a smaller DLOM, but later argued that the value should not be discounted at all. He did not apply a DLOC.

The family court found the husband’s expert more credible and agreed with her use of discounts. While it did acknowledge the “debate as to whether … discounts should apply in a divorce setting as the business is actually not being sold,” the court recognized that the valuation standard in such cases is fair market value, which assumes a hypothetical transaction between two willing parties. 

Mrs. Clark appealed the decision to the court of appeals, which agreed that a minority shareholder would not have control over the company and therefore upheld the family court’s decision to apply a DLOC, but reduced the size of the discount. The court of appeals rejected the DLOM, noting the husband did not intend to sell the business and relying on a precedent set in Moore v Moore. “To the extent the marketability discount reflected an anticipated sale, Moore deems it a fiction South Carolina law no longer recognizes.” The court found that because the husband did not plan to sell the business, the restriction on transfers of stock was moot. 

The decision compelled both parties to file appeals to the State Supreme Court.

Split Decision

The husband argued that the court of appeals erred in rejecting the DLOM when each party’s expert had applied one. The wife contended that the DLOM should not be considered because a DLOM accounts for the higher transaction costs inherent in a sale of an interest in a private company, and her husband did not intend to sell.

The Supreme Court affirmed the family court’s decision to apply a DLOM and a DLOC and the appeals court’s decision to reduce the DLOC. The decision states that a party’s interest in a closely held company is valued based on its fair market value, which has been well established as “the amount of money which a purchaser willing but not obligated to buy the property would pay an owner willing but not obligated to sell it, taking into account all uses to which the property is adapted and might in reason be applied.”

That said, the court acknowledges the tension between this principle of valuation and “the desire to fairly and justly apportion marital assets.” The court refuses to draw a bright line on the issue, stating that the applicability of such discounts is to be determined on a case-by-case basis.
The Supreme Court’s decision was not unanimous. Two of the five justices issued a dissenting opinion rejecting the application of either discount, stating that “under certain facts, faithful adherence to the concept of fair market value must yield to reality.”

The decision, while not directly applicable to New York cases, speaks to the complexities involved in divorce-related valuations and the need for valuation professionals to weigh competing considerations. If you have questions regarding the valuation issues in a divorce or another context, Advent’s professionals are here to help.

Read the Decision

You can read the rather colorful decision here:

https://adventvalue.com/wp-content/uploads/2020/06/Op.-27969-George-W-Clark-v.-Patricia-B-Clark.pdf

Changes in Bankuptcy Law a Lifeline for Struggling Businesses

Recent changes to U.S. Bankruptcy Law may provide additional relief for some struggling businesses. Photo by Melinda Gimpel on Unsplash

The novel coronavirus pandemic has caused many businesses to temporarily shut down or scale back operations. Slowly, states are allowing businesses to reopen to the public. But it may be too late for some businesses to bounce back. As a result, the number of businesses filing for bankruptcy is expected to skyrocket this summer.

Two recent changes to the U.S. Bankruptcy Code may provide greater relief for small businesses that seek to use the bankruptcy process to reorganize their finances and continue operating. The Small Business Reorganization Act (SMRA) increases access to Chapter 11 for small businesses. The Coronavirus Aid, Relief, and Economic Security (CARES) Act raises the debt threshold that qualifies for this protection. Here’s what small business owners should know.  

SMRA Basics

Effective on February 19, 2020, the SMRA creates a new subchapter (Subchapter V) of the Bankruptcy Code. To be eligible for relief under Subchapter V, a debtor, whether an entity or an individual, must have total debt not exceeding $2,725,625 (subject to adjustment every three years). The SMRA contains provisions for the following key improvements:

Streamlined reorganizations: The new law will facilitate small business reorganizations by eliminating certain procedural requirements and reducing costs. Significantly, no one except the business debtor will be able to propose a plan of reorganization. Plus, the debtor won’t be required to obtain approval or solicit votes for plan confirmation. Absent a court order, there will be no unsecured creditor committees under the new law. The new law also will require the court to hold a status conference within 60 days of the petition filing, giving the debtor 90 days to file its plan.

New value rule: The law will repeal the requirement that equity holders of the small business debtor must provide “new value” to retain their equity interest without fully paying off creditors. Instead, the plan must be nondiscriminatory and “fair and equitable.” In addition, similar to Chapter 13, the debtor’s entire projected disposable income must be applied to payments or the value of property to be distributed can’t amount to less than the debtor’s projected disposable income.

Trustee appointments: A standing trustee will be appointed to serve as the trustee for the bankruptcy estate. The revised version of Chapter 11 allows the trustee to preside over the reorganization and monitor its progress.

Administrative expense claims: Currently, a debtor must pay, on the effective date of the plan, any administrative expense claims, including claims incurred by the debtor for goods and services after a petition has been filed. Under the new law, a small business debtor is permitted to stretch payment of administrative expense claims over the term of the plan, giving this class of debtors a distinct advantage.

Residential mortgages: The new law eliminates the prohibition against a small business debtor modifying his or her residential mortgages. The debtor has more leeway if the underlying loan wasn’t used to acquire the residence and was used primarily for the debtor’s small business. Otherwise, secured lenders will continue to have the same protections as in other Chapter 11 cases.

Discharges: The new law provides that the court must grant the debtor a discharge after completing payments within the first three years of the plan or a longer period of up to five years established by the judge. The discharge relieves the debtor of personal liability for all debts under the plan except for amounts due after the last payment date and certain nondischargeable debts.

CARES Act Provision

In addition to the improvements under the SMRA, Congress decided to temporarily increase the debt ceiling for eligibility to $7,500,000 from $2,725,625 for new Subchapter V cases filed between March 28, 2020, and March 27, 2021. Thereafter, the debt limit will revert to $2,725,625.This change will make more small businesses eligible for Chapter 11 in the midst of the novel coronavirus crisis. However, the CARES Act permanently eliminates the eligibility to file for Subchapter V relief for any affiliate of a public company.

We Can Help

Businesses contemplating bankruptcy often benefit from the input of an experienced business valuation expert. Specialists with experience in accounting, valuation and mergers and acquisitions can help assess the severity of the financial crisis, determine whether liquidation or reorganization makes sense, and provide financial insight on everything from selling assets to shareholder disputes. Contact one of Advent’s business valuation professionals to facilitate the bankruptcy process and, if possible, get your business back on track.

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AICPA Issues FAQs for Valuing Distressed or Impaired Businesses

In light of the coronavirus pandemic, the American Institute of Certified Public Accountants has offered new guidelines for valuing distressed or impaired businesses. Photo by Matthew Henry from Burst

The American Institute of Certified Public Accountants has issued new guidance regarding the valuation of distressed or impaired businesses.

The guidance, which is presented as responses to frequently asked questions, distinguishes between distress, which may be a temporary condition, and impairment, which is usually permanent. The FAQs address the application of valuation adjustments and other considerations related to the coronavirus crisis.

The AICPA highlights both the perils of failing to consider the many implications of the pandemic and the risk of overcompensating for the effects of such an unprecedented event. In addition, it notes that the pandemic may have positive implications for some businesses, such as those that are able to increase market share as weaker competitors crumble.

You can read the AICPA’s guidance here: https://www.aicpa.org/interestareas/forensicandvaluation/resources/businessvaluation/faqs-on-valuation-considerations-for-distressed-or-impaired-businesses.html

Protect Cash Flow to Survive the Financial Crisis

Many businesses will need to restructure their finances to emerge from the financial crisis brought on by the COVID-19 pandemic. Photo by Kelly Sikkema on Unsplash

There is a substantial amount of information out there about how small businesses should respond to the COVID-19 pandemic, and the fear and uncertainty about the virus and what comes next. It is not hard to find articles about how to protect employees, customers and suppliers from infection and how to talk about the virus. In this article, I will focus on what businesses and their lenders and stakeholders must do to minimize losses and maximize financial stability in this unprecedented time.

Businesses, even high performers, need to consider the detrimental impact on cash flow resulting from the steps taken to slow the spread of the virus and “flatten the curve” of new cases. Some businesses are completely closed, while others are suffering disruptions such as reduced hours due to government restrictions. Supply interruptions are hurting business as well. Regardless of the industry, the inability to generate adequate cash flow endangers the ability to meet obligations to lenders, trade creditors and investors. Here are some things owners can do to navigate the crisis.

Generate Projections

While no one really wants to look, it is critically important that businesses recast operating cash flow projections or generate new ones. This includes revising assumptions, forecasts and business plans to reflect the new reality. Prepare projections that consider the best and worst cases for the next few months and longer.

If management hides its head in the sand, the company is likely not going to survive. Hiring an experienced restructuring advisor and legal counsel early can provide credibility when dealing with lenders, creditors and investors. It may also preserve business value.

Develop a New Financial and Operating Plan

Triage is important. Some businesses are proficient at managing operations in times of stress. However, few companies have ever faced a dramatic, escalating crisis like the current one. Businesses have little choice but to pivot meaningfully, and planning is key to survival. This planning must address the new reality reflected by revised and updated cash projections and should include these steps:

  • Protect working capital. This includes taking an inventory of existing working capital, drawing on existing lines of credit and developing and implementing a cost-reduction plan to achieve positive cash flow. Cash is king and needs to be preserved.
  • Identify any collateral that could secure additional financing. Seeking such financing may not be feasible in the current environment, but this may change. To the extent a company has unencumbered assets, additional liquidity may be easier to arrange. It is important to identify assets that might be available to secure financing, including real property, inventory and accounts receivable.
  • Monitor federal and state government relief initiatives.
  • Consider working with a professional financial advisor and legal counsel to open lender communications. Some business owners who need to obtain financing on an emergency basis think that engaging a professional is a sign of weakness or requires cash that the company would prefer not to use. In fact, involving professionals in the process provides significant credibility when asking creditors for relief. Lenders and stakeholders may be more willing to respond quickly and positively if provided with information that has been reviewed by the company’s financial advisors. Attempting to save money by not hiring a professional can put at risk the ultimate success of discussions with lenders and creditors.

What if maintaining existing financing is not viable?

Once management is aware of the business’s inability to perform, it must work with stakeholders to establish strategies for employees, lenders, suppliers, customers and investors. This strategy must include developing communication plans for each of these groups. Retaining advisors is critical to address potential debt defaults, contractual performance defaults and other obligations.

Management must have a plan in place to address these issues, and outside help may be necessary to weigh the options, minimize risk and maximize value. Management is accustomed to operating in a normal environment and may have no experience dealing these kinds of challenges. If the company has a board of directors, outside guidance is critical to its duty-of-care responsibility.

It is important to determine what requests for relief from lenders are necessary to allow the business to continue to operate in this unpredictable environment. Considerations include what is needed to avoid default on short- and long-term financing obligations and what is needed to maintain relationships with vendors and suppliers. This includes “asks” that reflect reduced operations. Relationships with lenders, investors and other creditors can be more easily maintained if communication is open and frank and if professional advisors help the company determine which “asks” are likely to be successful.

This article merely scratches the surface of the complexities businesses face because of COVID-19. This disaster will likely rewrite the playbook for financial and operating restructuring. It is clear that credit providers and businesses, in order to survive, must be unified in focusing on preserving business value until the “new normal” emerges.

If you have questions about how to address your business’s financial difficulties, please contact the professionals at Advent Valuation Advisors.