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The Difference Between Price and Value

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When a business is sold, it often sells for more (or less) than the appraised value. This may come as a surprise to laypeople, but valuators understand that there are many valid reasons that “price” and “value” may differ. Businesses that understand this subtlety are better positioned to make informed decisions.

Price is specific to an individual buyer and seller. It’s the amount of cash (or its equivalent) for which anything is bought, sold or offered for sale. It requires an offer to sell, an acceptance of that offer and an exchange of money (or other property). Some strategic or financial buyers may be willing to pay more than others because they can benefit from economies of scale or synergies that aren’t available to all potential buyers.

The term “value” often refers to “fair market value” in a business valuation context. The International Glossary of Business Valuation Terms defines fair market value as:

The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms-length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

Fair market value is essentially a consensus of what the universe of potential buyers would agree to pay for a business, a business interest or an asset. In the real world, sales may occur for more (or less) than fair market value, because the individual parties have their own perceptions of the investment’s risk and return, are under duress to buy (or sell), or lack relevant knowledge about the transaction or the subject company.

Another reason that value and price frequently differ is timing. In many cases, a valuator’s work is done months or years before the company is sold. Differences in market conditions or the company’s financial performance between the two dates could cause the company’s selling price to vary from its appraised value.

Real World Example

To illustrate how price and value may differ, consider the sale of a medical practice. There are primarily three potential buying groups for medical practices:

  • Another physician,
  • A physician group, or
  • A hospital.

To determine fair market value, a valuator would consider potential transactions to purchase the practice by all three of these groups, under the cost, market and income approaches. But in the real world, only one specific buyer would make an offer. So, for example, the analyses involving a physician or physician group wouldn’t be relevant if a hospital is buying the practice.

Price and Value Aren’t Synonymous

It’s critical for buyers and sellers to understand that the appraised value of a business interest may not reflect its future selling price. Value can vary substantially, depending on the effective date and the purpose(s) specified in the appraiser’s report.

When the purpose of a valuation is to establish an asking (or offer) price, valuators may provide a range of values that considers various buyers and transaction scenarios. This range can help a buyer and seller arrive at a reasonable selling price that’s based on the individual parties’ expectations of risk and return.

If you’re planning to buy or sell a business interest, the professionals at Advent Valuation Advisors are here to help.

© 2020, Powered by Thomson Reuters Checkpoint

Lost Profit Claims Face High Hurdles in NY

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Lost profits claims are difficult to prove under New York law. This is particularly true for a new business, or an existing business entering a new market or line of business.

A recent decision in a case heard in Arizona District Court – but involving a supply agreement governed by New York law – provides some insight into the hurdles faced by such claims.

In IceMOS Technology Corporation v. Omron Corporation (2:17-cv-02575) , the plaintiff, a business that sells semiconductor components, sued the defendant alleging breach of the supply agreement. The plaintiff’s claims included lost profits. The defendant countersued, and the case is ongoing.

In November, the court granted the defendant’s motion to dismiss the lost profits claim, finding that the plaintiff did not establish lost profit damages with reasonable certainty.

Three-Part Test

As explained in the decision, under New York law, there are two broad categories of damages that can result from a breach of contract. The first is the general damages that are the natural and probable consequence of the breach. The second is special or extraordinary damages that do not flow directly from the breach. A claim for lost profits is an example of a claim for special or extraordinary damages. New York uses a three-part test to determine if a party is entitled to recover lost profits:

  1. The damages must be caused by the breach of contract. 
  2. The loss must be proven with reasonable certainty. 
  3. The party making the claim must demonstrate that the lost profits were foreseeable, that they were in “the contemplation of the parties at the time the contract was made.”

For a new business, the bar is set even higher. In order to establish reasonable certainty, a new business making a lost-profits claim must generally support the claim “with evidence of a history of profit or comparison of the new business with other comparable and profitable businesses.”

In addition, a new company must consider general market risks that might hurt its future profits, such as new competitors, technological or regulatory changes, or general market movements.

The hurdles for new businesses also apply to existing businesses entering new markets. This was the case for IceMOS, which reached an agreement with Omron Corporation in 2011 under which Omron would fabricate semiconductor wafers for IceMOS over several years. IceMOS purchased just a small fraction of the agreed-upon quantity. The court found that the plaintiff was a new business, as IceMOS was entering a new market, and held it to the higher standard.

The plaintiff’s lost profits claim relied on projections by the company’s president and a pair of experts. The plaintiff did not show a history of profits or any comparisons with profits of similar businesses. The court noted that, in New York, projections are generally not sufficient to establish lost profits with reasonable certainty. “Without a history of profit or evidence showing the profitability of other like-businesses, Plaintiff cannot establish lost profit damages with the reasonable certainty New York law requires for new businesses.”

The decision builds upon a series of earlier rulings that address aspects of the three-part test and the heightened evidentiary burden for new businesses. You can read the decision here.

Advent Valuation Advisors provides a variety of litigation support services. Please contact us if you have questions about the determination of lost profits or the calculation of other types of damages.

Considering a Business Acquisition?

You wouldn’t perform a surgery on yourself. The same holds true when buying a business. Unless you’re well-versed in performing a comprehensive financial analysis of a business, it doesn’t make sense to buy one without using a due diligence and valuation specialist. A due diligence report:

  • Verifies the accuracy of the seller’s information.
  • Outlines a detailed understanding of the business.
  • Contains vital information that can be used for negotiating the transaction, obtaining financing, establishing the tax and accounting basis of the assets, and integrating the acquired entity into the buyer’s business.

Most of all, due diligence identifies possible deal-breakers. A seller may “prepare” a business for sale, making it look better than it really is, in order to obtain a higher price. A professional due diligence review guards against the overstatement of assets and understatement of liabilities. It also provides an analysis of historic earnings and the likelihood that forecasted operations can be met.

One crucial, but often overlooked, part of due diligence involves the tax consequences of the proposed transaction. Depending on the operating structure of the acquiring company and the target (for example, a C corporation, S corporation or partnership), it may be better to receive assets versus stock. Keep in mind that a badly structured sale can result in a tax disaster.

Contact Advent Valuation Advisors to learn how due diligence can keep a sale from resulting in costly errors.

© 2020, Powered by Thomson Reuters Checkpoint

Understanding the Terms of Engagement

When you need to know how much your business is worth, one of the first questions to ask is, how much work – and how much expense – will it take to get the job done?

In many circumstances, a comprehensive valuation is required or preferred. Sometimes, however, a relatively straightforward, and less costly, calculation of value may be sufficient. The purpose of the valuation will often dictate the scope of work that is appropriate.

Both the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA) have defined the scope of various assignments used to value a business, business ownership interest, security or intangible asset. In its Business Valuation Standards, The American Society of Appraisers (ASA) defines three types of engagements:

  • An appraisal engagement is the most comprehensive. It considers all relevant information as of the appraisal date and results in the expression of an unambiguous opinion of value, which is supported by all procedures the appraiser deems relevant.
  • A limited appraisal engagement is based on consideration of limited relevant information and limited procedures deemed necessary by the appraiser. It results in an estimate of value.
  • In a calculation engagement, the appraiser and the client may agree on the procedure or procedures to be performed. The appraiser collects limited information, performs limited procedures and provides an approximate indication of value.

The American Institute of Certified Public Accountants defines two types of engagements:

  • In a valuation engagement, the valuation analyst applies the approaches he or she deems appropriate. The result is a conclusion of value.
  • In a calculation engagement, the analyst and the client agree ahead of time on the procedures the analyst will perform, and these procedures are generally more limited than in a valuation engagement. The result is a calculation of value.

A full appraisal or valuation engagement will generally result in the production of a comprehensive report that describes in detail the procedures performed, while a calculation may result in an estimate, with limited additional information provided to the client. In any of the engagements described above, the resulting value may be a single amount or a range.

So, how does a business owner determine which type of engagement is appropriate?

The right tool for the job

There are times when a calculation may be sufficient. For instance, a small business owner who receives an offer to sell his or her business may simply want to gauge the fairness of that offer. According to the AICPA’s Statements on Standards, a calculation engagement also may be acceptable when acting as a neutral party in a dispute. For a matter involving the IRS or the Tax Court, a full valuation resulting in an opinion/conclusion of value is generally preferred.

The use of calculations in court matters has become a contentious matter. In a piece in the November 2019 issue of Business Valuation Update, Michael Paschall, an accredited senior appraiser and attorney, criticizes a phenomenon he terms “calculation creep,” the increased use of calculation engagements in litigation settings.

He claims the “incomplete and potentially biased aspects of calculation engagements represent a dumbing down of the valuation process and profession,” and calls on the governing bodies in business valuation to bar calculations for litigation, ESOPs, IRS purposes “or any other context where a reliable opinion of value is needed or third-party reliance is present.”

In Hanley v. Hanley, a case decided in June 2019 in New York State Supreme Court in Albany, the court rejected a value calculation produced by an accountant retained by one of the parties. The decision cites several concerns, including questions about the independence of the valuation professional and the lack of documentation in the valuation report, which did not describe the limited procedures or approaches used in the calculation.

At the end of the day, any valuation is only as credible as the professional who renders it. The judgment of the valuation professional is a key ingredient in every phase of the assignment, from determining the appropriate scope to selecting the best methods, reconciling the results of different procedures and, ultimately, deriving the indicated value.

Advent’s valuation professionals can walk you through the process and help you determine what type of engagement will best meet your goals.

Buy-Sell Agreements: What You Should Know

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For many of our clients, their investment in their business is the most significant financial asset they own. Many are baby boomers (individuals born between 1946 and 1964) who have reached or are approaching the transition from working to retirement. As that transition occurs, their small or medium-sized businesses will be sold or otherwise passed on to the next generation of owners.

It is often during these times of transition that the importance of buy-sell agreements becomes evident. Buy-sell agreements spell out the terms for transferring an interest in a business upon the death or departure of an owner. The time to create such an agreement is not during a transition, but rather at the start, when all of the owners are involved and an orderly transition can be planned. In our role as appraisers, we have seen many clients who either don’t have a buy-sell agreement or whose agreement simply doesn’t work as the shareholders expected.

As a shareholder, ask yourself three questions:

  1. Do you have a buy-sell agreement?
  2. Do you know what your buy-sell agreement says?
  3. How is your buy-sell agreement funded?

Even in companies that have agreements in place, we often find that they are not current, have a price determination that isn’t fair or workable for all parties, or lack funding arrangements for events that trigger a transfer. These situations can result in protracted litigation or even the demise of the business. If you have a buy-sell agreement, it may be time to review it.
The four most common ways that business owners exit their privately held businesses are a sale to a third-party, gifting ownership interests to family members, selling to employees and liquidating. Buy-sell agreements can provide guidance in all of these situations. Read your agreement to see if the language delivers the results you desire in each situation. 

A review of your agreement should focus on three key areas: triggering events, pricing and funding.

Triggering Events

The agreement should define the transfer process for triggering events such as shareholder retirement, termination of employment, death, disability, sale, divorce and bankruptcy.

Pricing

Transaction prices in buy-sell agreements are usually defined by a fixed price, a pricing formula or an appraisal.

Fixed prices are easy to understand and easy to set initially, but may be difficult to reset as time passes and interests diverge. The provisions are rarely updated, and inequities are likely to result.

Formula-based pricing provides a mechanism to update the value based on various metrics in the business. However, a formula selected at a point in time rarely provide reasonable and realistic valuations over time. Changes in companies, industries and the local and global economies may impact the true value of an enterprise relative to any set formula. And formulas may be subject to multiple interpretations.

If appraisals are used, all parties will understand the valuation process from the start, and they’ll know what to expect when a triggering event occurs. Appraisers can incorporate key business drivers and risks into the determined value. Periodic appraisals provide a mechanism for keeping a buy-sell agreement up to date, so that all parties know the current value of the business and their interests. An updated valuation provides valuable information for business and personal financial planning, as well.

We recommend clients consider appraisals of their businesses. Though this comes at an additional expense, owners should make the small investment to understand what their business is worth with an annual or periodic valuation. They will potentially save much more in litigation or exit costs later.

Funding

The buy-sell agreement should spell out how transactions will be funded in situations where the company buys shares back from shareholders. Management’s plan should spell out several key points:

  • Who will buy the shares? Other shareholders, the company or a combination?
  • Should the company hold life insurance to fund share purchases if an owner dies?
  • What are the terms of the transaction (down payment, interest rate, security)?
  • Are there any restrictions on share payments under the company’s loan agreements?

We have seen a variety of other deficiencies in buy-sell agreements. Some lack the signatures of current shareholders. Others have not been updated for several years. In others, the level of value is not identified.

As you can see, there are a number of issues which, if handled poorly, could result in your buy-sell agreement creating as many problems as it solves. Used properly, the buy-sell agreement is a great tool to provide guidance for all kinds of triggering events that affect shareholders. We encourage you to discuss these matters with shareholders and your attorney. If you are in need of a current appraisal, please call us.