Has the Seller’s Market Peaked?

Business Brokers Note Dip in Seller Confidence in First Quarter

Seller sentiment declined during the first quarter in four out of five price segments below $50 million, according to a survey of business brokers and M&A advisors. Photo by rawpixel.com from Pexels

It’s still a seller’s market, but the balance of power in business transactions has begun to shift, according to the latest edition of Market Pulse, the quarterly survey of business brokers conducted by the International Business Brokers Association and M&A Source.

The national survey is intended to capture market conditions for businesses being sold for less than $50 million. It divides that market between Main Street businesses with values of $2 million or less, and lower middle-market ones in the $2 million to $50 million range.

The report for the first quarter of 2019 describes a robust market in which sellers of businesses hold the advantage in all segments except the smallest (under $500,000). But it also notes that seller confidence declined over the preceding year across all market segments except for the $5 million to $50 million value range.

A seller’s market is reflected in seller confidence in excess of 50 percent.“Although it is still a strong seller’s market with strong values, this is the first time in years that we’ve seen four out of five sectors report a dip in seller market sentiment,” said Craig Everett, PhD, who is quoted in the report. Everett is director of the Pepper­dine Graziadio Business School’s Private Capital Markets Project, which compiled the survey’s results. “This is a sign the market has peaked, and more people are expecting a cor­rection in the year or two ahead.”

The first-quarter survey of 292 business brokers and M&A advisors was conducted from April 1-15.

Other takeaways from the report include:

Larger companies are selling at higher multiples than smaller ones. During the first quarter, sales for less than $500,000 carried a median multiple of price to seller’s discretionary earnings of 2.0. Businesses in the $1 million to $2 million range sold for three times SDE. The median EBITDA multiple paid for businesses in the $2 million to $5 million range was 4.3, compared to the median multiple of 6.0 for businesses in the $5 million to $50 million range.

Larger companies tend to sell for a greater percentage of asking price.
Lower middle-market companies ($5 million to $50 million in value) sold for 101 percent of the asking price or internal benchmark. Small Main Street companies (less than $500,000) sold for 85 percent of asking price.

One reason for the difference: Larger companies are more likely to attract interest from private equity or synergistic buyers, according to David Ryan of Upton Financial Group, who is cited in the report.

Smaller businesses also tend to depend more heavily on their owners, which means more value is lost when the owner leaves the business.
For more information on the report, go to: https://www.ibba.org/market-pulse

Businesses Sold at Lower Multiples in the First Quarter of 2019


The relationship between EBITDA and sale price for private business transactions has grown more volatile over the past two years, according to the DealStats Value Index data for the first three months of 2019. Source: DealStats Value Index, 2Q 2019

Bargain shoppers took center stage during the first three months of the year, as EBITDA multiples for sales of private businesses dropped sharply, according to the latest edition of the DealStats Value Index.

The ratio of median selling price to EBITDA (earnings before interest, taxation, depreciation and amortization) fell during the first quarter to 3.2, from 4.6 during the final three months of 2018. It was the lowest level reported since the second quarter of 2018, when the median multiple hit a five-year low of 3.1.

DealStats is a database of private-company transactions maintained by Business Valuation Resources. Those transactions are used by business appraisers when applying the market approach to valuation. Multiples such as sale price-to-EBITDA can be derived from transactions involving similar businesses and used to estimate the value of a company.

Business appraisers use ratios such as price-to-EBITDA in roughly the same manner that home appraisers use price-per-square-foot – to create a ballpark estimate of value, subject to adjustments for unique features of the entity being valued.

Other popular ratios are price-to-sales, price-to-EBIT (earnings before interest and taxes, aka operating profit) and price-to-discretionary earnings. We could spend a full column discussing that last one; for now, think of it as the total benefits available to the business owner.

Rising margins

While the sale price-to-EBITDA multiple declined during the first quarter, another measure tracked by DealStats increased. EBITDA margin – the percentage of revenue represented by EBITDA – rose to 15 percent during the first quarter of 2019, up from 11 percent in the previous quarter. EBITDA margin and the sale price-to-EBITDA ratio tend to move in opposite directions.

In short, companies sold during the first three months of the year were more profitable (as measured by EBITDA) than those sold in the previous half-year, but sold at lower multiples of that enhanced profit level.

Increased volatility

The relationship between selling prices and EBITDA has grown more volatile over the past two years, after moving in a more narrow range from 2014 to mid-2017, according to the DealStats Value Index.

What is driving this increased volatility? Answering that is a little like trying to explain the stock market’s roller-coaster ride of the past year. If we could divine satisfactory solutions to these riddles, we’d be in a different line of work, perhaps reading Tarot cards or playing the ponies.

One factor that can create the appearance of volatility is a shift in the mix of businesses that sell from one quarter to the next. Companies in different industries tend to sell for distinct multiples. The ratio of sale price-to-EBITDA for finance and insurance companies, for instance, was 7.5 during the quarter, according to BVR, while the multiple for retail trade was 3.8. If a wave of consolidation hits retailers, it could skew the overall multiples without implying anything regarding the appropriate multiples for any given industry or business.

Think of it this way: If a developer came to town and built a few dozen pricey Colonials over a year or two, the median sale price for homes in your town might increase substantially. That would not necessarily mean that your humble split-level with its well-manicured lawn and partially obstructed mountain views had increased in value proportionately.

It remains to be seen if the recent drop in the EBITDA multiple and spike in volatility are temporary blips or signals of more sustained change. Stay tuned.

NY developer charged with running Ponzi-type scheme

A developer and landlord in western New York is charged with running a fraud scheme that prosecutors say cost investors millions.

One of the largest landlords in the country has been charged with operating a Ponzi-like scheme that used millions in investor funds to make interest and principal payments to prior investors, and to cover up other fraudulent conduct.

Robert Morgan, Frank Giacobbe, Todd Morgan and Michael Tremiti were indicted May 21 on 114 counts, charged with conspiracy to commit wire fraud and bank fraud for their roles in what prosecutors describe as a half-billion dollar mortgage fraud scheme. The defendants each face various additional charges such as wire and bank fraud and money laundering. Robert Morgan and Todd Morgan are also charged with wire fraud conspiracy to defraud insurance companies.

The charges carry a maximum penalty of 30 years in prison and a fine of twice the loss caused by the crimes, which is currently estimated to exceed $25 million.

In a related civil case, the Securities and Exchange Commission alleges that Robert Morgan, Morgan Mezzanine Fund Manager LLC and Morgan Acquisition LLC, all of Pittsford, NY, made a series of fraudulent private securities offerings that operated in a “Ponzi scheme-like manner” by using new investor funds to repay prior investors.

Robert Morgan was the managing member and CEO of Morgan Management and controlled a large portfolio of properties, according to prosecutors. Morgan and his companies developed residential and commercial real estate projects, with most of its properties located in western New York and Pennsylvania. According to the SEC complaint, between 2013 and September 2018, Morgan and the related entities raised more than $110 million by selling securities directly to investors.

The money was supposed to be used to acquire multifamily residential properties and engage in other real estate development projects. Investors were promised 11 percent returns. More than 200 investors in at least 17 states poured money into Morgan’s notes funds.

According to the criminal complaint, Morgan Management provided property management, accounting and financial reporting services for properties owned by limited liability companies controlled by Robert Morgan. The defendants are accused of conspiring to manipulate income and expenses for properties to meet financial ratios required by lenders.

“The manipulation included, among other things, removing expenses from information reported to lenders and keeping two sets of books for at least 70 properties, with one set of books containing true and accurate figures and a second set of books containing manipulated figures to be provided to lenders in connection with servicing and refinancing loans,” according to the U.S. Attorney’s Office for the Western District of New York.

Prosecutors say that, between 2007 and June 2017, the defendants conspired with others to fraudulently obtain money, securities and other property from financial institutions and government-sponsored entities like Freddie Mac and Fannie Mae. The defendants are accused of providing false information overstating the incomes of properties owned by Morgan Management or certain principals of Morgan Management.

Many of the projects did not generate sufficient cash flow to repay both their secured lenders and the notes funds, according to the SEC. As a result, the defendants used the notes funds as “a single, fraudulent slush fund, repeatedly using the funds for purposes inconsistent with the representations and disclosures made to investors,” according to the complaint. “To conceal their fraudulent conduct, and to mislead their auditors, defendants papered these transfers using sham loan documents designed to make the transfers appear legitimate.”

Investors are owed more than $63 million, according to the complaint, and the notes funds have few if any assets aside from the receivables for the loans they have made to affiliated borrowers.

Both the criminal case and the SEC’s civil case are being heard in U.S. District Court for the Western District of New York.

For more information:

https://www.justice.gov/usao-wdny/pr/robert-morgan-three-others-indicted-multi-million-dollar-mortgage-fraud-scheme

https://www.sec.gov/litigation/complaints/2019/comp24477.pdf

Court Case May Herald Shift in Valuation of S Corporations

A recent District Court decision has implications for the use of tax-affecting in the valuation of S corporations. Photo by Sarah Pflug from Burst

Lorraine Barton
Advent Valuation Advisors

On March 25, 2019, the U.S. District Court – Eastern District of Wisconsin issued an important decision supporting the use of tax-affecting in valuing pass-through entities. In Kress v. United States, Chief Judge William C. Griesbach relied heavily on the taxpayer’s expert in valuing non-controlling interests in a Subchapter S operating company called Green Bay Packaging, Inc. (“GBP”).

In the taxpayer’s expert report, GBP was first valued as a C-corporation equivalent, which included tax–affecting. Next, quantitative and qualitative adjustments were made to address economic benefits attributed to the Subchapter S election.

The valuation community and taxpayers have been fighting the IRS over this issue for years, starting with Gross v. Commissioner (TCM 1999-254) in 1999, which rejected the use of tax-affecting when valuing pass-through entities. Courts have generally sided with the IRS in opposing the tax-affecting of pass-through entities in subsequent cases such as Estate of Gallagher v. Commissioner (TCM 2011-148) in 2011.

In Kress v. United States of America (Case No. 16-C-795, U.S. District Court, Eastern District of Wisconsin), plaintiffs James and Julie Ann Kress sued to recover an overpayment of gift taxes. The court accepted the taxpayer’s valuation report, in which GBP was tax-affected as a C corporation, supporting the point that valuation experts have been arguing for several years. While the District Court’s decision in Kress does not carry the precedential weight of a U.S. Tax Court decision, it should be valuable to other courts considering the issue.

In his report, the taxpayer’s appraiser tax-affected the earnings of the S corporation in appraisals filed as of December 31, 2006, 2007 and 2008. The court accepted the fair market value as filed by the taxpayer, with only minor adjustments to the applied discounts for lack of marketability (DLOM).

In their respective reports, the IRS’s appraiser and the taxpayer’s expert each tax-affected GBP’s S corporation earnings as if it were a C corporation. This is significant, because the IRS has held the position in recent years that earnings of pass-through entities (S corporations, LLCs and partnerships) should not be tax-affected, because they do not pay entity-level taxes. Business appraisers have generally endorsed the practice of tax-affecting pass-through entities, arguing that the tax benefit of pass-throughs should be based on the effective difference in the after-tax income of their owners.

In the Kress case, this was not an issue, as both appraisers tax-affected GBP’s earnings. The IRS’s expert also applied a pass-through benefit in its application of the income approach, while the taxpayer’s expert did not.

After acknowledging the efficacy of tax-affecting, the court went even further, stating, “The court finds GBP’s subchapter S status is a neutral consideration with respect to the valuation of its stock. Notwithstanding the tax advantages associated with subchapter S status, there are also noted disadvantages, including the limited ability to reinvest in the company and the limited access to credit markets. It is therefore unclear if a minority shareholder enjoys those benefits.”

In its decision, the court did not accept the S-corporation premium (pass-through benefit) put forth by the IRS’s valuation expert, resulting in a nearly complete victory for the taxpayer. The decision represents an important point of inflection in the controversy over the tax-affecting of pass-through entities and the application of a premium for pass-through entity status.

Over the past 20 years, the application of a premium to pass-through entities based on their pass-through tax status has been a heavily debated topic. In the Kress case, such a premium was not applied by the court. While not all concur, we believe that today, most valuation experts have concluded that pass-through entities may deserve a premium when compared to otherwise identical C corporations.

It is worth noting that the gifts in the Kress case were from 2006, 2007 and 2008, prior to the pass-through tax benefit gaining full traction in the debate within the valuation community. It will be interesting to see if prevailing thought and application change in the future.

Kress will clearly be an important reference for taxpayers in gift- and estate-tax appraisal cases where the IRS argues against tax-affecting of S corporation earnings and for a premium in the valuation of pass-through entities relative to otherwise identical C corporations. The case should be considered as support for tax-affecting the earnings of a company organized as a pass-through entity for income tax purposes.

Lorraine Barton is a partner with Advent Valuation Advisors. She can be reached at lbarton@adventvalue.com.

Former Business Journalist Joins Advent as Analyst

Michael Levensohn of Monroe, NY, an award-winning business writer and editor, has joined Advent Valuation Advisors.

Advent Valuation Advisors announced that Michael Levensohn has joined the firm as an analyst.

Michael, who lives in Monroe, NY, brings more than a decade of business journalism and editing experience to Advent. He was most recently the metro editor of the Times Herald-Record, a regional daily newspaper and media company serving Orange, Sullivan and Ulster counties in New York.

He has authored more than 1,500 articles on business and financial topics including mergers and acquisitions, residential and commercial real estate, the economy and bankruptcy. His writing and investigative skills garnered more than a dozen awards from the New York State Associated Press Association, the New York News Publishers Association and other journalism organizations. 

Michael is a graduate of Princeton University and is completing a master’s degree in accountancy from the University of Illinois. He can be reached at mlevensohn@adventvalue.com.

Protect Your Business from Employee Fraud

Installing a safe and securing cash and other valuables are among the many steps employers can take to fight workplace fraud. Photo by Nicole De Khors from Burst

The bookkeeper for a small Sullivan County business is charged with making $3,000 in personal purchases on the company credit card.

An employee of an Ulster County restaurant is charged with stealing $12,000.

The longtime office manager of an Orange County propane dealer pleads guilty to embezzling more than $1.3 million – the equivalent of four years of profits – by disguising thefts as payments to vendors.

Experts estimate that organizations lose 5 percent of their annual revenues to fraud. Organizations with fewer than 100 employees are more likely to be victimized by occupational fraud – acts committed against an organization by its own officers, directors or employees – than are larger ones. And the losses for small organizations, which are more likely to lack internal controls, are typically twice as large, according to the Association of Certified Fraud Examiners’ Report to the Nations 2018 Global Study on Occupational Fraud and Abuse.

The path to a more secure workplace

Organizations need strong internal controls to prevent theft and fraud. What can a small organization with limited resources do to protect itself? Consider these steps to help reduce risk:

  • Have a written code of conduct, documentation of policies/processes, and anti-fraud policies in place. Have staff review these documents each year.
  • Segregate duties when possible, bearing in mind the potential for collusion.
  • Conduct background checks on all potential hires. If red flags are detected, do not hire the applicant without a confirmed (hopefully, in writing), sound explanation.
  • Rotate job responsibilities when possible.
  • Require employees to use vacation days, and have their job duties covered by another employee who can discover any questionable activity. Follow up with the covering employee. Ask about job-efficiency suggestions, and if they identified any concerns.
  • Provide separate user names and passwords for all authorized IT users, with information-access rights limited to required users.
  • Use a safe and security cameras. Safeguard cash, checks, credit cards and inventory.
  • Take a physical inventory at least once a year.
  • Require authorizations, receipts and recording of all petty cash transactions.
  • Have copies of bank and credit card statements sent to the home of a key manager or board member who can review them.
  • Require detailed receipts for all credit/debit card charges shortly after they are incurred.
  • Require two signatures or written authorization for expenditures over a material dollar amount.
  • Require detailed invoices from vendors that clearly outline goods and/or services provided, related locations/job names, etc.


Give your organization a checkup

Conducting regular reviews of key checkpoints in your organization can help you detect fraud early. If maintaining a schedule is difficult, try random, unpredictable reviews as frequently as possible.

Here are a few ways to get started:

  • Review monthly bank statements. Ensure checks paid were properly authorized and signed. Test large checks to the related underlying documentation. If checks are out of chronological order, determine why, and locate any missing ones. Confirm total deposits match accounting records and investigate any discrepancies. Compare the bank statement to the bank reconciliation and note if any payee name differences exist. If payroll checks are issued, examine any payroll checks with two endorsements.
  • Investigate unexplained differences in monthly cash flows from prior periods.
  • Review monthly or quarterly payroll reports. Investigate unexplained compensation increases, overtime and/or unusual reimbursements. Verify that new employees exist and former employees are no longer being compensated. Investigate any employees with no withholdings.
  • For point-of-sale transactions, reconcile closeouts to bank deposits. Note if discrepancies regularly occur with a specific employee.
  • Investigate unexplained changes in sales from prior periods. Identify missing invoice numbers, unusual credits and potential over- or under-billings.
  • Review software audit trails and access logs to identify any questionable activity or patterns.
  • Compare financial statements to the former period and clarify any unexplained discrepancies.

Here’s a final piece of advice. To limit workplace fraud, build a fair organization. Avoid situations that promote fraud, such as unrealistic goals, poorly designed incentive compensation plans or unfair workloads. Encourage an atmosphere of open communication where problems can be identified and resolved.

If you think your organization may have been victimized by occupational fraud, contact Advent Valuation Advisors at info@adventvalue.com.

Meet Our New Partner, Lorraine Barton

Lorraine Barton

Advent Valuation Advisors, LLC, takes great pleasure in announcing that Lorraine Barton, CPA/ABV/CFF, CIRA, CVA, MAFF, MBA, has been admitted to the partnership. 

Lorraine joined Advent, an affiliate of accounting and advisory firm RBT CPAs, LLP, in 2015. She has an extensive and varied accounting, valuation and litigation-support background in private industry and public accounting.

Lorraine has provided bankruptcy-support services since 2002 and business valuation services since 2004. She previously served as interim chief financial officer of a $125 million credit card processing company operating in Chapter 11 bankruptcy, helping to facilitate the sale of the business and saving more than 100 jobs.

At Advent, she and her team provide valuation and litigation-support services to closely held businesses and their advisors for purposes including mergers and acquisitions, buy-sell agreements, divorce, estate and gift-tax planning and corporate reorganizations.

Lorraine has completed a 40-hour divorce mediation training program that meets the requirements of the New York Association of Collaborative Professionals. She and the firm have wide-ranging experience in matrimonial finance, including asset tracing, lifestyle analysis and forensic examination.

Lorraine lives in Fishkill and has two sons. She is a graduate of Leadership Orange and serves on the NYSSCPA Business Valuation Committee.

She is also a member of the American Institute of Certified Public Accountants (AICPA), the National Association of Certified Valuators and Analysts (NACVA), the Association of Insolvency and Restructuring Advisors (AIRA) and the Hudson Valley Collaborative Divorce & Dispute Resolution Association (HVCDDRA).

“We are so pleased to welcome Lorraine as the newest partner in Advent Valuation Advisors,” said Michael Turturro, managing partner of RBT CPAs. “Lorraine is a crucial part of our continued growth. I wish her congratulations and many years of continued success!”

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.