Articles

Divorce Case Highlights Value of Goodwill

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Photo by Nosiuol on Unsplash

While not a New York case, a recent divorce case in Delaware Family Court sheds new light on an old precedent for the treatment of enterprise goodwill in a sole proprietorship.

The couple in A.A. v. B.A. married in 1979 and divorced in February 2017, but the case lingered, with a decision regarding the valuation of the husband’s financial advisory practice, a sole proprietorship, coming in October 2020.

Both spouses hired experts to value the business. The experts reached widely divergent conclusions, with the husband’s expert valuing the business at $255,000, while the wife’s arrived at a value of $3,488,0000 to $3,500,000.

The court rejected the report by the husband’s expert, taking issue with both its failure to consider the business’s goodwill and its reliance on a flawed asset approach.

“From the outset, husband’s expert’s opinion was limited by his belief that Delaware law was settled that there could not be good will in a sole proprietorship,” reads the decision.

The husband’s expert had relied on a 1983 Delaware Supreme Court decision. In E.E.C. v. E.J.C., (457 A. 2d 688, Del. 1982), the court had rejected the consideration of goodwill in the valuation of a sole practitioner’s law practice. According to the decision in A.A. v. B.A., the husband’s expert took that oft-cited decision as an indication that Delaware case law does not permit the use of goodwill in valuing sole proprietorships under any circumstances.

The court rejected this premise: “The court notes that husband’s business in the present case is not a law firm and the practice and means of generating income are different. The court does not read E.E.C. as stating every sole proprietorship in every case has no professional good will.”

The court agreed with the wife’s expert, who assigned 5 percent of the total goodwill to the husband based on the value of his noncompete agreement, and the remaining 95 percent to the business. The court said both experts agreed that, if the husband could transfer goodwill such that he could transfer to a buyer his client base and stream of income, or even 95 percent of his stream of income, he could receive about $3.5 million for the business.

Misassessed assets

The court also took issue with the husband’s expert’s asset approach, which did not consider income earned but not yet paid to the business as of the separation: “Husband continued to run the business and the value receive[d] by husband through receivables, work in process or residual commission tails was well beyond the amount placed on it by husband’s expert. This would probably explain why the husband himself placed a value of $10 million on the business in his financial statements.”

The decision notes that, between the date of separation and late 2019, the husband extracted more than $4 million from the business, including commissions for work done during the marriage. This included a $600,000 commission received in 2018 that had been in the making for perhaps three years, according to the husband’s testimony.

The wife’s expert used a weighted combination of the income approach (capitalized income method) and market approach (transaction and guideline public company methods). The court relied on the wife’s expert, determining that the business’s value was $3,488,000.

The case is A.A. v. B.A., CN16-05018 (Del. Fam. Oct. 9, 2020). Read the decision here.

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If you require assistance with the valuation of your business in a matrimonial matter, please contact Advent for trusted guidance.

How Much is that Donated Stock Worth?

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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 

Lawsuit Turns on Credibility of Valuations

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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

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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 

Understanding the Terms of Engagement

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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.