Viewpoint on Value
Where do I start?
DCF method is only
as good as what lies beneath
It’s only reasonable
5 factors to help determine
Picking the “right”
standard of value in divorce
Cross-examining a valuator:
Where do I start?
ffective cross-examination takes patience, skill
and planning. You could ask a valuation expert a
thousand questions, but judges and juries obvi-
ously have limited attention spans. Save the extensive
inquiry for deposition. Then cherry-pick the most
relevant, and damaging, questions for the courtroom.
The best line of inquiry
As an advocate for your clients, you want to dem-
onstrate that the opposing expert is less qualified,
objective and knowledgeable than your own expert
witness. Some key questions with which to cast doubt
on the opposition include:
How does your background qualify you to value
the guideline public company and the merger-and-
businesses? Accounting and economics curricula
acquisition methods fall under the market approach.
normally don’t teach undergraduates how to value
Valuators consider all three approaches for every
businesses. Make sure the expert has a finance degree
valuation, but they may decide to omit one or two,
or some postcollege appraisal training. Real-world
depending on the facts and circumstances of the case.
experience tends to be more persuasive to judges and
juries than book learning.
Ask why they chose (or discarded) each approach,
especially if your expert selected different methods.
Also inquire about professional credentials.
Then ask what basis of value their methodology
Nowadays, a CPA license alone is not enough to
generates (for example, controlling or minority,
qualify an appraiser. Expect all testifying experts to
possess a valuation designation from an accredited
appraisal organization and to be current in their con-
Your own expert or a separate valuation consultant
tinuing professional education requirements.
(see “Use consultants to gain an edge” on page 3) can
help you dig deeper into the specific methodology to
What information did you rely on in arriving at
unearth flaws, subjective components and errors.
your conclusion? Most valuation reports list all the
professional publications and company documents
What adjustments did you make? Every appraisal
the appraiser used. The expert’s opinion could be
requires subjective adjustments. Examples include
compromised if a relevant piece of information, or
changes to the company’s financial statements as well
the most recent version of a key document, is not
as rates of return or pricing multiples derived from
listed. Some dishonest attorneys and clients strategi-
comparable companies. Appraisers also may adjust
cally limit an appraiser’s access to key information to
their preliminary value conclusions for specific items,
skew the expert’s opinion.
such as excess working capital, nonoperating assets or
What approaches did you use to value the busi-
ness? The three broad approaches to value a business
Find out how the expert quantified each adjustment.
are the cost, market and income approaches. Several
Did he or she rely on trade journals and benchmark-
methods fall under each approach. For example,
ing studies? Are these timely and truly comparable to
the subject company? All adjustments should be rea-
minority shareholder lawsuits. And don’t forget to
sonable and well supported by real-world data.
ask about the less common discounts and premiums,
such as key person discounts, blockage discounts and
Minor differences in adjustments can have major
swing vote premiums.
impacts on an appraiser’s conclusion. To drive this
point home, you can show how a 1% difference in,
On the attack
say, the long-term sustainable growth rate or small-
Before going to trial, read the valuator’s report, tak-
stock premium (components of the capitalization
ing notes and highlighting confusing sections. Ask
rate) might alter the valuator’s conclusion.
for clarity from your own expert or at deposition.
Also have a paralegal or junior associate recalculate
What discounts did you take? The most com-
the math underlying the valuation. You might find an
mon valuation discounts are for lack of control and
error or unearth an errant spreadsheet formula.
marketability. Compare the basis of value derived
from each method to the appropriate basis of value
Finally, review the opposing expert’s previous court-
for your case. Is a separate discount warranted, or
room transcripts and professional publications. Any
is it already implicit in the valuator’s methodology?
inconsistencies between what he or she has said in
How did the appraiser quantify the discounts? Never
the past and current courtroom testimony could dis-
accept an average or median from an empirical study
credit the expert.
without more in-depth support.
Preparation is key
Inquire whether statutes and case law permit valu-
Be sure to take the time to gain a general understand-
ation discounts. For example, many states do not
ing of valuation techniques and issues. You’ll be more
permit valuation discounts in dissenting or oppressed
effective and successful in cross-examination. l
Use consultants to gain an edge
Cross-examining a valuation expert can be a daunting task. The last thing you want is for your
unfamiliarity with appraisal techniques and jargon to provide an opportunity for the opposing expert
to showcase his or her expertise.
Fortunately, valuators can do more than merely prepare valuation reports and testify. They can also:
Perform a cost-benefit analysis to determine whether to settle or pursue a trial,
Strategize the most effective line of attack,
Review the opposing expert’s report and draft
rebuttal reports, and
Brainstorm relevant deposition and trial questions.
It’s often necessary to hire a separate valuator to act
as a consultant to preserve your testifying expert’s
perceived objectivity. Once a valuator crosses
the line between expert and advocate, there’s
no turning back — he or she will lose credibility
if attempting to fill both roles. Further, anything a
valuation consultant does for the case is generally
protected under attorney-client privilege.
DCF method is only
as good as what lies beneath
he decision in the case In re Bachrach Clothing
continued to pay the PE firm $400,000 a month in
reminds us that the discounted cash flow (DCF)
management fees. These changes eroded Bachrach’s
method is only as reliable as its underlying
borrowing base from $4.3 million to $1.3 million.
assumptions — and the objectivity of the experts
performing the analyses.
The court commented that
Bachrach Clothing, a 125-year-old men’s retailer,
“each expert generally
was sold to a private equity firm for $4 million cash
and $4 million in subordinated debt in 2005. The PE
selected parameters that
firm structured the sale as a leveraged buyout (LBO),
pushed his valuation in the
transferring stock to an affiliate entity and replacing
the company’s board of directors.
direction he wanted to go.”
The board appointed a new CEO, who made sub-
stantial changes to Bachrach’s operations. For
Bachrach began experiencing cash flow shortages in
example, she discounted inventory by $7 million,
early 2006. When the PE firm refused to contribute
paid $2 million in dividends, wrote off $3 million
additional capital, the company filed for Chapter 11.
in extraordinary expenses related to the LBO and
A fraudulent conveyance lawsuit was filed against
the former owners, alleging that Bachrach was insol-
vent at the time of sale.
Both sides’ valuation experts relied on the same cash
flow projections and used the DCF method to value
Bachrach on the LBO date. But their conclusions
were more than $6 million apart. The bankruptcy
court stated that “the disparity in their valuations is
striking given that they relied on the same data as
their starting point. It lends credibility to the concept
that the DCF method is subject to manipulation.”
The primary source of the discrepancy was the way in
which the experts determined the weighted average
cost of capital (WACC), which was used to discount
Bachrach’s cash flows to their net present value.
The debtor’s expert used a 19.5% WACC and the
seller’s expert used a 12.3% WACC. A lower WACC
results in a higher value. The court commented that
“each expert generally selected parameters that pushed
his valuation in the direction he wanted to go.”
Some important points the court made in the 2012 ruling
Overall, the court decided that the seller’s
about the parameters underlying the WACC include:
expert provided “better reasoned” explanations
for his DCF assumptions. Thus, his value of
Capital structure. The court recognized that the
approximately $6 million was “more aligned
company’s low leverage and high borrowing capacity
with real world events or contemporaneous
made it a valuable prospect in 2005.
Therefore, the judge sided with the seller’s expert,
The company had no long-term debt,
who used Bachrach’s actual capital structure to derive
was current on payables and held signif-
icant excess working capital in 2005.
So, the court ruled that Bachrach
Equity risk premium. The court opined that the
was solvent on the LBO date.
geometric mean, rather than the historic mean, is
appropriate when estimating the equity risk pre-
Make no mistake, the court did
mium (a component of the cost of equity). After
not disregard the DCF method in
reading materials cited by both experts, the judge
its opinion. It remains a technically
decided that the “arithmetic average return is likely
sound, widely used tool for valuing
to overstate the premium.”
private business interests. But the
case cautions business owners and
Size premium. The court accepted the smaller size
experts that shortcuts and bias won’t
premium set forth by the seller’s expert, because
lead to the desired result.
that expert had considered industry-specific evi-
dence to “inform” his decision about size.
Experienced valuators understand the need to
support their assumptions with objective, market-
Specifically, the expert’s research revealed that
derived evidence — as well as with sanity checks
smaller apparel shops tend to perform better than
and other valuation approaches — in order to
their larger counterparts, thereby warranting a
ensure a well-reasoned value conclusion that can
lower size premium.
withstand court scrutiny. l
It’s only reasonable
5 factors to help determine reasonable compensation
he question of reasonable compensation is fre-
business’s size and financial health; the business’s loca-
quently debated in shareholder disputes, divorces
tion; industry trends; and the state of the economy.
and IRS audits. Owners’ compensation is a dis-
cretionary expense that controlling owners can alter.
A valuator can help a company estimate a range of
It can vary significantly from company to company
reasonable compensation that eliminates “owner bias”
depending on many factors, including the owner’s
and adjusts income to a level that reflects economic
education, licenses, training and salary history; the
reality based on objective market data.
The IRS and the Tax Court weigh in
net income or capital value; the complexities of the
business; and general economic conditions.
It’s not unusual for the IRS to question the compen-
sation that closely held companies pay their owners.
4. Potential conflicts of interest. When an
But in a 1983 decision, Elliots Inc. v. Commissioner, and
employee controls a company, his or her relation-
in several subsequent decisions, including Multi-Pak
ship with it is closely scrutinized. For example,
Corp. v. Commissioner, the Tax Court provided some
does the relationship allow the company to disguise
guidance, articulating five factors, or tests, that often
nondeductible corporate distributions as compen-
come into play in determining whether an owner-
sation? However, in subchapter S corporations,
employee’s compensation is reasonable:
owner-operators may do the opposite — attempt to
disguise owner compensation as distributions. When
1. Employee’s role. This focuses on the employee’s
compensation is understated in this way to avoid
importance to the success of the business, including
payroll taxes, the IRS may challenge the amount.
his or her position, hours worked and duties per-
formed. For instance, in the Multi-Pak case, the court
The Tax Court may apply the “independent inves-
found that, during a two-year period, the owner
tor test.” According to the test, if the company’s
“made every important decision” for Multi-Pak’s
earnings on equity after payment of the owner’s
operations, and that his efforts “directly contributed”
compensation would satisfy a hypothetical inde-
to its financial condition.
pendent investor, the compensation would prob-
ably be reasonable.
2. Comparison with other companies. How
does compensation compare with that paid by
5. Internal consistency. An internal inconsis-
similar companies for similar services? This fac-
tency in the company’s compensation policies
tor frequently calls for expert testimony, because
may indicate that the payments are unreasonable
valuators have the expertise to evaluate appropriate
3. Company’s character and condition. This factor
considers the company’s size as measured by its sales,
Of course, reasonable replacement compensation
may, on occasion, differ from the criteria the Tax
Court uses to challenge executive compensation. In
the business world, for instance, it may be possible
to justify paying much more than what might be
considered reasonable to maintain the operation if
the company requires special talents to improve or
There are always exceptions, and reasonable-
ness is, to some extent, in the eye of the
beholder. But typically, reasonable compensa-
tion is objective, unbiased and based on rel-
evant empirical data.
But the Tax Court’s decisions and analysis
provide a valuable roadmap for withstand-
ing IRS challenges. Business owners,
attorneys and other interested parties can
benefit from understanding the five factors
the Tax Court takes into account when evalu-
ating reasonableness of an owner’s compensa-
tion. Qualified experts apply these factors — and
others — to help enable business owners and
attorneys to prevail in court. l
Picking the “right” standard
of value in divorce
n divorce cases that include a private business, attor-
neys and clients need to know how much the inter-
est is worth to equitably distribute marital assets.
But a universal standard of value that applies in all
divorce cases doesn’t exist. In fact, legal precedent
may conflict — even within your state.
Review case law carefully
Most states fail to define “value” in their marital disso-
lution statutes, probably to avoid being saddled by legal
precedent associated with valuations prepared for other
purposes. As a result, attorneys and valuators must deci-
pher case law to define “value” in a divorce context.
Fair value is typically taken from dissenting or
oppressed minority shareholder cases. In a nutshell,
But case law often is inconsistent, because family
fair value is fair market value without discounts for
court judges, who have wide discretion in distrib-
lack of control or marketability. Some states, includ-
uting marital assets, typically review only a hand-
ing New Jersey, Indiana and Washington, have bor-
ful of business valuation-related cases each year.
rowed the “fair value” definition for divorce cases.
It doesn’t help that court opinions are generally
much shorter for divorce cases than for tax or
dissenting-shareholder cases. When little relevant
The intangible asset of goodwill is another important
case law exists, judges sometimes consider case law
issue in divorce cases. A few states include all business
outside their jurisdictions.
value — both tangible and intangible — in the marital
estate. But most require goodwill to be separated from
tangible net worth. A handful of states specifically
Case law often is inconsistent
exclude goodwill from marital estates.
because family court judges
Many states require experts to distinguish between
personal and business goodwill. Personal goodwill is
typically review only a handful
inextricably linked to the owners’ reputation, skills
and training. It may be excluded from the marital
of business valuation-related
estate, depending on state law and the specific facts
cases each year.
and circumstances of the case.
Collaborate with a valuation
Know your options
The most common standards of value in divorce are fair
Hire a credentialed appraisal professional at the
market value and fair value. Fair market value — the
onset of your case to define “value” in a divorce
standard of value in all Tax Court cases — is essentially
context. An expert who is knowledgeable in divorce
the price that a well-informed hypothetical buyer and
is familiar with both relevant state divorce statutes
seller would agree on for a business interest without
and case law in your jurisdiction — and thus can
being under duress to transact.
minimize valuation-related complications. l
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other
professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In
addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations. ©2013 VVnd13
John M. Leask II CPA, LLC.
Business Valuation Services
PERMIT NO. 57
765 Post Road, Fairfield, Connecticut 06824
John M. Leask II (Mac), CPA/ABV, CVA, values 25 to 50 businesses annually. Often, Mac’s valuations,
oral or written, are compiled in conjunction with the purchase or sale of a business, to assist shareholders
prepare buy/sell agreements, or to set values when shareholders purchase the interest of a retiring share-
holder. Here are examples:
• Due Diligence & Assist with Purchase of a Business. Mac has assisted purchasers of businesses
by determining or reviewing the offer. He helps negotiate the price, perform due diligence prior to
closing and/or helps structure and secure financing. Services have included, but are not limited to,
verifying liabilities and assets, reviewing sales and expense records, and identifying critical issues
relating to future success, and helping management plan future operations.
• Family Limited Liability Partnerships, Companies & Closely Held Businesses. Mac regularly values
various sized business interests for estate and gift tax purposes. He provides assistance to estate and trust
experts during audits of reports prepared by other valuators.
Mac also helps business owners and their CPAs and/or lawyers in the following ways:
• Planning — prior to buying or selling the business
• Prepare valuation reports in conjunction with filing estate and gift tax returns
• Plan buy/sell agreements and suggest financing arrangements
• Expert witness in divorce & shareholder disputes
John M. Leask II CPA, LLC.
• Support charitable contributions
Business Valuation Services
• Document value prior to sale of charitable entities
• Assist during IRS audits involving other valuators’ reports
• Succession planning
• Prepare valuation reports in conjunction with pre-nuptial agreements
• Understanding firm operations & improving firm profitability
More information about the firm’s valuation services (including case studies) may be found at www.LeaskBV.com.
To schedule an individual consultation or to discuss any other points of interest, Mac may be reached at 203 – 255 – 3805.
The fax is 203 – 380 – 1289, and e-mail is Mac@LeaskBV.Com.
If you have a business valuation problem, Mac is always available to discuss your options — at no charge.