The Valuation Process

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The Valuation Process DiscoveryThe
Appraisers Perspective
John R. Johnson CPA/ABV CBA Managing Partner June
20, 2008 www.BSTco.com
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The Epic Quest for Knowledge

• There is no statutory standard of value for
  matrimonial matters
• Regardless of the standard of value employed
  (fair market value, fair value, intrinsic value,
  investment value), the process assumes that the
  hypothetical buyer has knowledge of all relevant
  facts
• Knowledge and information is the most important
  natural resource of the valuation process
• Many cases are won and lost based upon the extent
  and quality of the information gathered during
  the discovery phase of the litigation

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• The appraiser must determine what was known or
  knowable as of the relevant valuation date
• In a case where each party has hired an
  appraiser, the appraiser for the titled spouse
  has a distinct, inherent advantage over the
  other
• Only with extensive discovery can the playing
  field be leveled and that unfair advantage
  eliminated
• Must fight the inevitable over broad and
  burdensome defense by titled spouse

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The Discovery Process

• Issuance of the Document and Information request
  (the D I )
• Review and analysis of the documents produced
• Issuance of follow-up D I for original requests
  that remain unproduced and for new document needs
  that arose fro the review and analysis of the
  documents produced. This process is often
  repeated based upon the thoroughness of previous
  productions
• Management interviews, if permitted

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• Formal Depositions (Appraiser will assist counsel
  with drafting questions and may attend deposition
  to assist counsel with follow-up questions)
• Interrogatories usually ineffective in obtaining
  good information

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Documents Routinely Requested

• Marketing and promotional materials
• Year-end financial statements and tax returns
  usually for a period not less than 5 years
• Audit, Review or Compilation??
• Although valuation is a forward looking process,
  appraisers many times use historical performance
  as a basis for future expectation

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• Interim internal periodic financial statements,
  especially between last year end and the
  valuation date---usually the date of commencement
  for active business interests
• Consider a stipulation as to the valuation date
  to coincide with most recent year-end or
  quarterly financial statements to avoid costly
  cut-off procedures

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• Tax returns for the same historical period
  requested for the financial statements
• Need to understand any unique tax issues
  associated with the business
• Quantify tax related carryforwards
• Need to understand different accounting
  conventions utilized in tax returns vs. financial
  statements
• Cash vs. accrual vs. modified accrual
• Completed contract vs. percentage of completion
• Depreciation

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• When performing due diligence in actual purchase
  and sale transactions, it is performed in the
  now
• When conducting due diligence in a hypothetical,
  retrospective valuation, the appraiser must
  determine what was known or knowable on the
  historical valuation date
• Request business plans, budgets and projections
  that existed as of the valuation date that
  provide insight into managements expectations as
  of the valuation date
• Expectations that materially differ from what
  historical results would suggest may dictate the
  valuation methodology employed, i.e., discounted
  future returns vs. capitalization of weighted
  averaged historical results

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Supporting Financial Documentation

• Aged accounts receivable schedules
• Inventory schedules
• Accounts payable schedules
• Original books of entry
• General ledger
• Journals - Payroll, purchasing, receipts,
  disbursements
• Fixed asset ledgers or depreciation schedules

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Legal Organizational Documents

• Documents of organization bylaws
• Shareholder, partner and member agreements
• Stock transfer ledgers
• Employment agreements
• Significant leases and third party contracts
• Prior valuations and appraisals

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• Documents underlying previous transactions of
  ownership interests
• Previous offers to buy or sell the company or an
  interest therein
• Offering documents, e.g. letters of intent, due
  diligence lists, proposed or executed contracts
• Other relevant documents based on the entity
  being valued

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Forensic Appraisers

• In performing due diligence for an actual buyer,
  appraisers look for items that are
• Extraordinary, non-recurring or otherwise distort
  financial results
• Search for off-balance sheet assets and
  liabilities
• Search for items that can be eliminated due to
  synergies or as a result of the economies of
  combination

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• When performing valuation in the context of
  matrimonial litigation appraisers serve in a
  forensic capacity and may be asked to perform
  additional forensic procedures
• Review documents underlying travel and
  entertainment expenses and other categories where
  the expense item constitutes a personal benefit
  of the owner
• Can form the basis of a normalization adjustment
• Can be germane to the determination of income
  under DRL 240

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Forensic Procedures When Neutral or Court
Appointed

• Must have an unbiased, healthy professional
  skepticism and perform only those procedures that
  would be normally done to simply reach an opinion
  of value within a reasonable degree of
  professional certainty
• Can not alter procedures based on the
  unsubstantiated allegations of one party as to
  personal expenses and misappropriations
• Innocent spouse considerations

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E-Production Discovery

• E-Production recommended when documents are
  anticipated to be extensive and when paper
  production would be cumbersome.
• Documents are better indexed and more easily
  retrieved when needed
• E-Discovery only sought when the thoroughness,
  accuracy and veracity of the production is in
  serious question
• Professionals can be hired with specialization in
  e-discovery, securing data, copying
  data and metadata analysis

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Normalization Process(Pg 203 of Materials)

• Once the historical financial data has been
  analyzed, due diligence and forensic procedures
  performed, and additional information has been
  obtained through interviews and deposition, the
  historical figures can be normalized to
  eliminate the effect of extraordinary,
  non-recurring, discretionary items or any other
  item(s) that otherwise distorts, or
  over/understates income, expense, assets or
  liabilities.

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Common Normalization Adjustments

• Cash to accrual conversion
• Depreciation
• Perquisites, personal expenses and items
  discretionary to the owner
• Rents or other payments to affiliates, including
  assessment of fair rent on related party owned
  real estate
• Market replacement compensation for owners and
  related parties
• Non-operating income, expenses, assets and
  liabilities
• Income taxes

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Replacement Compensation(Pg 200 in Materials)

• Compensation of owners for valuation purposes
  must reflect the market rate of non-owner
  compensation for the services provided
• Care must be taken in identifying the duties and
  responsibilities of the owner under review and
  the compensation allowance should be reflective
  of those unique services
• Compensation specialist and head hunters can be
  hired to assist in the determination
• Otherwise, commonly used statistical sources are
  generally employed by the appraiser

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• Reasonable compensation is really a tax
  construct
• The normalization adjustment can go either way
• This adjustment must be considered in determining
  the income available for maintenance and support

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Standards of Value(Pg 196 of materials)

• Fair Market Value
• Fair Value
• Agreement Value
• Investment Value
• Value to Holder
• Intrinsic Value

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Approaches and Methods

• Income Approach
• Methods
• Capitalization of earnings (as defined)
• Discounted future returns
• Asset (Cost) Approach
• Method
• Asset Accumulation Method (Holding Companies) Rev
  Rul 59-60
• Usually for Majority Interests
• Market Approach
• Methods
• Transactional databases
• Publicly Traded Guideline Companies
• Prior Transactions
• Hybrid Approach
• Method
• Excess Earnings Method

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Determining the Return

• Once the historical financial statements and/or
  tax returns are properly normalized, the next
  step is to determine which historic periods or
  weighted average of those periods that are
  indicative of future expectation and, therefore,
  a reasonable basis for valuation. Whatever the
  weighting employed, it should not be the result
  of a cookbook approach (e.g. blindly applying a
  5,4,3,2,1 weighting) but rather a judgment by the
  appraiser of which period or combination of
  periods has the best probability of being
  realized in the future.

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Capitalization Rate (see page 206 of materials)

• Capitalization rate is determined by building
  up the rate starting from the risk free rate and
  adding equity risk premia, company specific risk
  premia and adjusting for a sustainable long term
  growth.
• Generally computed through the use of
• Build-up Method or
• Capital Asset Pricing Method (CAPM)

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Excess Earnings Method(See Pg. 209 of materials)

• Revenue Ruling 59-60
• Separate determination of Goodwill.
• Capitalization of earnings in excess of a return
  on tangible assets
• Recognizes the risk differences between tangible
  assets and intangible assets
• Tangible and Intangible components of value are
  added together to determine the value of the
  entity
• Used for small businesses and professional
  practices

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Battle Over Subsequent Information and Events

• Uniform Standards of Professional Appraisal
  Practice (USPAP) Standard 3
• AICPA Valuation Guide
• IRS Training Manual
• Subsequent data used to confirm trends as of the
  valuation date and otherwise help better
  determine what was known or knowable as of the
  valuation date. Should NOT be used as a
  foundational basis for the valuation opinion
  itself

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and to download your personal copy of the
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