CHECKLIST OF FATAL FLAWS IN BUSINESS APPRAISALS

COMMON ERRORS IN BUSINESS VALUATION

Many business appraisals contain errors which can result in the opinion of value being discarded by the Court, or it may significantly reduce the credibility of the business appraisal expert.  Commonly observed errors include:

1.            Applying an equity rate of return developed from empirical cash flow evidence to earnings, a non-cash flow number;

-          Rates of return based on Treasury notes, and returns available from other types of investments returning cash are not the correct rates to apply to an earnings number when using a discounted cash flow of capitalization approach.

2.            Valuing a minority interest using control interest assumptions without proper adjustment;

-          Minority interest holders CANNOT force liquidation so it is inappropriate to ever use liquidation valuation techniques (adjusted net asset values) when valuating operating entities.

-          When valuing minority interests using merger and acquisition information, or after making control adjustments (e.g. adjusting owner’s compensation to market or related party rent to market) requires an appropriate application of minority interest discount.

3.            Valuing a controlling interest using minority interest assumptions without proper adjustments;

-          Control interest valuations developed from public stock exchange per share pricing of comparable companies must reflect an adjustment for control which is not existent in per share exchange pricing.

-         Control interest valuations developed from cash flows in which owner’s compensation and other related party transactions have not been adjusted to market must reflect an adjustment associated with control since the controlling interest could and would adjust these items to her/his benefit.

4.           Failure to properly apply discount for lack of marketability (DLOM);

-         When valuing closely held business interests based on observed marketable securities’ multiples an adjustment must be made for the closely held interest’s lack of marketability.

-          When valuing minority interests in a closely held business there is always a marketability discount unless you are applying market multiples developed from transactions of minority interests in closely held businesses, or when applying a prescribed buy/sell agreement formula.

5.            Applying equity rates of return to cash flow available to total invested capital (before debt service), or applying a weighted average cost of capital (WACC) to cash flows available to equity (after debt service payments);

-         The nature of the cash flow being capitalized defines the rate of return to use, so that cash flow available to equity holders (cash flow which has been reduced for all required debt service payments) must be capitalized at equity rates, and cash flow available to all invested capital (cash flow developed without subtracting required debt service) must be capitalized at the rate of return associated with all invested capital (i.e. WACC), both interest bearing debt and equity.

6.           Valuing a business interest based upon cash flows to the investor AFTER personal income taxes applicable to the investor;

-         Valuation theory requires fair market value to be based on cash or other assets available to the investor(s) before investor taxation, since rates of return and market derived multiples are based on “before” investor level taxes.

7.            Capitalization rates require achievable long term growth rates;

-         Very few if any closely held businesses can achieve annual cash flow growth rates in excess 6% to 7% for any period of time beyond a few years, maybe 5 years, since, in percentage terms, the business/cash flow will get to large to achieve that percentage, or the potential cash flow growth rate will bring in significant competition.

8.           Failure to interview management;

-          Without management interviews the appraiser cannot adequately assess factors which dramatically impact the risk of the business (and subsequently the rate of return required by investors), such as customer concentration, vendor concentration, key employees, anticipated future capital needs, product/service obsolescence, market penetration, competition, niche development, etc.

9.            Reliance on historical financial information from time periods not consistent with current operations;

-         Reliance on operations which have substantially changed will relative to current operations lead to materially inaccurate cash flow projections.   Only those periods which reflect current services delivered or products produced and/or sold are reasonable surrogates for future period projections.

10.         Failure to recognize that revenue growth requires capital investment which reduces available cash from operations;

-          Even if additional investment in equipment, facilities, or workforce is not necessary to sustain projected increased revenues, increased revenues, in the absence of very unusual circumstances, will require increased capital investment in the form of additional working capital.

11.         Failure to recognize non-operating assets;

-          Assets owned by the business which can be removed without any impact on revenues or net operating income/cash flows are considered to be non-operating assets, and the value developed by capitalizing cash flows or applying market multiples do not incorporate the value of these non-operating assets.  The value of non-operating assets (e.g. excess cash, unnecessary vehicles and/or entertainment facilities) must be added to the value of the interest in operations in order to properly value an operating business holding non-operating assets.

12.         Failure to properly incorporate investment earnings when valuing an operating entity;

-          Interest income and other investment earnings generated from working capital necessary to continue operations should be included in operating cash flows when capitalizing cash flow, while interest income and investment earnings from non-operating assets (excess cash) should not be included in cash flows when capitalizing cash flows.

13.         Application of inappropriate market derived valuation multiples;

-          Observed market multiples (cash flow multiples of sales multiples) will define a range for the valuation multiple.  An application of a multiple which falls outside of the observed range is a violation of statistical theory and will generally result in an indefensible value estimate.

14.         Reliance on book values of debt and equity to develop an appropriate weighted average cost of capital (WACC);

-          As noted earlier, when developing values by capitalizing cash flow available to all invested capital (interest bearing debt and equity), the capitalization rate must be based on both the equity rate of return and the interest rate associated with the debt, blended based on the current value of the debt and the current value of the equity, NOT the book value of the equity.  The book value of equity only reflects historical costs of recorded transactions, omitting valuable unrecorded intangible assets.

15.         Reliance on Court decisions for quantifiable impacts;

-          Reliance on court decisions is appropriate only when determining appropriate methodology, but it is NOT appropriate to rely on specific court decisions or averages of court decisions when determining the applicable magnitude of discounts or premiums to apply to a specific valuation, since courts determined those on specific facts and circumstances of the case in question and the perceived quality of the case presented.

The errors noted above can easily render a valuation opinion indefensible and inaccurate.  Even if the error does not result in a significant error, the existence of such an error materially impacts the credibility of the expert and her/his report.

DO YOUR EXPERTS’ REPORTS CONTAIN THESE ERRORS?

DOES THE OTHER SIDE’S EXPERT’S REPORT CONTAIN THESE ERRORS?

JONES & ROTH, P.C.

William V. Mason II, ASA, CPA/ABV

Chris Hays, ASA, CVA, CPA/ABV

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