The Importance of a Credible and Competent Expert

The need for business valuation arises in many circumstances ranging from dispute resolution, estate planning, to the sale of a business to name only a few.  As in all professional disciplines, it is important to hire a knowledgeable expert who is abreast of current best practices and able to discern relevant facts that will determine value.  In short, a credible and competent practitioner can ensure a more accurate result.

Consider the following case that was decided upon in a New York Appeals Court.*

Two brothers and their uncle each owned a one-third interest in a distribution business.  The brothers had offered to buy out the uncle. The uncle refused, the relationship deteriorated, and the case became a matter for the New York courts to decide.

The brother’s expert was a CPA lacking a business valuation credential, who had reportedly performed about 50 business valuations. His valuation report was three pages in length, based on a review of the company’s tax returns, conversations with its accountant, and its principals.  He chose an income approach, using the capitalized income method.  His rationale for using just one approach was that he couldn’t find comparable market transactions and that the company was not public. Normalizing adjustments produced an income stream of $206,000. A derived 20% capitalization rate was based upon company-specific risk factors such as customer concentration and limited management; applied a 20% discount for lack of marketability. He concluded the uncle’s one-third interest was worth $230,000.

The uncle’s expert was a credentialed business appraiser.  His review included tax returns, general ledger, bank statements, and sales reports.  He found sales had doubled, gross margin declined, while officer compensation increased from $0 to $500,000. Further due diligence revealed 20% of sales were cash payments not recorded on the books. Analysis of sales reports found unrecorded sales of almost $1 million. Additionally, he imputed industry gross margins of 35% versus 25% company reported margins.  The income approach produced a normalized income stream of $486,000, a 12% capitalization rate, a 5% discount, and a $4,050,000 value. As a sanity check, he used the market approach with Pratt’s Stats transaction data. In applying market multiples for sales, gross profit, and EBITDA he found a range of values between $3,990,000 and $4,191,000. He gave a 70% weight to the income derived value; 10% weight to each market derived value.  He concluded the uncle’s one-third interest was worth $1,287,000.

The courts affirmed the uncle’s expert citing his “credibility and reliability of valuation methods.”  Specifically, the court noted his qualifications, the use of more than one method, and more objective and rigorous due diligence to support his conclusion.  Importantly, the uncle’s expert also demonstrated legal acumen regarding state law on the applicability of minority discounts.

his example illustrates the wide range of valuations that often takes place in the real world of business valuation.  The hypothetical valuation inherent in the Fair Market Value standard requires a rigorous analytical process that can be explained and understood.  The practice and theory of valuation continues to evolve and as the case above illustrates, relying on a single method or cursory view of an entity’s operations can omit key value determinants.

Whatever the intended purpose of a valuation, using experienced and accredited valuation professionals who are skilled in using a range of approaches and methods can provide you with the most accurate indications of value.

* Adelstein v. Finest Food Distributing Co., 2014 N.Y. App. Div. LEXIS 2542 (April 16, 2014); Matter of Adelstein v. Finest Food Distributing Co., 2011 N.Y. LEXIS 5956 (Nov. 3, 2011)