Recently, a Business Valuation Resources article cited a New York fair value trial case where “one of the 50% owners filed for dissolution and the other owner elected to buy him out.” However, the valuation expert for the owner who would remain with the business only used tax returns as a basis for his valuation. The expert furthermore testified that he “did not independently verify the financial information” his client gave him. The owner was still deriving value from the business, but despite this fact the business valuator opined that the business was “worth $-0-.”

Thankfully, the court saw through this thinly veiled scheme to keep the departing owner from receiving his share of the true fair value of the business. But it brings into question what many business owners may not realize: how do you know that the business valuator serving as an  expert witness in your case is doing the valuation work properly and forming the right opinion of value? To answer this question you need to consider the following four questions.

Can just anyone with financial experience serve as a business valuation expert witness?

No. Determining the value of a business requires a professional who has been accredited by a professional business valuation organization. While there are others, the most common of these credentials include the ASA from the American Society of Appraisers, the ABV from American Institute of Certified Public Accountants, and the CVA from the National Association of Certified Valuators and Analysts. Professional organizations such as these provide professional standards that mandate procedures to be performed when valuing a business in litigation, and also mandate adherence to codes of ethical conduct.

These are not mere suggestions or guidelines; rather, they are requirements. Complying with the requirements of professional business valuation standards and conforming to professional ethics comprise the Standard of Care for business valuators. Business valuators must meet the Standard of Care in performing business valuations to be an effective expert witness.  Failing this, Rule 702 of federal and various states Rules of Evidence provides guidance for courts of law to reject the testimony of expert witnesses providing business valuation opinions.

What documents should a business valuator review?

A major red flag in the business valuation of the case mentioned previously is that the business valuator looked only at tax returns for the business and did not examine the underlying financial data used to prepare the tax returns. When performing business valuations, our team requests and analyzes the company’s tax returns, financial statements, and general ledgers along with a lot of additional supporting documents and information. Although some may argue that a business valuation is really just some multiple of a business’ net income, it’s much more complex than that. First of all, how do you know that the net income number is right? Based on experience, if the financial data being reviewed has not been audited by a CPA applying generally accepted auditing standards or reviewed by a CPA performing accounting and review procedures, the net income number is most likely not right.  Simply applying a multiple to a bad number results in a bad value.

The process of business valuation involves the coordinated effort of:

• Analyzing historical financial statements and the transactions within them
• Identifying non-business activity within the financial statements
• Identifying non-recurring transactions and non-operating assets
• Reviewing/preparing projected financial statements when appropriate
• Analyzing non-financial data
• Assessing numerous and varied risk factors
• Determining the appropriate standard of value
• Determining the appropriate valuation method
• Analyzing market transactions where relevant
• Applying all of the required valuation procedures correctly

Additionally, there are a variety of factors including economic and industry data, trends and forecasts that will affect the value of a business at any given time.

The valuator in the case mentioned above failed to perform all of the valuation procedures required by professional standards, and for this reason his opinion of value was worthless; it was thrown out by the court.

What is “Known or Knowable” and why is it important?

A business valuator may only consider information that was Known or Knowable on the valuation date.  The valuation date is the “as of” date for which value is being determined.  For example, in a North Carolina divorce matter the “as of date” is the date of separation; in a South Carolina divorce matter the “as of” date is the date of filing for divorce (every state has its own law regarding this.); in other types of disputes the “as of” date is the date on which a critical event occurred.

Business valuation standards (the Standard of Care) require a valuator to close his/her eyes to anything that happens after that “as of” date.  Why? Because those things were not Known or Knowable on the valuation date (the “as of” date).  It does not matter that the valuator is performing the business valuation procedures months or years after the “as of” date and many things are now known that were not Known and could not have been Knowable at the valuation date.

This is Business Valuation 101 and is a critical component to properly valuing a business at any given point in time.

Will the business valuator be speaking on my behalf during any legal proceedings?

First and foremost, it is a requirement of business valuation ethical standards to not act in favor of one party – including the party that hired them and is paying them. Business valuators are to be objective, unbiased, free from conflicts of interest, and may not subordinate their professional judgment to that of anyone else.  Moreover, these attributes must be maintained while performing all of the valuation procedures and forming value opinions.  Determining the value of any business requires the application of professional judgment.  There are “black and white” aspects to performing valuation procedures and there are “gray” areas as well.

Failing to comply with these ethical requirements can tarnish the credibility of the valuator. Credibility is paramount to being an effective business valuation expert witness. Expert witnesses who are nothing more than “hired guns,” hired to do the bidding of the one who hired them, run the risk of exclusion under Rule 702.

Business valuators are there to examine and analyze the business’ numbers and the data underneath them. They are not there to make a character assessment of you or the business owner(s) from whom you may be separating. That’s why it’s important to have a business valuator involved who acts as a “fact-finder” and forms value opinions based on factual evidence, not speculation or conjecture. According to Greg Reagan, President and Founder of Reagan FVL, LLC, ethical business valuators in this space are there to “unearth the reality behind the numbers in order to determine real value.” Emotion or favoritism must not be part of the equation.

Untangling your business ownership interest from a co-owner (or owners) or needing to know the value of a business in a marital divorce, whether amicably or not, can be a sticky and emotional experience. There are a lot of factors that must be assessed in order to determine the right value for the business and the particular business ownership interest in question based on the facts at hand.

Having the right valuator to properly determine business value can provide peace of mind and will likely be critical to the outcome of the dispute. Learn how the Reagan team can support you now and in the future.