Purpose, standards and approach.
September 3, 2009
Several years ago, we were retained to assist a law firm representing a client in a lawsuit in which their client had purchased a business along with its assets. After acquiring the business and taking over its operations, the law firm’s client (the buyer) found the assets to be far less than purported to be. The buyer had not used an independent valuation analyst BEFORE purchasing the business and assumed that the statements the seller made were accurate and true. Unfortunately that was not the case and the buyer ended up in a costly lawsuit trying to recover monies he spent on what turned out to be a worthless business with worthless assets. Having gone through the exercise of helping create correct financial statements and hearing expert witnesses testify as to the true value of the business and its assets I spoke to Alan Tolmas to see how the buyer could have avoided the situation in which he found himself.
Alan Tolmas, CPA, ABV, CFF, ASA and president of Tolmas Consulting, which provides Investigative Accounting and Business Valuation Services in Dallas, Texas (not a CPA firm), explained how the situation could have possibly been avoided and just what falls under the umbrella of “forensic accounting.” As most Corporate Finance Insider readers already know, forensic accounting services generally involve the application of specialized knowledge and investigative skills possessed by CPAs to collect, analyze and evaluate evidential matter and to interpret and communicate findings in the courtroom, boardroom or other legal/administrative venue.
Tolmas explained that had the buyer done a business valuation in the beginning, they probably would not have had to deal with the steps the forensic accountants had to after the fact: both a Fraud Examination and a Financial Statement Fraud examination and supporting a suit for Economic Damages. Tolmas’ point was that if the buyer had focused on the business valuation before buying the business they would have at least been aware of the discrepancies in the financial statements, projections, sales, receivables, etc. They could have then made a more educated decision as to whether to pursue the deal or not.
I asked Tolmas to explain the steps and purpose of the valuation. Tolmas explained that the first thing an ABV (Accredited in Business Valuation — a CPA credentialed as a business appraisal specialist, and recognized for a unique ability to bridge between business valuation and accounting principles and standards), needs to understand is the purpose of the valuation. The purpose will determine the applicable “standard of value.” “Fair market value” and “fair value” are the most commonly applied standards of value, although other standards such as “investment” or “liquidation value” may be the appropriate standards in certain situations. Whereas the applicable standard of value may raise a legal question — and seeking the opinion of an attorney may be advisable — the appraiser will generally know which standard to apply.
Depending on the purpose of the valuation, other factors may need to be considered. In the example I used above, the purpose of the valuation would have been to determine not only the value of the assets but the accuracy of information the seller was providing.
Tolmas explained that, typically, the client (the seller in the above example) must provide a pretty exhaustive amount of documentation and information to the business appraisal specialist. Historical financial data and budgets, forecasts or projections if available must be provided before the valuation process can begin. Also important information for the business appraisal specialist to have is governing documents such as partnership or operating agreements as well as any buy/sell agreements. For efficiency, many valuation companies will not begin the valuation process until all information and documentation requested has been provided. Other documents and information typically requested are an organizational chart, contracts with customers and/or suppliers, debt agreements, lease agreements, profiles of upper management, employee information and a history of the company to mention a few.
Tolmas also pointed out that a valuation is a snapshot in time just as is a balance sheet. Thus, the valuation date can take on tremendous importance in the ultimate value of a business. The general rule in valuation is that information not known or knowable as of the valuation date is not taken into account in the valuation analysis. In the above example, the assets were worthless at the time they were sold not as a result of not known future information.
The business appraisal specialist may decide that one or more of these approaches are not appropriate for a particular valuation in which case the analyst is not required to develop and apply it (or them). For example, in valuing a holding company whose assets are comprised solely of publicly-traded securities, the business appraisal specialist need only rely on the asset-based approach. Conversely, for an operating company with significant goodwill value, the business appraisal specialist may decide that the asset-based approach is not appropriate and may rely only on the income and market approaches. In valuations for marital dissolution in some states, use of the income approach may not be acceptable because it includes future earnings of a divorcing spouse, which is considered non-marital or separate property.
Using an example from Tolmas’ past experience in a family law matter, the asset-based approach was the only applicable one. The business’ inventory represented the vast majority of the value of the business. The husband was adamant that the value was no more than $1 million whereas the wife firmly believed its value was no less than $8 million. Neither of the parties wanted to spend $3,000 to $5,000 to have an independent personal property appraiser value the inventory. The judge applying the Solomon (split-the-baby) method ruled the value to be $4 million. Needless to say, neither party was pleased with the outcome and regretted not having followed Tolmas’ advice to bring in an independent personal property appraiser.
In valuations of closely-held businesses, discounts for minority interests, premiums for controlling interest and discounts for lack of marketability must be considered. (Note that these are not the only reasons for discounts or premiums, and that there are many more.) Such premiums and discounts are applied differently to businesses or business interests, depending on the nature of the interest, the source of the indication of value under the various approaches and the standard of value.
For valuations of service businesses for acquisition purposes, the conventional assumption of an orderly transition of clients from the seller to the buyer may, in reality, prove to be incorrect. Tolmas told me of an engagement involving a dispute that arose from the acquisition of a dental practice. After the practice was sold, the selling dentist opened up a new dental practice just a few blocks away and most of the patients from the old practice followed him to the new location. (Don’t they teach covenants not to compete in dental school?)
Referring to our situation with a buyer trying to recover his losses, Tolmas explained that forensic accounting provides services that all played a part in his attempted recovery; helping determine economic damages, fraud detection and, financial statement fraud. He emphasized that had they started with the valuation services provided in forensic accounting they may have avoided the need for the other services forensic accountants provide.
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Allen M. Liebnick, CPA, CFF is president of Overpaid Payables Recovery, Inc. A former associate professor, Liebnick has been providing accounts payable, sales tax and telecommunications post audit recovery services for over 15 years. He serves clients in the U.S., Canada and Mexico. He is a member of the New York State Society of CPAs as well as Texas Society of Certified Public Accountants. Liebnick thanks Alan Tolmas for participating in this article. Corporate Finance Insider readers who have questions can contact Tolmas directly via e-mail. Feel free to contact him and tell him Allen sent you.