By Judy Doyle | CPA Withum AAML NJ Gold Sponsor
Imagine that you are a family law associate set to embark on your ﬁrst cross-examination of a business valuation expert. It can be a daunting task; you are going face-to-face with an expert. And while you have the Rules of Evidence at your disposal to control the witness, see, e.g., N.J.R.E. 611(c), the expert has years of education, training, and experience. Fear not, this article co-authored by Mat Nunn, Esq., Alyssa Engleberg, Esq., Judy Doyle, CPA (Withum) and Megan Sartor, CPA/ABV/CFF is intended to provide advice to the novice attorney who has not had experience with business valuations.
The ﬁrst piece of advice, and this pertains to cross-examination of any expert, is that you may never know the core “science” or area of expertise as well as the expert. But you can know enough to be dangerous—you should know more than enough to be very dangerous.
Next, business valuations are not rote, black-and-white tasks; some may even say they are “an art.” This is so because there exist areas that require subjective input and, in turn, opinions. Having said that, accountants hired to prepare business valuations are guided by the Statement on Standards for Valuation Services (SSVS 1) issued by the American Institute of Certiﬁed Public Accountants (AICPA).
You must also know that New Jersey is guided by the “fair value” standard discussed in Brown v. Brown, 348 N.J. Super. 466 (App. Div. 2002). Brown stemmed from a divorce that involved the husband’s minority interest in a family business (a ﬂorist) with his mother, who maintained the controlling interest. The trial court utilized, and the Appellate Division approved, a “fair value” approach as opposed to a “fair market value approach.” The fair value approach does not discount the value of the entity due to either: (1) lack of marketability (i.e., there is a small pool of potential buyers for a closely held ﬂorist); or (2) lack of control (i.e., a reduction based on the husband’s less than controlling interest in the ﬂorist). A reading of Brown will also steer you toward two other (non-family law) cases that will help your understanding or fair value, see Balsamides v. Protameen Chemicals, 160 N.J. 352 (1999), and Lawson Mardon Wheaton v. Smith, 160 N.J. 383 (1999), which collectively stand for the following: “Neither a marketability nor a minority discount should be applied absent extraordinary circumstances.” Brown, 348 N.J. Super. at 483 (emphasis added).
Against that backdrop, there are generally three approaches to value that are to be considered in each valuation engagement: the asset, income and market approaches.
This approach essentially replaces the historical cost of certain assets reported in the balance sheets with fair market value for those assets if readily ascertainable either from independent appraisals, stipulation by the parties, or through other estimation means. This approach is often referred to as the “ﬂoor value” and is used when the subject company has a signiﬁcant level of machinery and equipment (heavy construction companies) or are real estate holding entities. This approach can be important in determining a subject company’s value when a company has historically not generated enough income and cash ﬂow to allow for an expected return on assets of a potential investor.
This approach is closest to “pure valuation theory,” which states that the value of an investment is equal to the present value of all future cash ﬂows. It provides an indication of value by either capitalizing the results historically achieved by the entity (capitalization of earnings/cash ﬂow) or by discounting the projected future earnings (discounted future returns), however deﬁned (e.g., net income, cash ﬂows, etc.). The income approach may be used when there exists a stable history and expectation of positive earnings or where there exists a projection of positive earnings for the year(s) subsequent to the date of valuation that are not indicated by historical results. In doing so, there should be sufficient and reliable historical information available to reasonable estimate expected normalized earnings or detailed and supported projections and forecasts prepared. This is the approach most frequently encountered in New Jersey family law cases.
This approach provides an indication of value based upon historical transactions of comparable publicly traded or privately held businesses. It is not necessary that the companies be identical, but rather comparable. This approach is useful as it places all indications of value developed from the marketplace into the larger context of market realities. The resultant value is determined through the application of derived valuation multiples to the subject company. There are various transaction databases utilized in practice including BizComps, DealStats, and CapitalIQ. However, there may be insuﬃcient information available in these databases for each individual transaction.
A link to the full article can be found here.
Please do not hesitate to reach out to the forensic and valuation team at Withum with any questions relating to this article.