Advantages And Disadvantages Of Free Cash Flow Valuation Method Divorce – Eight Landmines to Avoid in Business Valuations

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Divorce – Eight Landmines to Avoid in Business Valuations

Whether attacking or defending your expert business valuation in a divorce case, it’s important to know and avoid eight landmines that could blow up your case:

  1. Reasonable owner compensation – A business valuation usually requires an expert to make adjustments to the subject company’s income statement. This process is called “normalization”. Normalizing a company’s financial statements allows valuation experts to compare the subject company to other businesses in the same geographic area and industry. One of the most common normalization adjustments is owner compensation, which can be increased or decreased to reflect market levels. An appraiser is not a business expert, so how can he/she give an opinion on what a business owner should earn? Business valuation experts often rely on published sources of survey data for the industry in which the subject business is engaged. This is one reason why interviewing or deposing a business owner is essential to learn about their skills, duties, work hours, compensation, and perks. If the survey data the appraiser is relying on doesn’t match this particular owner’s specifications, this land mine could detonate his/her value opinion!
  2. Adjusting property values ​​for market – Another common generalization adjustment is the “adjustment to book.” Tangible assets such as real estate, inventories, and equipment must be adjusted to their market value if the “book value” or “excess earnings” approach is used. Again, most businesses are not expert appraisers, so it may be helpful to engage real estate appraisers or equipment appraisers to provide their opinions. Many business experts rely on the business owner’s opinion, which can be dangerous. Review the limiting conditions in the assessment report to see if the expert is tiptoeing between landmines.
  3. Adjusting rents for market – If the company pays rent to owners or other insiders, the rent may be higher or lower than market. The safest way is to hire a real estate appraiser to provide an estimate of a fair rental value. If the business expert relies on the market rent owner’s opinion, it should be disclosed in limited circumstances.
  4. Specific company risk – Perhaps the most common method of choosing a capitalization rate in business valuation is called the “Ibbotson build-up” method. Valuation professionals rely on data published annually by Ibbotson Associates to calculate the risk associated with a particular business. There are generally four elements of risk that add up (thus, “build up”). The first three components – risk-free rate, equity risk premium and size premium – are pretty cut-and-dried. Real subjectivity comes into play when an expert adds a specific company risk premium. Before going to trial, it is very important for the lawyer to understand the specific company risk and talk to the experts about his opinion and how it was obtained.
  5. Rate matching – Many lawyers do not know that the capitalization rate is calculated differently to match different types of profit streams: pretax cash flow, after tax cash flow, pretax net income, after tax net income, surplus earnings, projected cash flow, etc. When preparing for the trial, don’t forget to ask an expert to explain how the capitalization rate matches the profit stream.
  6. Taxes and transaction costs – Most divorce courts have not addressed the issue of whether to “tax-effect” the earnings of a subchapter “S” corporation. Another issue is whether to deduct taxes and transaction expenses from the notional income the business owner may receive on the sale of the company. This requires the expert to allocate the selling price and perhaps even give an opinion on the broker’s fee. This is uncharted territory, so don’t forget to bring your metal detector when traversing this minefield!
  7. DLOM/DLOC – Many business experts apply the discount for lack of marketability (DLOM) to their valuation of closely held companies. They can also apply exemption for lack of control (DLOC) for minority interests in the business (less than 50%). In recent years, US tax courts have aggressively challenged business valuation experts who apply the exemption for estate and gift tax purposes. Intuitively, this means that investors will pay less for businesses that cannot exit as easily as publicly traded stocks; And the disadvantages of having a minority interest in a company are obvious. However, the evidence quantifying these concessions is less clear and bears close scrutiny.
  8. Identifying non-operating assets – Some companies maintain investment portfolios or own assets that are not used in business operations. On the other hand, some businesses need capital reserves to replace expensive equipment or inventory, to secure bonding or financing, or for other reasons. Non-operating assets usually increase the value of the business because the business specialist will isolate those assets and add them to the capital gains of the remaining assets.

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