GPSolo Magazine - April/May 2004

How Much Is a Business Worth?

I was introduced to Dr. Nova Cane in the reception area of Fred Blaise, attorney at law. The doctor was a petite woman with a warm smile. She did not fit my mental picture of dentists (i.e., with hands the size of baseball gloves and dripping fangs).

Fred didn’t look up as we were shown into his office. His face was drawn, and I noticed a small tic making his left eyelid dance just a bit. He sighed heavily, gathered up the reports he had been studying, and tossed them across the desk to me. “You’re a CPA. Tell me—how can this be?” he asked. His frustration was verging on desperation.

What he had given me were two business valuations, both prepared by qualified CPAs, for Dr. Cane’s dental practice. One showed a value of $30,000 and the other a value of $275,000. Being heavily committed to self-preservation, I quickly assessed the situation. I was about to become the sacrificial goat for the seeming incompetence or malice of my peers. In these types of situations, I switch into output mode and give the attorney and the client as much information as I can, as quickly as I can. Then, while they are thinking it over, I make my escape.

The Standard Isn’t Standard

“Let’s talk about Betty,” I ventured.

“Who?” the attorney asked. He was a little mystified. So far, so good.

Betty was a former client of mine. She had owned a small company that delivered water to homes that didn’t have municipal water or wells. She sent me the information on the business and asked me to place a value on it. I came up with a preliminary value of about $50,000 for the business and sat down to discuss it with her. “Why does anyone care what I think the business is worth?” I asked her. “Why don’t you just put a great big price tag on it and see what happens.” She did. The business sold for $150,000.

The heart of most business valuations is a concept known as fair market value (FMV). It can be defined as the amount at which a business would change hands between a hypothetical willing seller and a hypothetical willing buyer when neither is acting under compulsion and when both have reasonable knowledge of the relevant facts.

So what happened with Betty? Why was the fair market value of her business so out of line with the actual sales price? The answer is Hank. Hank happened to own the only other water delivery business in the area. Therefore, he was willing to pay a big premium for Betty’s business because he could eliminate his competition.

Hank’s purchase is politely called a synergistic acquisition. Actually, he bought himself a monopoly. Hank was a specific buyer with a specific goal. These types of situations will confuse our attempts to place a value on a business.

Let’s assume that Betty died before the business was sold and that the business had to be valued for estate purposes. Would the value be $50,000 or $150,000? The Internal Revenue Service has stated that without question, the standard of value that it will apply in all circumstances is fair market value. So the business value would be $50,000 for tax-reporting purposes.

Now let’s assume that Betty is alive and well, but she is getting a divorce. The fair market value is $50,000. Betty’s husband presents in court a written offer from Hank to purchase the business for $150,000. The judge drops the hammer (establishing case law on the way) and says, “The fair market value of the business is $150,000,” and puts that amount into the marital estate division.

So now we have two values for the business, both defined as fair market value, $100,000 apart.

What the court selected as a value for divorce purposes was simply that, a value for divorce purposes. It was not fair market value. The court could have called it divorce value, expected sales value, fair value, intrinsic value, investment value, value to Hank, or just about anything else to help us reduce the confusion, but courts usually don’t make the distinction—and thus they fertilize the field of confusion.

Upon hearing this story, Fred thought for a moment then said, “So the IRS and the judge would come up with two different values using two different standards. Things could be confused because the judge called it fair market value when it wasn’t. But we’re not dealing with a judge here, were dealing with two CPAs. I’m sure they’d call a spade a spade.”

Except when it’s a shovel.

What’s in a Name?

Another story: I had been called as a neutral in a divorce case. Two CPAs, solidly accredited, experienced, and knowledgeable, had submitted their values for a medical practice. The doctor was in a partnership with four other doctors. One CPA came in with a fair market value of the partnership share of $180,000 and the other CPA with a fair market value of the partnership share of $225,000. This was pretty close by valuation standards, so I figured there wouldn’t be much of a problem in this area. As part of the case assessment, I reviewed the partnership agreement. The partners had agreed, “no partner may sell his partnership interest. Upon leaving the partnership, any rights, properties, values, (etc.) . . . revert to the remaining partners.” How can a practice that can’t be sold have a fair market value? It can’t.

I asked one of the attorneys in the case how something that can’t be sold can have a fair market value. He protested, saw my point, and then countered with, “But the practice has value to the doctor, and the practice certainly has value in the eyes of the soon-to-be-ex-wife.” Exactly; it has an intrinsic value, or a divorce value, or an investment value. It does not have a fair market value. The CPAs had the same problem as the judge did in Betty’s imaginary divorce.

“Great,” said Fred. “Now I have differences in standards, and I can’t even tell what standard is being used because everybody calls a spade a spade even when it isn’t. Let me guess, you have more good news.”

King Solomon

Actually, it’s not King Solomon; it’s Judge Solomon. He thinks his job is to make everyone equally unhappy. This judge has a history of splitting the difference between the two parties’ positions instead of selecting the correct one. So what will happen when I’m called in as a valuator in a case before this judge? I don’t need a crystal ball to predict the future. If the other valuator is working for the party that is seeking a low value for the business, she’ll rock bottom the price. If I bring in a value where I think it should be, the judge will split the difference—and the final value will be too low. If I value the business higher to counter the other valuator, my conscience slaps me.

The solution? Given the opportunity, I tell the court that all valuations contain an element of subjectivity, and that change in the assumptions in this subjective component can cause different values. The court is then effectively presented a range of values from which to choose. I’m off the hook because I have told the court that my value is at the top of the range; along the way I have also told the court that the other valuator is at the bottom.

“So the valuators in my case could be responding to the judge assigned to the case?” asked Fred. “That’s not very objective.”

I answered, “It’s in response to the conditions of the assignment. Sometime it’s called atmospheric pressure.”

Atmospheric Pressure

Some judges write opinions with the primary goal of avoiding reversal by a superior court. Take the example of two construction companies. Both have $700,000 of equipment. One business makes $285,000 annually for its owner, and the other is new and has never made a dime. Which would have greater value in a divorce? I have asked a couple dozen attorneys and others this question. The answer is always the same: “A business making money is worth more than one that isn’t.” Good thinking. However, in one court the value of the business that made $285,000 was held to be $700,000, the value of the equipment. Then the judge turned around and awarded the spouse of the business owner 62 percent of the marital estate. Why? His thinking might have been as follows: “Well, the case could be appealed and maybe overturned if I don’t adopt the husband’s value. But how can he appeal the fact that I just think it’s a good idea that the wife gets more of the marital estate because the husband makes so much money?” As it turns out, he was correct; there was no appeal, and the wife got almost as much money as she would have had the court adopted a reasonable business value. Looking only at the valuations, however, we’re left with a judge who has said that a business that makes money is worth the same as one that doesn’t.

Good Ol’ Boys

Then there is the cultural issue. Men and women are equal before the law, correct? Well, yes, but there is always some clown who doesn’t get the word. You will find pockets of resistance to modern thinking virtually everywhere. I generally refer to them as the “good ol’ boy networks.” So what happens when you run up against these good ol’ boys? If you are working for the woman, you are handed your head in a bag. If you are working for the man, you are one fine attorney.

Chaos Theory

Then there is that pesky problem known as the Chaos Theory. Kind of like cosmic rays, bad things happen to valuations that are litigated in a random, unpredictable fashion. For example, take the case I handled for Hazmat Handler. Mr. Handler had a hazardous material disposal business and was going through a divorce. Snidely, the opposing expert, had valued the business as of December 31, 2001. Well, as it turns out, the business of Hazmat Handler had one customer (Snidely failed to mention this in his report). Businesses with one customer typically have very low values compared with the same types of businesses that have many customers. If Hazmat Handler’s one customer should ever put the contract out for bid, Hazmat could be out of business. That is exactly what Hazmat Handler’s one customer did, and the contract was awarded to another business effective January 1, 2002.

I figured this was not going to be too tough. The judge was intelligent and fair, and the situation obvious. Hazmat Handler didn’t have any customers, and, because of a series of other problems, had no way of getting more customers. He was out of business. I carefully explained the situation to the judge and came in with a liquidation value for the business of about $100,000. The other expert came in with a range of value between $275,000 and $325,000, carefully ignoring the fact that the business did not have any customers.

Then the Chaos Theory raised its ugly head. The judge had a new clerk who had been out of law school three months at the time of trial. The judge handed the case to the clerk no doubt thinking to start the clerk with something easy. The clerk misunderstood the intent of the court, established the value of the business at $300,000, and prepared the divorce decree. Then the judge, being distracted by two jury trials back to back, signed the order thinking he had reviewed it. My reaction was not good. However, within ten days they had my medication adjusted to the point where they could let me out of the restraints so I could go back to court and do it all over again.

When I finished telling this story, I glanced over at Dr. Cane. She was very pale. Fred raised an eyebrow and said, “You’re not giving us much hope here.”

It’s Not Impossible

I explained to Fred and Dr. Cane that a business valuation is like any other report or opinion from any other type of expert. It is based on assumptions. The first job in defending or refuting a valuation is to discover the assumptions that were made. Every business valuation, whether it is five pages or 80 pages, has two or three pages that are the key. Scanning the two conflicting valuation reports that Fred had given me, I found those key pages in each report.

I turned to the doctor, “Let’s say you are selling your practice, and you go about it two different ways. In the first scenario, you toss the keys to the new dentist on your way out the door. In the second scenario, you stay in the business a year and introduce each of your patients to the new dentist. Under which scenario would the new dentist pay the most for the practice?”

Dr. Cane didn’t hesitate, “The second scenario. The new dentist would be getting the patients and the income from them. He could afford to pay me off.”

I continued, “That’s the difference between the two valuations. The $30,000 is only the value of the equipment in your practice. Basically, it assumes that there is no orderly transition of the practice. The $275,000 assumes not only a value for the equipment but also a value of the income stream that can be generated from the practice.”

Fred looked at the doctor and then at me, “So what’s the correct value?”

“That would depend on whether you get Judge Solomon, Judge Good Ol’ Boy, or Judge Chaos,” I responded.

Fred smiled for the first time since the meeting started. He already knew the judge, and now he knew what the experts had done. You could see the wheels turning in Fred’s mind, building his case. I quietly slipped out.

Nicholas Bourdeau is a certified public accountant in Great Falls, Montana. As well as being a CPA, he holds an Accreditation in Business Valuation and is a Certified Fraud Examiner. He is a veteran of an estimated 1,000 family law engagements. He can be reached at n.bourdeau@bresnan.net.

 

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