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In This Issue:

Tricks of the Trade in Detecting Rigged Valuations

Did you ever read a business valuation report where you knew the valuation was rigged to obtain a higher or lower value? Unfortunately, some valuation analysts manipulate the process in order to please their client and/or win at all costs. This can often happen in contentious divorce engagements.

Where to look: One place to look for evidence of rigging is in the discount rate, which has several inputs susceptible to manipulation. The size premium is one input that appears to be a good candidate for abuse. However, the size premium differs depending on the data breakdown you use and the historical time frame of the data, which can explain the difference. But where the discount rate can be manipulated the most is in the company-specific risk adjustment, which is based purely on the judgment of the expert. This is a prime area where opponents will try to detect valuation bias and try to discredit the analysis.

In Gatekeeper Role, Court Trains Attention on Expert Methodology, Not Conclusions

Acosta v. Wilmington Trust, N.A., 2019 U.S. Dist. LEXIS 9246 (Jan. 18, 2019)

In this ESOP litigation, both parties tried to exclude the opposing side’s valuation expert testimony under Rule 702 and Daubert. The court noted that, at this stage in the proceedings, its focus was on whether the experts applied reliable principles and methods, not on the experts’ conclusions. This case serves as an important reminder to attorneys and experts that the role of the court as gatekeeper is different from its role as evaluator of the sufficiency of the evidence (as the court in another case, Washington v. Kellwood Co., explained so well). Put differently, simply because the expert opinion is admissible does not mean it will hold up in terms of the ultimate outcome of the case.

Questioning ESOP valuation. The U.S. Department of Labor (DOL) sued the defendant trustee (and others) alleging the trustee violated its duties under ERISA by causing an employee stock ownership plan (ESOP) to purchase the outstanding stock in a graphite processing company (Graphite Sales Inc.). According to the DOL, the purchase was for greater than fair market value, which meant the trustee caused the ESOP to overpay by approximately $6 million. At the time of the transaction, an independent valuation firm appraised the company. As part of the transaction, the sellers received stock warrants that amounted to an 18% equity stake in the company. Also, two officers received stock appreciation rights, representing a 10% equity interest. Further, an investor received rights to a 7% equity stake in the company.

The crux of the case was the valuation of the company. The DOL offered expert testimony that called into question the ESOP valuator’s contemporaneous appraisal. The defendant trustee presented its own trial expert to testify and rebut the opinion of the DOL’s expert. Both parties challenged the opposing testimony under Rule 702 of the federal rules of evidence and under Daubert and its progeny. Further, the DOL argued the opposing expert opinion was inadmissible under Rule 403, which provides for exclusion of relevant evidence on various grounds (unfair prejudice, confusing the issues, misleading the jury, etc.). The court’s discussion focused on Rule 702 and Daubert.

In a nutshell, Rule 702 and Daubert provide for testimony by a qualified expert whose “scientific, technical, or other specialized knowledge will help the trier of fact to understand the evidence or to determine a fact in issue.” The testimony must be based on sufficient facts and data and must be “the product of reliable principles and methods.” In assessing the testimony, a court considers whether the testimony “has been tested, is the subject of peer review and publication, has a permissible error rate, follows established standards, and receives ‘general acceptance’ within a ‘relevant scientific community.’”

“At this gatekeeping stage,” the court in the instant case said, the court’s focus is “on principles and methodology, not the conclusions that they generated.”

Objections to DOL expert testimony. In trying to exclude the DOL’s expert, the defense broadly claimed the expert’s value opinion was nothing more than ipse dixit, or “I say so.” This argument, the court found, was based on the expert’s statement during his deposition that he “could not speak for the entire industry.” In other words, he suggested different valuation experts might interpret certain facts differently.

“Of course, [the expert’s] concession … does not mean that his own interpretation is made up,” the court said, dismissing the defendant’s argument.

The defendant also attacked the expert’s methodology on specifics. For example, it took issue with the DOL expert’s statement that the ESOP appraiser should have used multiples of revenue and EBITDA, not multiples of EBIT and EBITDA, in valuing the company. The defense claimed the DOL expert’s view conflicted with a cited treatise that said the expert’s proposed approach was applied most frequently to startups and service businesses, neither of which the subject company was.

“The defendant is wrong,” the court said. It noted the treatise “explicitly contemplates” use of the expert’s approach “in circumstances other than start-ups and service companies.”

Secondly, the defendant objected to the DOL expert’s claim that the ESOP appraiser erred by using the exit multiple method rather than the Gordon growth model for its discounted cash flow analysis. The defendant said the expert’s critique was wrong because treatises permit the use of either method.

“Even if true,” the court said, the defense argument does not affect admissibility because it simply contests the DOL’s expert choice among accepted valuation methodologies.

Thirdly, the defendant claimed it was improper for the expert to consider the stock warrants and appreciation rights when valuing the company. The defendant noted that the expert, in deposition testimony, “admitted” that the warrants could be considered part of financing the transaction.

The court noted that, in the same testimony, the expert pointed to another “motivation” for the warrants: They were “a form of contingent consideration” and should have been added to the purchase price, he said.

The court said that the defendant would have a chance to probe this issue at trial. However, in terms of admissibility, the defendant failed to show the expert’s view was based on insufficient facts or conflicted with accepted principles and methodologies.

Moreover, the defendant raised questions related to the DOL expert’s application of the principles and method to the facts of the case. For example, the expert criticized the ESOP appraiser’s projections. The defendant, in turn, claimed the expert failed to give proper consideration to the management projections and ignored various other pieces of financial evidence.

The court noted that none of “these purported errors” showed the DOL expert “made up” his revenue projections or used unsound methods. The defendant failed to show that accepted valuation principles compelled the expert to weigh the evidence differently or consider certain evidence, the court said.

Another defense objection was to the expert’s criticism of the ESOP appraiser’s selection of guideline companies and the latter’s choices related to the application of the guideline company method. The defense claimed the expert’s criticism contradicted the expert’s own analysis on other topics. The defendant said there was no reason to use the expert’s preferred method.

According to the court, the defendant’s objection went toward the weight of the opposing opinion, but it did not “even remotely suggest” the opposing expert’s opinion was based on an unsound methodology.

Similarly, the DOL’s expert criticized the ESOP appraiser’s use of a 10% control premium to the guideline companies’ stock. The defendant suggested that the DOL expert’s analysis of control was wrong and made his calculation wrong.

The court disagreed again, noting that this type of application error “would not show that [the expert’s] views are inadmissible.

Objection to defense expert testimony. The court quickly dismissed the DOL’s claim that the defense expert’s testimony was inadmissible because he improperly proposed a damages methodology when doing so was the role of the court.

The court noted the defense expert’s approach—comparing what the ESOP paid for the stock with the fair market value of the stock on the date of the transaction—was the same approach the DOL expert used. Further, this analysis was a legally approved methodology.

In general, the court suggested that the parties mostly quarreled over the opposing expert’s conclusions but failed to show the conclusions were unscientific—the requisite inquiry for purposes of determining admissibility of expert testimony.

Both expert testimonies were admissible in their entirety, the court found.

Editor’s Note: A digest of the above-mentioned case, Washington v. Kellwood Co., 2016 U.S. Dist. LEXIS 92309 (July 15, 2016), and the court’s opinion are available at BVLaw.

Divorce Court Finds No Personal Goodwill Value in Single-Owner Business

Stephanos v. Stephanos (In re Marriage of Stephanos), Case No. 502013DR007061XXXXSB, Circuit Court of the Fifteenth Judicial Circuit, Palm Beach County, Florida, J. Samantha Schosberg Feuer, Final Judgment (Dec. 28, 2018)

A Florida divorce case is noteworthy for its multifaceted goodwill analysis, which included an examination by the court of which party had the burden of establishing that goodwill was either enterprise or personal in character and was either a marital asset or not. The nub of the problem was that the husband, who held sole title to the contested company, had a damaged business reputation but still claimed any goodwill existing in the business should be attributed to him. The wife, through expert and lay testimony, was able to show all of the goodwill was enterprise goodwill. The husband was not vital to the company’s continuing existence and success. Further, the court found a noncompete analysis (or “real world transaction”) would not change the goodwill attribution.

Owner’s problems with the law. The parties first filed for divorce in 2003. They then reconciled and dropped their divorce petitions. Ten years later, in June 2013, the husband filed another petition for divorce, which, in November 2013, prompted a counterpetition from the wife. The husband was active in the hormone replacement industry. At one point, he and a business partner equally owned a company, Palm Beach Rejuvenation (PBR). However, in 2007, during the reconciliation period with the wife, the husband and his brother became targets of a federal investigation and were indicted by the state of New York. PBR was raided. The events were on the cover of Sports Illustrated in 2007.

The husband pled guilty to a third-degree felony in the state case and was found guilty, placed on probation, and prohibited from ever providing human growth hormone services to anyone in New York state. The wife gave financial support for the husband’s defense and also provided funds for the creation of a separate entity, Nationwide Synergy Inc. (NSI), which operated in the hormone replacement industry but was not a professional practice. The valuation of NSI was a flashpoint during the divorce proceedings.

The parties also argued over whether PBR morphed into NSI or essentially stopped functioning because of the husband’s legal problems. The trial court ruled that NSI was mostly a separate entity, even though the businesses shared similarities and the husband had bought PBR’s assets and opened NSI in an effort to rebrand. Besides those two entities, between 2007 and 2013, the spouses, and the husband’s brother, also created other businesses involved in hormone replacement therapy.

Importantly, the NSI stock was in the husband’s name alone. The court noted the reason for this arrangement was strategic, to protect the wife from potential legal exposure in light of the husband’s past problems regarding PBR.

The husband was CEO, and the wife served as the CFO of NSI. The evidence showed she made an initial contribution of approximately $850,000 of her nonmarital assets and dealt with the company’s financial activities. She also supervised employees and assisted in creating an important database, and she worked on developing a reputation for NSI and the other entities.

In the company’s beginning, the husband recruited salespersons and put in place people who were key to generating cash. But, once the company grew, other employees became key persons, including the spouses’ son and another employee. The latter two developed a network of physicians who performed clinical valuations of potential customers who wanted to buy the company’s products over the internet. This medical assessment became federal law in 2008. NSI’s key employees established the necessary protocol at the company.

Between 2007 and 2016 (the valuation date), the value of the company went from about zero to $5.3 million and $5.7 million, according to the valuations the parties’ highly qualified experts offered at trial.

Equitable distribution principles. The overriding issue was for the court to determine whether NSI was a marital asset that was subject to equitable distribution.

The applicable statute (Fla. Stat. § 61.075) provides for a three-step process. In essence, the court first has to classify the assets and liabilities as marital or nonmarital. Next, the court has to value the “significant” marital assets based on “competent, substantial evidence.” Under case law, a court must not simply “split the difference” between the values the parties proposed but has to “cite to specific evidence or lack thereof in the record to arrive at its conclusions.” Finally, the court must distribute the assets and liabilities under a presumption in favor of equal distribution, “unless there is a justification for an unequal distribution based on all relevant factors.” Also, under the statute, all assets a couple acquires after the date of marriage that are not specifically established as nonmarital assets are presumed to be marital assets and liabilities. This presumption may be overcome by showing that the assets are nonmarital assets.

Residual method. The court’s inquiry focused on whether there was goodwill value in the company. The question was how to calculate the goodwill value and how to determine whether it was personal or enterprise goodwill.

The applicable statutory provision (Fla. Stat. § 61.075(3)(b)) and case law require a valuation based on the fair market value standard of value.

The clearest method would be the fair market value approach, which is best described as what would a willing buyer pay, and what would a willing seller accept, neither acting under duress for a sale of the business. The excess over assets would represent goodwill. See Thompson v. Thompson, 576 So. 2d 267 (Fla. 1991) (available at BVLaw).

The court explained that Thompson was the controlling case on the issue of business goodwill in the divorce context. Thompson says that enterprise goodwill is value attributable to the company/entity as opposed to value related to the reputation or continued presence of a particular person (“the marital litigant”). In Florida, enterprise goodwill is a marital asset, whereas personal goodwill is not.

The court noted that, when it came to the overall valuation of NSI, the parties’ experts achieved a fair market value determination that was remarkably close. The difference was less than $250,000. The wife’s expert found the company was worth $5.3 million, and the husband’s expert determined it was worth $5.7 million.

The more contentious issue was the goodwill calculation. The court noted the husband’s expert suggested he was unable to extrapolate any goodwill value from the fair market value. Although it respected the expert’s opinion, the court found the claim somewhat “dubious” given the expert’s “extensive expertise and knowledge in the area of business valuation and goodwill.”

In contrast, the wife’s expert used the residual method to determine the value of goodwill, which the husband’s expert allowed was a proper approach. By subtracting the net asset value from the entity’s FMV, the expert achieved a residual value (goodwill) of $2.2 million.

Burden of proof issue. The court noted that it found no reported cases that addressed which party had the burden of establishing the value of enterprise goodwill. Here, the husband claimed that all of the goodwill at the company was personal, whereas the wife claimed personal goodwill in the company was nonexistent or negligible. Accordingly, the husband contended the wife should have the burden of showing all of the goodwill was enterprise goodwill, while the wife argued the burden was on the husband to show he was entitled to the goodwill value as he claimed it was personal to him. Both parties cited cases to support their positions. The court concluded that, since the wife claimed there was goodwill, it was appropriate that she had the burden of showing that enterprise goodwill existed—”through competent and substantial evidence”—and that, therefore, the goodwill was a marital asset.

The court rejected the husband’s position that it was impossible to extract the value of personal goodwill from the residual value. Instead, the court relied on testimony from the wife’s expert as to the purchase price allocation approach and on other testimony and factors to come to the conclusion that there was no personal goodwill attributable to the husband.

The court specifically noted that the husband was a convicted felon who was “unable to compete in certain markets”; his reputation was blemished. He could not point to any customers his efforts brought in. He had no role in developing the database or sales force, both of which were critical parts of the business. He had no relationships with the company’s physician affiliates. Further, all employees of NSI had signed noncompetes and, therefore, were precluded from aligning themselves with the husband in a similar business. In addition, members in the physician affiliate network were bound by noncompetes and confidentiality agreements to protect NSI’s intellectual property. The physicians in the network had relationships with the two key employees, not the husband. The company’s advertising did not mention the husband because the company specifically determined that, if his affiliation with the company were known, it could hurt the business. Most of the company’s revenue stream was generated by website sales; the website in turn was managed by another employee, not the husband. Any web domains and phone numbers belonged to the company and would transfer in the event of a sale.

Company employees spoke of the husband’s limited role and said they did not know what he actually did there. One key employee said that, if the husband were to leave for a year, the company would continue to function as it always had. Also, as of 2016, the husband had limited his role in the company. He was rarely in the office and only communicated sporadically via email.

There was no credible evidence that showed the husband was key to the company, the court found. It decided that the entire residual value was enterprise goodwill. This amount was a marital asset, subject to equitable distribution.

Noncompete goodwill theory. That said, the court also considered the husband’s alternate theory in support of his position that the goodwill was personal to him. He and his expert contended that, in the real world (i.e., in an actual, as opposed to a hypothetical, transaction), a buyer would only be willing to purchase NSI’s stock if the husband executed a noncompete agreement.

The court noted, however, that the ASA’s business valuation standards do not require consideration of a noncompete when calculating fair market value. The court also noted it was not aware of any precedent “from any substantive authority in this State wherein the specificities regarding value and methodology address the criteria to value a covenant not to compete in a ‘real world’ situation.” In other words, there was no specific appellate opinion addressing the valuation of a noncompete.

The wife’s expert proposed looking to Internal Revenue Service guidelines for the purpose of valuing a noncompete. The nine factors included:

  1. The seller’s ability to compete;
  1. The seller’s intent to compete;
  1. The seller’s economic resources;
  1. The potential damage to the buyer the seller’s competition posed;
  1. The seller’s business expertise in the industry;
  1. The seller’s contacts and relationships with customers, suppliers, and others in the business;
  1. The buyer’s interest in eliminating competition;
  1. The duration and economic scope of the covenant; and
  1. The seller’s intention to remain in the same geographic area. See Langdon v. Commissioner, 59 Fed. Appx. 168 (8th Cir. 2003) (citing Lorvic Holdings, Inc. v. Commissioner, 1998 Tax Ct. Memo 283 (1998).

The court said it would rely on the analysis of the wife’s expert for the calculation of value (assuming there was any) of a noncompete. Several case-specific facts were critical, including the fact that all 16 sales force members of the company had executed noncompete, nonsolicitation, and confidentiality agreements, as did the 14 “non-sales force” employees.

Further, all 32 physicians in the company’s physician affiliate network were bound by noncompetes. The company had established a proprietary database related to customers. And there was an established relationship between the entity and the patients/customers the company served.

Considering all the restrictions in place, the court found a real-world transaction analysis that centered on the existence or nonexistence of the husband’s noncompete also would not change the outcome as to personal goodwill. Under either continued presence or noncompete analysis, the goodwill value personal to the husband was nonexistent or negligible, the court concluded.

In the final analysis, the court awarded the company to the husband. For equitable distribution purposes, the court adopted the $5.3 million valuation the wife’s expert had proposed as well as this expert’s determination that goodwill in the company was about $2.2 million and was enterprise goodwill that was subject to marital distribution.

Editor’s note: Hat tip to Josh Shilts (Villela & Shilts LLC) for alerting us to this important goodwill decision.

Pratt’s Stats/DealStats Analysis Holds Up in Divorce Litigation

Hultz v. Kuhn, 2019 Md. App. LEXIS 151, 2019 WL 852109 (Feb. 21, 2019)

A Maryland divorce case illustrates the difficulties an appraiser charged with valuing a small company in the divorce context may face and how he or she may prevail in court.

The wife was the sole shareholder in a tree services business. The issue at divorce was the size of the monetary award to the husband. Initially, neither spouse offered much valuation evidence. The trial court performed a value determination based on a recent tax return that an en banc panel overturned. At the remand hearing, both parties presented expert testimony from CPAs who had valuation credentials.

The wife’s expert found the company had a value of zero. The husband’s expert explained in detail the numerous obstacles he encountered to performing a valuation. The company did not provide all of the requested financial information and the company’s tax preparer and management did not answer most of the questions the expert had asked. The company only made available four years of tax returns and a QuickBooks file, which did not “match up” from an accounting point of view. The expert also said that, from other “tax work,” he was able to see there were accounting problems. He noted “some troubling trends regarding … revenues to operating costs … as time passed.” Sales were declining, but expenses were increasing, he noted.

The expert considered all three valuation approaches but concluded here the market approach generated the only reliable indicator of value. He made it clear that he normally would prefer to do an income analysis, but he didn’t have the necessary information and the information he received was problematic. For the market approach, he used Pratt’s Stats (now DealStats) and attained a value of about $408,000, which he decided was too high for this kind of company. In light of the company’s poor performance, he applied a “very heavy discount for lack of marketability,” i.e., 50%. He recognized the significant payroll tax liability, which would make it less likely that someone would buy the business. The DLOM reduced the fair market value to $204,000.

The trial court found it difficult to reconcile the zero value with the company’s employing 11 people, paying the employee who took over the husband’s job a $65,000 annual salary, allowing the wife to pay herself $40,000 and $50,000 in 2014 and 2015, respectively, and other factors. The court credited the opinion of the husband’s expert, noting his credentials and the detailed explanation he gave of the various valuation methods and the obstacles he faced in doing the valuation.

The state Court of Special Appeals upheld the trial court’s findings.

Takeaway: Courts may be sympathetic to an expert whose work is stymied by the other side’s lack of cooperation. Therefore, talk about it!

Important Utah Goodwill Ruling Concerning One-Person Business

Marroquin v. Marroquin, 2019 UT App 38 (March 14, 2019)

The Utah Court of Appeals examined the nature of goodwill in a one-person business and, in so doing, expanded on the state’s goodwill jurisprudence. The appeals court upheld the trial court’s finding that there was no institutional (enterprise) goodwill in a business that entirely depended on the owner-spouse’s efforts and reputation for competency.

Personal relationships: At issue was the value of a vending machine business that operated throughout Salt Lake City. The husband owned 99% of the business (someone else owned the remaining 1%) and was the only employee. He developed and maintained the relationships with the property owners where the vending machines and kiosks were located. Most of the contracts were month-to-month, making it easy for a property owner to replace one vendor with another.

The company was a marital asset subject to division. But the parties disagreed over the nature of goodwill related to the business. Under Utah law, enterprise goodwill is a marital asset, subject to division, but personal goodwill is not.

The trial court credited the husband’s expert, a CPA and experienced business valuator, who valued the company under the net asset approach and who determined the company had no “institutional goodwill.” The expert noted that, “without the relationships that exist for the places where the vending machines are located, there is no potential for goodwill. There’s no income earning capacity that would be in excess of the value of the assets.”

“[T]he goodwill of [the company] is solely attributable to [the husband’s] work, his efforts, and his reputation for competency,” the trial court said. The goodwill was based on the husband’s “being the face of the business” and his personal relationships with the property owners that allowed him to continue to conduct business on their property on a month-to-month basis.

The wife unsuccessfully challenged this finding in a post-judgment motion and then on appeal. The Court of Appeals agreed with the trial court that the business was essentially a kind of sole proprietorship in which the wife had minimal involvement. The husband was the one who remained in contact with the entities that enabled the business to continue operating, the appeals court noted. While the wife claimed that “anybody could step into [the husband’s] shoes and carry on with the business under its name and with its assets,” she offered no evidence to support this assertion, the court said.

The appeals court found the trial court did not abuse its discretion in finding there was no institutional goodwill to be included in the company’s valuation.

Hat tip to Daniel Rondeau (Sage Forensic Accounting Inc.) for alerting us to this important decision.


Dan Rosio Partner, Valuation Services
Andy Manchir Partner, Business Valuation & ESOP Services

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