Business Valuation - What Tennessee Judges Need to Know

Business Valuation –

What Tennessee Judges Need to Know

Presented by:

Robert Vance, CPA, ABV, CFF, CVA, CFPForensic & Valuation Services, [email protected]

If You Don’t Remember Anything Else Today

The Essence of a Business Valuation

A business valuation is essentially the Present Value of the

future expected benefits (cash flow)

The particular owner’s interest is being valued, not the

entire company (unless he/she owns 100%)

A closely-held business is, in reality, only worth the present value of the future cash flow over and above a “normal” owner compensation; a.k.a Ongoing Earning Capacity

The Ongoing Earning Capacity is the return on investment the willing buyer “receives” by investing in this particular business

Definition per IRS Revenue Ruling 59-60

“The price at which a property would change hands between a

willing buyer and a willing seller when the former is not under

any compulsion to buy and the latter is not under any

compulsion to sell and both parties have reasonable knowledge

of the relevant facts.”

Do we presently have or do we need an official “Divorce”

Standard of Value?

Standard of Value in TN: Fair Market Value

Powell v. Powell - 2003 The Fair Market Value Standard as in IRS Rev. Rul. 59-60

does not have to be strictly followed when valuing a closely-held business in a Tennessee divorce

What does that mean? We must follow case law even if it is contrary to generally accepted procedures and methods used in non-divorce valuations such as in the application of discounts and allocation of goodwill

124 S.W.3d 100 (Tenn. Ct. App. 2003)

Standard of Value in TN: Fair Market Value

1) Asset Approach

Think of a balance sheet; Identifiable Tangible & Intangible

Assets Adjusted to FMV – Liabilities

2) Market Approach

Think of this as being similar to pricing your home for sale

using comps in the neighborhood

3) Income Approach

Net present value of expected future benefit, usually cash

flow, with the discount rate being risk adjusted

Three Approaches to Valuation

Each with Underlying Methods

What is Included in Each Approach?

The inclusion of both Personal and Enterprise

Goodwill is implied in the final conclusion of value

using the valuation approaches of :

Market Approach - Yes

Income Approach - Yes

Asset Approach - No

Usually all assets and debts of the business are

included with the Market and Income Approach

conclusions of value

Normalization Adjustments

Usually must be made to any set of financials or tax

returns used as a valuation basis

1. Owner’s compensation and perks

2. Personal expenses & excess fringes run through the company

3. Non-recurring and/or one-time events

4. Non-operating assets

Real estate, excess cash, obsolete inventory, cars, airplanes,

vacation homes, yachts, etc.

The Asset Approach

Fred Jones, Jr., DDS d/b/a Mid-South Smiles Factory

Adjusted Net Asset Value Method

Unadjusted

Balance Sheet Adjusted

Per Internal Balance

Books Adjustments Sheet

Cash $15,000 $0 $15,000

Accounts Receivable 0 65,000 65,000

Supplies 0 4,500 4,500

Equipment 55,000 120,000 175,000

Total Assets 70,000 189,500 259,500

Accounts Payable 0 (35,000) (35,000)

Credit Cards 0 (9,500) (9,500)

Business LOC (20,000) 0 (20,000)

Payroll Taxes Due (3,500) 0 (3,500)

Total Liabilities (23,500) (44,500) (68,000)

Book Value a.k.a. Net Equity $46,500 $145,000 $191,500

The Market Approach


Market Transaction Method Using The Goodwill Registry for General Dentistry

Total Value

Gross Revenues $925,000

Goodwill Registry Average Price/Rev % 66.6%

Indicated Selling Price - Includes Equipment $616,050

Total Goodwill Value

Gross Revenues for Year $925,000

Goodwill Registry Average GW/Gross Revenues % 49.2%

Indicated Goodwill Included in Selling Price $455,100

Capitalization of Earnings Method Dec Dec Dec Dec Dec

Developing an Ongoing Earning Capacity 2014 2013 2012 2011 2010

Net Income Reported $15,500 $12,500 $10,000 $11,500 $8,500

Normalizing Adjustments:

Actual Deducted Compensation 475,000 435,000 375,000 362,500 350,000

Mean Compensation for Independent Dentists (240,000) (235,000) (225,000) (220,000) (205,000)

Adjusted Net Income 250,500 212,500 160,000 154,000 153,500

Adjusted Depreciation and Amortization 16,500 18,000 16,250 17,500 10,000

267,000 230,500 176,250 171,500 163,500

Weight 1 1 1 1 1

stream weight 267,000 230,500 176,250 171,500 163,500

Depreciation and Amortization 16,500 18,000 16,250 17,500 10,000

Weighted Average 201,750

Less: Ongoing Depreciation/Amortization (15,650)

Taxable Base 186,100

State Taxes 6.50% (12,097)

Federal Tax Base 174,004

Less: Federal Taxes 25.00% (43,501)

Sub-Total 130,503

Add Back Ongoing Depreciation/Amortization 15,650

Expected Ongoing Capital Expenditures (CapEx) (10,000)

Ongoing Earnings Capacity 136,153

The Income Approach

Future cash flow over and above a “normal” owner compensation

The Income ApproachCapitalization of Earnings Method Dec Dec Dec Dec Dec








267,000 230,500 176,250 171,500 163,500

Weight 3 2 1 0 0

stream weight 801,000 461,000 176,250 0 0

Depreciation and Amortization 49,500 36,000 16,250 0 0




State Taxes 6.50% (14,479)



Sub-Total 156,203




The Income ApproachCapitalization of Earnings Method Dec Dec Dec Dec Dec








267,000 230,500 176,250 171,500 163,500

Weight 1 1 1 1 1

stream weight 267,000 230,500 176,250 171,500 163,500

Depreciation and Amortization 16,500 18,000 16,250 17,500 10,000




State Taxes 6.50% (12,097)



Sub-Total 130,503




In perpetuity!

The Income ApproachCapitalization of Earnings Method

Developing a Capitalization Rate Using the Buildup Method

Risk-free Rate of Return 4.0%

Common Stock Equity Risk Premium 6.0%

Small Stock Risk Premium 9.0%

Company Specific Premium

Depth of Management 3.0%

Importance of Key Personnel 4.0%

Diversification of Product Line 1.0%

Financial Structure 1.0%

Company Specific Premium 9.0%

Net discount rate 28.0%

Less Sustainable Growth 3.0%

Next Year Capitalization Rate 25.0%

Capitalization Multiple 4.00

$136,153 = $136,153 x 1

0.25 0.25

1 = 4.00

0.25

The Income Approach

Even

Heavier Weighting

Even Recent Higher

Weighting Weighting CapEx

Capitalization Of Earnings Indicated Value

Ongoing Earning Capacity $136,153 $163,162 $111,153

Capitalization Rate ÷ 25.0% 25.0% 25.0%

Indicated Value, Net of Debt = $544,611 $652,647 $444,611

Capitalization Of Earnings Indicated Value

Ongoing Earning Capacity $136,153 $163,162 $111,153

Capitalization Multiple x 4.00 4.00 4.00

Indicated Value, Net of Debt = $544,611 $652,647 $444,611

Conclusion of Value


Conclusion of Value

Indicated Weighted

Value Weight Value

Capitalization Of Earnings Method $544,611 75% $408,458

Market Transaction Method $616,050 25% $154,013

Adjusted Net Asset Value Method $191,500 0% $0

Conclusion of Equity Value 100% $562,470

Personal Goodwill in a Tennessee Divorce

Definition: The excess of the purchase price [or

value conclusion] of a company over its book value

which represents the value of goodwill as an

intangible asset (Merriam-Webster)

Tennessee has a well-established case law history

that does not provide for the inclusion of Personal

Goodwill (a.k.a. professional goodwill) as an asset

of the marital estate, but does allow for the inclusion

of Enterprise Goodwill (a.k.a. business goodwill)


Personal goodwill is generally not to be considered

in the valuation of professional practices and small,

closely-held businesses primarily dependent upon

the individual for success or profits

Excellent staff, branded name that is not the owner’s

name, equipment in place, ancillary services,

superior location, etc. make profit “independently”

from the owner - like widget machines in a widget

factory


Fair Market Value standard inherently includes both

Personal and Enterprise Goodwill when valuing with

a going concern premise

The inclusion of both Personal and Enterprise

Goodwill is implied using the valuation Approaches

of Market and Income, but not Asset

Hazard (1991) - No Goodwill Allowed

Dr. Hazard’s practice was highly specialized and very

dependent upon personal referrals from other physicians

Goodwill in a professional practice is not a marital asset

subject to equitable distribution

Sole practitioner professional practice is to be valued using

the “net tangible assets with ascertainable value.” Cites Smith

v. Smith

Net Asset Value a.k.a. Net Book Value

Hazard v. Hazard, 833 S.W.2d 911 (Tn. Ct. App. 1991)


Witt (1992) - Enterprise Goodwill Allowed

If the professional practice or closely-held business is large

and diverse enough and not solely dependent on the

individual, goodwill may be considered as part of the

ownership interest

Dr. Witt’s clinic was found to have separate goodwill that was

not directly related to his professional or personal goodwill

Size Does Matter

Witt v. Witt, No. 01-A-019110CH00360, 1992 WL 52746 (Tenn. Ct. App. Mar.

20, 1992)


Eberting (2012) - Enterprise Goodwill Allowed

Orthodontia practice value at FMV by Vance at $700k;

included Enterprise (not Personal) Goodwill

Opposing expert valued practice At $224k (net book value

with no Goodwill)

Trial judge found value to be $500k, which was a value

indicated by the owner in a personal financial statement;

judge knew that any value north of $224k was including

Goodwill

Eberting v. Eberting, No. E2010-02471-COA-R3CV, 2012 WL 605512 (Tenn.

Ct. App. Feb. 27, 2012)


Hartline (2013) – No Goodwill Allowed

W’s expert used an income approach which included

enterprise goodwill; H did not

Did not brand his name separately

Confusion of professional vs. personal goodwill

terminology?

Trial: value between $468k and $500k which included

goodwill

Appellate court remanded for a value with no goodwill

Hartline v. Hartline, No. E2012-02593-COA-R3CV, 2014 WL 103801 (Tenn.

Ct. App. Jan. 13, 2014)


Hartline (2013) – No Goodwill Allowed

“..sole practitioner of an unincorporated dental practice,

whether his business could continue without him is

speculative, leading to the conclusion that the goodwill of

Husband’s practice should not be considered in valuing said

practice.”

No separation of personal from enterprise goodwill, thus

baby out with the bath water (from my analysis)


Barnes (2014) – Enterprise Goodwill Allowed

Enterprise goodwill allowed in dental practice

Practice branded with the name of Shelbyville Family

Dentistry with large staff and great location

H’s expert used income approach-$735k

Income approach provides for goodwill (enterprise &

personal)

Personal goodwill of $678k calculated using present value of

two years of Dr. Barnes’ salary plus benefits, then deducted

from the $735k value to arrive at $57k

Barnes v. Barnes, No. M2012-02085-COA-R3-CV, 2014 WL 1413931 (Tenn.

Ct. App. Apr. 10, 2014)



W’s expert used the Multi-Attribute Utility Model (“MUM”)

method although not identified as such; goodwill of 30% was

deemed personal

Goodwill Allocation: ratio of associate’s years of service of

12 ÷ Barnes’ years of 21 x goodwill of $678 = $349k (math

error; deduction should have been $387k not $349k)

Trial court used H’s expert figure of $735k less personal

goodwill of $349k leaving enterprise value of $386k



Applied a Discount for Lack of Marketability (“DLOM”) of

15% to arrive at $328k

Value upheld by appellate court, but, held that DLOM was

error based on Bertuca

Valuation should not have been impacted by the lack of

marketability of H’s interest, unless of course there was some

indication that a sale of his interest was necessary or

desirable


Allocating Personal vs. Enterprise Goodwill

Conclusion of Equity Value Indicated Weighted

Value Weight Value

Capitalization Of Earnings Method $544,611 75% $408,458

Market Transaction Method $616,050 25% $154,013

Adjusted Net Asset Value Method $191,500 0% $0

Conclusion of Equity Value 100% $562,470

Enterprise Goodwill Component Breakdown Using a Build-Up

Conclusion of Equity Value $562,470

Less Adjusted Book Value a.k.a. Net Equity (191,500)

Total Implied Goodwill (a plug figure using this build-up) $370,970


Find an objective method to analyze subjective data

Multiattribute Utility Model (MUM)

Decision making matrix for applications such as:

Placement of surplus weapons-grade plutonium

Plant and treatment facility locations

Restoration of contaminated ecosystems in the former Soviet

Union

An now allocation of goodwill between personal and

enterprise

Importance Existence Multiplicative

Personal Goodwill Attributes Utility Utility Utility Percent

Ability, Skill & Judgment 1 4 4 16 7.8%

Lacks Transferability 2 5 0 0 0.0%

Age & Health 3 5 3 15 7.3%

Personal Staff 4 3 2 6 2.9%

Personal Reputation 5 4 3 12 5.9%

Personalized Name 6 4 3 12 5.9%

Marketing & Branding 7 2 2 4 2.0%

In-bound Personal Referrals 8 5 2 10 4.9%

Knowledge of End User/Customer 9 2 2 4 2.0%

Important Personal Nature 10 3 2 6 2.9%

Total Personal Utilities 37 23

Total Personal Multiplicative Utility 85 41.5%

Importance Existence Multiplicative

Enterprise Goodwill Attributes Utility Utility Utility Percent

Enterprise Staff 1 5 4 20 9.8%

Business Reputation 2 4 3 12 5.9%

Business Name 3 5 4 20 9.8%

Marketing & Branding 4 4 4 16 7.8%

Business Locations 5 5 3 15 7.3%

Years in Business 6 4 2 8 3.9%

Systems & Organization 7 3 2 6 2.9%

Out-bound Referrals 8 3 1 3 1.5%

Repeating Revenue Stream 9 5 4 20 9.8%

Total Enterprise Utilities 38 27

Total Enterprise Multiplicative Utility 120 58.5%

Total Multiplicative Utility 205 100.0%


Enterprise Goodwill Component Breakdown Using a Build-Up


Less Adjusted Book Value a.k.a. Net Equity (191,500)

Total Implied Goodwill (a plug figure using this build-up) $370,970

Allocation of Goodwill Between Personal and Enterprise

Total Implied Goodwill $370,970

Estimated Personal GW % per MUM 41.5%

Estimated Personal GW $ per MUM $153,817

Total Implied Goodwill $370,970

Estimated Enterprise GW % per MUM 58.5%

Estimated Enterprise GW $ per MUM $217,153

Estimated "Divorce" Value Available for Equitable Distribution


Less Estimated Personal GW $ per MUM (153,817)

Total "Divorce" Value $408,653

Calculating Discounts and Premiums

Depend on the interest to be valued and the techniques

used to establish the value conclusion

Discount for lack of control (DLOC)

Premium for control

Discount for lack of marketability (DLOM)

Key person discount


Discount for Lack of Control a/k/a Minority Interest

Discount

Shares of stock or an LLC or partnership interest that is 50%

or less in total ownership is worth less per share than if 51%+

is owned by an individual

Lack of control in a closely held company implies you are at

the mercy of the controlling owner(s)

Substantial discounts may be necessary to attract an investor

to purchase a minority interest in a closely held company

Could be in the range of 15% to 50%


Discount for Lack of Marketability

The time required to convert an ownership interest to cash

affects the level of marketability

Factors that affect marketability:

Distributions of earnings

Active market or industry roll-up

Key person

Number and profile of owners e.g., family owned

Restrictions on transfer of stock

This a real discount despite Bertuca

Business Valuation Summary

1. A business valuation is essentially the Present Value of the

future expected benefits (cash flow) over and above a

“normal” owner compensation

2. The particular owner’s interest is being valued, not the entire

company (unless he/she owns 100%)

3. The Ongoing Earning Capacity is the return on investment

the willing buyer “receives” by investing in this particular

business

4. The inclusion of both Personal and Enterprise Goodwill is

implied in the final conclusion of value using the Market &

Income Approaches


5. Usually all assets and debts of the business are included with

the final conclusion of value using the Market & Income

Approaches

6. Scrutinize the normalization of Owner’s compensation

7. Heavier weighting reflects the analyst’s future expectations

8. Capital Expenditure (CapEx) estimate must be based on

history or future expectations in perpetuity

9. The market comps should be close under Market Approach

10. Personal goodwill is generally not to be considered in the

valuation of professional practices and small, closely-held

businesses primarily dependent upon the individual for

success or profits


11. Staff, branded name, equipment, ancillary services, location,

etc. make profit “independently”

12. Enterprise goodwill has been allowed in Tennessee cases on

numerous occasions

13. A Discount for Lack of Control (DLOC) may be applicable

for a 50% or less interest

14. A Discount for Lack of Marketability (DLOM) can be a real

issue despite Bertuca

Thank You!

Robert Vance, CPA, ABV, CFF, CVA, CFP

Forensic & Valuation Services, PLC

901-507-9173

www.forensicval.com

[email protected]

Date post:	16-Jul-2015
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Business Valuation - What Tennessee Judges Need to Know

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