As a forensic accountant, I work on litigation matters involving partnership or corporate ownership disputes. These disputes often require the valuation of the entity at the time of the dissolution, or as of the date the stock is to be sold back to the company.

When such litigation disputes arise, a forensic accountant trained in valuation, is retained to either prepare a business valuation or conversely analyze the valuation prepared by the opposing party. This article provides examples that are typical areas of dispute.

Since business valuations prepared by a forensic accountant can be used as evidence in court, a business valuation in connection with a litigation matter needs to be sufficiently thorough and complete to withstand adversarial legal proceedings. CPAs in forensic practice with special training in valuation techniques are often retained to evaluate the credibility of a business valuation prepared by the opposing party and issue an opinion regarding any deficiencies and adjustments to the valuation. The following is a summary of some common adjustments to an opposing expert’s business valuation using the income approach.

The Income Approach

Forensic accountants may use any of three methods to valuate a business. These are asset, income and market. Valuation professionals apply experience and their professional judgment to determine which methods
are appropriate.

The income approach is based on the premise that when an investor buys an interest in a company, they are buying a stream of prospective economic benefit. As a result, the value of the subject business is based on the present value of the projected economic benefit, measured as free cash-flow. Free cash-flow represents the expected cash-flow generated by the subject interest. This free cash-flow is then discounted using an appropriate rate of return, or cost of capital. During the course of forensic analysis, you will often find that the projected free cash-flow does not reflect the true economic reality of the enterprise and adjustments may need to be considered for items such as the following:

• Non business related expenses: These should be added back to the prospective cash-flow in order to reflect the economic reality of the entity. I worked on a case in which a closer look at the general ledger for a defense contractor revealed that the books contained amounts for nonbusiness related expenses such as polo ponies, fur coats and expenses related to personal residences. These are examples of expenses that would be added back to the prospective free cash-flow as deducting such expenses understates the value of the business interest.
• Extraordinary and unusual nonrecurring expenses: Costs such as legal expenses related to an unusual lawsuit, or expenses incurred as a result of a natural disaster may need to be added back to the prospective cash-flows in order to reflect normal recurring cash-flow.
• Extraordinary and unusual nonrecurring income: Items such as cash awards received from a lawsuit or funds generated from the sale of equipment not in the normal course of business should be deducted from the prospective cash-flow.
• Employee and executive compensation: Closely held companies often show compensation paid to relatives or other related parties that may not be representative of a market-level salary. Compensation should be adjusted to reflect the market value of services provided to the subject entity.
• Expenses for payments to related parties: These costs can include rent payment for building facilities owned by the owner or costs associated with work subcontracted to related parties. These amounts may require an adjustment to the going market-rate for
  such facilities.

Discount Rates

Another component of a business valuation that is often disputed in litigation is the discount rate used to compute the present value of the prospective cash-flows. The discount rate represents the expected rate of return that an investor would have to give up by investing in the subject company instead of other investments with a comparable level of risk. A method often used to develop the discount rate is the “build-up” method. Under this method, the discount rate is developed using a risk free rate as a starting point and is then adjusted for additional risk factors. One such adjustment is equity risk. This represents the additional compensation an investor will expect to receive for holding an equity stake in any company. The equity risk is based on extensive empirical research studies of S&P 500 stock returns. Other risk factors typically considered include premiums for the size of the company, risks specific to the relevant industry and the subject company. The valuator will need to use experience and professional judgment to evaluate issues such as management practices, product diversification and depth of management.

Often business valuation for the opposing side does not take into consideration all of the relevant risk factors. The impact of applying a risk-free rate without consideration of the various risk factors such as the equity risk or the risks specific to the subject company can have a significant impact on the value and result in a business value that is overstated and disputed in court.

Another component of the valuation process that impacts the value of a business is the discount for lack of control. The discount for lack of control is often referred to as the discount for minority-ownership interest. The discount for lack of control can be impacted by the following elements:

• Statutes that require a supermajority: Restrictions that will limit the ability of an owner (of the interest being valued) to effect specific corporate actions can reduce the minority discount.
• Provisions in the entities’ articles of incorporation: The shareholders, by agreement, may require that minority shareholders be offered the same price that majority shareholders receive in a change of control transaction. A provision such as this one can reduce the discount for lack of control.
• Swing vote rights: Similarly, where the minority interest may have elements of control through combined voting rights of another ownership group, the valuation may need to consider a controlling interest valuation.

During the analysis of a business valuation prepared by the opposing party, the forensic accountant may find it necessary to apply a discount to the value for lack of control as a result of considering the aforementioned elements, which may have not been considered by the opposing side.

Conclusion

A business valuation in connection with a litigation matter needs to be sufficiently thorough and complete to withstand adversarial legal proceedings. Since forensic accountants are involved in disputes over the value of an entity will likely be used as evidence in court, they should be prepared for their business valuation to be dissected and subject to a high degree of scrutiny. As a result, the professional should be well versed in valuation theory and the generally-accepted methodologies and techniques accepted by the courts in these cases.

Frances Franco, CPA/CFF, is a senior manager in the Los Angeles office of RGL Forensics. A seasoned accounting professional with 20 years experience in both public and private industry, she has more than 10 years of experience in the areas of forensic accounting, litigation consulting and business valuation. Her expertise includes financial analysis for matters involving business valuation, fraud, bankruptcy, economic damages and a variety of other forensic accounting services on behalf of legal, corporate and insurance clients.