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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
Fred Jones, Jr., DDS d/b/a Mid-South Smiles Factory
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
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 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
Weighted Average 239,708
Less: Ongoing Depreciation/Amortization (16,958)
Taxable Base 222,750
State Taxes 6.50% (14,479)
Federal Tax Base 208,271
Less: Federal Taxes 25.00% (52,068)
Sub-Total 156,203
Add Back Ongoing Depreciation/Amortization 16,958
Expected Ongoing Capital Expenditures (CapEx) (10,000)
Ongoing Earnings Capacity 163,162
The Income ApproachCapitalization 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) (35,000)
Ongoing Earnings Capacity 111,153
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
Fred Jones, Jr., DDS d/b/a Mid-South Smiles Factory
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 in a Tennessee Divorce
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
Personal Goodwill in a Tennessee Divorce
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)
Personal Goodwill in a Tennessee Divorce
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)
Personal Goodwill in a Tennessee Divorce
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)
Personal Goodwill in a Tennessee Divorce
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)
Personal Goodwill in a Tennessee Divorce
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)
Personal Goodwill in a Tennessee Divorce
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)
Personal Goodwill in a Tennessee Divorce
Barnes (2014) – Enterprise Goodwill Allowed
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
Personal Goodwill in a Tennessee Divorce
Barnes (2014) – Enterprise Goodwill Allowed
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
Personal Goodwill in a Tennessee Divorce
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
Allocating Personal vs. Enterprise Goodwill
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%
Allocating Personal vs. Enterprise Goodwill
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
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
Conclusion of Equity Value $562,470
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
Calculating Discounts and Premiums
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%
Calculating Discounts and Premiums
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
Business Valuation Summary
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
Business Valuation Summary
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