Chris Hamilton Business Valuation | Chris Hamilton Forensics

Case studies: Business Valuation

#1: Court-appointed Expert
#2: Business Valuation, Dissenting Shareholder, Joint Report
#3: Fair Buy-Out Price of Business from a Widow
#4: Valuation of an Earnout Provision in Acquisition
#5: Purchase Price Allocation
#6: Valuation for Portion of Business Ownership to be Donated
#7: Avoiding Litigation When Shareholders Leave
#8: The Impact of Valuation Errors on Estate Planning
#9: Avoiding Litigation When Shareholders Leave
#10: Reviewing and Critiquing a Valuation Report
#11: Partner Dispute and the Business Valuation
#12: Business Valuation, Dissenting Shareholder, Joint Report
#13: Valuing Multiple Entities under Common Ownership
#14: Valuing 50% Ownership Interest

#1: Court-appointed Expert

Four businesses were the subject of litigation and the judge contacted Chris Hamilton Forensics to prepare the valuations. Chris Hamilton Forensics was appointed as the court appointed experts to prepare the valuation reports.

#2: Business Valuation, Dissenting Shareholder, Joint Report

Chris Hamilton Forensics was retained by defense counsel to prepare a joint business valuation of a business that was the subject of costly dissenting shareholder litigation. Plaintiff’s counsel also retained an expert and the court appointed a third neutral valuation expert. Because of our knowledge of, and prior work against, both of the other experts the engagement was marked by professional courtesy and vigorous efforts to resolve the dispute. The result was the successful issuance of a joint report that was agreed to by all three valuation experts.

#3: Fair Buy-Out Price of Business from a Widow

Issue: What is the fair buy-out price of a widow after the untimely death of her husband?

Chris Hamilton Forensics Work: We met with the business partner of a man who had died an early and shocking death. There were several factors that made the meeting and situation that much more difficult. First, his business partner was his brother. Second, his brother had died right in front of him, his wife, and his children in a boating accident. All the nieces and nephews were present and were greatly traumatized. Third, the family was close. The two brothers had been inseparable and their respective families followed suit. The brothers were partners in a struggling personal service business that was very dependent on the skills, knowledge, and relationships of both partners. Historically, the business supplied a livable salary to each of the brothers. In short, the death of one of the partners meant the loss of half the business. There was no plan for the death of a partner – no life insurance, no shareholders agreement, and no buy-out plan. For the widow and her family, it also meant the immediate loss of income – the ability to pay bills. The estate/corporate attorney contacted Chris Hamilton Forensics with a request that I assist the parties in arriving at a fair price for the surviving brother to pay to the widow for her share of the business. By most definitions there was no value. Or, if there was value, it was minimal. However, the surviving partner knew all his brother left to his family was whatever he could pay for his share of the business. He knew the business had no value beyond the salary he earned but he wanted me to define and quantify some basis for a buyout so his sister-in-law would not feel like it was charity and also feel like the price was fair.

Result: Chris Hamilton Forensics worked off of an assumption that the standard of value was “fair value” meaning that there were no discounts for control or marketability. An analysis was done to determine how much the surviving partner could afford to pay over a period of time assuming some growth and cutting overhead. The value was agreed to and the surviving partner worked for several years to support both families. It is doubtful that the surviving family will ever fully understand the sacrifices he made to provide them a “fair” value. It was a difficult assignment for Chris Hamilton Forensics. However, it allowed us to assist a remarkable man serve his distraught and needy family.

#4: Valuation of an Earnout Provision in Acquisition

Type of Matter: Valuing a business certainly is not always straightforward. Sometimes it requires thinking outside the box to develop an approach that works for the particular situation. Such was the case when Chris Hamilton Forensics was recently engaged in an acquisition that was about to get ugly with potential litigation.

A business owner sold their business and the negotiations involved how much would be paid after the close of the transaction and how much would be based on the future performance of the company. It is typical that such payments (earnout provisions) are put in contracts to incentivize the seller to work towards the buyer’s success. It also allows for the possibility that the seller can make some extra money on the sale than they might otherwise be paid.

For tax and litigation reasons, Chris Hamilton Forensics was contacted in this particular case to value the earnout provision. The seller needed to know the fair market value of the potential earnout cash flow as of the date of sale.

Chris Hamilton Forensics Work: For the valuator, an earnout element adds to the complexity of determining and quantifying the differences between value, price, and proceeds. In this particular case, we knew the price but the actual value of the business and proceeds of the transaction were unknown. Potential earnout payments were based on future performance that may or may not materialize. Also, there were questions whether the company would actually be able to meet the required payments without permanently damaging the company.

Valuing a transaction as of the close date, when there are potential additional future payments, presents great difficulty in determining the Fair Market Value of the business as of that date. There is no real alternative to using the income approach since the cash flows are complex, uncertain, and maybe even speculative, depending on the negotiations and terms. Variations on the income approach range from a clear-cut discounted cash flow approach to complex Monte Carlo Simulation models addressing the probability that cash payments will be earned and paid out. It is also common to see probability-weighted return methodology applied within an income approach to valuing earnouts. The additional difficulty was that actual future performance could not be considered in valuing the earnouts. Only facts known or knowable as of the date of the sale could be considered in the valuation of the earnout.

In this case, the potential future benefit streams were probability weighted and then discounted using a discount rate that was derived from the actual transaction and then adjusted. The adjustments included consideration of additional risk factors such as transaction risk (the risk that the relationship between seller and buyer would deteriorate and/or that the additional compensation to the seller will actually be difficult for the company to honor) and performance risk (the risk that the business simply cannot achieve growth rates that exceed those contemplated in the original deal).

Result: An opinion of value was determined and accepted. The case settled and expensive litigation was avoided.

#5: Purchase Price Allocation

Type of Matter: A competitor business purchased 100% of the outstanding stock of a successful closely-held business. The business effect of the combination capitalized on synergies that would have been dormant had the businesses not joined forces. Shortly after the transaction was completed, the buyer’s auditors informed management that GAAP standards required an independent valuation report allocating the purchase price between tangible and intangible assets.

Background: When a business is acquired, accounting rules dictate how the transaction is to be disclosed for financial statement purposes. FASB ASC Topic 805 – Business Combinations (ASC 805) is the definitive guidance on business combinations for reporting all items related to the transaction in financial statements. ASC 805 is a comprehensive guideline for establishing the principles and requirements for how an acquirer recognizes and measures identifiable assets, recognizes and measures either goodwill or gain from a bargain purchase, and the disclosures to be made in the financial statements.

Chris Hamilton Forensics work: First, even though a transaction just took place, the entire business enterprise must be valued under the specific guidelines of ASC 805. This is in recognition of the concept that price, value and proceeds are potentially very different. It is common for the enterprise valuation under ASC 805 to present a different value than the actual purchase price. This has to do with the potential for different standards of value in play during the deal than required under generally accepted accounting principles.

In this case, the buyer financed the purchase price with cash, preferred stock, notes, and assumption of debt. All those elements, particularly the preferred stock, presented complex valuation issues. Historical data was barely looked at during the transaction negotiations since the driver of the deal was the potential synergy of the combined operations. Therefore, the enterprise valuation under ASC 805 was prepared based on those projections. An enterprise value was determined using a Discounted Cash Flow approach which was supported and consistent with the results of using the market approach (private company transactions).

Once the enterprise value was determined, an allocation to tangible asset value was made and the remainder was, of course, intangible value. ASC 805-20-25-10 requires that, “The acquirer shall recognize separately from goodwill the identifiable intangible assets acquired in a business combination. An intangible asset is identifiable if it meets either the separability criterion or the contractual-legal criterion described in the definition of identifiable.” Extensive work was done to determine those intangible assets that met the criteria for identification and valuation, and then to apply the appropriate valuation methodology to placing a value on customer and vendor relationships, patents, trademarks, non-compete agreements, and employment agreements.

Result: A valuation report was issued (several hundred pages) and reviewed extensively by the auditors and their in-house valuation experts. The report was accepted without change and financial and tax reporting of the transaction was prepared based on the Chris Hamilton Forensics valuation report.

#6: Valuation for Portion of Business Ownership to be Donated

Type of Matter: A non-control owner of a privately-held business wanted to donate a portion of her shares to a charitable organization. Time was short since there were several potential buyers approaching the business and it appeared that the business might sell pretty quickly.

Background: Depending on the size of the donation, the IRS requires a qualified appraisal of the common stock to substantiate the deduction. Large donations require that the valuation report be submitted with the tax return. The standard of value for tax valuations is “Fair Market Value.” IRS Revenue Ruling 59-60, Section 2.02 defines Fair Market Value as follows:

The price at which the 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, both parties having reasonable knowledge of relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.

Chris Hamilton Forensics work: Two issues had to be addressed as the project developed. One was the premise of value. In most FMV valuations, the premise is “going concern” meaning that the business is assumed to continue in its present form in perpetuity. However, as the work progressed it became obvious that the business was likely to sell pretty quickly. Therefore, the valuation of the enterprise (a necessary first step) was prepared on the going concern premise and the non-control interest being donated was valued using a liquidation premise since the owner was going to be bought out and the interest would no longer exist. The practical implication of this was there were no discounts taken for lack of control and the consideration of marketability discounts was very slight. Both decisions are unusual when valuing a small minority interest in a closely-held business but perfectly appropriate given the circumstances.

The second issue was also posed by the imminent sale. There were several written letters of interest from potential buyers that included details of proposed terms and consideration. To the extent the offers are arms-length and serious they are a reasonable and even persuasive estimate of the Fair Market Value of a business. Here, because of the probability of a transaction very soon after the donation there was almost no choice but to use them to value the enterprise. The complexity arose due to IRS case law and regulations that state that personal goodwill cannot be donated. To the extent that consideration for the sale included covenants not to compete, earnouts, and compensation contracts for existing shareholders the prices considered to value the business must be allocated between personal and business goodwill. Using the assumption that the sale would take place and that the letters of interest reflected what the terms of the deal would eventually be, analysis and allocations of selling price to compensation for personal goodwill were excluded from the value conclusion.

Result: After determining the above fundamentals for the valuation of the enterprise, Chris Hamilton Forensics completed the valuation on a timely basis and within budget. The report was accepted without change and financial and tax reporting of the transaction was prepared based on the Chris Hamilton Forensics valuation report.

#7: Avoiding Litigation When Shareholders Leave

Type of Matter: A non-control owner/employee of a closely-held business was terminated as an employee and the other owners wanted to terminate the shareholder relationship, too. This was a matter that was wrapped in bad feelings and clearly heading for litigation to resolve the issue of how much the “out” partner was to be compensated for his/her shares.

Background: A shareholder dispute in a closely-held company is often referred to as a corporate divorce. The only real difference to the emotional difficulties of divorce cases in family court is that there are no children involved. Although, for some business owners the business might as well be called another child for all the similarities in sensitivities exposed in a dispute over the ownership and value of their “baby.”

Chris Hamilton Forensics was retained by the remaining owners to place a value on the business primarily for the purpose of settling the case. Our clear instructions were to be fair to all sides, objective, and to prepare a compelling case supporting our opinion – whatever it was. It was our clients’ intent to share our report with opposing counsel in the hopes that the report and its conclusion would be persuasive enough to serve as the basis for agreement before formal litigation commenced. Unfortunately, there was no written shareholder agreement and there were several versions of what the oral agreements might have been.

Chris Hamilton Forensics Work: The financial history of the business was irregular and profitability was volatile. Consequently, historical results could not be relied upon to value the business so we asked for projections. There was no agreement among any of the partners as to what the economic future of the business would be. As a result, Chris Hamilton Forensics looked pretty deeply at market transaction databases to identify similar private companies that had sold. While some were found that could serve as a means to value the company, we were dissatisfied with the persuasive nature of that evidence.

Chris Hamilton Forensics had also asked for details about the buy-in transactions for current owners, as well as shareholder buy-out transactions over the history of the company. When analysis was done comparing the values in those transactions to current underlying operational metrics (sales, net income, EBITDA) a very compelling relationship was established that coincided with the multiples we found in market transactions that were obtained from independent transaction databases. Now we had a compelling story to tell.

Result: The valuation report was prepared, issued, and distributed. As a result, the valuation issues were negotiated and resolved before lawsuits were filed.

#8: The Impact of Valuation Errors on Estate Planning

Type of Matter: A large closely-held business had engaged expensive attorneys and valuation experts to facilitate a complex multi-year and phased gifting and estate plan commensurate with a large estate. The first five years into the implementation of the plan produced unusual results and the forecasted long-term results of a fully implemented gifting plan caused the board of directors to seek a second opinion.

Background: Chris Hamilton Forensics was retained to prepare a current valuation and to prepare analysis of the previous reports and calculate values as of the previous dates using current assumptions. The board of directors had obtained two valuations over the five years of the plan. The company value dropped over 20% between those two valuation dates even though there had been little change in the operations. The board retained Chris Hamilton Forensics to review prior valuation reports to provide affirmation of the value conclusions and the methodologies employed to arrive at the values.

Chris Hamilton Forensics Work: Chris Hamilton Forensics was retained to prepare a current valuation and to prepare analysis of the previous reports and calculate values as of the previous dates using current assumptions. We found several anomalies that clearly demonstrated that the company was being vastly overvalued and that the estate plan was completely overblown for the size of the business.

The valuation errors ranged from basic mistakes to subjective judgments that vastly misstated the reality of the business enterprise and the fractional interests being valued/gifted:

An after-tax risk rate was used to value pre-tax income. This is a common error that results in a theoretically inaccurate conclusion.
Risk rates (capitalization and discount) appropriate to value very large public companies were used to value the income of a comparatively tiny company.
The appraiser added back marketable securities held by the company as non-operating assets without asking management about the investments. Management inquiry would have prevented that mistake.
Discounts for lack of control and marketability for fractional interests in the business were negligible.
Result: Chris Hamilton Forensics’ conclusion was that the business was overstated by more than 300%. As a result the complex gifting plan was abandoned, multiple prior gift tax returns were amended, and the estate plan was restructured to more reasonably reflect the size of the estate.

##9: Avoiding Litigation When Shareholders Leave

Result: The valuation report was prepared, issued, and distributed. As a result, the valuation issues were negotiated and resolved before lawsuits were filed.

#10: Reviewing and Critiquing a Valuation Report

Type of Matter: A business valuation was prepared immediately before a complex stock transaction was finalized. That valuation report was later scrutinized in response to a claim that it was improper and erroneous.

Background: A complex stock-for-stock transaction was contemplated between owners of a closely-held business involving over 20 subsidiaries. In contemplation of that transaction, the company retained a valuation expert to place a value on a portion of the business. The transaction was consummated at the value determined by that expert. Subsequently, the valuation conclusion was challenged and Arxis was retained to evaluate the report.

Arxis Work: A copy of the complete report and all documentation that was originally supplied to the valuation expert was provided to Arxis. With that information we attempted to replicate the calculations, assumptions, and conclusions presented in the report. As a result, numerous substantial errors were identified. It was a collection of some of the most common valuation errors wrapped up in one report:

An invested capital risk rate (WACC) was used to value a cash flow to equity benefit stream. This, by definition, results in an incorrect conclusion.
The expert properly concluded that public companies were inappropriate to use as guideline companies. However, throughout the rest of the report public companies were used to project cash flow, capital expenditure levels, and working capital.
Public company data was used to determine the WACC rate for the subject company. This was inappropriate given the conclusion that public companies were not comparable to the subject company.
The expert did not consider, or adjust for, non-operating assets and non-operating income and expenses.
The sale of similar privately held companies (Market Approach) was not considered. This was problematic since there were hundreds of transactions in the same SIC code as the subject company available.
Prior transactions (several) of company stock were not considered.

Result: The report was so flawed that all parties agreed it had to be set aside and a new valuation performed. A substantial amount of money had been spent on a valuation that was flawed on every level.

#11: Partner Dispute and the Business Valuation

Type of Matter: A widow received a questionable offer to buy her departed husband’s business from his previous general partner. Questions arose and then litigation ensued.

Facts: A woman became a widow very suddenly and unexpectedly. Unfortunately, the aftermath of that tragic death added salt to the wound. Throughout the marriage, the husband maintained all the finances and investments. He was a sophisticated investor. Included in the portfolio of investments was a limited partnership interest in a mid-size business located and operating in another state. His wife knew nothing about the business, or partnerships, or the relationships with the other partners that died with her husband. In the midst of her grief, she barely grasped the concept that his partners had now become hers, along with all the rights and obligations of ownership.

The general partner saw an opportunity. He approached his new widowed partner and offered her a sum of money to buy out her limited partnership interest. He had obtained an “appraisal of the business” and used it as the basis to value the limited partnership interest. He observed the obvious distress and naivete of his new partner and pressed for a quick conclusion to the transaction. Fortunately, she sensed that there was something wrong. She contacted a law firm that did not understand her situation any better than she did. Fortunately, she switched law firms and, finally, had an advocate who saw the issue and understood the realities of her situation and the possibility of concluding the matter in a much more satisfactory manner.

Arxis Work: The law firm, after preliminary discovery and inquiries, recognized that valuation assistance was needed. They forwarded to Arxis the “appraisal of the business” that was used as the basis for the initial buyout offer. Almost immediately, we noticed that the appraisal was for the land and buildings only. The appraisal was inadequate and, mostly, a waste of time and money. We immediately recognized that a valuation of a non-control limited partnership interest was needed – not an appraisal of some of the assets of the business. In short, it was not an appraisal of the business at all. The appraisal did not include several assets, the most material being intangible asset (goodwill) value.

Result: We prepared a valuation of the limited partnership interest and the case settled on the eve of trial. The buy-out price ended up substantially higher than originally offered. From that standpoint it was a typical case with a normal ending. But the case highlighted several observations and recommendations to avoid and resolve similar litigation:

When a business interest is in dispute, an asset appraisal is, with some rare exception, not relevant or helpful. Appraisals tend to address tangible asset values but ignore intangible assets. Intangible assets are, for most businesses, the most important and valuable assets of the business. Ownership of a business interest includes the value of all the assets, and debt, of a business.
The partnership agreement in this case described the method and manner of valuing the partnership interest for a departing partner. The “buyer” tried to ignore it and the “seller” did not understand it. Both were a little disappointed with the results. The owners’ agreement, with some exception, will drive the valuation process for better or worse. It is advisable that business owners understand that agreement before trouble comes.
A “standard of value” is a set of assumptions that must be used to arrive at the value. Fair Market Value (FMV) is the standard of value that most everyone has heard of – and is least relevant in litigation involving owner/partner/shareholder disputes. When parties to a dispute retain a valuation/appraisal expert they often tell the professional that they want to know the fair market value. Rather, the attorney and valuation/appraisal expert should discuss the relevant standard of value and proceed on that basis. A lot of money is wasted on valuation and appraisal reports using the wrong assumptions.

A distressed seller makes for potentially bad deals. Any transaction involving an interest in a closely-held business should be concluded only after review by a professional that understands valuation.

#12: Business Valuation, Dissenting Shareholder, Joint Report

Litigation, estate and gift tax planning, financial and business succession planning, Family Court, and bankruptcy are some of the most common circumstances requiring a business valuation. Many believe that the process is inordinately expensive and, in some cases, do not get the work done because of the perceived cost. It is common in our office to take a phone call from someone fully prepared to over-pay for valuation work. We talk ourselves out of business all the time.
There is a great potential to misunderstand the level of valuation service that is required, and the following cases illustrate that point and inform of the range of available services. The key difference in the cost of a valuation is the amount of written reporting required. In short, not every valuation engagement requires a report of 100+ pages.

Calculation of Value: It is common in a shareholder dispute or upon the death, retirement, disability, or other separation of a partner/shareholder in a business that the buyout provisions of the shareholder agreement come into play. The starting point of analysis, whether in litigation or negotiation, is to figure out the buyout price based on the written agreement. We receive a lot of calls requesting our help with this and it is common that the caller is surprised that this is probably a relatively inexpensive engagement. Since the method of valuation is being dictated by the written contract, this type of work is described by the professional standards as a calculation of value. The only documents needed are a copy of the shareholder agreement and the relevant financial reporting dictated by the methodology described in the agreement. There is no need for a full-disclosure business valuation report in this situation. A short report disclosing the calculation is all that is needed.

Summary Report: When we receive a phone call from a group of owners wondering what their business is worth, either for planning or transaction purposes, we explain that they do not need a full-disclosure report. More likely, they need a brief (summary) report that explains the value of the business and how it was determined. In any case where a tax, regulatory, or judicial authority is not requiring a report, a summary report is likely adequate and should be considered. A summary report is significantly shorter in length without the depth of a full-disclosure valuation report. The same analysis and development work is done to determine the value of the business but the report is shorter excluding much of the detail that may not be relevant to the users, anyway. It is also of note that in this example the business appraiser can report on a range of values rather than a single number. There is no reason to pay for the precision of a single number. It is likely more helpful and relevant to have the business appraiser provide a range of values and describe the variables that will impact the sale price. The ability to provide a range of values reduces the amount of analysis and documentation required to arrive at a single number thus costing less.

Full–disclosure Report:
There are cases where a full disclosure report is required. In a valuation practice like ours, this is rare. Even in matters of litigation, it is rare that a full disclosure report will be written. The exception to this is Federal court where the rules require a full-disclosure report. Additionally, a full disclosure report is required for ESOP, Gift tax, estate tax, and income tax purposes.

Oral Report: Most users of valuation services do not realize that one option available is an oral report. Obviously, this is the least expensive and is particularly helpful and useful to a sole proprietor, single shareholder, or even a small group of owners who, for various reasons need a “ballpark” estimate of the value of the business.

#13: Valuing Multiple Entities under Common Ownership

Summary of Issue: Long-time partners built a very successful business. One of the older/original owners was ready to retire and enjoy the wealth that was created in “the business.” Arxis Financial was contacted to calculate that value and assist the owners with negotiating a buy-out. While that sounded simple, without advance planning, it rarely is. In this case, multiple businesses were created over the years for licensing and other purposes. “The business” was really several businesses with different ownership structures and cash flow. Therefore, there was no buyout of ownership in “the business,” it would be the buy-out of several businesses.

Arxis work: Entrepreneurs think a lot about the end of the business-building process. That thinking generally extends to developing the plan to create wealth, and then someday far off into the future enjoying the created wealth. Rarely, unfortunately, does that thinking involve establishing legal structures and entity identity that lends itself to a smooth exit strategy. But once the exit process begins, attorneys, CPAs, and valuation experts must deal with the situation as it is, not how it might have been, or how one of the owners meant for it to turn out.

In this case, there were several complexities that are presented below as entirely representative of many situations where there is little thought to the “end game”:

Intellectual property – Business names, relationships, formulas, goodwill, patents, contracts are all intangible assets that require valuation triggered by an exit event. The first step in that valuation process is understanding the ownership of the asset. In a setting where there are multiple entities, the shareholders are often surprised by a report showing which entity actually owns the intellectual property.
Cash flow – In closely-related businesses, the source and use of cash flow associated with the equity interest in a business can be difficult to assess. With limited internal controls and accounting policies, accounting and transaction flow can become disconnected from economic reality. In this case Income from business A was deposited in the checking account for Business B and several expenses, such as rent, were paid by Business C, although the expenses were properly allocable to all businesses.
Ownership structure – None of the complexities described so far would matter very much if all the entities were commonly owned by the same shareholders in the same proportion. If two people each owned 50% of the equity of each of the entities, the entities could be more easily valued. In this case, there was disparate ownership percentages and, additionally, some equity owners did not have an interest in all the businesses the entities. Therefore, everything needed to be valued separately, requiring separate representative annual cash flows established for each of the businesses.

The departing partner was involved in the day-to-day operations of one business and, for years, had paid little attention to other lines of the business. His perspective and understanding of the profitability of the business was distorted and inaccurate leading to unrealistic expectations of the value of what in his mind was “the business.” It also led to underestimating the difficulty and effort needed to value the business.

Result: The buyout of the departing owner was a big disappointment. There was no evidence of dishonesty or malfeasance in the accounting for the companies, just years of neglect and ignorance of the consequence of adding owners and entities. The actual costs associated with the various businesses had been masked; extensive work was done to identify the cash flow and intangible assets associated with each business. In the end, the “original” business had very little value and the subsequently formed businesses (where ownership had been “given away to keep employees”) were more valuable.

Beyond the valuation issue, the key take-away from this case from a business ownership perspective is the ongoing necessity (throughout the life of all related businesses owned and intellectual property developed) of working with attorneys and CPAs to properly structure any new business entities, and overall ownership structure, to meet the business transition goals of ownership. Contact Arxis Financial if you need such assistance.

#14: Valuing 50% Ownership Interest

Summary of Issue: Two people decided to start a business together. They were friends, entrepreneurs, and believed they would both contribute in different ways to the success of the business. One partner was the “rainmaker,” and the other was the management/administrative genius. They both agreed that they should each have an equal say in the operations of the business and, since they saw eye-to-eye on everything, there would be little to no disagreement anyway. They visited an attorney and established the corporation reflecting a 50/50 ownership and decision-making structure. Both owners were content that they had equal control and ownership. They proceeded to buy an existing business and began operations that turned out to be wildly successful.

What Could Possibly Go Wrong?!: In short, everything can go wrong in this scenario and, too often, it does. When nobody has “control” or the ability to break a tie, nobody has the necessary authority. Starting out, both parties feel like they have mutual and equal control but, in a dispute, neither party has the control to move past a disagreement. The vagaries of 50/50 ownership are usually exposed at one of two extremes: 1) The business becomes successful producing a lot of cash flow, or 2) the business struggles or even begins to fail. Either of these two extremes tend to produce disagreements that cannot be resolved in a 50/50 environment.

In this case, decisions regarding distributions of profits, preserving cash for working capital and growth, and expansion plans were frozen by the 50/50 tie. As is usually the case, one of the two partners decided to step into the control role and began making decisions that forced the other owner to either ignore, accept, or challenge those decisions. And, as in most similar cases, the decision to challenge was deferred as long as possible but eventually was unavoidable. Once decisions were challenged, the relationship between the parties disintegrated to such a degree that there were accusations of theft, embezzlement, diversion of business assets, and more. It was not long before there were active discussions and negotiations regarding a corporate divorce and the need for a business valuation. It is not unusual for attorneys to be involved at that point and, where there are attorneys, there is the likelihood of litigation.

What started out well (a new business), would not end as satisfactorily! Litigation was initiated to resolve the civil fraud claims and the business valuation/buyout issue. The court authorized a forensic fraud examination, producing a 100+ page report, and appointed a panel of valuation experts designed to resolve such disputes, in accordance with the law of the state. The ensuing drama went on for over two years at a cost estimated in the hundreds of thousands of dollars.

Arxis Work: We were one of the three appointed valuation experts. Because of the length and complexity of the fraud examination report, the court requested the panel to make a determination regarding the existence of fraud, its impact on the value of the business, and to provide a buyout value.

A difficulty in achieving the court’s request was whether the value could be determined if there was credible evidence of unreported (stolen) receipts and fraudulent (personal) expenses recorded in the financial statements of the business (i.e., the value would be impacted by such unreported fraud amounts).

Additionally, the valuation panel unanimously found the fraud report unreliable and completely speculative – in essence, unhelpful. Consequently, the panel conducted discovery and multiple interviews of the owners and management team. The panel discovered that the IRS and local government agencies had conducted comprehensive audits of the business corporate tax returns in the recent past and issued “no-change” audit letters. That seemed to be persuasive evidence that, at minimum, reported income and expenses were reasonably accurate. There was no better evidence produced one way or the other.

Result: The business was valued based on the financial statements of the business. The court ruled that one of the shareholders could be bought out at the amount derived from the valuation panel’s conclusion, or the business would be ordered sold or liquidated. It was an outcome that could not possibly have been anticipated when two friends decided to start a business together and “share” all the control of the business. It is likely that neither party was happy with the result. Neither shareholder could have felt that they had any control of their destiny throughout this process. A lesson to be learned – think long and hard before entering a 50/50 partnership!

Business Valuation