Nicholas L. Bourdeau
Bourdeau Conflict Relief, pllp
PO Box 6363
Great Falls, MT 59406
Phone: (406) 727-8365
Fax: (406) 727-3708
How Much Is a Business Worth?
I was introduced to Dr. Nova Cane in the reception area of Fred Blaise, Attorney at Law. The doctor was a petite woman with a warm smile. She did not fit my mental picture of dentists: hands the size of baseball gloves and dripping fangs.
Fred didn’t look up as we were shown into his office. His face was drawn, and I noticed a small tic making his left eyelid dance just a bit. He sighed heavily, gathered up the reports he had been studying and tossed them across the desk to me. “How can this be?” asked Fred. His frustration was verging on desperation.
What he had given me were two business valuations, done by qualified CPAs, for a dental practice. One showed a value of $30,000 and the other a value of $275,000. Being heavily involved in self-preservation, I quickly assessed the situation. I was about to become the sacrificial goat for the seeming incompetence or malice of my peers. In these types of situations, I switch into output mode and give the attorney and the client as much information as I can, as quickly as I can. Then while they are thinking it over, I make my escape.
The Standard Isn’t Standard
“Let’s talk about Betty,” I ventured.
“Who?” the attorney asked. He was a little mystified. So far, so good.
Betty owned a small company that delivered water to homes that didn’t have municipal water or wells. She sent me the information on the business and asked me to place a value on it. I came up with a preliminary value of about $50,000 for the business and sat down to discuss it with her. “Why does anyone care what I think the business is worth?” I asked her. “Why don’t you just put a great big price tag on it and see what happens.” She did. The business sold for $150,000.
The heart of most business valuations is a concept known as Fair Market Value (FMV). It can be defined as the amount at which a business would change hands between a hypothetical willing seller and a hypothetical willing buyer when neither is acting under compulsion and when both have reasonable knowledge of the relevant facts.
So what happened with Betty? Why was the fair market value of her business so out of line with the actual sales price? Well, Hank. Hank happens to own the only other water delivery business in the area. Therefore he was willing to pay a big premium for Betty’s business because he could eliminate his competition.
Hank’s acquisition is politely called a synergistic acquisition. Actually, he bought himself a monopoly. Hank was a specific buyer with a specific goal. These types of situations will confuse our attempts to place a value on a business.
Let’s assume that Betty died before the business was sold and that the business had to be valued for estate purposes. Would the value be $50,000 or $150,000? The Internal Revenue Service has stated that without question, the standard of value that it will apply in all circumstances is fair market value. So the business value would be $50,000 for tax reporting purposes.
Now let’s assume that Betty is alive and well, but she is getting a divorce. The fair market value is $50,000. Betty’s husband presents in court a written offer from Hank to purchase the business for $150,000. The judge drops the hammer (establishing case law on the way) and says, “The fair market value of the business is $150,000,” and puts that amount into the marital estate division.
So now we have two values for the business, both defined as fair market value, $100,000 apart.
What the court selected as a value for divorce purposes was simply that, a value for divorce purposes. It was not fair market value. The court could have called it divorce value, expected sales value, fair value, intrinsic value, investment value, value to Hank, or just about anything else to help us reduce the confusion, but courts usually don’t make the distinction and thus fertilize the field of confusion.
Fred thought for a moment then said, “So the IRS and the judge would come up with two different values using two different standards. Things could be confused because the judge called it fair market value when it wasn’t. But we’re not dealing with a judge here, were dealing with two CPAs. I’m sure they’d call a spade a spade.”
Except when it’s a shovel.
What’s in a Name?
I had been called as a neutral in a divorce case. Two CPAs, solidly accredited, experienced and knowledgeable had submitted their values for a medical practice. The doctor was in a partnership with four other doctors. One CPA came in with a fair market value of the partnership share of $180,000 and the other CPA with a fair market value of the partnership share of $225,000. This was pretty close by valuation standards, so I figured there wouldn’t be much of a problem in this area. As part of the case assessment I reviewed the partnership agreement. The partners had agreed, “…no partner may sell his partnership interest. Upon leaving the partnership any rights, properties, values, (etc.)…revert to the remaining partners.” How can a practice that can’t be sold have a fair market value? It can’t.
I asked one of the attorneys in the case how something that can’t be sold have a fair market value. He protested, saw my point, and then countered with, “But the practice has value to the doctor, and the practice certainly has value in the eyes of the soon to be ex-wife.” Exactly; it has an intrinsic value, or a divorce value, or an investment value. It does not have a fair market value. The CPAs had the same problem as the judge did in Betty’s imaginary divorce.
“Great,” said Fred. “Now I have differences in standards, and I can’t even tell what standard is being used because everybody calls a spade a spade even when it isn’t. Let me guess, you have more good news.”
Actually it’s not King Solomon, it’s Judge Solomon. His job is to make everyone equally unhappy. The judge has a history of splitting the difference between the two parties’ positions instead of selecting the correct one. So where does this leave the valuators? If I know the judge, the attorneys, and the other valuator I don’t need a crystal ball to predict the future. If the other valuator is working for the party that is seeking a low value for the business, he or she will rock bottom the price. If I bring the value in at where I think it should be, when the judge splits the difference between the valuations, the final value will be low. If I value it to counter the other valuator, my conscience slaps me. The solution? I say it. Given the opportunity, I tell the court that all valuations contain an element of subjectivity, and that changes in the assumptions in this subjective component can cause different values. The court is then effectively presented a range of values from which to choose. I’m off the hook because I have told the court that my value is at the top of the range. I have also along the way, told the court that the other valuator is at the bottom.
“So the valuators in my case could be responding to the judge assigned to the case?” asked Fred. “That’s not very objective.”
I answered, “It’s in response to the conditions of the assignment. Sometimes it’s called:
Some judges write opinions with their primary goal being the avoidance of reversal by a superior court. Take the example of two construction companies. Both have $700,000 of equipment. One business makes $285,000 annually for its owner and the other is new and has never made a dime. Which would have greater value in a divorce? I have asked a couple dozen attorneys and others this question. The answer is always the same, “A business making money is worth more than one that isn’t.” Good thinking. However, in one court the value of the business that made $285,000 was held to be $700,000, the value of the equipment. Then the judge turned around and awarded the spouse of the business owner 62% of the marital estate. Why? To paraphrase: “Well, the case could be appealed and maybe overturned if I didn’t adopt the husband’s value. But how can he appeal the fact that I just think it’s a good idea that the wife gets more of the marital estate because the husband makes so much money?” Well, as it turns out, he was correct; there was no appeal, and the wife got almost as much money as she would have had the court adopted a reasonable business value. However, that leaves us out here in the cold with a judge who has said that a business that makes money is worth the same as one that doesn’t.
Good Ol’ Boys
Then there is the cultural issue. Men and women are equal, correct? Women should get paid the same for the same work, have the same opportunities and generally get the same respect, right? Well, yes, but it’s kind of like the military. There is always some clown who doesn’t get the word. You will find pockets of resistance to these high minded ideals virtually everywhere. I generally refer to them as the “Good ol’ boy networks.” Small, rural, agricultural towns are where these infestations are usually (but not always) found. Some of the symptoms of the disease are the treatment of women as indentured servants, absence of female community leaders, and the only female business owner in the area is the hair dresser. Barefoot and pregnant isn’t just a source of pride, it’s a holy mantra. In our so called liberated society, you would think that the slaves in these pockets would rise up and demand fair treatment, but it doesn’t happen. They know that this is the way their mothers were treated, and their mothers’ mother were treated, so it has to be right. So what happens when you sink into one of these sacs of good ol’ boys? If you are working for the woman, you are handed your head in a bag. If you are working for the man, you are one fine attorney. The women vote the way they are told to vote. Judges who don’t comply with the secret handshake quickly find themselves untroubled by the tasks of public office. So in these lesions of our society, does it matter how many credentials I have behind my name? Does it matter whether I spend two or two hundred hours doing the valuation? Does it matter whether the attorney has broken his back to show an obvious and overwhelming preponderance of the evidence? Nope. They can’t have them women gettin’ uppity now.
Then there is that pesky problem known as the Chaos Theory. Kind of like cosmic rays, bad things happen to valuations that are litigated in a random, unpredictable fashion. Take, for example, the case of Hazmat Handler. Mr. Handler had a hazardous material disposal business and was going through a divorce. Snidely, the opposing expert, had valued the business as of 12/31/01. Well, as it turns out, the business of Hazmat Handler had one customer (Snidely failed to mention this in his report). Businesses with one customer typically have very low values compared with the same types of businesses that have many customers. This is because if Hazmat Handler’s customer put the contract out for bid, Hazmat could be out of business. That is exactly what Hazmat Handler’s one customer did and awarded the contract to another business effective 1/1/02.
I figured this was not going to be too tough. The judge was intelligent and fair and the situation obvious. Hazmat Handler didn’t have any customers, and because of a series of other problems, had no way of getting more customers. He was out of business. I carefully explained the situation to the judge and came in with a liquidation value for the business of about $100,000. The other expert came in with a range of value between $275,000 and $325,000, carefully ignoring the fact that the business did not have a customer.
Then the Chaos Theory raised its ugly head. The judge had a new clerk who had been out of law school three months at the time of trial. The judge handed the case to the clerk, no doubt thinking to start the clerk with something easy. The clerk misunderstood the intent of the court, established the value of the business at $300,000 and prepared the divorce decree. Then the judge, being distracted by two jury trials back to back, signed the order thinking he had reviewed it.
My reaction was not good. However, within ten days they had my medication adjusted to the point where they could let me out of the restraints so I could go back to court and do it all over again.
I glanced over at Doctor Cane. She was very pale.
Fred raised an eyebrow and said, “You’re not giving us much hope here.“
It’s Not Impossible
A business valuation is like any other report or opinion from any other type of expert. It is based on assumptions. The first job in defending or refuting a valuation is to discover the assumptions that were made.
Every business valuation, whether it is five pages or eighty pages, has two or three pages that are the key. I found them in each report.
I turned to the doctor, “Let’s say you are selling your practice, and you go about it two different ways. In the first case, you toss the keys to the new dentist on your way out the door. In the second case, you stay in the business a year and introduce each of your patients to the new dentist. Under which case would the new dentist pay the most for the practice?”
Dr. Cane didn’t hesitate, “The second case. The new dentist would be getting the patients and the income from them. He could afford to pay me off.”
I continued, “That’s the difference between the two valuations. The $30,000 is only the value of the equipment in your practice. Basically it assumes that there is no orderly transition of the practice. The $275,000 assumes not only a value for the equipment, but a value of the income stream that can be generated from the practice.”
Fred looked at the doctor and then at me, “So what’s the correct value?”
“That would depend on whether you get Judge Solomon, Judge Good Ol’ Boy, or Judge Chaos,” I responded.
Fred smiled for the first time since the meeting started. He knew the judge, and now what the experts had done. You could already see the wheels turning, building his case. I quietly slipped out.
Nicholas L. Bourdeau, “How Much Is a Business Worth?” GP SOLO, (American Bar Association, April/May 2004), 10-13