Why Do Business Valuation Experts Draw Competing Conclusions?
By Thomas Keane, Partner, Advisory Services
It happens more often than you might think: You engage a well-known business valuation expert with years of matrimonial and industry experience to value your client’s privately held business. You check in with your expert throughout the valuation process and understand all the salient issues addressed in the report. The analysis appears well-supported and reasonable. But when you exchange valuation reports with opposing counsel, you see their expert value is triple your expert’s valuation conclusion. How can this be?
Both experts received the same financial information — tax returns for the last five years and a copy of the general ledger. Both had access to the company’s customer lists, accounts receivable, pertinent loan documents, etc. So how could two experts with the same education, training, and experience review the same information and arrive at such wildly different conclusions?
Assuming for this discussion that both experts chose objectivity over advocacy, the answer frequently comes down to access to management. Information gathered by talking with a company’s management is a vital step in the valuation process. A business appraiser must make numerous decisions, such as which valuation approach (asset, income, or market) is most appropriate. If they are considering the income approach, the appraiser must make judgments and assumptions about the company’s expected future cash flows and the risks involved in achieving those cash flows. These decisions should not be based solely on a review of the company’s financial information, but should include, and can be greatly influenced by, discussions with the company’s management.
A valuation expert working with the spouse who owns the business (the titled spouse) may be at a distinct advantage. Answers to important questions, such as how to interpret historical results or the company’s future plans, may only be a phone call away. Follow-up interviews or access to other more knowledgeable members of the management team, such as the head of sales or the CFO, are easily arranged and may help the appraiser better understand the company’s standing in the market or potential sales prospects. This additional knowledge may directly impact the appraiser’s valuation assumptions related to the company’s growth, capital expenditure requirements, capacity issues, or likelihood of achieving its financial goals.
The expert working for the non-titled spouse typically has less access to company management. Often, access to the business owner may be limited to one management interview (60 to 90 minutes) and a one-time site visit. In more difficult cases, the attorney may conduct the management interview on behalf of the valuation expert via deposition. In this format, asking follow-up questions is more challenging and it’s harder to drill down into valuation areas important to the appraiser.
For obvious reasons, the titled spouse may accentuate the negatives and gloss over any positives in the business when speaking with the non-titled spouse’s valuation expert. For example, a business owner may highlight the rising payroll costs and the negative impact of those costs on the company’s bottom line. To properly evaluate this information, an appraiser needs to understand the reasons for the increase — is it due to an increase in the cost of labor, or has the business owner hired additional workers? The latter suggests the business owner may foresee growth that is not yet reflected in the current revenues. That overall increase in cash flow could increase the value of a company.
At the same time the expert representing the titled spouse is sorting through the barrage of negative information from the business owner, the expert for the non-titled spouse may have a pile of positive information to consider. The non-titled spouse may be reciting, through no fault of their own, only the positive developments that were shared with them over the course of the marriage. The titled spouse may have only discussed the “good news,” such as signing an important client or a significant contract. Again, it is important for the appraiser to put this information into the proper perspective. Does information from the non-titled spouse provide the whole picture? How reliable is it?
Relying too much on the optimistic information provided by the non-titled spouse may cause the appraiser to overstate the value of the company. In contrast, relying on the doomsday information provided by the titled spouse may result in an understated valuation — hence the disparity between the two experts. In either case, access (or lack thereof) to company management plays a significant role in shaping the appraiser’s assumptions. A business appraiser must examine both the written and verbal information provided and assess both its validity and its relevance. Only then can the appraiser formulate the assumptions underlying the valuation report to arrive at a supportable estimate of value.