As Presented August 19, 2010: Tennessee Bar Association General Practice Summit 2010

1. As Presented August 19, 2010:Tennessee Bar AssociationGeneral Practice Summit 2010 Business Valuations in Divorce: What Family Lawyers Need to Know Presented by: Robert Vance,CPA/ABV/CFF,CVA,CFP Forensic & Valuation Services, PLC 901-507-9173 www.ForensicVal.com rvance@ForensicVal.com

3. What is the Essence of a Business Valuation? Estimation of two primary components • The future expected benefits • The risk related to receiving those future expected benefits A valuation measures the: • Amount of benefits • Present Value of benefits (e.g. The Time Value of Money; a dollar today is worth more than a dollar in one year)

4. What is Present Value? The process of converting future cash flow(s) into a current, present value, lump-sum figure End of Year 0 +1 +2 +3 +4 15% $100,000 $100,000 $100,000 $86,957 $75,614 $65,752 $228,323 = PVA3

5. What are the Standards of Value? • Fair Market Value • Fair Value • Investment Value • Intrinsic (Fundamental) Value • Book Value

6. Fair Market Value 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.”

7. Fair Market Value Powell v. Powell1 • Fair Market Value Standard as in IRS Rev. Rul. 59-60 does not have to be strictly followed when valuing a business in a divorce • Business owners can be held to values in personal financial statements submitted to banks • Credentials and experience of business valuation analysts are critical 1. Powell v. Powell, 124 S.W.3d 100 (Tn. Ct. App. 2003)

8. “Look, it tells time simultaneously in Monte Carlo, Beverly Hills, London, Paris, Rome, and Gstaad.” Louis Winthorpe, III (Dan Aykroyd) Trading Places, 1983

9. What are the Approaches to Valuation? Blasingame v. American Materials, Inc.2 “There are a number of acceptable methods available to determine the value of a corporation.” Blasingame recognized three of these methods [approaches]: • Market Value [approach], • Asset Value [approach], and • Earnings Value or Capitalization of Earnings [Income] [approach] 2. Blasingame v. American Materials, Inc., 654 S.W.2d 659, (Tenn. 1983)

10. What are the Approaches to Valuation? • Market Approach • Expected benefit = some level of earnings (reve-nue, net income, EBITDA, gross profit, etc.) • Expected risk and growth are measured by a market multiple (P/E, MVIC/EBITDA, etc.) • Market multiples are obtained from public com-panies, from sales of similar companies, or prior sale of the subject company or interests in the subject company

11. What are the Approaches to Valuation? • Market Approach (cont’d) • Example: Price to Seller’s Discr. Cash Flow Ratio = 2.5 Seller’s Discr. Cash Flow = $100,000 $100,000 x 2.5 = $250,000 Value Beware of this value as it may or may not include Goodwill and may not include all assets like cash and liabilities like A/P

12. What are the Approaches to Valuation? • Asset Approach Adjusted Net Book Value method is similar to the classic accounting formula: Assets - Liabilities = Equity or Identifiable “Hard”* Assets Adjusted to FMV – Liabilities = Value * “Hard Assets”: Cash, A/R, N/R, WIP, Patient Records, Equipment, Purchased Goodwill, etc.

13. What are the Approaches to Valuation? • Income Approach • Expected benefit = net cash flow or other measure of: • Forecasted benefits • Normalized historical benefits • Expected risk is measured by the weighted average cost of capital, capitalization rate or discount rate • Net present value of expected benefit

14. What are the Approaches to Valuation? • Income Approach (cont’d) • Example: Capitalization Rate = 25% = 4.0 Multiple Weighted Adjusted Net Income = $100,000 $100,000 x 4.0 = $400,000 Value Value includes Goodwill and usually all assets and liabilities. Cap. Rate measures the risk.

15. How is Personal Goodwill Handled in a Tennessee Divorce? Generally • Fair Market Value inherently includes Goodwill when valuing with a going concern premise • Personal goodwill is generally not to be considered in valuation of professional practices and small, closely-held businesses primarily dependant upon the individual for success • Courts often use a standard other than FMV

16. How is Personal Goodwill Handled in a Tennessee Divorce? Hazard v. Hazard3 • Dr. Hazard’s practice was highly specialized and very dependent upon referrals from other physicians • Court rejected gross income approach to value Husband’s medical practice • Goodwill in a professional practice is not a marital asset subject to equitable distribution 3. Hazard v. Hazard, 833 S.W.2d 911 (Tn. Ct. App. 1991)

17. How is Personal Goodwill Handled in a Tennessee Divorce? Hazard v. Hazard (cont’d) • Sole practitioner professional practice is to be valued using the “net tangible assets with ascertainable value.” Cites Smith v. Smith4 • Net Asset Value a.k.a. Net Book Value 4. Smith v. Smith, 709 S.W.2d (Tn. Ct. App. 1985)

18. How is Enterprise/Business Goodwill Handled in a Tennessee Divorce? Witt v. Witt5 • 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 good-will that was not directly related to his professional or personal goodwill 5. Witt v. Witt, 17 TAM 15-6 (Tn. Ct. App. 1992)

19. How are Buy-Sell Agreements Handled in a Tennessee Divorce? Harmon v. Harmon6 • Dr. Harmon was a doc in a large medical practice • Buy-sell agreement contained an artificially low value formula if a doc terminated • Buy-sell agreement of a closely-held corporation, not signed by the non-shareholder spouse, is not binding on that spouse and is only a consideration in the valuation 6. Harmon v. Harmon, 25 TAM 15-22 (Tn. Ct. App. 2000)

20. How are Buy-Sell Agreements Handled in a Tennessee Divorce? Harmon v. Harmon (cont’d) • Goodwill was considered as part of the marital ownership interest • “[s]ince [the] Husband will continue to experience the benefits of being a ... shareholder and an employee, factors such as those deleted from the valuation [like goodwill] in the buy-sell agreement are pertinent to the valuation of Husband's interests for purposes of the division of marital property.”

21. “I'm givin' this whole thing as a promotional expense, that's why I invited clients instead of friends. You havin' a good time, Mark?” Louis (Rick Moranis) Ghostbusters, 1984

22. Are Other Closely-held Businesses Treated Like Prof. Practices in a Tennessee Divorce? Koch v. Koch7 • Mr. Koch was a commercial painter • Sole proprietorship likened to a professional practice • Business goodwill of a professional practice or a sole proprietorship is not a marital asset for the purpose of equitable distribution 7. Koch v. Koch, 874 S.W.2d 571 (Tn. Ct. App. 1993)

23. Financial Statement Adjustments Are all financial statements equal?

24. Financial Statement Adjustments • Adjustments for Generally Accepted Accounting Principles (“GAAP”) departures • Year end accruals • Accelerated depreciation • Cash basis to accrual (inventory, accounts receivable) • Prepaid assets • Intangibles (work in process, medical files)

25. Financial Statement Adjustments • Adjustments for Normalization • Personal expenses • Owner’s salary • Non-operating assets • Shareholder loans • Nonrecurring income and expenses • Income taxes

26. Discounts & Premiums • Discount for Lack of Control (Minority Interest) • Premium for Control • Discount for Lack of Marketability • Discount for Key person They depend on the interest to be valued and the techniques used to establish the value conclusion

27. Discounts & Premiums • Discount for Lack of Control (Minority Interest) Anderson v. Anderson8 “The reasons given by Warren to discount the value of the husband’s minority interest are persuasive, and the evidence does not preponderate against discounting the value by 38.3%.” 8. Anderson v. Anderson, 2006 WL 2535393, at*4

28. Discounts & Premiums • Discount for Lack of Marketability Anderson v. Anderson9 “However, he reduced the value by an additional 10% for a ‘marketability discount’. We conclude this further discount was inappropriate because no sale was ordered and there is no indication in the record that the husband has any intention of selling his minority stock.” 9. Ibid.

29. Male #1:“Surely you can't be serious.” Male #2: “I am serious... and don't call me Shirley.” Ted Striker (Robert Hays) Dr. Rumack (Leslie Nielson) Airplane!, 1980

30. The Top Ten DOs and DON’Ts Dealing With an Expert Witness DO • Involve the Expert early in the case and allow him to issue a document request list • Keep the Expert in the loop of deadlines and date changes!! • Allocate as much time to the Expert as he requests • Make sure the Expert is paid • Understand the business valuation case law and standards of the jurisdiction • Allow the Expert to make a conflicts check (or at least give him the parties’ names on the front end) before delivering documents or discussing the case in detail

31. The Top Ten DOs and DON’Ts Dealing With an Expert Witness DO • Engage an Expert that will give you opposing viewpoints and will pinpoint weaknesses in the case • Expect the Expert to use technology and present convincing, but simple graphs, tables and trial exhibits • Allow/expect the Expert to assist with formulating deposition and trial questions for the opposing expert or party • Gain an understanding of the financial concepts of present value and discounting

32. The Top Ten DOs and DON’Ts Dealing With an Expert Witness DON’T • Designate an Expert in a case or use his name without first informing and actually engaging him with a retainer • Withhold information from the Expert thinking: “what he doesn’t know won’t hurt him” • Engage a “hired gun” • Assume the valuation analyst has testimony experience • Engage a “second tier” Expert expecting to save money

33. The Top Ten DOs and DON’Ts Dealing With an Expert Witness DON’T • Limit the Expert’s access to the client • Assume the Expert possesses all of the necessary documents unless you ask • Pretend you understand business valuation if you don’t; ask the Expert for a crash course • Allow the Expert to use a lot of techno-jargon with you, at deposition or trial • Expect a five day turn around

34. Questions?