Are valuations recyclable?
The paper a valuation report is printed on may be recyclable, but in most cases the content is not. In fact, recycling a valuation may be downright hazardous to your legal health.
2 problems
Recycling valuations poses two major problems: First, the value of a business or other asset can change dramatically over time — in some cases, overnight. Second, a valuator’s methods and conclusions depend to a large extent on the valuation’s purpose.
So, unless you need to value an asset “as of” the same time and for the same purpose, reusing a previous valuation can lead to inaccurate results, not to mention admissibility problems.
Conflicting standards
Business owners may be tempted to stretch their valuation dollars by using a single valuation for several different purposes. But a valuation conducted for one purpose is likely to be inappropriate when used for another.
The most widely recognized valuation standard is fair market value, but several business and legal situations call for a different standard.
A business owner contemplating a sale, for example, would likely start with fair market value to get a feel for a reasonable asking price. But suppose a specific buyer is positioned to take advantage of tax benefits or operational synergies that wouldn’t be available to other buyers. In that case, investment value might be more appropriate.
In a legal context, state or federal statutes, regulations or case law may impose a specific standard of value. In dissenting shareholder litigation, for instance, most states use fair value to determine a fair price for a shareholder’s stock. But not all states define fair value exactly the same way. In some states, for example, it’s similar to fair market value but doesn’t recognize some adjustments, such as discounts for lack of marketability. Fair value also may exclude stock value appreciation or depreciation in anticipation of the event, such as a merger, that gave rise to the dispute.
Costly mistake
Let’s look at a hypothetical example where recycling a valuation goes awry.
Frank is the owner of Frank’s Auto Repair, which specializes in servicing European luxury imports. In 2007, he gives a 20% interest in the business to his son, Frank Jr. In connection with this gift, Frank has the business valued by a professional appraiser at $1 million. The appraiser also values the gift to Frank Jr., after applying a 30% combined discount for lack of control and lack of marketability, at $140,000.
In early 2009, Frank and his wife get divorced. To save money, he reuses the 2007 valuation and stipulates that the value of his 80% interest is $800,000. This is a big mistake. Not only is the valuation out of date, but high gas prices and a struggling economy have discouraged consumers from buying luxury cars, so Frank’s business has suffered. Had Frank consulted a valuator in 2009, he would have discovered that the business’s value had declined to $900,000, so that his 80% interest is now worth only $720,000.
The valuator also would have advised Frank that, in his state, personal goodwill is excluded from the marital estate. The business depends heavily on the many repeat customers who patronize the repair shop because of Frank’s reputation for reliability and integrity. The valuator would have concluded, therefore, that 40% of his interest in the business, or $288,000, consists of goodwill and that 60% of that amount, or $172,800, is attributable to Frank’s personal goodwill.
By recycling a two-year-old valuation prepared for a different purpose, Frank overvalues his interest in the business, for divorce purposes, by $252,800.
More trouble than it’s worth
In our example, Frank’s reliance on a recycled valuation costs him a lot of money. But it could have been worse. Suppose his wife had hired a valuator who valued the business at $1.2 million and concluded that Frank’s 80% interest was worth $960,000.
In light of the limited relevance of Frank’s valuation to the case at hand, a court would likely disregard it and rely on the opposing expert’s conclusions. You can avoid Frank’s mistake by obtaining a new valuation for any type of litigation in which valuation is an issue.
Sidebar: “Goodwill” in divorce
Different valuation standards may apply in divorce cases, particularly when a significant marital asset, such as a business or professional practice, needs to be divided. Although most states apply fair market value, the treatment of goodwill varies dramatically from state to state.
Most states treat some or all goodwill as a marital asset, while a handful of states exclude goodwill entirely from the marital estate. Many states, however, make a distinction between personal goodwill (that is, goodwill associated with an individual spouse) and enterprise goodwill (that is, goodwill associated with the business, or practice, itself).These states include enterprise goodwill as part of the marital estate but treat personal goodwill as the owner-spouse’s separate property.