How the recession has impacted business valuation
As the economy continues to limp toward recovery, the values of many businesses remain depressed. Valuing distressed businesses should be fairly uncomplicated. Investors are inherently risk-averse but are more so during economic downturns. Generally, private companies experience the same downturn trend as their public counterparts during a recession. But what about businesses that were valued on the eve of the economic downturn? Should they be revalued in light of subsequent events? That was one of the issues in the Florida Court of Appeal case of Mistretta v. Mistretta.
October 2007 valuation date
Mistretta involved the valuation of a restaurant business for purposes of equitable distribution in a marital dissolution case. The trial court used Oct. 31, 2007, as the valuation date, though final judgment wasn’t entered until Aug. 25, 2008. The court valued the business at $845,000 and ordered Mr. Mistretta to make a cash “equalization payment” to Ms. Mistretta based largely on the business’s value as of Oct. 31, 2007.
Mr. Mistretta moved for rehearing, arguing that the economic recession that began in December 2007 caused the business to sustain an almost $58,000 loss in 2008 and that this “newly discovered evidence” warranted a new trial and revaluation of the business. The trial court granted Mr. Mistretta’s motion on equitable grounds, noting that the “present recessionary economy was totally unforeseen” and that “no one could reasonably anticipate the severity of same.”
Changed circumstances not enough
The court of appeal reversed the trial court’s ruling, explaining that “newly discovered evidence” sufficient to warrant a new trial “cannot simply show some change in circumstances since the trial.” In this case, the alleged new evidence consisted of a recession that began months after the valuation date and financial results that weren’t available until well after the trial.
The court also discussed the impact of subsequent events on business valuation. A valuation involves projections of future financial results that depend “not only on known or knowable facts already in existence, but also on assumptions about the future that will not always, if ever, be entirely accurate.”
Recessions, the court said, “like other vagaries in the business cycle, are contingencies appraisers must take into account in valuing a business.” But the fact that the future turns out differently than business appraisers assumed is not a basis for a new trial.
Moreover, there was no reason to believe that a revaluation of the business would be any more reliable than the original. The trial court emphasized that the recession’s impact “was essentially unknown to . . . various experts who provided testimony,” but it didn’t explain, the appellate court observed, why those experts “were more likely to predict future economic conditions accurately on rehearing.”
For example, the appellate court said, “The parties’ experts might not have predicted the precise economic conditions on April 6, 2009, the day the order under review was entered, or, for that matter, the reported improvements in economic conditions since.”
Are subsequent events ever relevant?
Mistretta confirms that, when valuing a business, appraisers generally shouldn’t consider events that take place after the valuation date. This principle is supported in various published valuation standards.
The AICPA’s Statement on Standards for Valuation Services, for example, instructs valuators that “subsequent events are indicative of conditions that were not known or knowable at the valuation date, including conditions that arose subsequent to the valuation date. The valuation would not be updated to reflect those events or conditions.” (Different standards apply to financial reporting; see the sidebar “Accounting for subsequent events.”)
Some courts and valuation experts believe that subsequent events are properly considered in valuing a business if they were reasonably foreseeable on the valuation date or, even if they weren’t reasonably foreseeable, they provide evidence of the business’s value on the valuation date. An example of the latter might be a post–valuation-date sale of the business being valued or of a comparable interest in a guideline public company, provided market conditions haven’t materially changed since the valuation date.
Critics of this approach argue that fair market value is based on what willing buyers and sellers know or reasonably should know on the valuation date and that subsequent events, by definition, don’t fall within that category. They also point out that market conditions change on a daily basis and depend on a variety of internal and external factors, so it’s difficult to determine whether market conditions have changed (and if so, how much), even shortly after the valuation date.
Handle with care
Even in courts that accept evidence of subsequent events, the circumstances under which they’re relevant to business valuation are limited. So it’s important for you and your valuation experts to consider this issue carefully before relying on events that take place after the valuation date.
Sidebar: Accounting for subsequent events
The Financial Accounting Standards Board (FASB) has its own standards regarding the treatment of subsequent events for accounting purposes — that is, events occurring after the balance-sheet date but before financial statements are issued or finalized.
The standards, found in Accounting Standards Codification (ASC) 855, identify two types of subsequent events:
1. Recognized subsequent events (such as settlement of litigation pending on the balance-sheet date), which provide additional evidence about conditions that existed on the balance sheet date, and
2. Nonrecognized subsequent events, which provide evidence about conditions that arose after the balance sheet date.
Recognized subsequent events are recorded in the financial statements. Nonrecognized subsequent events are not, but may need to be disclosed to prevent financial statements from being misleading.