This is a guest article by BVR Advisory Board member Lynne Z. Gold-Bikin, a partner at Wolf Block Schorr& Solis-Cohen in Norristown PA
Business valuations are a complex undertaking; experts in the field understand and are facile in concepts of valuation, types of valuation, (market approach, income approach, and asset approach), revenue rulings, capitalization rates, and how to incorporate all of these into a credible report on what they think a willing buyer would pay a willing seller, under no compunction to buy or sell, to a reasonable degree of valuation certainty. To challenge such a value, what does a cross-examining lawyer have to know? What credentials should the testifying expert have? As a practical matter, we as attorneys will never know as much as the expert does, a fact true for any cross-examination an expert in almost any field. Do we really want to dance in their arena, or can we pull them in to ours?So, what does the effective cross-examiner need to know, where do we find it, and how do we use it? Hopefully, this article will give you guidance in answering these questions. First and most important, business valuations is NOT an exact science. What that means is, there are judgment calls in almost everything the expert does. Our job is to find the subjective parts of the report, the soft under-belly, and attack the report from that point of view.
The revenue rulings, mentioned above are guides to how appraisals are to be done from a tax point of view. Revenue Ruling 59-60 is truly the core of an evaluation. This revenue ruling, lays out the framework for business valuations. Originally focused on the valuation of the stock of closely held corporations, it has been amplified by later revenue rulings, 83-120; 80-213; 77-287; and 65-193. The purpose of the revenue ruling, as stated in its purpose section, is to “outline and review in general the approach, methods, and factors to be considered in valuing shares of the capital stock of closely held corporations for estate and gift tax purposes.” It also sets out the statement of the necessity of capitalization rates but acknowledges the difficulty of setting the rates due to the wide variation of rates of returns even in the same industries and points out the factors that go into that rate. They involve (1) the nature of the business; (2) the risk involved and (3)the stability or irregularity of earnings. The importance of this revenue ruling to an effective cross-examination is the subjective nature of these factors. Can’t reasonable evaluators differ on the risk of a particular business? Can’t they differ on the ranges of that risk? Once the “cap” rate has been constructed, aren’t pieces of it subjective in the eyes of the witness? The important thing to know here is that the higher the cap rate, the lower the value of the business and the lower the cap rate, the higher will be the business value. It is never surprising to note that the expert appraising the business for the spouse who wishes to keep the business usually has the higher cap rate. Revenue Ruling 68-609 expanded the scope of 59-60 to make its guidance applicable to the valuation of corporate guides for income and other tax preparers, as well estate and gift tax preparers.
Occasionally 68-609 will be misused by the careless witness. Sometimes there is a gross misuse of the rates of return used; since it’s a formula only, there is always a subjective finding of the value of intangible assets such as corporate good will. These findings are ripe for cross-examination as good experts may differ on them.
One of the areas of cross-examination, then, is asking the witness about the construction of the “ cap” rate. What risk rate was used? All of these factors have a range of possible choices; the risk might be between 10 and 15 percent. Why did this expert choose 10%? How differently would be the value of the subject business had the expert used 12% or 13%? Make them go to the board in the court room and do the math. Often this one exercise will bring that value closer to your own expert.
Another area to challenge is the minority discount, the discount often used to reduce the value of the business because the seller has less than a 51% share and, theoretically, has no say in the management of the venture. This is another subjective area, as the expert can again choose a number within a range. Revenue ruling 93-12 amplifies this area, by dealing with blocks of minority stock where it is a family business. The resulting rule ignores the relationship of the donor to the donee. But, should there be a discount for a minority interest where a purchaser may have little or no say in how the business is run? And if so, what should the discount be? Isn’t this another area to challenge as chosen by expertise and opinion? And how would the value change if the number in the range moves up or down? Can’t reasonable experts differ?
These revenue rulings, while guidance to the experts, can also guidance to the cross-examining attorney. Do we have to know and understand every aspect? Perhaps not, but we should certainly be familiar with them. If the witness doesn’t follow their guidance, that’s a challenge to their credibility. It is also important to be familiar with the various approaches to valuation and when they are appropriate. Also, the weighting of earnings is another area of potential challenge. If the business is on a long term growth projector and the last find years are used, have they weighted the most recent years more heavily than the earlier years? So too, in a falling economy, shouldn’t the most recent years be given the heavier weight?
What reasonable compensation was used for the managing partner of the company? From what source was it derived? This is subjective and opened to different opinions? Did they fail to eliminate the personal good will in those states that do not permit it to be valued?
No article can completely prepare you for the serious adventure of cross-examining a good expert. A consulting business appraiser is always a good idea, to review the offending report and give guidance on a plan of attack. Having your own challenging and testifying expert available toou the places to challenge may save your day. The most important thing to remember, however, is never to assume you know more than the testifying expert about their field. You don’t.