In a recent case, Gross Mendelsohn was asked to value a franchisee with three separate locations, including an unused license for a fourth location.
During early 2010, there was a disagreement between the four franchise owners regarding the expansion of one of the locations. Since two of the owners (our clients) wanted to move forward with the expansion and two of the owners did not, the state statute required the determination of a buyout price as of the date of dissociation, which was set as March 10, 2010.
After completing our analysis, we determined that the overall value of the company was approximately $1.9 million. Upon our receipt of the opposing business valuator’s report, our clients’ attorneys were shocked to see that the same business had been valued at approximately $4 million.
While many people will argue that business valuation is an inexact science, what was the attorney to do when presented with two widely different reports? Obviously, our clients’ attorneys were happy with our lower number as it meant a smaller potential payout for their client, but how could they go about explaining in court the differences in value offered by two experts?
In this case, one of the main differences between the two reports was the financial data that was used in the valuation. Clients frequently have a variety of different records, which can tell very different stories. These records could be internal financial statements, tax returns and financial statements prepared by an external CPA, including audited, review or compiled financial statements. So what is the best choice in a business valuation? The answer, of course, is … it depends.
Based on our conversations with our clients and their attorneys, we determined that the franchisee did not have any financial statements prepared by an external independent CPA. Audited financial statements typically are the best source of financial data to use in a business valuation, as the auditor has expressed an opinion that the financial statements are presented fairly, in all material respects, in accordance with accounting principles generally accepted in the United States. Absent financial statements prepared by an external CPA, we then requested the annual tax returns, as well as any internal financial statements prepared by the client.
While tax returns can be prepared using different accounting methods, including cash and accrual, they are signed by a corporate officer and include the following language in the signature box:
Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct, and complete. Declaration of preparer (other than taxpayer) is based on all information of which preparer has any knowledge.
As a result of this language, and the fact that corporate tax returns are frequently prepared by an external accounting firm (although with no type of assurance as in an audit or review), tax returns can be a reasonable alternative if no external financial statements are available. Our client provided us with corporate tax returns for the years ended December 31, 2009 and 2010.
Our client also provided us with a copy of their internal financial statements, by month, for the years ended December 31, 2009 and 2010. We noted upon review of these internal financial statements that they tied directly to the corporate tax returns filed by the client.
In this case, the client had also prepared various internal financial documents that were submitted to the franchisor. These documents included yearly profit and loss statements for each of the three locations, completed using the franchisor’s template. The client was able to provide profit and loss statements for each of the three locations for the years ended December 31, 2009 and 2010. We tried to tie the franchisor reports to the corporate tax returns and were unable to do so. We noted that the corporate accountants had made numerous adjusting journal entries to correct depreciation expense, officer loans, interest and other accounts that were not properly reflected on the franchisor reports. As a result, we decided that we could not rely on these statements. In addition, in an actual sale of the business, a buyer would probably place more reliance on the corporate tax returns over internal financial statements or those prepared solely for the franchisor.
So, we had the choice of using the corporate tax returns, including the internal financial statements that were the source for the balances, or the internal financial documents that were submitted to the franchisor. For some of the reasons discussed above, we elected to rely on the corporate tax returns and used them as the starting point for our analysis. After examining the opposing valuator’s report, we noted that they had used the internal financial documents that were submitted to the franchisor as a starting point for their analysis.
During our testimony at trial, we showed the court that had the opposing valuator used the same financial data that we used in our analysis, their value would have been within $50,000 of the value we determined. This comparison analysis allowed our client’s attorneys the opportunity to highlight the key difference to the court, the starting financial data. By boiling down the difference in values to the starting financial data used by each valuator, the attorneys were able to avoid complex discussions of variables such as discount rates, specific company risk premium, anticipated long-term growth rate, and weighted average cost of capital. In fact, these variables were almost identical between the two reports.
We explained to the court why we selected the corporate tax returns as a starting point and also pointed out the reasons why we felt the franchisor reports were unreliable.
While the court has not yet ruled on this case, it highlights the need for attorneys to understand the differences between two different valuation reports so they can tailor their strategy accordingly.
Our Forensics & Litigation Support Group can help. We specialize in business valuation and forensic accounting. Contact us online or call 800.899.4623.