It’s a common saying among data scientists: “garbage in, garbage out.” In other words, bad inputs lead to bad conclusions. It’s no different in business valuation, where an analyst synthesizes many data inputs to arrive at a single estimate of value.
Bad data inputs lead to unreliable conclusions, which can be detrimental for the business owner, especially in litigation. Sometimes, the bad data comes from the business owner. Attorneys who hire valuation analysts for their cases should know the pitfalls of relying on client-provided data.
Let’s look at some examples of mistakes valuation analysts have made in over-relying on client-provided data.
Mistake #1: Relying On Unreliable Tax Returns or Financials
The financial statements are the foundation of any analyst’s valuation and if these numbers are wrong or unreliable it can lead to an unreliable conclusion.
Frequently, a very small business does not have a dedicated bookkeeper on staff or has someone inexperienced handling the bookkeeping. In these instances, valuation analysts should be careful to review the financials for possible errors and be prepared to make the appropriate adjustments.
Analysts in these instances often consider using a business’s income tax returns as they are frequently prepared by CPAs. However, the analyst should also be aware of the potential for tax fraud. To minimize taxable income, it is not unusual for businesses to understate income and overstate expenses. This risk is higher in self-prepared returns, but unfortunately it can still occur with accountant-prepared returns.
Failing to consider the risk of being provided potentially unreliable financials or tax returns can spell trouble. In a previous divorce case where we were engaged, both parties in a divorce hired their own experts to value the marital business. The opposing expert chose to rely on the business’s tax returns for their valuation. However, one of the parties had already admitted that the returns were falsified and grossly underreported the business’s income. As a result, the opposing expert’s conclusion of value was rendered unreliable.
Mistake #2: Taking Client Statements At Face Value
During a valuation, analysts meet with the business owners to get an understanding of the business and its operations. While these discussions are a great way to get a better understanding of that specific business, valuation analysts should always take with a grain of salt statements made during these meetings and consider what the business owners’ incentives are.
If the valuation is for a prospective sale, the business owner has an incentive to maximize the business’s performance to garner a higher valuation.
If the valuation is for a divorce, the business owner has an incentive to minimize the business’s performance to get a lower valuation.
In certain states that account for personal goodwill in a business valuation for divorce purposes, that same business owner going through a divorce has an incentive to over-emphasize their importance and involvement with the business to increase their percentage of personal goodwill and decrease the prospective payout to their spouse.
In a recent divorce case out of Utah (Rothwell v. Rothwell), a valuation expert valuing one of the marital businesses relied on statements made by the husband that he was central in sourcing new contracts. Accordingly, the expert set the husband’s personal goodwill at approximately 40%. However, trial testimony contradicted the statements the husband made (the court stated that the statements the husband had made were “faulty and inaccurate”).
The court settled on a personal goodwill figure that was half of what the expert had originally decided. In fact, when the husband appealed the decision, the Utah Court of Appeals affirmed the trial court’s initial opinion stating, “In reaching this conclusion, the district court could very well have concluded that [the husband]’s goodwill had no value or, at least, that it could not assign it a value due to a lack of credible evidence.”
Similarly, analysts can sometimes rely on client-prepared reports in their valuations. Valuation analysts frequently rely on financial projections prepared by the business. The analyst should take care in evaluating and using the projections and keep in mind the client’s motivations and biases.
In that same case out of Utah, the expert also relied on projections provided by the business’s management team in determining the marital business’s value. Those projections anticipated prospective financial losses and, as a consequence, the valuation expert showed that the value of the company had declined from the previous year. When the case went to trial, however, the court found that the business’s actual performance did not align with the projections provided to the expert. Consequently, the court questioned the reliability of the valuation and chose to not rely on it.
In another case we were engaged in, the non-owning spouse argued that the marital business was poised for explosive growth within the next few years. They presented projections that showed they expected the company to be generating between $20 million to $40 million annually within the next few years; however, historically the company’s revenue had been just under $1 million annually. The spouse didn’t present any substantial evidence to support their projections and as such, we determined that their projections could not be used in our valuation. If we had relied on them, there would have been a substantial risk that we would have appeared unreliable or biased in front of the court.
Engaging a Valuation Professional
A qualified valuator will be cognizant of potential errors in client information, as well as potential client biases. It is important when considering engaging a valuation professional, especially for litigation, that the valuation professional has a reputation for being good and thorough.
Although clients are sometimes tempted to go with a valuator that will take their statements at face value, it does not usually end in their favor when the valuation is stress-tested, especially in front of an opposing expert or a knowledgeable judge.
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