Financial valuation Applications and Models phần 9 potx

Reasons to Use the Database The database is used to support: • Damages in an intellectual property litigation case • Reasonable royalty percentage rates • Accurate valuation conclusions

remainder or residual amount equates with goodwill Keep in mind, goodwillincludes assembled workforce, but assembled workforce was valued separately toobtain a contributory return for IPR&D and technology As a result and pursuant

to SFAS No 141, the indicated value of assembled workforce must be added to theindicated value of goodwill to arrive at the fair value of goodwill for financial state-ment reporting purposes.96

For financial reporting purposes, included in the goodwill value is the fair value

of the assembled workforce of $1,790,000 Based on this analysis, the fair value ofGoodwill on December 31, 2001, was $62,050,000 (Exhibit 20.14)

ALLOCATION OF PURCHASE PRICE

The summary allocation of values is presented in Exhibit 20.15 In this exhibit, thevaluation conclusions are separated into three groups: total current and tangibleassets, total intangible assets, and goodwill Individual asset valuations are pre-sented within each group

In addition to presenting the summary of values, this schedule provides a eral sanity check in the form of a weighted return calculation The weighted returncalculation employs the rate of return for each asset weighted according to its fairvalue relative to the whole The weighted return can equal or approximate the over-

gen-96 FASB, Statement of Financial Accounting Standards No 141, at B169.

Exhibit 20.14 Target Company: Valuation of Goodwill as of December 31, 2001 ($000s)

Less: Fair Value of Intangible Assets

Note: Some amounts may not foot due to rounding.

© Copyright 2002 by John Wiley & Sons, Inc Used with permission.

all weighted average cost of capital for the business, although the rates may notexactly be equal because the WACC equates to the business’s invested capital (here,

$184,000,000) while the weighted return calculation represents total asset value($209,000,000)

The returns for each asset are those actually used in the forgoing valuationmethodology, that is, for tangible assets and contributory intangible assets For con-tributory intangible assets that were valued using a form of the income approach(trade name and noncompete agreement), the return is equal to the discount rateused to value that asset Finally, the return for the assets valued under the multi-period excess earnings approach is also their discount rate

It should be clear that the one asset for which we do not have a return is will and, admittedly, the return assigned is determined by trial and error The good-will return is imputed based on the overall weighted return needed to equal theweighted average cost of capital

good-Exhibit 20.15 Target Company: Valuation Summary as of December 31, 2001 ($000s)

Percent To Fair Market Purchase Weighted

Machinery and Equipment, net 19,000 8.00% 9.1% 0.73% Total Current and Tangible Assets $ 82,500

Total Intangible Assets $ 66,240

Goodwill (excluding assembled workforce) $ 60,260 28.00% 28.8% 8.07% Total Assets $209,000 16.05%

Note: For financial reporting purposes, the fair value of goodwill includes the fair value of assembled workforce

for a total fair value of residual goodwill of $62,050.000.

Note:Some amounts may not foot due to rounding.

© Copyright 2002 by John Wiley & Sons, Inc Used with permission.

If a goodwill return of, say, 10 percent is required to achieve a weighted return

of approximately 16 percent, this signals a problem and the analyst will have to goback and review and revise his or her work—something is wrong! In this calcula-tion, the goodwill return of 28 percent suggests that goodwill is substantially riskierthan all of the other assets but, at a return of 28 percent, still well within reason for

a proven going concern Thus, the returns chosen for each asset are reasonable

By its nature, goodwill is the riskiest asset of the group and fore should require a higher return than the overall business return

there-ValTip

APPENDIX — INTELLECTUAL PROPERTY

One of the major difficulties in valuing intellectual property is determining value in thecontext of licensor/licensee negotiations All too often this context is assumed or sim-plified, resulting in market royalty rates being applied out of context Most valuationanalysts traditionally develop royalty rates from any of three traditional sources:

1 Negotiated licensing agreements

2 Surveys performed by various professionals, generally in cooperation with tradeassociations

3 Judicial opinions which vary greatly depending on individual fact patternsThese traditional tools can now be augmented by databases of licensing agree-ments extracted from publicly available sources Such direct market data is some ofthe most compelling evidence available to determine the appropriate royalty rate in

3 compare and apply the guideline license transactions’ financial and operationalaspects with the subject intellectual property; and

4 reconcile the various value indications into a single value indication or range ofvalues

Empirical Research and Verification of Royalty Rates

Proprietary research of intangible assets and intellectual properties is important inbusiness valuation The value the market perceives in intellectual property-intensivecompanies is associated with their intangible assets and intellectual properties.Valuation of such companies is often an exercise in intangible asset valuation meth-ods rather than traditional business valuation methods Emphasis should be placed

on proprietary studies (industry research, industry pricing metrics, and comparableintellectual property transactions) Research and verification of comparable datacan be a time-consuming process Recently, advances in information technology andthe availability of online public records have made research of intellectual propertytransactions a realistic endeavor

Databases that gather and organize comparative intellectual property tions are rapidly becoming the tool of the future to those analysts who specialize inintellectual property valuation At the time of publication, three Internet sites pro-vide information for a fee:

transac-1 RoyaltySource (www.royaltysource.com)

2 Consor®(www.consor.com)

3 The Financial Valuation Group (www.fvginternational.com)

Comparing and Applying the Data

Intellectual property transactions should be compared to the subject company usingthe following guidelines:

• The specific legal rights of intellectual property ownership conveyed in the line transaction

guide-• The existence of any special financing terms or other arrangements

• Whether the elements of arm’s length existed for the sale or license conditions

• The economic conditions that existed in the appropriate secondary market at thetime of the sale or license transaction

• The industry in which the guideline intellectual property was or will be used

• The financial and operational characteristics of the guideline properties, pared with the company’s intellectual property

com-Reconciliation

The last phase of the market approach valuation analysis is the reconciliation Thestrengths and weaknesses of each comparable transaction are considered; the relia-bility and appropriateness of the market data are examined, including the analyti-cal techniques applied After considerable review, transactions selected should bereasonably comparative to the company transaction and then synthesized into a rea-sonable range

Detailed Example of an Intellectual Property Database

The intellectual property transactions database of The Financial Valuation Group isbased on publicly available data It includes approximately 40 fields comprised of thenames of the licensor and licensee, both the Standard Industrial Classification (SIC) andNorth American Industry Classification System (NAICS) numbers for the licensor andthe licensee, the type of agreement (i.e., trademark, patent, copyright), the industryname, the remuneration structure, royalty percentages (base rate, the low end and highend of variable rates), royalty dollars (base flat fee, annual and variable fees), a descrip-tion of the product or service, and so on Custom searches of the database (using key-words, SIC/NAICS numbers, or both) can be performed to obtain market comparables.Searches of “all transactions” in The Financial Valuation Group database at thepublication date revealed:

Transactions by Industry

Industry groups as represented by the first two digits of the U.S government SICcodes are represented in transactions in the database as shown in Exhibit 20.16.Intellectual Property Typically Licensed

While there are approximately 90 distinctly different intangible assets, the majority

of assets licensed are intellectual property assets which can be grouped within gories as shown in Exhibit 20.17

cate-Patents tend to be the most-licensed intellectual property, with trademarks,products, and technology following respectively

Payment Structures of Intellectual Property Transactions

A comparison of the royalty payment structures disclosed in each transactionreveals that approximately half of the licensing agreements are based on a set per-centage or set dollar amount There are many transactions that involve high/lowpayments, which are usually based on performance, sales, or both Annual Fee andMonthly Fee agreements tend to be set at a fixed amount paid on a regular basisthroughout the life of the agreement Exhibit 20.18 shows the various royalty ratepayment structures by the reported transactions analyzed

Reasons to Use the Database

The database is used to support:

• Damages in an intellectual property litigation case

• Reasonable royalty percentage rates

• Accurate valuation conclusions

• Rebuttal of unreasonable value estimates put forth by others

• Transfer pricing opinions

Because royalty rates derived from transactions take so many economic tures, it is difficult to interpret them in a manner that is useful for a particular need.Analysis of licensing transactions similar to a particular fact situation would be nec-essary to determine a market royalty rate applicable to that situation The analystwith requisite skill, education, and experience will be able to draw upon the data toform better-founded and defensible conclusions and opinions

struc-Exhibit 20.16 Intellectual Property Transaction Database — Transactions by Two-Digit SIC Industry

Exhibit 20.18 Payment Structures of Database Transactions

Fixed Dollars and Fixed Percent Combined (12%)

Fixed Percent (25%) Percent Variable (14%) Percent and Dollar Combined, Variable (7%)

Dollar Variable (4%) Fixed Dollars (25%) Royalty Free (8%) Undisclosed/Unknown (5%)

© Copyright 2002 The Financial Valuation Group, LC Used with permission.

Exhibit 20.17 Database Percentages for Intellectual Property Types

21.9 17.5

16 15.9 8.3

Marketing, Managing, and Making Money

in a Valuation Services Group

PURPOSE AND OVERVIEW

In addition to providing intellectually challenging work projects with almost endlessvariety, the field of business valuation offers potential for outstanding compensation.However, it is possible to win an engagement and provide quality client service but fail

to bill and collect a fair fee and/or incur sizable cost overruns due to poor practicemanagement Optimizing the potential of a business valuation practice is not acciden-tal, nor is it the natural result of merely “doing good work.” It involves developing astrong skill set in nontechnical areas such as marketing and practice management.For the purposes of this chapter, the term “good economics” will be used toindicate a business valuation practice that has optimized its potential, given suchpractice characteristics as the types of clients, the geographic market served, type ofservices offered, staff size and quality, and age of the practice This chapter exploresthe key determinants of good economics for a given business valuation practice,summarized as:

• The qualifications of the practice professionals to provide the particular servicesoffered by the firm

• The existence of niche valuation services that the firm can serve profitably

• The temperament suitability of the practitioners, especially the leadership, for thetype of engagements undertaken

• The practice’s acceptance criteria for engagements and its adherence to thesecriteria

• The management/operating practices of the firm

When the three Ms—marketing, managing and money—are all properly chronized, business valuation in a professional services firm can be a rewarding career

syn-It is important to note that these very broad and informal engagement andpractice guidelines outline suggested goals that may not be achievable depending onthe nature and type of practice They are also more applicable to a group practice

WHAT GOOD ECONOMICS LOOKS LIKE

Record Maintenance and Analysis

To attain good economics, a practice should set realistic goals for operational resultsand analyze unfavorable variances to determine the changes that should be made to

21

achieve specified goals Management should keep complete and timely records ofkey practice results and analyze the results against previous periods and againstbudgets and goals.

Higher Billing Rates

Until a practice’s reputation is established in the marketplace, it may not be able tocommand top fees However, practices should attempt to exit a market or type ofservice that will not allow for higher rates over time, unless there are compelling rea-sons to remain in that market or offer that service, such as a high volume of engage-ments, to gain experience or because of the type of marketplace

Realization and Productivity

If the practice’s rate structure (hourly or fixed fees) is appropriate for its skill setsand marketplace, and engagements are managed for top efficiency, then the realiza-tion percentage should be more than 90 percent

Most practices count standard hours as 2,000 or 2,080 a year, or the number

of hours a part-time professional is available Obviously, to attain a healthy age, the less experienced people should be 90 percent or more productive and theprofessionals with leadership and sales responsibilities should be less productive.Unless the practice fields a large team, say more than 8 people, then the practiceleader(s) should be productive for 40 to 50 percent of standard hours, since thepractice’s highest billing rates are charged by its leadership and leadership isinvolved in marketing and other critical, nonbillable work

aver-Some practices whose revenues are based primarily on fixed fees makethe mistake of failing to maintain or to evaluate time records and otherinformation about efficiency and profitability that would indicateproblem areas that need corrective action

ValTip

It is desirable that chargeable hours for engagements should, on age, result in billings equal to 90 percent or more of the recorded hours

aver-ValTip

Few Uncollectible Accounts

Bad debts and postengagement fee adjustments are unavoidable Many tioners view them as a cost of doing business With appropriate engagementacceptance processes, including collecting significant retainers that are held asdeposits, and close engagement management, uncollectible receivables can be min-imized Since uncollectible accounts and billing adjustments occur on a client-by-client basis, there does not seem to be a minimum or “acceptable” range for which

practi-to strive

Profit Margin Greater Than 40 percent

Before any compensation charges for the practice leaders, but after all otherexpenses, the profit margin of the practice can be at least 40 percent A well-man-aged and efficient, highly productive practice can maintain a 50 percent or moreprofit margin Obviously this has a lot to do with the type of services offered andthe percentage of fixed fee competitive work

Right Fit

Practices often start their life taking whatever type of valuation services they can get,

or whatever the leader is accustomed to performing or comfortable delivering Overtime practices may evolve to other lines of services and may become entrenched inone or more specific service niches To attain good economics, the practice leader(s)and key senior professionals must become highly qualified in a particular service lineand be temperamentally well suited for the requirements of the service For exam-ple, not everyone is comfortable with or interested in the requirements of disputeresolution work

On average, a group practice should be charging billable hours toengagements for more than 70 percent of the standard hours availablefor them to work

ValTip

In spite of the higher profits offered by litigation services, some tioners find that being an expert witness is disruptive to the processesneeded to direct a practice that must deliver valuation reports on a reg-ular basis

practi-ValTip

Each practice should frequently evaluate the services it offers and consider thesequestions for possible action:

• Which services are more profitable than the others and should be encouraged,and which ones are below the acceptable range of profitability?

• Which services are susceptible to the practice adjusting its pricing and tional approaches to attain more profitability?

opera-• Which lines of valuation services really suit the skill sets, the temperaments, andcareer goals of the practice team and its leader(s)?

OPERATIONAL KEYS FOR GOOD ECONOMICS

Certain key attitudes and habitual actions in operating a business valuation practiceare important to the attainment of good economics

Bias toward Proactivity

Successful and profitable engagements do not result from sitting back and waitingfor information to come from clients, third parties, or the practice engagement team.Practice leaders can establish a tight, clearly documented schedule for each engage-ment and anticipate in advance changes in client needs or the ability of the practice

to deliver that schedule Close monitoring and communication with the engagementteam and, for some matters, with the client must be a key component of eachengagement This is particularly applicable to litigation services engagementsbecause of the many stops, starts, and long delays involved and because most of theengagement direction and delivery dates are determined by third parties, such as theclient’s attorney

Bias toward Continual Marketing Activities and Sales Results

Since the profitability of a professional practice is dependent on a high level of ductivity, there must be an order input rate that consistently is greater than the out-put rate In other words, the practice cannot run out of work for any significantperiod of time Some fortunate practices have a steady supply of work, but eventhose fortunate ones recognize that maintaining ongoing activities is a critical factorfor future sales When practice rainmakers are busy with client work, marketingoften takes a backseat Good economics require marketing and sales results to befairly constant to maintain an order input rate greater than output rate In some

pro-Since a business valuation engagement is a consulting project, proactiveplanning and control is key to maximization of the efficiency, quality,and profitability of the work process and product

ValTip

practices, that may require the leader to hire a seasoned or more experienced fessional Doing this will free up time to market and sell.

pro-Bias toward Planning and Communication

Certified Public Accountants are familiar with the General Standard of theAmerican Institute of Certified Public Accountants that work is to be planned andadequately supervised This standard not only promotes the delivery of quality pro-fessional service, but is also key to superior profits The profitable practitioner mustdevelop a bias for continuous and timely planning for engagements and otheraspects of the practice, and for communication of those plans to other profession-als in the practice

Bias toward Flexible Resources, Especially Staffing

In spite of the best marketing activities and planning for engagements, fluctuations

in the work flow will occur These range from having too little work available tokeep the present staff busy to having more work than the staff can accomplish ontime Therefore, the practice must strive for resource flexibility, especially its mostcostly resource, the professional staff

Any practice that operates in a competitive marketplace can form alliances withother practices to share staff during slow times and can cultivate part-time profes-sionals to pick up the slack during times of high activity

Another smoothing methodology is to parcel out segments of an engagementfor various professionals to perform For instance, one person performs the eco-nomic and industry research while another performs the valuation approaches forthe same subject company Some practices, particularly those that produce a signif-icant volume of reports, believe this method promotes quality and efficiency Inaddition, some professional staff prefer to perform one part of an engagement ratherthan another, and these preferences also can result in superior quality and efficiency.Resource flexibility calls for a practice to look ahead to the nonhumanresources that it may need and planning for economical ways to attain thoseresources quickly These resources include new databases, software, and other time-saving and quality-enhancing resources

Bias toward Quality Results and Client Value

If a practice unit does not have a culture of providing quality results and client value

in its engagements, then the work product may not meet client expectations, may

Resource flexibility is a rich area for practice leaders to explore as theyseek to smooth the peaks and valleys of the work flow

ValTip

result in unpaid rework or reduction in fees, and could damage the practice’s tation.

repu-An often overlooked element of quality results and client value is the nity to collaborate with other qualified business analysts on some aspects of a par-ticular engagement The input of other qualified professionals can enhance thequality of the information utilized, the methods selected and implemented, and theprofessional judgments used throughout the valuation

opportu-Bias toward Training and Quality Improvement

All business valuation practitioners are “practicing” their craft and seek, like otherprofessions, to constantly improve their performance A practice aspiring to goodeconomics must invest in regular training and improvement of its staff’s and lead-ership’s abilities to provide quality services

KEY ENGAGEMENT PRINCIPLES

An organized and disciplined approach is required for engagements with severalteam members to coordinate the tasks required for the completion of the project

Practices that aspire to good economics are advised to develop their own form but flexible processes for engagement organization and control Theseprocesses can take the form of checklists, reporting deadlines, schedules for clientcommunication, team meetings, and other means to promote disciplined engage-ment activities

uni-Practices should consider developing written “guidelines” for appropriateengagement processes and procedures that also allow flexibility for the particular

Unless the practice has a bias toward quality and client value, there isless chance for good economics, at least for any sustained period oftime

ValTip

Litigation services engagements in particular need an organized anddisciplined approach because so often the engagement criteria identi-fied at the start are augmented and revised over the life of the project

ValTip

needs of an engagement that are resolved by professional judgment A “guidelineapproach” to engagement organization and control would address suggested proce-dures for these areas:

• Engagement acceptance process

• Terms and objectives of the engagement approach, resources, work plan, budget,fees and collections

• Engagement control

• Achievement of quality and client value

• Litigation services engagements

ENGAGEMENT ACCEPTANCE PROCESS

Guidelines that assist professionals in the engagement acceptance process can vent the acceptance of an unprofitable engagement as well as properly establish therequirements and environment for a profitable engagement

pre-Profile of Acceptable Engagements

An important element of the written guidelines for the acceptance process is a file of acceptable clients and engagement types for the practice or, in the alternative,

pro-a profile of unpro-acceptpro-able engpro-agements For expro-ample, pro-a prpro-actice mpro-ay not be willing

to accept engagements for valuations for marital dissolution or for employee stockownership plans

The profile should be well known and adhered to with discipline unless thepractice leader makes an exception Discipline is particularly important when thepractice has a low backlog of work, for it is easy to rationalize that “any work isbetter than no work.” The fallacy of this rationalization is that any given engage-ment can result in the loss of time that could be used more profitably for marketing,training or vacation, or performing an engagement later that is more profitable

Questionable Opportunities

The acceptance process should include consideration of the ability of the practice toobtain needed resources to perform the engagement and other matters that wouldqualify the unit to accept a given opportunity Sometimes the best engagement of theyear is the one that was declined and/or referred to another firm

A practice may not want to accept engagements for individuals (asopposed to companies) as clients without receiving substantial retainers

ValTip

Guidelines for acceptance should include procedures to identify the tics of a potential client that contribute to a profitable engagement This includes thewillingness of the client to assist in the engagement and to agree on a reasonable deliv-ery schedule An important client characteristic to search for in the acceptance process

characteris-is whether the client characteris-is both willing and able to pay for the anticipated services

Relationship Checking Process

The firm also may want to construct a database of prior relationships with tial clients and third parties The database can be used to research the desirability ofthe potential client prior to accepting an engagement Such a database also can beused to determine if relationships with opposing clients or attorneys exist Such adatabase should be kept current

poten-Client Expectations

The acceptance process should include communications with the client tive before work begins to explain how the engagement process works and what theterms of the engagement will be for such matters as fees and payment, client assis-tance, and deliverables To maximize the opportunity for good economics, clientsshould know at the outset the expectations for their role and all of the anticipatedeconomics and contractual terms of the engagement

representa-FEES, RETAINERS, BILLING, AND COLLECTION

Engagement guidelines will include procedures for setting fees, retainers, and clientbillings and collections These items should be discussed in detail during the accept-ance process with the potential client The decisions as to whether to accept theengagement and how to structure the terms of the engagement must take note of anybalking by the potential client about the practice’s guidelines

Determining the Fee Schedule

Hourly rates charged and fixed fee minimums should be fair for the market and thequalifications of the practice and fit the risk and complexity of the engagement Thiscan mean different rates and fees for different engagements The practice shouldmonitor rates of its competitors frequently Given its own portfolio of services andclients, it should examine rate schedules periodically to adjust to market rates, costs

of the practice, and changing trends in the industry On a given engagement, the rateschedule should not be an issue with the client, although the overall fee may be anissue regardless of the rates

Retainers—By All Means

The firm should strive to obtain a retainer in advance of starting work on eachengagement, often held as a deposit until final bills are paid Retainers are collected

to insure against future or unknown problems beyond the control of the analyst.The amount received should cover a reasonable portion of the total engagementand, depending on the size of the engagement and the type of client, may be 50 per-

cent or more of anticipated fees It is not usually wise to start working on an ment until the retainer is received There are obviously exceptions to this rule, such

engage-as working with known clients or attorneys who have good reputations regardingpayment of fees

Retainers also serve as a client qualification tool Beware of the potential client,particularly the new client who refuses to pay a retainer, or who wants to heavilyreduce the requested retainer or continues to decline to remit the agreed-uponretainer These are warning signals of a potential client who is not willing to pay feesand are a precursor to future fee problems These traits can be included in the pro-file for unacceptable engagements

Work Plans and Budgets

A sensible approach to engagement planning and control and to engagement nomics is to prepare a work plan and budget for some engagements In someinstances, it is desirable to obtain approval from the client and client’s attorney forthe work plan and budget

eco-The budget may need to be revised during the course of the engagement Forthis reason, it is important to discuss with the client as soon as possible why addi-tional work must be done and to arrange a fee increase Clients are usually under-standing about fair compensation for needed changes but do not want to besurprised about an increase in fees

Prompt and Frequent Billings

Guidelines should include procedures for prompt and frequent billings on ments Analysts should explain to clients during the engagement acceptance processhow billings work, and what expectations are for prompt payment Include specificpayment terms in the engagement letter, including the provision that valuation

engage-In most situations, if you are good enough to be engaged, you are goodenough to be paid a portion of the fee in advance

ValTip

Work plans and budgets, where appropriate, can be valuable tools thataid in the supervision and control of the engagement team, and can becritical in obtaining efficiency on the job

ValTip

reports will not be issued, nor will expert witness reports be issued or testimony indeposition or trial be provided, unless outstanding bills are paid Develop a processfor fixed fee engagements that results in bills being accepted and paid at fixed inter-vals of time or engagement performance.

Collecting Fees

Monitor compliance with payment schedules and follow up as necessary with calls

to the client decision maker Slow payment of billings may indicate an unspokenproblem with the engagement, so troubleshoot all laggards Send reminder notices

of unpaid accounts on a regular basis

ENGAGEMENT CONTROL

Becoming more efficient and increasing the practice’s realization are functions ofexercising engagement control Part of this control involves managing client expec-tations and setting timetables, but most of it lies primarily with the ability of theengagement leader(s) to be knowledgeable of the engagement details and to makecritical judgments and take prompt corrective action Unless the leader knows what

is going on, corrective action will be delayed and the result will be an expensive

“redo.”

Many engagement leaders are reluctant to get into the details or tasks of theengagement; after all, they worked hard and learned their craft in order to delegatework to others But the profits are in the details, and depending on the type ofengagements, the leader must plan and monitor the work and carefully manage timedevoted by the team to the engagement

Sometimes the best approach to take with an engagement that is dering economically is to take the practice’s best people and put them

floun-on the job to finish it up

ValTip

The old adage “People do what you inspect, not what you expect”applies to valuation engagements, for team members may not know oradmit on a timely basis that they are off track about the direction theirwork is headed

ValTip

The key is to review the status of each team member on a timely basis to avoidmisdirection of his or her efforts This principle can also apply to the engagementleader The reason for the universal application of this principle is that performingbusiness valuations and consulting engagements requires the exercising of a consid-erable degree of sequential and overall judgment Anyone can “get off track” some-where within the planning, framework, and conclusions of an engagement.Everyone can benefit from collaboration with another professional, if appropriateand applicable.

LITIGATION SERVICES ENGAGEMENTS

Litigation services present significant differences from typical business valuationengagements, even though the engagement may entail only performing a businessvaluation or evaluating the work of another analyst Some of the reasons for the dif-ferences between typical valuation assignments and litigation services are:

• The uncertainty of the nature, scope, and timing of dispute resolution work

• The fact that dispute resolution engagements can and often do end abruptly, withunbilled work in process and unpaid billings

• Third-party involvement and influence, especially the client’s attorney and anadversary expert

• High stress on the analyst due to many reasons, including an emotional client

• Some of the work may have to be done alone or with less-experienced staff

• Written reports, required by U.S District Courts, that are not typical valuationreports

• Disruption to normal nondispute work flow, including time lost while waiting totestify or obtain guidance

Practically everything that is required to produce good economics is magnifiedwith litigation services, including the opportunity to bill practically all hours athigher profits To avail oneself of this opportunity, the practitioner must be morecareful and diligent in observing many of the principles discussed in previous sec-tions of this chapter

A very general rule of thumb for frequency of inspection by a tice leader or engagement manager is that the work of juniors/novicesshould be reviewed every two hours The work of all other profes-sionals should be inspected on a time interval of three hours for eachyear of their experience This is particularly affected by the type andcomplexity of the engagement, the staff person, and the practiceleader

prac-ValTip

Planning and Communication

Because of the consulting nature of dispute work, an organized problem-solvingapproach should be used in the planning stages and as the engagement progresses.One such approach is commonly called the “look-back” approach due to its tech-nique of visualizing all the elements needed at various stages of delivery and thenlooking back to plan in reverse all the tasks that are needed to reach the deliverypoint on time

The analyst’s qualifications for the potential engagement are considered fully because someone else may challenge the work product, especially if the engage-ment is for expert witness testimony or court-appointed valuations Depending onthe type of engagement, practitioners may be well advised to collaborate withanother experienced practitioner on dispute resolution engagements, especially lessexperienced expert witnesses

care-Timing of Work

Because disputes begin with a number of key unknowns about data to be used andtasks that are needed, and because disputes are prone to end abruptly due to settle-ment, the scope of work assigned to the analyst at the outset often changes signifi-cantly Due to this factor, anticipated revenue flow may terminate prematurely.When work is assigned, it should be completed as soon as possible within the sched-ule agreed on with the client or the attorney This may help an attorney in the set-tlement process Also due to the shifting nature of the tasks within the scope of adispute engagement, when the completion date for a task is delayed but not can-celed, a timely completion of this task according to the original schedule will mean

it will not have to be completed at a later date, possibly under more stressfulconditions

Work Plans, Budgets, Billings, and Collections

Again, the nature of disputes—with their uncertain scope of work and propensityfor an abrupt ending—requires an even greater awareness and attention to the prin-ciples needed to attain good economics

Additional work plans and budgets may be used as the engagement progresses.Prompt and frequent billings and payments are important, all of which should beexplained in the acceptance process and insisted on during the engagement In ahigh-fee engagement, billing should occur more frequently than monthly, perhapsweekly or every two weeks Determine at the outset the billing format desired by the

Preparing a work plan and budget for known tasks and obtainingapproval, aid the client and the attorney to understand the likely feelevels required

ValTip

client and the attorney Plan the scope of written reports as soon as possible, andbudget liberally for time to prepare the reports and review them with the client andattorney The cost to prepare written reports, especially Rule 26 reports for U.S.District Courts, can be a great surprise.

Supervision and Engagement Control

The engagement leader is often involved in certain details of litigation services tasks,regardless of whether he or she is to be a consultant or expert witness Three majorreasons for this are:

1 The consulting role calls for the analyst to provide a wide range of ideas andproblem-solving advice

2 The testifying expert must know all the details of the work plan that provide thefoundation for opinions

3 Other than the preparation of the business valuation aspects of dispute ments, some of the tasks to be performed may be unique, and staff may not be

engage-as experienced with this type of work

Working with the Client’s Attorney

In litigation engagements, the client’s attorney is likely to be directly involved withthe analyst’s work, and the client may have little or no involvement For good eco-nomics and other reasons, the analyst needs to communicate proactively, clearly,and often with the attorney on many aspects of the engagement The client’s attor-ney is also very likely to be the go-between for all client communications, whichplaces a premium on clear understanding with the attorney about retainers, fees,payment of invoices, and any action required by the client

CONCLUSION

Professionals in service firms, particularly the leaders, need to practice the three Ms(Marketing, Managing, and Making Money) to ensure a rewarding and fulfillingcareer and successful practice The disciplines of planning and supervision willgreatly assist in the achievement of the desired goals of the practice and its profes-sionals

Do not assume anything without frequent and clear communicationwith the client and the client’s attorney

ValTip

Business (Commercial) Damages

This chapter discusses the legal principles and quantitative issues and methodsrelated to determining business (commercial) damages in litigation matters Itillustrates the differences between the estimation of value for a business valuationand the calculation of lost profit damages The theory and practice describedapply to both testifying experts (professionals who expect to testify as expert wit-nesses) and consulting experts (professionals who do not expect to testify but whowill serve as consultants to attorneys) Only compensatory damages (lost profitsand diminution of value) are discussed in this chapter Benefitof-the-bargain,recovery of out-of-pocket expenses, punitive damages, and other types of recov-ery allowable under the law are not discussed Nor are areas of the law with spe-cific criteria for determining recoverable damages such as patent infringementcases addressed

ROLE OF THE LAW AND FINANCIAL EXPERTS

The law drives all litigation matters including damage issues Case law and tory law are the most important areas of the law that apply to financial experts

statu-As a practical matter, the financial expert may want to become familiar withimportant cases and statutory law in the jurisdiction in which a particular matterwill be tried

Financial professionals who serve as testifying experts will be retained by theplaintiff or defendant or will work as a jointly retained or court-appointed expert

In commercial damage cases, the plaintiff’s expert will present an opinion of theamount of damages and the basis for the opinion The defendant’s expert will either

22

Although financial experts are usually not attorneys and are notexpected by their professional standards to know the law, attorneys fre-quently choose experts who have some knowledge of the law thatapplies to a particular litigation matter

ValTip

critique the plaintiff’s damage opinion and/or offer an alternative damage culation.

cal-LEGAL PRINCIPLES GOVERNING DAMAGES

For the plaintiff to be awarded damages in commercial litigation, they must provetwo things:

1 The defendant was liable (e.g., it breached the contract or its product was tive)

defec-2 The plaintiff suffered damages as a result of the defendant’s actions

In most commercial litigation, the financial expert is not involved in the ity portion of the case (with some exceptions, e.g., proving accounting malpractice).Therefore, only legal principles most relevant to the financial expert are discussed inthe following sections

liabil-Reasonable Certainty

The plaintiff must prove that the damages claimed are reasonably certain, that is, it

is reasonably certain that the plaintiff would have earned the amount of claimed lostprofits or the company would have been worth the specified business value

Accountants who compile financial statements (as opposed to audited andreviewed financial statements) and who prepare tax returns are accustomed toaccepting client representations without independent verification or testing.However, in a litigation setting, similar blanket acceptance of key client representa-tions should not be done unless they are considered reasonable by the expert.Critical assumptions that have not been evaluated for reasonableness may not beaccepted by the trier of fact (e.g., jury, judge, arbitrator) and may render the expert’sdamage opinion invalid Therefore, it becomes imperative for the financial expert toevaluate the key assumptions to the damage opinion, including those provided bythe client, under the principle of reasonable certainty

Business plans (or litigant’s financial projections) sometimes are used as a dation for damage calculations because business plans and projections created prior

foun-to the wrongful actions are independent of the litigation motives of the parties.However, since some courts have ruled that unproven business plans and financial

Establishing reasonable certainty involves rigorous analysis, of whichthe identification and testing of key assumptions may be an importantpart Some of these key assumptions are based on client representa-tions

ValTip

projections are not adequate to provide the base assumptions for damages tions, they still should be evaluated for reasonableness.

calcula-Proximate Cause

The plaintiff also must prove proximate cause, that is, that damages have been

proximately (directly) caused by the defendant’s wrongful conduct Sometimes

proximate cause is simply referred to as causation Under the principle of proximate

cause, only that portion of the decline in plaintiff profits attributable to defendant’swrongful actions is recoverable For example, loss of profits due to a slowdown inthe economy are not recoverable

Foreseeability

Another legal principle applicable to contract claims but not torts is foreseeability,

that is, “whether and to what extent damages, to be recoverable, must havebeen foreseeable as a natural and probable result of a breach of contract at the timethe contract was made.”1In other words, the plaintiff must show that, at the timethe contract was made, the claimed lost profits were a foreseeable result of thedefendant’s wrongful actions Damages that actually may have occurred but werenot foreseen as a probable result of a hypothetical breach during the making of thecontract by the parties, are not recoverable

Example: A parts manufacturer was delinquent in delivering goods to an

auto-motive plant according to the schedule specified in the contract This delay at oneplant had a compounding effect and caused three other plants to be shut down.Based on the foreseeability principle, the plaintiff recovered its losses at all fourplants because both parties, during the making of the contract, had contemplatedand understood the compounding effect of a scheduling delinquency

In the 1990s, several court cases raised the standards for the admissibility of expert

testimony in federal jurisdictions The most notable is Daubert v Merrell Dow

Pharmaceuticals, Inc (113 S Ct 2786, 125 C Ed., 2d 469 [1993]) This case

estab-lished trial judges as “gatekeepers” over the admissibility of expert testimony at trial

Attorneys sometimes request that financial experts offer opinions oncausation The expert should evaluate whether he or she has the qual-ifications and foundation to render such an opinion

ValTip

1R Dunn, Recovery of Damages for Lost Profits, 5th ed (Westport, CT: Lawpress

Corporation, 1998), § 1.8.

The Daubert factors are enumerated in Supreme Court of the United States

No 92-102, William Daubert, et ux, etc., et al, Petitioners v Merrell Dow

Pharmaceuticals, Inc.:

• “ whether a theory or technique can be (and has been) tested.”

• “ whether the theory or technique has been subjected to peer review and lication.”

pub-• “ the known or potential rate of error and the existence and maintenance

of standards controlling the technique’s operation.”

• “ explicit identification of a relevant scientific community and an expressdetermination of a particular degree of acceptance within that community.”Since the Court stated that these factors should be applied flexibly and that other

factors also may be considered, the Daubert factors are not necessarily applied literally Congruent with Daubert, Federal Rule of Evidence 702, “Testimony by

Experts,” states that an expert witness may testify “if (1) the testimony is basedupon sufficient facts or data, (2) the testimony is the product of reliable principlesand methods, and (3) the witness has applied the principles and methods reliably tothe facts of the case.”

Daubert and Rule 702 emphasize that expert witnesses must apply accepted

methods in the proper context and should expect to defend such methods not only

through ipse dixit (“because I said so”) but also through external proofs of various kinds Since the 1993 Daubert case, the federal courts have been moving resolutely

toward excluding “junk” testimony In addition, some state courts have adoptedstricter criteria for the admissibility of expert testimony

What does this mean for the financial expert providing testimony? The expertshould be prepared to prove that the methods and damage theory being used aregenerally accepted in the professional community The expert should know the rel-evant professional standards and apply them properly The expert should be knowl-edgeable of and be prepared to reference the appropriate professional literature forgenerally accepted methods Furthermore, critical underlying data and assumptionsshould be reasonable

MEASURE OF DAMAGES: DIMINUTION OF VALUE

OR LOST PROFITS

Commercial damages typically are measured by one of two standards: lost profits

or diminution of value When is each of these measures appropriate? The followingscenarios will provide guidance from which to answer this question

Although Daubert involved a scientific expert, the court set forth four

criteria by which a trial judge could evaluate the reliability of all experttestimony

ValTip

Scenario 1: Temporary Impairment

The defendant breached a five-year contract to purchase merchandise from the tiff These lost revenues represented only a portion of the plaintiff’s entire business.The company mitigated its damages by eventually replacing the lost sales, and thebusiness continued to operate The results of the breach are illustrated in Exhibit22.1 The measure of damages for a temporary impairment is considered lost profits

plain-Exhibit 22.1 Temporary Impairment

Scenario 2: Immediate Destruction of Business

The defendant breached a five-year contract to purchase merchandise from theplaintiff These lost revenues represented substantially all of the plaintiff’s revenues,and the remaining customer revenues did not cover the business’s fixed costs As aresult, the plaintiff went out of business soon after the breach The results of thebreach for this example are illustrated in Exhibit 22.2

Exhibit 22.2 Immediate Destruction of Business

▲

Where an immediate destruction of the business occurs, diminution of valuegenerally would be indicated as the most appropriate measure of damages Underthe income approach of valuation, the present value of the future earnings (lostprofits) is the value of the company under the discounted future earnings methodusing the business’s cost of capital as the discount rate.

Scenario 3: Slow Death of Business

The defendant breached a five-year contract to purchase merchandise from theplaintiff These lost revenues represented a substantial portion of the plaintiff’s rev-enues The company struggled to stay in business for a few years before it eventu-ally closed due to the breach The results of the breach for this example areillustrated in Exhibit 22.3

Exhibit 22.3 Slow Death of Business

The slow death of a business, as presented above, might use a combination ofthe two measures For the period after the breach in which the business still oper-ated, a lost profits calculation could be done When the business ceased its opera-

tions, a value for the business might be established as of that date, using the

diminution of value measure

Reasonable certainty and proximate cause also would have to be demonstrated

to calculate damages by any measure

DIFFERENCES BETWEEN DAMAGE COMPUTATIONS AND

BUSINESS VALUATIONS

The differences between the assumptions and methodologies used in commercialdamage calculations and those used in business valuations are slight in some regardsand great in others The most common differences between business valuations and

lost profit calculations are summarized in Exhibit 22.4 Several of these differencesare discussed in depth.

Level of Scrutiny

The level of scrutiny of a business valuation in a litigation setting is significantlyhigher than valuations done for other reasons Often opposing counsel will ask aseries of questions designed to attack the expert’s credibility and destroy his or hertestimony In most nonlitigation situations, however, the distribution of the valua-tion professional’s report is limited, as is scrutiny of report details, underlying data,and the valuation professional’s qualifications

Exhibit 22.4 Common Differences Between Lost Profit Calculations and Business Valuations (FMV)

Actual, specific litigant-may be unwilling buyer/seller Need to calculate costs that would have been incurred, had plaintiff made projected lost revenues

Often required to calculate interest payable to plaintiff between date of injury and date

of trial Often based on what would make the plaintiff whole under the circumstances

Either income or cash flow Use after-tax discount rate on pre-tax lost profits

All information through date of trial usually considered

Business Valuations

Typically low outside of litigation, otherwise high Valuation done as of specific date and company usually assumed to continue in perpetuity

Hypothetical willing buyer and seller

Not applicable

Typically not done by appraiser

Based on company’s cost of capital

Typically cash flow Matching of after-tax discount rate with after-tax benefit stream

Usually information considered

up to valuation date

Period of Recovery

The period of recovery is sometimes called the damage period or period of loss In

a lost profits model, the damage calculation is made for a specific time period (e.g.,from the date of injury to date of trial plus three years), implying a time limitationfor recoverable lost profits

For example, if a defendant has breached a long-term contract with 20 years ofthe term remaining, can a lost profits calculation for 20 years in the future pass thetest of reasonable certainty? What economic or industry factors might affect a 20-year lost profits projection and, thus, create a problem with the test of proximatecause? Due to the speculative nature of such long-term projections, many courts andexperts believe that, in most situations, lost business profits can be projected aboutthree to five years into the future (at most) and still pass the tests for reasonable cer-tainty and proximate cause.2 In any event, the damage period will not extendbeyond a reasonable time for the plaintiff to fully recover from the injury inflicted

by the defendant

Business valuations are based on a value estimate as of a single, specific dateand usually assume the business will operate into perpetuity

Protagonist—Litigant versus Hypothetical Willing Buyer/Seller

In business litigation, the objective is to make the plaintiff whole Doing thisrequires the consideration of a specific plaintiff’s unique facts and circumstances In

In litigation, the financial expert can expect to be challenged regardingqualifications, the proper application of valuation theory, and theappropriateness of the underlying assumptions and facts

ValTip

One of the most challenging aspects of a lost profits calculation isdetermining how far into the future to project ongoing lost profits Theperiod of recovery largely depends on the facts and circumstances ofthe case and on the tests for reasonable certainty and proximate cause

ValTip

2For example, see B Brinig et al., Guide to Litigation Support Services, 5th ed (Fort Worth, TX: Practitioner Publishing Company, 2000), ¶ 303.37 and Dunn, Recovery of Damages,

§ 6.19.

many situations, this may not fit the standards established by the business valuationprofession for fair market value

In business valuation, not only do the fair market value standards exclude cific buyers and sellers in favor of the “hypothetical” buyer/seller, but they alsorequire that the hypothetical buyer/seller be willing and fully informed In businesslitigation, none of these requirements for buyer and seller may be met

spe-Incremental Costs

Incremental costs are those expenses that, due to lost sales, the plaintiff does notincur In damage calculations for businesses that have been partially impaired, theincremental costs associated with lost revenues will be used to reduce those lost rev-enues and arrive at an estimate of lost profits

Example: If a tire factory lost a contract order for $1 million in sales, the costs

of manufacturing and selling those tires will be deducted as incremental costsaccording to the following formula:

Lost Revenues
Incremental Costs  Lost ProfitSince business valuations typically focus on valuing the company’s earnings orcash flow, all the company’s expenses are usually considered in the computations

Prejudgment Interest

In business litigation, the financial expert may be required to value the plaintiff atsome date in the past and then provide an additional damage calculation, called pre-judgment interest, from the date of injury up to the date of trial

If the law is silent regarding prejudgment interest, the expert will want to ine judicial practice in the jurisdiction of the trial and ask the attorney whether thecourt or the expert will perform prejudgment interest calculations If there is nolegal guidance available, the expert will have to select and apply a discount rate he

exam-or she believes is appropriate, taking into account that a discount rate to be usedwith past lost profits may need to be different from that to be used with future lostprofits

Prejudgment interest is not normally calculated in a traditional businessvaluation

In many jurisdictions, the law mandates the treatment of interest, often

by prescribing a statutory interest rate, generally based on simplerather than compound interest calculations

ValTip

Discount Rates

The discussion in this section uses “nominal” currency amounts and rates of returnthat include the effects of inflation rather than “real” currency amounts and rates

of return where the effects of inflation have been eliminated.3

Discount rates are used in lost profit calculations for determining the presentvalue of lost future income The selection of the discount rate has a significant effect

on the present value of the future lost profits and, thus, on the amount of the ages awarded to the plaintiff Exhibit 22.5 provides an example of the magnitude ofthis effect

dam-Exhibit 22.5 Effect of Discount Rates on Lost Profits (Midyear Convention)

Total Lost Profits for 3 Years into the Future

There is little guidance in finance literature or case law to direct the expert inselecting the appropriate discount rate for future lost profit damages Financialexperts generally have viewed the appropriate discount rate for lost profit damages

in three ways:

3 Nominal amounts are the actual currency amounts or rates of return including inflation Real amounts are inflation-adjusted currency amounts or rates of return Some economists present rates of return in damage calculations as real rates, or inflation-adjusted rates A 5 percent real rate of return for a safe investment would be reduced by inflation of, say, 3 per- cent, to result in a real return of 2 percent.

The purpose of compensatory damages is to make the plaintiff whole.That is, the plaintiff should receive no more or no less than is necessary

to make it whole

ValTip

1 Use a risky projection of future lost profits and apply a higher discount rate toconsider the higher level of risk.4

2 Use a low-risk (conservative) projection and apply a low-risk discount rate

3 Use a discount rate based on how the plaintiff will invest the damage award andapply it to a projection of future lost profits that is “reasonably certain.”The first and second approaches of determining a discount rate are analogous

to the determination of the cost of capital in the discounted cash flow (DCF)methodology in business valuations The third approach focuses on the plaintiff’sinvestment return on the damage award

This approach suggests the consideration of how the plaintiff can be expected

to reasonably “invest” the portion of a court award related to future lost profits.Using the previous table, if the plaintiff reasonably expects to invest a court awardreceived today at a rate of return of 10 percent, then it would receive $285,251 from

a court award today and invest it at 10 percent to compensate it for the $330,000

of profits it would have received over the next three years An award based on a 5percent discount rate but actually invested at 10 percent would overcompensate theplaintiff An award based on a 20 percent discount rate but actually invested at 10percent would undercompensate the plaintiff

Several benchmarks that could be used to assist in selecting appropriate count rates include:

dis-• Return on a conservative investment

• Return on an investment portfolio

• The company’s cost of debt

• The company’s weighted average cost of capital

• The company’s cost of equity

• Return on an investment similar to the destroyed business

The facts and circumstances necessary to select one of these will vary from case

to case The selection of a discount rate in any specific lawsuit may depend on ters of fact and matters of law For example, the requirement of a risk-free discountrate might be a matter of law mandated by a prior case in the jurisdiction Matters

mat-of fact might include consideration mat-of these types mat-of questions:

• If a plaintiff is partially impaired, does it have the ability to reinvest a damageaward in the company?

• If the plaintiff is totally destroyed, should it be assumed that the plaintiff shouldinvest a damage award in another investment similar to the destroyed business?Some practitioners believe the discount rate also should factor in the risks asso-ciated with achieving projected future lost profits, as is commonly done in businessvaluations However, some courts have rejected this approach.5As previously men-

4The case that is often cited is Jones & Laughlin Steel Co v Pfeifer, 462 U.S 538 (1983),

which discussed parity in risk, parity in inflation, and parity in income taxes However, this case was related to personal injury.

5See American List Corp v U.S News & World Report, Inc., 75 N.Y.2d 38, 550 N.Y.S.2d

590 (1989) In this case, the trial court found a higher discount rate (18 percent) should be used to factor in the risk the plaintiff would not be able to perform the contract in the future The appellate court rejected the higher discount rate.

tioned, in determining the discount rate, there is little guidance from case lawregarding what factors to consider.6

The following are cases that address the discount rate in future lost profitdamages

Energy Capital Corp v The United States7

The plaintiff had a contract with the U.S government to originate $200 million inloans related to government-assisted housing The contract was breached In deter-mining future lost profit damages, the court stated, “there is relatively little author-ity respecting the discount rate that should be used in reducing prospective damages

to present value.” The court also said that it believes issues about discounting areseparate from issues about reasonable certainty It stated “[t]he Plaintiff’s accuracy

in discounting does not affect whether it has calculated its lost profit damages withreasonable certainty.” It also stated “[t]he discount rate reflects the concept that themoney awarded today will accumulate interest and grow to approximate the moneythat the Plaintiff would have earned in future lost profits over the course of the con-tract.” This ruling on the appropriate discount rate was based on a matter of lawrather than fact Therefore, this court did not relate the risk in the projections offuture profits to a risk-related discount

The court separately found that the plaintiff’s claim for lost profits was madewith “reasonable certainty” (and it noted that “absoluteness” was not necessary).The plaintiff’s expert used a discount rate of 10.5 percent and the defendant’s expertused a 25 percent rate Both of these were risk-adjusted discount rates (The plain-tiff’s 10.5 percent rate was based on mortgage real estate investment trust returnsplus a 2 percent premium adjustment.) The court found that the appropriate dis-count rate is the rate of return on “conservative investment returns” as a matter oflaw and determined it to be 5.9 percent based on 10-year Treasury notes as of a dateclose to the ruling

Burger King Corporation v Barnes8

In this case, Barnes had operated a franchised fast food restaurant for 29 months.The court allowed Burger King Corporation’s damages related to future lost royal-ties to be projected for 210 months (17.5 years) into the future over the remainingterm of the franchise agreement based on the amount of the restaurant’s historicalsales The opinion indicates that neither inflation nor any other increase in profitswas projected above the actual historic sales The future lost profits were discounted

at a 9 percent discount rate Therefore, the 9 percent is a real rate of return ratherthan a nominal rate

Knox v Taylor9

The appellate court did not overturn the use of a 7 percent risk-free discount rate in

a lost-profit damage calculation as a matter of law

6Dunn, Recovery of Damages, p 504.

7Energy Capital Corp v The United States, 47 Fed Ct 382 (U.S Claims 2000).

8Burger King Corporation v Barnes, 1 F Supp 2d 1367 (S.D Fla 1998).

9Knox v Taylor, 992 S.W.2d 40 (Tex App 1999).

Olson v Neiman’s, Ltd.10

The appellate court allowed the expert’s damage opinion for the plaintiff that used a19.4 percent discount rate based on a 14.4 percent normal return for public companiesplus a 5 percent premium for risk The discount rate was applied to lost royalty income.For a more detailed quantitative analysis on taxes and discount rates, see G.Hallman and M Wagner, “Tax Effects of Discount Rates in Taxable Damage

Awards,” CPA Expert (Winter 1999): 1-5.

Tax Considerations

Business damages are subject to taxation under the Internal Revenue Code.11Therefore, the Internal Revenue Service will tax a court award or settlement, andtaxes should be considered in the damage calculation The thought process and cal-culation go as follows:

Had the plaintiff remained in its original condition before the injury, it wouldhave earned certain profits and paid the associated income taxes Exhibit 22.6demonstrates the expected profits of the plaintiff, XYZ Inc., “but-for” the defen-dant’s actions, for three years into the future Year 0 represents the current base yearused in projecting future profits for years 1 to 3 Assume that XYZ Inc has a con-stant effective tax rate of 40 percent

Exhibit 22.6 XYZ Inc.: Expected Future Income But-For the Defendant’s Actions

Exhibit 22.7 XYZ Inc.: Calculation of Damages for Future Lost Profits

Future Lost Profits

10Olson v Neiman’s, Ltd., 579 N.W.2d 299 (Iowa 1998).

11 Only compensatory damages related to personal physical injury or sickness are excluded from taxable income See Internal Revenue Code § 104(a)(2).

In a court award, XYZ would receive $306,285 as full compensation for futurelost profits After a 40 percent tax hit, XYZ would have $183,772, which it couldreinvest at its WACC of 12 percent.

Exhibit 22.8 presents the calculations for determining how much XYZ Inc.expects to have at the end of a three-year period during which it has reinvested thenet-of-tax damage award of $183,772 at its WACC of 12 percent

Exhibit 22.8 Reinvestment of Damage Award Net of Taxes

Annual Amount at Earnings (12%) End of Year

How does this amount in Exhibit 22.8 compare to what it would have received

“but-for” the defendant’s actions, as determined in Exhibit 22.6? Exhibit 22.9 ents the plaintiff’s position at the end of year 3, using the “but-for” net income datafrom Exhibit 22.6

pres-Exhibit 22.9 But-For Net Income Plus Accumulated Earnings Through the End of Year 3

But-For Net No of Years Future Value

The results of both calculations (Exhibits 22.8 and 22.9) are identical

Were the effective tax rate to vary rather than remain constant over the tion period, a different analysis might be necessary

projec-In contrast to this treatment of taxes in damages calculations, in a business uation income approach, discounts rates are developed from market data that typi-

val-This demonstrates the concept of discounting future pretax earnings by the appropriate after-tax discount rate in calculating damages.

ValTip

cally are based on after-corporate-tax rates of returns for investments in public panies Once a valuation professional has determined the appropriate discount rateusing this market data, it is applied to the subject company’s after-tax earnings,

com-matching an tax discount rate with tax earnings Theoretically, an

after-tax discount rate could be adjusted to a preafter-tax discount rate and applied to the ject company’s pretax earnings to arrive at the same value However, in manysituations, this is not a common business valuation practice

sub-Subsequent Events

Compensatory damages in litigation seek to make the plaintiff whole at the time thetrier of fact renders its decision (e.g., the date of trial) Therefore, damage compu-tations usually consider events through the date of trial, including events subsequent

to the date of injury (i.e., date of valuation)

A business valuation determines the fair market value of a business on a cific date (i.e., the valuation date) by contemplating what a hypothetical willingbuyer would pay for it on that date Only the information that was known orknowable to the hypothetical buyer and seller on that date is usually considered.Events that occur subsequent to the valuation date usually are not consideredbecause they are unknowable to the hypothetical buyer and seller

spe-Example: Sample Corp was destroyed in September 2002 by a hurricane If a

financial expert were asked to calculate Sample Corp.’s lost profits damages for aninjury that impaired the business in August 2001, and the trial occurred in October,

2003, the expert would need to include the effect of the hurricane in the calculations

to ensure that Sample Corp was not going to be made more than whole (this wouldnot be true if the law did not allow consideration of the hurricane)

However, if the same financial expert were asked to value Sample Corp for taxpurposes as of August 31, 2001, the expert may not include the effect of the hurri-cane in the calculations since it was unknowable on the date of the valuation (e.g.,August 31, 2001)

CAN BUSINESS DAMAGES EXCEED THE FAIR MARKET VALUE

OF THE BUSINESS?

There is no general legal guidance for an expert in determining whether lost profitdamages can exceed the value of a business Since the expert does not have any mat-ter of law as a guide, the matters of fact in each specific case determine the answer.Business damages could exceed the fair market value of the business for two reasons:

1 The facts and circumstances of the case

2 The differences between lost profit damage calculations and the business tion fair market value standard

valua-Since the goal of awarding compensatory damages is to make the plaintiffwhole, there are valid facts and circumstances under which a damage award for thefair market value of the business might not achieve that goal

Example: A governmental entity decided to widen a public road and

con-demned part of the land owned by a franchised fast food restaurant As a result oftaking away the land, the restaurant lost one-third of its parking and could no

longer operate profitably from that location Due to limited availability of otherrestaurant sites and possible infringement on the territories of other franchisees, therestaurant could not relocate The restaurant was forced to cease operations andhad no opportunity to mitigate its losses Should damages be limited to the fairmarket value of the fast food restaurant?

Assuming the restaurant’s cost of equity was 25 percent, and assuming damageswere limited to the fair market value of the business, an award would have beenmade based on the theory that the plaintiff would put the award into an investmentyielding a 25 percent rate of return for the future In reality, however, there were noconventional investments that would generate a consistent 25 percent rate of return Although the argument might be made that the plaintiff could use the award tobuy another comparable business yielding a 25 percent rate of return, from a legalstandpoint should the plaintiff be forced to undergo the risks and effort involved in

a search for such a hypothetical business, which may not actually exist? In addition,suppose the plaintiff was a passive owner, 60 years of age, and in poor health? What

if the plaintiff only had skills in operating a fast food restaurant? How should thesespecific facts be considered in computing the plaintiff’s damages?

In this example, it is clear that a damage award limited to the fair market value

of the business may not make the plaintiff whole

Therefore, it is important to consider the unique facts and circumstances of thecase when determining the best approach to measure the plaintiff’s damages Eachcase is different, and the plaintiff’s situation should be considered In addition, locallaw should be taken into account

of the opinion of experts and others

Other Valuation Services Areas

This chapter presents limited and general information on other valuation servicesareas that analysts sometimes encounter The following sections only provide anoverview of each topic Future editions of this book may expand on these areas.A: Valuation Issues in Mergers and Acquisitions

B: Valuation for Public Companies and/or Financial Reporting

C: Valuation Issues in Buy-Sell Agreements

D: Valuation Issues in Pass-Through Entities

E: Valuing Debt

F: Valuation Issues in Preferred Stock

G: Restricted Stock Valuation

H: Valuation of Early-Stage Technology Companies

I: Valuation Issues Related to Stock Options

J: Real Option Valuations

K: Maximizing Shareholder Value

A: VALUATION ISSUES IN MERGERS AND ACQUISITIONS

One of the first things to consider in preparing a valuation for a merger oracquisition is the rationale for the transaction, because it lays the groundwork forthe valuation and will identify value drivers right from the start Reasons for trans-actions often include:

23

1Tom Copeland, Tim Koller, and Jack Murrin, Valuation Measuring and Managing the Value

of Companies, 3rd ed (New York: John Wiley & Sons, Inc., 2000), pp 112–118.

• Value creation through synergy of the combined firms

• Diversification to reduce risk

• Value creation through restructuring and better management

• Undervaluation of the target by the markets or the target is a “good investment”

• Hubris on the part of senior management

The rationale for a transaction presents the framework for the valuationmethodology to be used For example, if the reason for the transaction is to cre-ate value through the synergy of the combined firms, then the value of the poten-tial operating or financial synergies should be explored If the rationale for thetransaction is that the target is a good investment, then the company should bevalued as a stand-alone entity and compared to either its selling price or its per-share price on the public exchange If the acquirer is seeking to diversify to reducerisk, then the target’s cost of capital should be analyzed for its impact on the com-bined firms

In many respects valuation methodology for mergers and acquisitions is lar to valuations for other purposes Valuations or pricing analysis in transactionswithin a particular industry are often based on market-derived multiples of recentsimilar transactions within that industry Many valuation analysts also utilize dis-counted cash flow analysis as an additional methodology to price a transaction.Certain valuation issues heavily influence transaction value:

simi-• Appropriate standard of value in a transaction

• Value of synergy

• Control premiums versus acquisition premiums

• Cost of capital in a transaction

• Accounting issues in business combinations

• Fairness opinions and pricing analysis

Standard of Value

After determining the motive for the merger or acquisition, one of the first valuationissues that must be considered is the standard of value, which may differ according

to the motive for the acquisition (see Chapter 1)

Fair Market Value

Fair market value assumes a hypothetical willing buyer and seller, each with sonable knowledge of relevant information, but neither under any compulsion tobuy or sell These conditions rarely, if ever, exist in a transaction Normally theseller has much more information than the potential buyer Often there are con-ditions that make the bargaining power of one party greater than the other Inspite of this, however, fair market value sometimes is used as a standard of value

rea-in a transaction

A valuation under fair market value may take into consideration some creation assumptions, such as normalizing salaries and other adjustments that anyacquirer would make to increase value A valuation for a potential acquisitionusing fair market value as the standard of value can be helpful in pricing a targetsince it may include adjustments that most “hypothetical” acquirers would make

value-Intrinsic Value

Analysts often use intrinsic value in making buy or sell recommendations of shares

of publicly traded companies Analysts will estimate the company’s intrinsic valueusing traditional valuation methodologies, such as discounted cash flow analysis,and compare the results from these analyses to the publicly traded price of the com-pany If the intrinsic value of the company indicated from these methodologies ishigher than the publicly traded price, then the analysts make a buy recommenda-tion If the intrinsic value is less than the market price, then the analysts may make

a sell recommendation

Similarly in valuing a target for a potential acquisition, it is common to valuethe target’s intrinsic value The intrinsic value can be thought of as the value of thetarget under existing conditions based on the characteristics of the investment.Understanding the intrinsic value of the target can help a potential acquirer “price”the transaction when making an initial offer

Investment Value

The International Glossary of Business Valuation Terms defines investment

value as “the value to a particular investor based on individual investment ments and expectations.” Investment value differs from both fair market value andintrinsic value in that it may take into consideration the benefits specific to the trans-action itself Under investment value, the synergies derived from the transactionitself often are considered in determining value

require-In many instances, as a starting point in pricing a transaction, abuyer will analyze the value of a transaction using assumptions thatare the same as or similar to those that would be used under fairmarket value This provides the buyer with a “baseline” valuation,which is a valuation of the target without any effects of the transac-tion itself

ValTip

A standard of value that can be used in a transaction is valuing the get company’s intrinsic value

tar-ValTip

Fair Value

Somewhat controversial, fair value is often a standard of value in litigation mattersconcerning dissenting rights and shareholder oppression The fair value standard iscontroversial because there is no uniform definition of fair value that is used in alljurisdictions and little consensus as to what is “fair.” This can also be consideredwhen a company is interested in buying out minority stockholders and wants toknow the value if it ends up in this type of litigation

In a business combination, fair value is the standard of value in determining theallocation of a purchase price to the individual assets acquired In a financial report-ing context, fair value often is considered similar to the fair market value standard,although certain aspects of investment value are sometimes considered Fair value isthe standard of value utilized in statements for business combinations, (SFAS 141) andgoodwill and other intangible assets (SFAS 142), which are discussed in a later section

One of the most difficult aspects of a valuation for a transaction is estimating thepotential value of synergies which should result in a “increase in cash flows in addi-tion to what two companies can generate independently.”

The most common standard of value for a merger or acquisition isprobably investment value

ValTip

Fair value also is used as a standard of value in accounting nouncements For financial reporting purposes, the fair value of anasset is defined as “the amount at which that asset (or liability) could

pro-be bought (or incurred) or sold (or settled) in a current transactionbetween willing parties, that is, other than in a forced or liquidationsale.”2

ValTip

2FASB, Statement of Financial Accounting Standards No 141, Business Combinations (June

2001).

3This section was previously presented as an article in the Fall 1999 edition of CPA Expert,

published by the American Institute of Certified Public Accountants Copyright 1999 by the American Institute of Certified Public Accountants, Inc Reported with permission.