Mistakes Women Make When Contemplating Divorce

Women are Too Nice:  Since most women are typically non-confrontational, they instead “hope” that by being amicable in a divorce, the marital assets (especially the husband’s business) will be divided equally and the support for them (and their minor children) will be equitable.  Unfortunately, in some cases, their hope backfires since their husbands have different objectives as the in-spouse, who remains in charge of the business. Bottom Line: Hope is not a game plan and “nice girls” may finish last.

Women Can Be Too Emotional (and Less Intellectual): Emotions often cloud intellect.  Divorce is like any crisis.  We all have an emotional response.  Women, much more than men, have an emotional response to divorce.  Even professional and successful women have an understandable emotional response to divorce and the fear of the unknown.  Women need to focus more of their energy on the legal and economic facts instead of dwelling on less relevant (though important) issues such as their husband’s infidelity or addiction.  Bottom Line: Divorce is like drowning.  The more we panic (an emotional response), the more likely we are to drown.

Women are Too Trusting (of Just Any Divorce Attorney):  Sometimes even after women’s trust have been violated, they are still too trusting.  Often, in the midst of contemplating a divorce, women do not have the tools or filters to decide on the “right” attorney.  Most women (as well as men) do not have the experience or familiarity when deciding on the “right” attorney.  Women  generally rely on the advice of friends or family when it comes to selecting their divorce attorney.  However, divorce attorneys are diverse in their attitude, approach and qualifications.  Unfortunately, the attorney they choose may have been great for their friend but not for them.  Women may need an aggressive or “pit bull” attorney or they may need an attorney that can modulate or adjust their attitude depending on the circumstance.  Women may need a litigator since their husbands may be playing “hide-the-ball” or they may need an attorney who believes in mediation or collaboration as the only approach (in order to preserve the family).  Women may need an attorney that is also a CPA (especially if their case is financially complex).  Bottom Line: When it comes to divorce attorneys, “one size” does not fit all. 

Women Should Understand Their Divorce:  Women need to understand of the divorce process since it is their divorce.  Women who are not active participants or actively engaged in the process of understanding their divorce will be disappointed.  Women should not micro-manage their attorney, instead they should understand the overall process and objectives of their divorce and the probabilities of success for each objective by asking their attorney probing questions about their divorce.  They should understand that their case could have success several motions, of which some may be denied by the judge.  They should understand that the process of information gathering (discovery) might be frustrating and that they may never receive all the information or the cost of receiving all the information is expensive because their husbands are obstructing the process.  Before trial, women need to understand the distinction between what is right and what can be “objectively” proved (preponderance of the evidence).  Bottom Line: What you don’t know (or understand) may hurt you.

Women Try to Be Financially Astute (All at Once):  Since women are probably wage earners or full-time parents, they are typically the out-spouse (or not “in-charge” of the business).  As a result, they don’t necessarily know or understand the finances of the husband’s business.  However, women facing divorce attempt to instantly “digest” the financial picture of the husband’s business when they have been more involved with raising their children most of their married lives.  Bottom Line: Call Greg at CROSSCOR Valuations & Forensics Inc. and tell him your financial story.  Greg will provide his financial perspective in the context of a divorce, which may be one among several points of view for women to consider . 

Important Notice
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.

Posted in Arbitration Support, Collaborative Divorce, Divorce Support, Family Law Support, Forensic Accounting, No Court Divorce | Comments Off

Taxation on Property Transfers (IRC §1041)

The transfer of property that is not a gift is generally a taxable event requiring the transferor to recognize a gain or loss on the difference between its fair market value and adjusted basis. Prior to 1984, tax regulations required that appreciated property transferred to a non-transferor (receiving) spouse incident to a divorce result in a gain to the transferor. Since then, Internal Revenue Code (IRC) Section 1041, as part of the Tax Reform Act of 1984, does not recognize a gain or loss on the transfer of property between spouses, former spouses or trusts for the benefit of former spouses incident to divorce.

IRC §1041 includes all property in the marital estate that is transferred between spouses because of divorce. Assets and liabilities cannot be “cherry picked” because this section is mandatory for all transferred property. The section recognizes that these transfers occur over time and not just when the marriage ends. The regulation states that the transfer is related to the end of the marriage if (a) it is required under the divorce or separation instrument and (b) it takes place within six years from the date of the divorce. A transfer of property is incident to the divorce if the transfer (a) occurs not more than one year after the date on which the marriage ends or (b) is related to the end of the marriage. A divorce or separation instrument is defined in the regulations as the divorce decree and its modifications or amendments.

The transfer is subject to taxation if not related to the end of the marriage or when it is not required under a divorce or separation instrument and it occurs more than six years after the end of the marriage. However, the transfer can still be made without tax consequences upon failing either requirement if it can be shown that there were legal or business factors delaying the earlier transfer attempts such as disputes concerning the property value owned when the marriage ended or barriers connected to the property transfer. It must also be shown that the transfer was made immediately after these legal or business factors were resolved.

Tax court cases have supported the position that the transferor spouse escapes all tax consequence on proceeds received from the stock redemption under IRC §1041. In Arnes, the Tax Cound found that the transferor spouse, in this case the wife, did not have a tax liability under IRC §1041. The Appellate Court found that the wife did not receive a constructive dividend by selling her shares because her husband was not relieved of his “primary and unconditional”obligation under the divorce decree. If the non-transferor (receiving) spouse is released from this obligation, then the transferor spouse has met the legal standard for “constructively” receiving a dividend. Because both parties were not taxed and the tax avoidance was repeated in other Tax Court cases, the IRS issued proposed regulation5 that effectively closes the ‘loop hole’ thereby taxing someone on corporate stock redemptions incident to divorce.

Under IRC §1041, the transferor spouse must supply the non-transferor (receiving) spouse with adequate records that establish the adjusted basis and holding period of the property as of the date of the transfer. If the the transferor spouse does not provide adequate documentation, questions regarding the facts and circumstances of who controlled the asset records in the family will be asked.

IRC §1041 states that property transfers between spouses is not a taxable event. Courts generally disregard the tax liability unless the marital property (sale of the business or business interest) and resulting tax are imminent. A constructive dividend may be realized by the transferor spouse if stock is redeemed. A valuation analyst must know the tax impact in order to advice an attorney.

Other than in divorce, valuations by a business valuation analyst are important in financial, tax and litigation matters.

Posted in Arbitration Support, Business Valuations, Collaborative Divorce, Divorce Support, Family Law Support, Forensic Accounting, IRS, Litigation Support, Mediation Support, No Court Divorce, Non-Litigation Support, Taxes | Leave a comment

Bankruptcy Risk Planning: The Z-Score

Bankruptcy occurs when a company is unable to meet maturing financial obligations and petitions a Federal court either for liquidation (Chapter 7) of its assets or reorganization (Chapter 11) of its debts. A company generally receives debt relief in Federal court if it is unable to liquidate its debts as they come due by transferring its assets to a trustee or by agreeing to reorganize its liabilities. It is possible that a company filing for bankruptcy did not adequately evaluate its bankruptcy risk. How then can a company sufficiently evaluate its bankruptcy risk? More specifically, how can a company use financial ratios to best evaluate its potential to fail sufficiently in advance so that corrective action can be taken?

Various financial ratios were studied from a quantitative perspective as bankruptcy predictors, but most of the studies were confined to academics. These researchers attempted for years to identify the best ratio for predicting company bankruptcy. One study concluded that the cash flow to debt ratio was the best bankruptcy predictor; whereas, another study concluded that the net working capital to total assets ratio was the better. The critical shift from a single best ratio as a bankruptcy predictor came in 1968 when Dr. Edward Altman built a comprehensive statistical model using multiple discriminant analysis (MDA).

Z-Score
Dr. Altman’s model, called the Z-Score, represents the probability for bankruptcy and provides the ability to evaluate the general financial condition of a company. His model measures the probability of a company entering bankruptcy within the next two years. Although his original model is for publicly traded manufacturing companies, he developed models for privately held manufacturing and service companies using the same MDA approach. Dr. Altman is known today as the founding father of predicting company bankruptcy using statistics with a high degree of accuracy and his Z-score is the world standard for measuring the overall health of any business.

The Analysis
Dr. Altman developed his original Z-score from an analysis of 33 manufacturing companies that filed for bankruptcy between 1946 and 1965. He started by testing 22 financial ratios that were intuitively possible as bankruptcy predictors. After repeated testing, he excluded the ratio that contributed least to predicting bankruptcy. He eventually came up with a model containing five ratios that, when added together in proportions determined by the MDA procedure, correctly classified 94% of the bankrupt companies one year before they filed for bankruptcy and 72% two years before they filed. The Z-score calculates five ratios:

  • Working Capital to Total Assets
  • Retained Earnings to Total Assets
  • Return on Total Assets
  • Sales to Total Asset (Asset Turnover)
  • Equity to Debt

How It Works
Dr. Altman’s Z-Score is the sum of adding the results of five ratios each multiplied by a predetermined weight (factor). The formula is Z = 1.2A + 1.4B + 3.3C + 0.6D + E, where:

A is the Working Capital to Total Assets ratio (X1)
B is the Retained Earnings to Total Assets ratio (X2)
C is the Earnings Before Interest and Taxes to Total Assets ratio (X3)
D is the Market Value of Equity to Book Value of Total Debt ratio (X4)
E is the Sales to Total Assets ratio (X5)

The data needed for the Z-Score is easily found in the financial statements:

  • Net Sales
  • Earnings Before Taxes
  • Total Assets
  • Working Capital
  • Total Liabilities
  • Market Value (or Book Value) of Equity
  • Retained Earnings

A higher Z-Score means a lower the probability of bankruptcy, so a score of 4.0 is better than a score of 2.0, but it does not necessarily mean it is twice as good since the model is not linear. A score above 3.0 indicates that bankruptcy is unlikely and a score below 1.8 indicates that bankruptcy is probable. Notably, a score below 1.2 indicates a strong (almost certain) probability of bankruptcy. A score between 1.8 and 3.0 (referred as the ‘gray are’ or ‘ignorance zone’ area by Dr. Altman) is inconclusive meaning that if the score falls within this range, the company has a chance of going bankrupt, but it is not certain that it will. Higher scores generally occur when a company has a high level of equity (or a low level of debt).

Why It Works
The Z-Score’s predictive power is best explained by looking at each ratio separately.

Working Capital to Total Assets: This ratio measures the working capital (or the net liquid assets) of a company relative to its total capitalization. Working capital is the difference between current assets and current liabilities. Assets are current if they are converted into cash or used within one operating cycle, which is usually one year but could be longer. Cash, accounts receivable and inventories are examples of current assets. Current liabilities are obligations a company expects to pay within one operating cycle. Accounts payable, short-term debts and taxes payable are the most typical current liabilities. A company with negative working capital generally has difficulty meeting its short-term obligations because there are not enough current assets to cover them. Conversely, a company with positive working capital rarely has problems paying its short-term obligations. A company with consistent operating earnings will have increasing working capital relative to total assets.

Retained Earnings to Total Assets: This ratio measures the retained earnings of a company relative to its total capitalization. Listed on the balance sheet (or statement of financial position), retained earnings are the total amount of a company’s net earnings since it began less dividends paid to stockholders. Retained earnings are a part of stockholders’ equity and represent the company’s assets financed from its profits rather than from selling stock to investors or borrowing from external sources. Significant retained earnings imply a general history of profits; whereas, low or negative retained earnings imply a general history of losses. The incidence of bankruptcy is lower when a company has a history of profits.

Earnings Before Interest and Taxes to Total Assets (Return on Assets): This ratio measures a company’s ability to generate earnings from its assets before any leverage or tax factors (earnings before interest and taxes or EBIT). EBIT, which excludes extraordinary items (unusual and non-recurring items), is often used a proxy for cash flow generated by a company available for distribution between three major groups of claimants: creditors (interest and principal), government (taxes) and shareholders (dividends). A company is technically in default if it does not meet its creditor and government debt obligations.

Market Value of Equity to Book Value of Total Liabilities (Equity to Debt): This ratio measures the stock market’s estimate of a company’s value (or market capitalization) relative to its liabilities. The market value of a company’s equity is the number of its outstanding common stock multiplied by its market price. The value of preferred stock may be included depending on its particular characteristics. Total liabilities are a company’s current and long-term liabilities. A higher ratio means lower leverage.

Sales to Total Assets (Asset Turnover): This ratio measures how efficiently a company generates sales from its total assets. It is determined by dividing net sales by average total assets. A higher ratio means a more efficient company.

Equal Opportunity
The market generally perceives that a publicly traded company with significant market capitalization has a lower risk of bankruptcy because the market believes in its solid financial position and, if it experiences temporary financial difficulties, it could raise money by issuing more common stock. In addition, its creditors will sustain high liquidation costs if they force it into bankruptcy making it an unattractive option. Nevertheless, there has been a trend of larger companies filing for bankruptcy over the past several years. With combined assets of nearly $300 billion, the five largest bankruptcies since 1980 include WorldCom, Inc. (2002), Conseco, Inc. (2001), Enron Corp. (2001), Financial Corporation of America (1988) and Texaco, Inc. (1987).

Cooked Books
In the recent bankruptcy of WorldCom, its management improperly recorded billions of dollars as capital expenditures instead of as operating expenses, which overstated its earnings and assets. The Z-Score would have withstood this type of accounting irregularity because the overstated earnings would have slightly increased the X3 ratio (because both earnings and assets increased) and the overstated assets would have decreased the X1, X2, and X5 ratios (because total assets, the denominator, increased). Notably, the combined weight of the X1, X2, and X5 ratios is greater than the weight of the X3 ratio. Therefore, the overall impact on WorldCom’s Z-score is likely to be downward. However, a similar result could have been achieved by a profitable WorldCom making significant capital investments; therefore, care must used when drawing a conclusion using the Z-Score.

Qualitatively Speaking
From a qualitative perspective, to name a few factors, a company has a higher bankruptcy risk if a company is or has:

  • Aging or poorly maintained capital assets
  • A cyclical business
  • Deficient accounting and financial reporting systems
  • Dependent on a few customers
  • Dependent on a few suppliers
  • Fraudulent
  • High fixed costs
  • In a declining industry
  • Inadequate insurance coverage
  • Lacks quality management
  • Less liquid assets
  • Less valuable assets
  • New or immature
  • Privately held
  • Significant financing restrictions
  • Susceptible to commodity shortages
  • Technologically obsolete
  • Thinly traded (publicly held)
  • Unable to obtain adequate financing
  • Volatile or unstable earnings or cash flow

Other Uses
Other than for evaluating a company’s general financial condition and its bankruptcy risk, the Z-Score has other uses:

  • Merger analysis
  • Loan credit analysis
  • Investment analysis
  • Auditing analysis
  • Legal analysis

Conclusion
The Z-Score is one of several analytical tools used to evaluate a company’s bankruptcy risk. It does not, however, replace experienced and informed personal evaluation because company, industry and economic factors sometime influence the numbers that go into the Z-Score. A trend analysis covering the most recent three to five completed fiscal years must be performed when using the Z-Score. If the trend of a company over a number of years is downward, then that company has problems that could be corrected allowing it to survive – but only if it is caught in time.

Important Notice
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.

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Royalties

Royalties for licensing intellectual property (IP) such as patents and trademarks are paid to licensors by licensees. The licensors, among other reasons, enter into licensing agreements when they do not have the capital to commercially exploit their patents. In exchange for licensors substantially conveying the rights to their patent, the licensees usually agree to exclusively manufacture, market and distribute their products. Since there are no absolute formulas for determining the market royalty rate of any patent, the agreements between licensors and licensees are difficult and often debated. The agreements may require a decreasing royalty rate or amount as the product’s retail price declines over its life cycle. The licensees may receive more royalties as their products increase in sales volume over their economic lives.

IP surveys consistently demonstrate that there is a large variation of royalty rates even in the same industry. A 2001 comparison of IP transactions with royalty payments by the Financial Valuation Group (FVG) reveals that 24% of the licensing agreements are based on a fixed percentage and 26% on a fixed dollar amount. The database also reveals that the average royalty rate was 7.83% with the highest and lowest rates at 75.00% and .003%, respectively. The electronics industry, for instance, represents 25% of FVG’s database and patents represent 22% of the database.

Since every IP is unique, licensing agreements will have different royalty rates and economic structures. A fair licensing agreement may be determined by using ‘25% royalty rule’ popularized by Robert Goldscheider (Technology Management: Law, Tactics and Forms, Clark Boardman Callaghan, 1984). The rule suggests that an equitable royalty based on sales should be equivalent to 25% or the appropriate share of the licensee’s pre-tax profit from the use of the license. As Goldscheider states in ‘The Negotiations of Royalties and Other Sources of Incomes From Licensing’ (IDEA, The Journal of Law and Technology, 1995, No. 1, Vol. 36), a baseline allocation of 25% assumes that the licensee assumes the greater risk though the licensor may offer a ‘strong technology bundle’ (of intellectual property and other intangible assets). This rule has been used persuasively in the presentation of expert evidence when a court requires a reasonable estimate of hypothetical royalties in a dispute involving intellectual property infringement. A study published in 1999 of industry royalty rates in 1991 by Rose Ann Dabek with Procter & Gamble partly corroborates. The electronics industry had royalty rates between from 2% to 25%, with half the rates between 2% to 5%, according to her study. The FVG and Dabek studies, however, do not mention the related economic benefit of the rates.

Important Notice
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.

Posted in Business Law Support, Business Valuations, Economic Damages, Intangible Assets, Intellectual Properties | Tagged | Leave a comment

Law Practice Valuation

The value of a business is usually the present value of its expected future earnings. Price is what you negotiate. Value and price, therefore, are not always identical (as evidenced by the differences between asking and selling prices). Time and timing, for instance, are factors affecting price. It takes time to sell a business and if wait until you are old or disabled, you may not have the leverage to negotiate a better price.

Like a typical business, the value of a law practice is affected by its location and reputation. Unlike a typical business, it is more difficult to value (and sell) a law practice because it is a service business that involves relationships of trust. This is why most lawyers believe that their sole practice has no measurable value. I partly disagree.

I believe that a portion of the law is becoming a commodity business. If a lawyer can charge a fixed fee for a legal service, then chances are that service is a commodity. If it is a commodity, then the law practice related to the commodity can be transferred to another lawyer with minimal loss of revenue. The strategy, therefore, is threefold: First, make a legal service into a product. Second, brand the product. And third, produce the product more efficiently by leveraging technology, for instance.

By making a legal service into a product, the buying lawyer benefits because he is buying a predictable revenue stream (and some goodwill) from an established law practice. The selling lawyer, of course, benefits by realizing a return of his investment from building goodwill. If the selling lawyer hires and associate or partners with another lawyer well before he retires, then the clients benefit because upon his retirement they continue receiving competent (and familiar) representation.

As a footnote, a recent survey shows that 77% percent of owners have a will but only 33% have a succession plan for their business whether the triggering event is a buyout, retirement, disability or even death. Is your client’s divorce today a triggering event for better legal planning that you can do? Do you, as a lawyer, have a succession plan?

Important Notice
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.

Posted in Business Valuations, Earnouts, Intangible Assets, Intellectual Properties | Leave a comment

Intangible Assets (2 of 2)

In the first intangible assets article, we discussed the “economic phenomena” of intangible assets and the tests for its economic value and legal existence. These tests, if passed, may indicate the existence of identifiable intangible assets. Intangible assets have two general categories: real and personal property.

Intangible real property includes fractional ownership interests in real estate, including leases, easements, air rights and subsurface rights. Intangible personal property includes patents, copyrights, secret processes and formulas, goodwill, trademarks, brand names and franchises. Identifiable intangible assets are also divided by similar nature and function and by similar economic analysis methods. The general categories, which do not include patents and copyrights (see below), are as follows:

  • Technology Intangibles: engineering drawings, proprietary technology, technical know-how, systems and procedures, technical manuals and documentation.
  • Customer Intangibles: proprietary customer, client, patient and even mailing lists, whether they are made up of customers or prospects and customer and referral relationships.
  • Contracts Intangibles: certificates of need, licenses, affiliation agreements and non-competition agreements.
  • Data Processing Intangibles: computer software and automated databases.
  • Human Capital Intangibles: trained and assembled workforce and employment agreements.
  • Marketing Intangibles: trademarks, trade names or franchise agreements.
  • Location Intangibles: beneficial leasehold interests.
  • Goodwill: all other intangible assets not separately identified and valued.

Intellectual Property
Intellectual property is a special classification of intangible assets that enjoy special legal recognition and protection. Unlike other intangible assets created in the normal course of business, intellectual property is created by specific and conscious human intellectual activity. Because of this creative process, intellectual property is generally registered under and protected by specific Federal and State statutes.

Like other intangible assets, intellectual property has economic value and legal existence and is also categorized according to similarities in nature, features, methods of economic analysis, methods of creation and legal protection. Patents and patent applications are categorized as innovative and their worth depends on the patent’s economic and legal life and the strength of the patent claim, which is difficult to determine if the patent has never withstood litigation. Copyrights are categorized as creative and are trickier to value than patents because their practical value may be short lived even though they have a long legal life. This is especially true for technical works that quickly become outdated and the previous success of the author’s written work.

Illustration
Customer lists are especially valuable to a business if the relationships are ongoing. Consider, for example, a magazine’s list of advertisers who makeup a significant chunk of its overall revenue. Without this list, therefore, the magazine would be less future profitable in the future. The same company may have a favorable supplier contract that allows it to purchase paper at below-market. Or it may have a contract that allows it to sell its magazines for a higher-than-normal markup through certain retailers. The longer the term of the beneficial contracts, the greater the value to a company. The magazine may have developed proprietary data processing software specific to their businesses that provides efficiencies that save the company time and money. Without the software, the benefits wouldn’t otherwise be realized. Franchises with long track records and well-recognized brands have significant market value over newer, lesser-known franchises. This magazine may dominate its market and industry because of its well-known trademark and trade name.

Accounting Rule
Until recently, intangible assets were booked at cost and amortized over as many as 40 years. SFAS 142 eliminated this practice for fiscal years beginning after December 15, 2001. The new accounting rule now requires that intangible assets and goodwill must be separately identified, be valued or tested annually and written down to fair market value if they have depreciated or have been ‘impaired’. The value in excess of the net tangible and identifiable intangible assets is goodwill. The new rule assumes that these assets have unique and indefinite useful lives and that their values do not necessarily decline over time. Weakening market and business conditions, and not accounting rules, will determine the depreciation of the asset. Strengthening market and business conditions can never appreciate or write up the asset. The ‘rule requires the fair value’ and not the fair market value as the standard of value. This standard is similar to the ‘investment value’ that assumes an intrinsic or synergistic value to a specific buyer, which is not the value paid for by a hypothetical buyer under the fair market value standard.

Other than in intangible assets, valuations by a business valuation analyst are important in financial, tax and litigation matters.

Important Notice
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.

Posted in Business Valuations, Intangible Assets, Intellectual Properties | Leave a comment

Intangible Assets (1 of 2)

FACT: A study a few years ago by an international accounting firm revealed that intangible assets accounted for almost 80% of the S&P 500’s total value. These companies are not new economy companies, but instead are in low-tech industries like banking, oil and retail. It is then remarkable that, based on this study, the market value of the majority of corporate America’s balance sheets is about four times their book value. Even if their market value is inflated, reducing it by half still produces a huge gap between their market capitalization and book value. To reconcile the difference between the book value a company and the stock value assigned by the market, we must first define exactly what is an intangible asset.

Definition
Tangible assets can generally be touched and are simpler to value. Inventory, land, buildings and equipment are examples of tangible assets. On the other hand, intangible assets do not have tangible qualities and are more difficult to value. Examples include goodwill and software developmental costs. Under Generally Accepted Accounting Principles (GAAP), with limited exception, intangible assets purchased by a company are recognized on the company’s balance sheet at cost, which is equal to the cash, liabilities or stock exchanged for the asset. If their values appear on the balance sheet, then there is no debate that these assets exist.

Debate
The debate, instead, is over the existence and value of intangible assets not recognized on the balance sheet illustrated by the following: Company A invested millions of dollars to develop software. Company B valued Company A’s intangible asset and agreed to purchase the software for $5 million. Once it makes the purchase, Company B recognizes the software on its balance sheet. The same intangible asset, however, never appeared on Company A’s balance sheet. Had Company B backed out of the deal, Company A’s intangible asset would have been ‘trapped’ within the company. Although just a scenario, major banks, as a practical example, have generally lent 30% of the valuation of a brand name because of the incremental profit it provides. By filing appropriate legal documents, these banks even obtained a perfected security interest in the brand name. The preceding examples illustrate that intangible assets exist and are valuable though often unrecognized on balance sheets.

Tests
A recent article defined intangible assets as ‘economic phenomena’. The authors concluded that, for an intangible asset to exist, it should have a specific bundle of legal rights. Their ‘tests’ for determining their legal existence are, in the form of questions, as follows:

  • Is it subject to specific identification and recognizable description?
  • Is it subject to legal existence and protection?
  • Is it subject to the right of private ownership that can be legally transferable?
  • Is there some tangible evidence its existence such as a contract, a document, listing file, printout, registration statement or flow chart?
  • Was it created or did it come into existence at an identifiable time or as a result of an identifiable event?
  • Is it subject to being destroyed or its existence terminated existence at an identifiable time or event?

The distinction between an intangible asset’s legal existence and its economic value is important because, the authors argue, intangible assets can exist without economic value. For instance, a patent that is never used has legal existence but no economic value. The tests or questions of economic value are as follows:

  • Does the owner or user receive some measurable economic benefit?
  • Does it enhance the value of other assets?
  • Does the owner or user enjoy a high market share?
  • Does the owner or user enjoy high profitability?
  • Does the owner or user enjoy a positive reputation?
  • Does the owner or user enjoy a monopoly position?
  • Does it have market potential?

This economic benefit is valued in several ways using net income, net operating income and net cash flow. The intangible asset’s economic benefit is measured by comparing the income stream received by the owner or user to the income stream had the intangible asset not otherwise existed. Intangible assets may enhance the owner’s or user’s operating assets, tangible personal property, real estate or even other intangible assets.

Other than in intangible assets, valuations business valuation analyst are important in financial, tax and litigation matters.

Important Notice
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.

Posted in Business Valuations, Intangible Assets, Intellectual Properties | Leave a comment

Family Law: Understanding the Hypotehical Seller and Buyer

FACT: The emotions of spouses involved in a divorce often obscure the value of a company (or ownership interest), one of their most important marital assets. The spouse keeping the company (in-spouse) often argues that the company is less valuable. On the other hand, the spouse leaving the company behind (out-spouse) often argues that the company is more valuable. The company is less valuable because:

  • The in-spouse can open-up next door and compete
  • The in-spouse can close-up shop and walk away
  • The employees will not work for anyone else but the in-spouse
  • Nobody else but the in-spouse knows how to run the business

The out-spouse argues the company is more valuable because:

  • The next owner could improve the business
  • The in-spouse could improve the business
  • Some of the business contacts could become customers
  • The business would be doing better but for the divorce
  • The economy will improve and so will the business

While the spouses may believe their emotional arguments have merit, California family law courts base a company’s value on either the fair market value (FMV) or the fair value standard. The FMV standard uses the hypothetical financial buyer and the fair value standard uses the specific investment buyer (in-spouse). Unlike the FMV standard, the California courts have disallowed discounts for lack of control and marketability when using the fair value standard resulting in company values higher than FMV, which may become a factor of contention between the spouses.

True FMV is determined by the actual sale of a company on the open market. Since the actual sale of a company is not contemplated in divorce cases (and other legal cases), the FMV standard requires that a company’s value be determined by considering the hypothetical willing and able seller and buyer. FMV is defined as:

The price, expressed in terms of cash equivalents, at which a property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy nor to sell, and when both have reasonable knowledge of the relevant facts.

The FMV standard uses a price range concept with the fair market value falling within a range of prices. The bottom of the range is the lowest price a hypothetical willing seller seeking the highest price would accept and still sell the company. Whereas the top of the range is the highest price a hypothetical willing buyer seeking the lowest price would accept and still buy the company. An actual (and therefore hypothetical) sale cannot be completed if the seller’s lowest price is higher than the buyer’s highest price. Therefore, a valuation analyst must always think about what a ‘hypothetically’ real buyer and seller would think and do under similar circumstances. A real buyer will not often pay a premium for what he brings to the table; instead, he will pay for the FMV of the future performance that a company has proven. The real world and divorce courts lean more toward the buyer’s perspective. The following are a few examples of what a real seller and buyer would consider in valuing a company. A real seller would:

  • Not threaten to compete with the buyer
  • Keep the workforce intact for a new owner
  • Not give the company away
  • Train the new owners how to operate the business
  • Not close the business when there is potential to sell it
  • Seek the highest possible price for the business

A real buyer would:

  • Consider the ability of the company to meet owner salary requirements (market)
  • Generally rely on past and recent operating history
  • Consider how a sale might affect relationships with existing customers
  • Consider the capital outlay and cost requirements to make improvements
  • Consider the economy, industry and market
  • Seek the lowest possible price for the business

Regardless of the emotional arguments by each spouse, a valuation analyst must adhere to the basic willing and able seller and buyer requirements of the FMV standard for determining the FMV of a company. A valuation analyst should bring reason into divorce business valuation situations, which can often assist the parties in settling property division issues rather than depending upon the courts. In the event that a trier of fact (judge or jury) is involved, a valuation analyst can provide great assistance in determining if the FMV requirements have been met.

Other than in divorce, valuations by a business valuation analyst are important in financial, tax and litigation matters.

Important Notice
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.

Posted in Arbitration Support, Business Valuations, Collaborative Divorce, Divorce Support, Family Law Support, Forensic Accounting, Litigation Support, Mediation Support, No Court Divorce, Non-Litigation Support | Leave a comment

Medical Practice Valuation

A physician needs to value his medical practice for many important purposes. A physician selling his practice or ownership interest and a practice associate buying into a practice are the most typical. Other important purposes include divorce, estate planning and insurance. This article discusses some valuation concepts used when a physician is either buying or selling a practice.

Business valuation is the process of estimating the value within a reasonable range of a business entity or ownership interest by a qualified, impartial and disinterested person. Differences in value among valuation analysts often arise since the process is an imperfect science that combines both professional judgment and opinion. A Certified Valuation Analyst (CVA), regarded as being technically qualified to perform business valuations, has to abide by ethical standards while performing valuations. The CVA is one of four industry-accepted credentials and is one of two requiring a CPA license. Fewer than 3% of CPAs in public practice have earned a valuation credential.

The product of a valuation is a report, which comes in many formats. Full valuations are necessary for estate and litigation matters, for instance, but not when a physician is contemplating the sale of his practice. An analyst instead writes a short report after calculating the practice’s asking price and floor value. Good reports generally include the features, background and financial information of the business and the valuation methodology and conclusion of the analyst.

Valuation Standard
Value and price are separate economic concepts. Value has different standards or meanings: fair market value is one. The Internal Revenue Service (IRS) defines fair market value in its Revenue Ruling 59-60 as the market price which property would change hands between a hypothetical willing buyer and seller for cash or its equivalent with neither under any undue outside influence. The IRS issued this ruling in 1959 and it remains one of the most important guides for valuation analysts. The true test of practice value, however, is the market price a willing buyer pays a willing seller.

The other standards of value include fair value, investment value and intrinsic value. The legal requirements in divorce, estate and shareholder matters determine the standard used by the valuation analyst. If not required by the law, the client and analyst can agree on the standard based on the client’s preferences. The standards are based on different premises of value such as going concern and orderly liquidation. Each premise assumes the most likely transactional conditions surrounding the purpose of the valuation. A practice can have several values depending on the purpose, standard and premise.

When selling a practice, a physician is influenced by his motivations and perceptions and often thinks his practice is more valuable. If a physician by himself prices the practice higher than it should be, it may not sell quickly (or not at all) possibly resulting in patients, practice associates and other employees unwilling to risk the uncertainty to leave. The buyer may also experience financial difficulty by paying too much. A physician should therefore use a business valuation analyst for establishing the value before selling his practice. For this purpose, an analyst would use the fair market value standard in a going concern premise. If the practice were inappropriately valued using an orderly liquidation premise, a more conservative premise than going concern, it will be a mistake as costly as a physician pricing his practice too low. Proper valuations may be costly, but not having one could be costlier.

Valuation Approach
Valuation analysts use one or combine any of the three principal approaches to value medical practices: Income, Market and Asset. Practice value is the sum of monetary, tangible and intangible assets. Though many factors affect practice value, value is closely related to future economic benefits such as sales, earnings or cash flows over a forecasted period. For practical purposes, the term earnings represents the quantification of all these economic benefits. Earnings should yield a fair and consistent rate of return on the investment because its mere existence is not enough to justify investing in a practice.

Of the three approaches, the Income Approach is based on the practice’s ability to generate earnings and is more commonly used to estimate medical practice value. In the Friendly Hills and Harriman Jones Medical Center transactions, valued at $165 million and $20 million, respectively, the IRS preferred the discounted cash flow (DCF) method. The DCF, which is one of several methods under the Income Approach, uses multiple period discounting when the earnings and growth rate are forecasted to be materially different from its past performance. The valuation analyst converts the earnings forecasted by the practice into a present value using a discount rate appropriate for medical practices in today’s market. The single period capitalization method, by comparison, is used for practices with stable earnings and a constant growth rate. Unlike the two medical centers, the vast majority of transactions are for sole or small group practices with values less than $1 million in which the excess earnings method is frequently used and is still accepted by the courts and the IRS. This method is included in the IRS’ Revenue Ruling 68-609 for valuing intangible assets.

The Market Approach involves comparing the medical practice with similar practices sold in the private marketplace using public data. This approach may be the most credible and understandable of the three when data on comparable practices are available. Since comparable data are seldom available, an analyst may have to make certain adjustments to make the transactions comparable. If the practice is exceptional in its marketplace (i.e., more profitable) or if its future performance will be different from its past, the value using this approach may not be relevant.

A valuation analyst adjusts the balance sheet or book values of a medical practice’s assets to fair market value and liabilities to current value using the Asset Approach. The difference between the adjusted assets and liabilities is the net book value or equity of the practice, which is generally its minimum value. The replacement costs of tangible or physical assets are used to adjust office furnishings, medical instrumentations and real estate (i.e., land and office buildings) owned by a practice. An analyst uses net asset value, asset accumulation and excess earnings methods under this approach.

A physician may estimate his medical practice’s value using a ‘rule of thumb’, which is mathematical relationship between variables based on industry experience and observation. It is generally expressed as a multiple such as ‘one times earnings’ and usually applies to a specific type of business. Rules of thumb have never been more than minimally accurate and are increasingly unreliable because of changes in and diversity and complexity of the medical marketplace. Therefore, they are seldom used exclusively by an analyst and are not a substitute for a proper valuation. They do, however, provide a useful frame of reference of practice value. If an analyst sets the practice value on the lower end of the range and its value in the marketplace is anywhere between ‘one to four times earnings’, then the physician may be less concerned that the value is unreasonable. If an analyst sets the value well outside the range, in either direction, then the physician may be more concerned.

The median price for primary care practices was about 28% of the past year’s gross sales with some practices selling for between 50 and 100 percent during the 1990s according to the National Goodwill Registry. The April 2003 issue of Medical Economics, a healthcare publication, mentioned that prices for medical practices are often as low as 5% and rarely exceed 30% of the past year’s gross sales. Exceptional practices get at least 25% while most practices get no more than 20%. Managed care has influenced the values of medical practices. Intangible assets account for about 90% of the purchase price when accounts receivable is excluded and 70% when included. A practice’s accounts receivable, a monetary asset, can have substantial value while its tangible assets, except for real estate, usually have minimal value. Those familiar with business valuation methods rarely value practices based exclusively on a percentage of gross income — a rule of thumb.

Questions
The answers to the following questions affect the value of the medical practice:

  • Is the medical practice a solo or group practice?
  • How is the practice income shared by the members of the group?
  • What are the specialties of the practice?
  • How many years has the practice been in business
  • What are the contracts of the practice?
  • Is the goodwill in the practice personal or practice (enterprise) goodwill?
  • Does the practice have Buy-Sell agreement in place?

Goodwill
Intangible assets are the sum of all identifiable and unidentifiable (goodwill) non-physical assets with earnings (economic value) and ownership rights to those earnings (legal existence). Intangible assets such as unused patents can, however, exist without economic value. Goodwill is an intangible asset that arises from factors such as name, reputation, patient loyalty and location not separately identified. Stated differently, goodwill is the excess of monetary, tangible and identifiable intangible assets. Since lay people confuse goodwill, the term will mean the sum of all intangible assets. Goodwill is the biggest component of a medical practice’s value. Not surprisingly, the existence, nature and extent of goodwill when valuing a practice for any purpose is controversial. A valuation analyst can determine the factors contributing to goodwill and whether ‘professional goodwill’ and ‘personal goodwill’ is distinguishable. As mentioned earlier, practice value is closely related to earnings. As the marketplace matures, earnings are driven down requiring a practice to have a competitive advantage, or goodwill, to sustain above-average earnings for long periods. A physician may not pay for goodwill perceived as personal. If he does, he should pay for it only when the seller enters into a non-competition agreement.

Non-Competition Agreements
Non-competition agreements restrict the rights of owners and employees from profiting from their past ownership or employment relationships. The agreement may, for instance, restrict a physician from taking patients after selling his practice or ownership interest. The agreement may also prohibit a practice associate, both during employment and for a period afterwards, from working for a competitor. A practice associate may also be restricted from taking patients after leaving employment or starting a competing practice. In addition, the agreement may be used to guard against the possibility of a key employee giving confidential information to a competitor or a practice associate starting his practice with the proprietary knowledge. The period and radius guidelines for these agreements vary. Without proper planning, a physician may fail to update his agreements before marketing his practice possibly resulting in a lost sale.

Laws enforcing non-competition agreements vary by state and require an attorney with specialized healthcare knowledge. Courts do not enforce these agreements when, in recognizing that our economic system is based on free competition, the agreements restrain competition. On the other hand, courts enforce these agreements to protect the legitimate interests of medical practices in keeping the competitive advantages they developed (goodwill). Attorneys often recommend having non-competition agreements signed upon employment and having employment agreements that contain non-competition language. In those states allowing non-competition agreements, a buyer may require that practice associates and key employees agree to the transferability of their agreements.

A business valuation of a medical practice by a business valuation analyst is important when a physician is either buying or selling a practice or an interest in one. Valuations are also important in other financial, tax and litigation matters.

Important Notice
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.

Posted in Arbitration Support, Business Law Support, Business Valuations, Buy-Sell Agreements, Cash Flow, Collaborative Divorce, Divorce Support, Earnouts, Economic Damages, Family Law Support, Forensic Accounting, General Civil Law Support, Litigation Support, Mediation Support, Medical Practice, No Court Divorce, Non-Litigation Support, Reasonable Compensation | Leave a comment

Divorce Financial Engineering

Financial engineering is the design of creative solutions to problems in finance. From a business valuation perspective, financial engineering is used to increase or decrease the value of a business depending on the motives of the business owner. Unlike publicly traded companies that are motivated by increasing shareholder value by artificially increasing profit and equity, business owners in a divorce are motivated by decreasing business value by decreasing profits and equity.

The value of a business is driven by three things: profits, risk and growth. The minimum value (suggesting zero implied goodwill) of a going concern business is its net book value (assets less liabilities) or its equity. Financial engineering focuses on profits and (to a lesser extent) equity of the business. Financial engineering is common to both accrual and cash basis of accounting.  In the accrual basis accounting, revenue and expenses are respectively recognized when earned and incurred.  In the cash basis accounting, revenue and expenses are respectively recognized when received and paid.  If the business owner wants to decrease the value of his business, he would decrease his profits and equity by:

  • Recording personal expenses of the business owner as business expenses, which are paid for by the business’ cash or credit .  Often the personal expenses are in obvious accounts such as meals and entertainment and automobile.  Sometimes; however, business owners spread their personal expenses across several not-so-obvious expense accounts.  Nevertheless, the effect would be a decrease in profits (P-) and a decrease in equity (E-).
  • Recording assets purchases as expenses (P-;E-)
  • Not recording cash sales (P-;E-)
  • Reversing, deleting or voiding an open invoice when the cash is received and not recording the cash (P-;E-)
  • Same as above, but recording the cash as equity contributions (P-;E+)
  • Delaying invoices to customers (P-;E-)
  • Accelerating expenses to vendors and suppliers (P-;E-)
  • Recording monies lent to the business owner as business expenses (P-;E-)
  • Creating phantom employees, suppliers and vendors (P-;E-)
  • Recording cash sales as “phantom” or related party liabilities (P-;E=)
  • Recording cash sales as equity contributions (P-;E+)
  • Overestimating or accelerating depreciation and amortization expenses (P-;E-)
  • Overestimating reserves (or allowances) for impaired or worthless accounts receivables, inventory and fixed assets (P-;E-)
  • Writing-off or writing-down collectible accounts receivables, salable inventory and productive fixed assets as impaired or worthless assets (P-;E-)
  • Recording sales as other income, which suggests that it has a non-operating quality and therefore has no future economic value (P+;E+)
  • Recording the same vendor invoice twice in one year, paying for it once in the same year and then reversing the second invoice in the next year (after the divorce)

If intent is proven, then the financial engineering is fraud. Unfortunately, studies have shown that only about 20% of fraud is discovered through transaction testing. So here are some accounting signs that may suggest financial engineering:

  • Lack of separation of function.  for example, the business owner is also the bookkeeper.
  • Poor or unorganized books and records.  While more commonly an indicator of negligence, it may also be an indicator of financial engineering.
  • Not closing the books on a monthly basis (most QuickBooks users close annually)
  • Recording adjustments in closed periods (closed months or years)
  • Unusual accounts receivable, inventory and fixed assets write-offs and write-downs
  • Unusual or numerous general journal or general ledger entries (instead of using the accounts receivable and payable ledgers, which have a better “paper trail”)
  • Even dollar amounts (like $2,000 or $6,500)
  • High-dollar miscellaneous accounts
  • High-dollar travel, meals and entertainment
  • High-dollar personal expenses
  • Decreasing sales or increasing expenses while cash and liabilities are increasing
  • Internal financial statements that do not reconcile (within reason) to tax returns

Time and money is spent uncovering potential financial engineering in litigated divorces. Although the parties operate in the context of openness and honesty in mediated and collaborative divorces, just be open to the possibility of some financial engineering.

Important Notice
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.

Posted in Arbitration Support, Business Valuations, Cash Flow, Collaborative Divorce, Divorce Support, Expert Witness Testimony, Family Law Support, Forensic Accounting, Litigation Support, Mediation Support, No Court Divorce, Non-Litigation Support, Reasonable Compensation | Leave a comment