1. Business Valuation – What Tennessee Judges Need to Know Presented by: Robert Vance, CPA, ABV, CFF, CVA, CFP Forensic & Valuation Services, PLC 901-507-9173 www.ForensicVal.com rvance@ForensicVal.com

2. If You Don’t Remember Anything Else Today The Essence of a Business Valuation A business valuation is essentially the Present Value of the future expected benefits (cash flow) The particular owner’s interest is being valued, not the entire company (unless he/she owns 100%) A closely-held business is, in reality, only worth the present value of the future cash flow over and above a “normal” owner compensation; a.k.a Ongoing Earning Capacity The Ongoing Earning Capacity is the return on investment the willing buyer “receives” by investing in this particular business

3. Definition per IRS Revenue Ruling 59-60 “The price at which a property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell and both parties have reasonable knowledge of the relevant facts.” Do we presently have or do we need an official “Divorce” Standard of Value? Standard of Value in TN: Fair Market Value

4. Powell v. Powell - 2003  The Fair Market Value Standard as in IRS Rev. Rul. 59-60 does not have to be strictly followed when valuing a closely- held business in a Tennessee divorce  What does that mean? We must follow case law even if it is contrary to generally accepted procedures and methods used in non-divorce valuations such as in the application of discounts and allocation of goodwill 124 S.W.3d 100 (Tenn. Ct. App. 2003) Standard of Value in TN: Fair Market Value

5. 1)Asset Approach  Think of a balance sheet; Identifiable Tangible & Intangible Assets Adjusted to FMV – Liabilities 2)Market Approach  Think of this as being similar to pricing your home for sale using comps in the neighborhood 3)Income Approach  Net present value of expected future benefit, usually cash flow, with the discount rate being risk adjusted Three Approaches to Valuation Each with Underlying Methods

6. What is Included in Each Approach? The inclusion of both Personal and Enterprise Goodwill is implied in the final conclusion of value using the valuation approaches of : Market Approach - Yes Income Approach - Yes Asset Approach - No Usually all assets and debts of the business are included with the Market and Income Approach conclusions of value

7. Normalization Adjustments Usually must be made to any set of financials or tax returns used as a valuation basis 1.Owner’s compensation and perks 2.Personal expenses & excess fringes run through the company 3.Non-recurring and/or one-time events 4.Non-operating assets  Real estate, excess cash, obsolete inventory, cars, airplanes, vacation homes, yachts, etc.

8. The Asset Approach

9. The Market Approach

10. The Income Approach Future cash flow over and above a “normal” owner compensation

11. The Income Approach

12. In perpetuity!

13. The Income Approach

15. Conclusion of Value

16. Personal Goodwill in a Tennessee Divorce  Definition: The excess of the purchase price [or value conclusion] of a company over its book value which represents the value of goodwill as an intangible asset (Merriam-Webster)  Tennessee has a well-established case law history that does not provide for the inclusion of Personal Goodwill (a.k.a. professional goodwill) as an asset of the marital estate, but does allow for the inclusion of Enterprise Goodwill (a.k.a. business goodwill)

17. Personal Goodwill in a Tennessee Divorce  Personal goodwill is generally not to be considered in the valuation of professional practices and small, closely-held businesses primarily dependent upon the individual for success or profits  Excellent staff, branded name that is not the owner’s name, equipment in place, ancillary services, superior location, etc. make profit “independently” from the owner - like widget machines in a widget factory

18. Personal Goodwill in a Tennessee Divorce  Fair Market Value standard inherently includes both Personal and Enterprise Goodwill when valuing with a going concern premise  The inclusion of both Personal and Enterprise Goodwill is implied using the valuation Approaches of Market and Income, but not Asset

19. Fred Jones, Jr., DDS d/b/a Mid-South Smiles Factory

20. Mid-South Smiles Factory

21. Fred Jones, Sr., DDS

23. Fred Jr. vs. Sr. Who has more Enterprise Goodwill? Jr.

24. Hazard (1991) - No Goodwill Allowed  Dr. Hazard’s practice was highly specialized and very dependent upon personal referrals from other physicians  Goodwill in a professional practice is not a marital asset subject to equitable distribution  Sole practitioner professional practice is to be valued using the “net tangible assets with ascertainable value.” Cites Smith v. Smith  Net Asset Value a.k.a. Net Book Value Hazard v. Hazard, 833 S.W.2d 911 (Tn. Ct. App. 1991) Personal Goodwill in a Tennessee Divorce

25. Witt (1992) - Enterprise Goodwill Allowed  If the professional practice or closely-held business is large and diverse enough and not solely dependent on the individual, goodwill may be considered as part of the ownership interest  Dr. Witt’s clinic was found to have separate goodwill that was not directly related to his professional or personal goodwill  Size Does Matter Witt v. Witt, No. 01-A-019110CH00360, 1992 WL 52746 (Tenn. Ct. App. Mar. 20, 1992) Personal Goodwill in a Tennessee Divorce

26. Eberting (2012) - Enterprise Goodwill Allowed  Orthodontia practice value at FMV by Vance at $700k; included Enterprise (not Personal) Goodwill  Opposing expert valued practice At $224k (net book value with no Goodwill)  Trial judge found value to be $500k, which was a value indicated by the owner in a personal financial statement; judge knew that any value north of $224k was including Goodwill Eberting v. Eberting, No. E2010-02471-COA-R3CV, 2012 WL 605512 (Tenn. Ct. App. Feb. 27, 2012) Personal Goodwill in a Tennessee Divorce

27. Hartline (2013) – No Goodwill Allowed  W’s expert used an income approach which included enterprise goodwill; H did not  Did not brand his name separately  Confusion of professional vs. personal goodwill terminology?  Trial: value between $468k and $500k which included goodwill  Appellate court remanded for a value with no goodwill Hartline v. Hartline, No. E2012-02593-COA-R3CV, 2014 WL 103801 (Tenn. Ct. App. Jan. 13, 2014) Personal Goodwill in a Tennessee Divorce

28. Hartline (2013) – No Goodwill Allowed  “..sole practitioner of an unincorporated dental practice, whether his business could continue without him is speculative, leading to the conclusion that the goodwill of Husband’s practice should not be considered in valuing said practice.”  No separation of personal from enterprise goodwill, thus baby out with the bath water (from my analysis) Personal Goodwill in a Tennessee Divorce

29. Barnes (2014) – Enterprise Goodwill Allowed  Enterprise goodwill allowed in dental practice  Practice branded with the name of Shelbyville Family Dentistry with large staff and great location  H’s expert used income approach-$735k  Income approach provides for goodwill (enterprise & personal)  Personal goodwill of $678k calculated using present value of two years of Dr. Barnes’ salary plus benefits, then deducted from the $735k value to arrive at $57k Barnes v. Barnes, No. M2012-02085-COA-R3-CV, 2014 WL 1413931 (Tenn. Ct. App. Apr. 10, 2014) Personal Goodwill in a Tennessee Divorce

30. Barnes (2014) – Enterprise Goodwill Allowed  W’s expert used the Multi-Attribute Utility Model (“MUM”) method although not identified as such; goodwill of 30% was deemed personal  Goodwill Allocation: ratio of associate’s years of service of 12 ÷ Barnes’ years of 21 x goodwill of $678 = $349k (math error; deduction should have been $387k not $349k)  Trial court used H’s expert figure of $735k less personal goodwill of $349k leaving enterprise value of $386k Personal Goodwill in a Tennessee Divorce

31. Barnes (2014) – Enterprise Goodwill Allowed  Applied a Discount for Lack of Marketability (“DLOM”) of 15% to arrive at $328k  Value upheld by appellate court, but, held that DLOM was error based on Bertuca  Valuation should not have been impacted by the lack of marketability of H’s interest, unless of course there was some indication that a sale of his interest was necessary or desirable Personal Goodwill in a Tennessee Divorce

32. Allocating Personal vs. Enterprise Goodwill

33. Find an objective method to analyze subjective data Multiattribute Utility Model (MUM) Decision making matrix for applications such as:  Placement of surplus weapons-grade plutonium  Plant and treatment facility locations  Restoration of contaminated ecosystems in the former Soviet Union  An now allocation of goodwill between personal and enterprise

35. Allocating Personal vs. Enterprise Goodwill

36. Calculating Discounts and Premiums Depend on the interest to be valued and the techniques used to establish the value conclusion  Discount for lack of control (DLOC)  Premium for control  Discount for lack of marketability (DLOM)  Key person discount

37. Calculating Discounts and Premiums Discount for Lack of Control a/k/a Minority Interest Discount  Shares of stock or an LLC or partnership interest that is 50% or less in total ownership is worth less per share than if 51%+ is owned by an individual  Lack of control in a closely held company implies you are at the mercy of the controlling owner(s)  Substantial discounts may be necessary to attract an investor to purchase a minority interest in a closely held company  Could be in the range of 15% to 50%

38. Calculating Discounts and Premiums Discount for Lack of Marketability  The time required to convert an ownership interest to cash affects the level of marketability  Factors that affect marketability:  Distributions of earnings  Active market or industry roll-up  Key person  Number and profile of owners e.g., family owned  Restrictions on transfer of stock  This a real discount despite Bertuca

39. Business Valuation Summary 1.A business valuation is essentially the Present Value of the future expected benefits (cash flow) over and above a “normal” owner compensation 2.The particular owner’s interest is being valued, not the entire company (unless he/she owns 100%) 3.The Ongoing Earning Capacity is the return on investment the willing buyer “receives” by investing in this particular business 4.The inclusion of both Personal and Enterprise Goodwill is implied in the final conclusion of value using the Market & Income Approaches

40. Business Valuation Summary 5.Usually all assets and debts of the business are included with the final conclusion of value using the Market & Income Approaches 6.Scrutinize the normalization of Owner’s compensation 7.Heavier weighting reflects the analyst’s future expectations 8.Capital Expenditure (CapEx) estimate must be based on history or future expectations in perpetuity 9.The market comps should be close under Market Approach 10.Personal goodwill is generally not to be considered in the valuation of professional practices and small, closely-held businesses primarily dependent upon the individual for success or profits

41. Business Valuation Summary 11.Staff, branded name, equipment, ancillary services, location, etc. make profit “independently” 12.Enterprise goodwill has been allowed in Tennessee cases on numerous occasions 13.A Discount for Lack of Control (DLOC) may be applicable for a 50% or less interest 14.A Discount for Lack of Marketability (DLOM) can be a real issue despite Bertuca

42. Thank You! Robert Vance, CPA, ABV, CFF, CVA, CFP Forensic & Valuation Services, PLC 901-507-9173 www.forensicval.com rvance@forensicval.com