Business Valuation expert Shannon Pratt has written numerous books that articulate many of the concepts used in modern business valuation around the world.
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An Interview with Shannon Pratt
In addition to being a published author and authority on the subject of business valuation, Shannon Pratt is the chairman and C.E.O of Shannon Pratt Valuations, a business valuation firm headquartered in Portland, Oregon. He is also a member of the board of directors of Paulson Capital Corporation, an investment banking firm that specializes in Small Cap IPOs. Over the last 35 years, Shannon has performed valuation engagements for everything from mergers and acquisitions, to employee stock ownership plans, fairness options, gift and estate taxes, other business valuation purposes, and, of course, business valuations for divorce cases.
Under what circumstances would a family lawyer use your firm’s services?
Anytime a client is considering a divorce and the marital estate includes a business or an interest in a business, you or your client should engage a professional business appraiser.
What should a family lawyer look for in a business valuation expert?
First of all, top qualifications—be sure that your expert out-qualifies the opposing expert and has better credentials. This includes writing, testifying, speaking, and experience.
Number two: to be an excellent communicator, you have to be able to explain complicated business valuation concepts for a judge, who is unfamiliar with financial concepts, to understand. And most family law judges aren’t familiar with financial law concepts, because most cases are non-financial most of the time. So, when business valuation comes before them, they are largely unfamiliar with those concepts.
Number three (and most importantly): the appraiser should be unbiased. He should have a reputation for fairness, not given to extreme positions in favor of the client.
Is it important for the business valuator to have experience in any particular industry?
Not generally. A good expert can obtain the necessary industry knowledge that they need.
How does the attorney work with the appraiser?
Well, the attorney has to make the assignment clear. Elements under that are the property to be appraised, the standard of value, and the schedule.
What is meant by the phrase “standard of value”?
If you’re an attorney and it’s not clear what is meant by the phrase “standard of value,” don’t feel bad. Many judges also do not have an understanding of this. There are several well-defined standards of value; the most frequently encountered are fair market value, investment value, fair value, and intrinsic value.
Now, fair market value is the most common and that’s because it is the single standard of value that is mandated for federal tax purposes. Frequently, judges start out with fair market value, but they don’t continue with fair market value as the appraisers understand it. So, there’s lots of confusion in terms of standard of value.
There’s no single state that has a statutorial standard of value for divorce, so you have to look at the case law. Some states have one standard of value for family law, while others do not. Another wrinkle is that within the states there are jurisdictions and some have different standards of value. You have to look at the particular standard of value in which the case is being tried.
What elements should the lawyer include in the assignment?
A complete description of the property being appraised; there are some aspects that most lawyers don’t think about, such as the name of the company or companies and subsidiaries, the type of company (sole proprietorship propriety and so forth), the state of incorporation, and registration, because state laws sometimes have bearings on the standard of value. In other words, the valuation basis is minority or control: the standard of values, which we discussed, or the premise of value, which is in the standard of value. The premise of value can be liquidating value, going concern value, and so forth; in other words, going concern on an ongoing basis, or going concern on a limited basis.
The purpose of the valuation, the number of shares out of the outstanding percentage of the partnership interests, and the class of interest—that’s the description of the property.
It is also the attorney’s responsibility to give the appraiser the effective date or dates of the valuation, the jurisdiction under which the case would be tried, the name of the client, the name of the law firm that deals with the client, the schedule and a written report on all testimony. Some states require written reports, others use oral reports, and others use one or the other depending on the attorney’s preference.
Should the lawyer give the expert guidance as to the value he desires the analysis to conclude?
No, absolutely not.
Professional ethics require that the appraiser be independent. During the hiring interview, the lawyer may ask the expert his position on certain matters that might become issues in the case. If the lawyer doesn’t like the answers, then he can move on to interviewing another expert.
Also, the lawyer might ask the expert to provide a range within which the valuation might fall and at some point early enough the lawyer might find another expert.
However, if the first expert is good, then another expert providing something outside that range might not be credible. If the opposing attorney can prove a hint of bias in the mind of the judge or jury, the expert testimony might be significantly weakened.
Should there be a site visit and management interviews?
Yes, almost always. It gives the expert a better understanding of the business and enhances the expert’s credibility. When one expert has done a site visit and management interviews and the other one hasn’t, the one who has, virtually, always has more credibility.
What if an attorney who is representing a non-operating spouse doesn’t want there to be site visits?
When the attorney goes to court and requests a site visit on behalf of the expert, I’ve never, in my experience, had the court refuse. Of course, the expert has to arm the attorney with reasons as to why a site visit is necessary.
Should the attorney be present during the management interviews?
If the opposing attorney insists on being present, then, by all means, counsel for the client should be present. If the attorney has a good rapport with the client, perhaps the client would be more comfortable with the attorney present than he would this stranger.
If the attorney does not know the company well, perhaps this would be a good time for the attorney to learn. But absent any of the foregoing, I’m often more comfortable, and the management is more comfortable, especially if the company is the opposition if I am alone or just with another analyst. I like to keep the interview as informal as possible.
What can the attorney do to help the expert?
Number one is to facilitate the discovery. If the company drags its feet on getting expert requested information, the attorney should help. Number two is to keep the expert informed of the schedule. Number three, of course, is to pay the expert on time, if the client is slow to pay fees.
Can you give a general outline as to the hierarchy of approaches and methods applicable to valuation?
Well, there are three general approaches: the income approach, the market approach, and the asset approach.
What methods are under the income approach?
The discounted cash flow method, where the projected or given expected income or cash flow in each given year ahead or period is discounted back to a present value at a discount rate. Or the capitalized cash flow method, where you simply project the expected cash flow or earnings in the coming year and you capitalize that at a capitalization rate.
What methods are under the market approach?
The guideline of a publicly traded company method, where you use public companies in the same industry as guidelines and you subtract your ratios, like your price earning ratio, from those.
What are the methods for valuing under the asset approach?
Number one is the asset accumulation method. You mark all the assets to market values and you bring on the balance sheet, meaning all balance sheet liabilities or all balance sheet assets, and you revalue all liabilities to their current value; then the assets minus the liabilities, if their current value is equal, and then asset value, which is the ownership interest.
Number two is the access earnings method and that’s a hybrid method, sometimes classified under the income approach. We categorize it under the asset approach because you revalue all the tangible assets and get a reasonable return on the tangible assets, and then revalue the business as a whole and subtract the value of the tangible assets.
Given that there are a variety of approaches that you have now explained, which approaches or methods do you usually use?
Well, that’s where the expert’s expertise comes in. Many factors are involved, for example, the industry and the data available. The expert should at least consider all three approaches; not necessarily use all three, but usually two or more for crosscheck. Occasionally, one approach will dominate.
Do you do report reviews?
I have two credentials that specify specifically for that: the credit and business appraisal review and the ARM, which is issued by the American Society of Appraisers. Both of those are credentials for reviewing other people’s reports. Now, we critique the opposing expert’s report and, if the attorney has already hired an expert, his own expert’s report. Sometimes, if it is a big enough case, it is worthwhile to have two testifying experts. The report reviews are a minor cost, they are often important and they often lead to a bigger assignment.
What forms of feedback does the lawyer receive when you review a report or reports?
You always want oral feedback with these; he may not want written feedback in the record if it is something he doesn’t like or it doesn’t do his client objectives—and if he desires, he can have a written report follow-up.
We hear a lot about double dipping. What exactly is double dipping?
Double dipping is splitting the value of the marital asset, that is, the value of business, between the parties and using it again as a basis for alimony.
Now, the value of business—the discounted present value—is its future earning capacity. The business value is forward-looking, that is the present value of the expected future cash flow. The present feature cash flow is split among his attributive assets, so it’s unfair to use the cash flow again as a basis for alimony, although I am constantly surprised at how often this happens.
Shannon, you have written quite a few books on business valuation. Is there anyone or two that you would specifically recommend to family lawyers?
I would recommend the Lawyer’s Business Valuation Handbook, by my colleague Alina Niculita and I. It is now in its second edition and is published by The American Bar Association.
If you want to go deeper, I would suggest Valuing a Business, also by Alina Niculita and myself. This one is now in its fifth edition with a seminal book on business valuation, originally published in 1980. It is published by McGraw Hill and it is available on Amazon.
Shannon P. Pratt, CFA, ARM, ABAR, FASA, MCBA, CM&AA, is the founder of Shannon Pratt Valuations, Inc., a national business valuation firm located in Portland, OR. Dr. Pratt has more than ten books in print on various business valuation topics including valuations for marital dissolution purposes, and he has testified on hundreds of occasions in various types of litigated matters including divorce cases. www.shannonpratt.com.