Flawed Business Valuations
Flawed Business Valuations - Common Mistakes
Common mistakes in business valuations in matrimonial cases
In this brief article I will explore some of the common failings that I come across in business valuations prepared by business owners or their advisers. I review many company valuations including those provided in the Form E disclosure and am regularly instructed to review these valuations as a shadow adviser.
Business valuation in divorce – an overview
Business valuation is subjective and two expert valuers are unlikely to arrive at the same figure. However, there is a reasonable range within which we would expect the valuations to fall.
Valuing companies in family law cases is a theoretical exercise to give an opinion on what the market price for the shareholding may be. A fundamental assumption is that in providing a market value we assume there is a willing buyer and a willing seller.
What follows are the key issues that I regularly encounter in business valuations in matrimonial cases.
Using an inappropriate valuation methodology
Most valuations of trading companies will use the “future maintainable earnings” basis. This is an income approach and it applies a valuation multiple to an estimate of future maintainable earnings (“EBITDA” - the adjusted Earnings Before Interest, Tax, Depreciation and Amortisation) to give the Enterprise Value. Adjustments are then made for any surplus cash, debt or non-business assets to arrive at the Equity Value. This approach is normally adopted as long as the company is making maintainable profits after deducting a commercial salary for the business owners.
However, I have seen company valuations which are based on the company net assets rather than its future maintainable profits. In essence, a valuation based on net assets ignores the goodwill value that exists in a successful trading business. A net asset valuation can be significantly lower than a market valuation based on the profits a company is generating. This use of the net asset methodology may be justified in circumstances where the business owner would not support a sale. However, as I have explained above, in family law cases we value companies on the assumption of a willing seller.
A valuation based on net assets may then be decreased further by adjusting for the notional costs of “winding up” the business, even though there is no intention to cease trading.
In my May article on this website, I explored the various valuation methodologies in detail and I will not repeat this here.
Applying an EBITDA multiple to Profits Before Tax
I have often seen valuations where care has been taken to select an appropriate EBITDA multiple but this is then applied to the Profits Before Tax (“PBT”) rather than EBITDA. PBT will be after deduction of depreciation, amortization and interest and so may be significantly lower than the EBITDA. For example, if a company’s PBT is £75,000 and the EBITDA is £100,000 and the appropriate EBITDA multiple is 5X, the valuation will be undervalued by £125,000 or 25%.
Adding the net assets to Enterprise Value
The Enterprise Value is the value of the business including all the assets and liabilities used within the trade. This should then be adjusted by the surplus cash, debt and any surplus “non-trade” assets to arrive at the Equity Value. I have seen valuations where the whole net assets figure is added to the Enterprise Value. This is double counting the trade assets and can significantly overvalue the company.
Adopting an onerous tax rate
In valuing a shareholding for a divorce case, it is necessary to give a view on the appropriate tax that would apply on a sale or transfer of the shareholding. Normally an expert would provide for capital gains tax (“CGT”) on the value of the shares and typically at the lower rates after applying Business Asset Disposal Relief (“BADR”). However, I have reviewed valuations where it is assumed Income Tax should be applied and possibly adopting the additional rate on dividends of 39.35%. This rate compares to the 20% rate for CGT or 10% on gains qualifying for BADR. If the shareholding is valued at £1 million and would qualify for BADR the value net of tax is £900,000 or if treated as taxed as income the value reduces to £605,000 (the shares are undervalued by 33%)
Conclusion
Valuation is subjective and it is a mixture of art and science. However, there are some fundamentals to valuation methodology. Additionally, there are some general practices which are applied when valuing private companies for matrimonial cases and these are not always considered in the valuations prepared by business owners and can also be overlooked in those prepared by their advisers. My advice is to be cautious and, if you are concerned that the valuation may be overstated or understated, to consider getting expert valuation advice either from a Shadow Adviser or by the appointment of a Single Joint Expert.
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