Primary or secondary role

The impact of real estate on business value depends on the role it plays in the business. For some businesses — such as cemeteries, amusement parks and certain farming operations — their value is inextricably tied to the real estate. Not only is the real estate itself the focus of the business, but it would be difficult or impossible to use it for any other purpose. In these situations, a valuation of the real estate (and, for the most part, the business itself) usually focuses on the property’s income-generating potential.

Other businesses have special real estate needs, but their revenues are derived from producing goods or providing services. Examples include gas stations, restaurants and auto dealerships — all of which have specific real estate requirements but whose activities don’t focus on the real estate itself. Typically, these properties can be adapted for other uses without exorbitant expense. In these situations, valuators may separate the business from the real estate and then value each on a standalone basis.

Valuation methodology

Keep in mind that the need for separate valuations of business and real estate arises only when the same person or persons own both. Under those circumstances, business and real estate values may overlap, which isn’t an issue when a business rents its facilities from a third party.

Businesses and real estate are generally valued using one or more of the three basic valuation approaches — income, market and cost — although the methods may be somewhat different. Businesses that own their own real estate generally don’t record any rental expense; they incur related expenses such as building depreciation, real estate taxes, building insurance, and repairs and maintenance. Also, a real estate appraiser using the income approach may overvalue the real estate if cash flows from the business itself are included in the computation.

Standalone business and real estate valuations often produce more accurate results. A valuator removes real estate–related expenses (such as those mentioned above), determines the real estate’s fair market rent and deducts that amount from the business’s cash flows as if it were paying rent to a third party. Fair market rent is also used in the income stream on which the real estate’s value is based. The business and real estate values are then combined to arrive at the enterprise’s total value.

When large sums are at stake, consider engaging an independent “critiquing” expert to ensure the expert’s report will withstand adversarial scrutiny.

Choosing a critiquing expert

A critiquing expert can help uncover mathematical or typographical errors, missing or incorrect assumptions, inconsistencies, questionable methodologies, and invalid or unsupported conclusions — any of which might cast doubt on the expert’s reliability in the eyes of a judge or jury. This expert may also identify alternative approaches that the testifying expert didn’t consider.

The critiquing expert should have similar qualifications and industry experience as the testifying expert. In addition, the critiquing expert should be fully independent and objective so he or she can evaluate the expert’s report from the opposition’s perspective.

Building a “wall”

Most notes, correspondence, workpapers, reports and other materials prepared by or relied on by a testifying expert are discoverable by opposing parties. To protect a critiquing expert’s work product against disclosure, you must ensure that he or she is considered a consulting rather than a testifying expert. The best way to do that is to use a critiquing expert who has no ties to the expert whose report he or she will review.

Be prepared

When the outcome of a case turns on expert testimony, an independent critiquing expert can help spot errors or weaknesses in the testifying expert’s report and, if necessary, request a revised or supplemental report that addresses any issues. If the critiquing expert is involved early enough in the process, his or her comments can be worked into the expert’s original report. Even if the expert’s report is sound, the review process can help anticipate the opposition’s attacks and be better prepared to counter them.

Consider this scenario: In 2010, a company fires an employee for stealing trade secrets. It goes to court to recover the lost profits it likely would have earned in the future had the employee not divulged the secrets to a competitor. But what’s the best way to determine those lost profits?

It’s not an easy answer. But a skillful financial expert can discount future damages to present value, providing the ammunition businesses need to receive a just award.

Recognize the impact

Many plaintiffs don’t recognize the impact that discounting can have on damages awards. The difference between discounted and undiscounted damages awards, however, can be substantial. A defendant who fails to object to an undiscounted award may end up overpaying. Suppose that a plaintiff recovers damages for lost profits of $500,000 per year for five years. Without discounting, damages would total $2.5 million. But discounting those damages to present value (using a 10% discount rate) would reduce the award by more than $250,000.

If an award is discounted, parties on both sides must ensure the discount rate is reasonable. Even small rate variations can affect the damages amount.

Understand what affects the discount rate

The discount rate is the rate of return a hypothetical investor would demand, given the level of risk or uncertainty associated with the plaintiff’s “but for” profits and, specifically, with the probability those profits would materialize.

If the plaintiff’s company has a track record of consistent earnings and its risk of falling short of projected future earnings is low, a modest rate of return may be appropriate. But if the plaintiff’s company is in a high-risk industry or has volatile earnings, an investor would require a higher return to compensate for the risk.

Financial experts choose from several methods of calculating a discount rate; each involves a risk factor analysis. The “build-up” method, for example, begins with a “risk-free” rate of return — typically the yield on long-term government bonds. The expert methodically increases that rate to reflect the risks associated with the projected lost cash flows.

Know how to approach damages

Once they have a discount rate, financial experts can use two approaches to calculate lost profits damages. They can determine the plaintiff’s expected future income stream and then discount it to present value using a risk-adjusted discount rate. Or, they can also incorporate risk considerations into the future income projection and then reduce projected income to present value using a lower-risk discount rate.

No easy task

Many plaintiffs simply don’t recognize the impact that discounting can have on damages awards. As a result, it’s critical that they retain a financial expert who understands the ins and outs of discounting future losses to present value.

3 broad approaches

Business valuation methods generally fall within one of three approaches:

1. The income approach, in which the valuator converts expected economic benefits (such as earnings or cash flows) into a present value,
2. The market approach, in which the valuator analyzes and applies valuation multiples derived from transactions or stock prices of comparable companies, and
3. The cost or “asset” approach, in which the valuator calculates the replacement cost or market value of a company’s assets.

Because valuation is an inexact science, valuators typically use several techniques, each of which serves as a cross-check on the others. Determining which methods to use and the relative weight to assign each method depends on the nature and financial condition of the company being valued as well as the quality of data available.

An underwater company

In Hanover Direct, the issue was the fairness of a going-private merger to the company’s public shareholders, who were cashed out at $0.25 per share. The company had been heading toward insolvency for some time, and its combined debt and contractual obligations to preferred shareholders exceeded the value of its common stock.

After consulting with an independent financial advisor that valued the company, the board of directors approved the merger proposal. The board concluded that the $0.25-per-share price exceeded the stock’s fair value. The court arrived at a similar conclusion: The company was “underwater,” so the per-share value of its common stock was less than $0.00. Accordingly, any merger price above zero was fair.

Several shareholders filed suit against the company, claiming that $0.25-per-share was entirely or grossly unfair. They asserted that the stock’s intrinsic value at the time of the merger was $4.75 per share.

An unconvincing expert

Resolving the valuation issue came down to a battle of experts. The company’s expert used three valuation techniques — a discounted cash flow (DCF) analysis, a comparable company analysis, and a comparable transaction analysis — arriving at a per-share value of less than $0.00. The shareholders’ expert relied solely on a comparable public company analysis.

The court questioned the reliability of the data used by the shareholders’ expert, noting that she included “data points that seemed to be at worst outliers and at best failure by the expert to adjust appropriately even for the possibility that these data points were outliers.” But the most significant problem was that her valuation “was based entirely on one valuation technique .  .  . rather than on a blend of techniques.”

Because of these and other weaknesses in the shareholders’ valuation, the court concluded that it could not place any confidence in the $4.75-per-share price calculation. The company expert’s valuation, on the other hand, used multiple valuation methods and data that raised no reliability issues, thus leading the court to accept the company’s valuation.

The court acknowledged that there may be circumstances in which a single valuation methodology is the “best and only method by which to value a particular company.” Those circumstances did not exist, however, in this case.

Choose your weapons

Hanover Direct illustrates the importance of using multiple valuation methods whenever possible to support value conclusions. And in cases where a single methodology is appropriate, your valuation expert should be prepared to explain why such an approach is valid and reliable.

In a litigation context, the same business interest may have different values depending on the nature of the case, applicable law, and other variables. Here are some factors to consider.

Subject of the valuation

The valuation process cannot begin until the subject ownership interest is clearly identified. Is it a complete, “fee simple” interest or is it something less, such as a term or life interest? What are the interest owner’s rights in the business? If the interest takes the form of stock, are there any preferences or restrictions related to voting rights, dividends or liquidation? If it’s a partnership interest, what rights or limitations are in the partnership agreement?

An ownership interest is defined by the legal rights it confers on the owner, and each of those rights impacts the value conclusion.

Standard of value

The most widely recognized valuation standard is fair market value (FMV). It’s often used as the standard of value for businesses or business interests for sale or for a variety of federal and state tax purposes. FMV typically is defined as the price at which property would change hands between a willing buyer and a willing seller, neither being under a compulsion to buy or sell and both having reasonable knowledge of relevant facts.

FMV assumes a hypothetical willing buyer and seller. But at times it’s necessary to calculate “investment value,” which is based on a specific buyer’s or owner’s investment requirements and expectations. This measure may be appropriate, for example, in calculating damages for destruction of a business. If a defendant’s wrongful conduct drives a plaintiff out of business, it may be appropriate to value the business from the plaintiff’s perspective.

In certain types of litigation, the standard is prescribed by law. In shareholder litigation, a dissenting shareholder’s stock is usually priced at “fair value” — a statutorily defined value that’s intended to be fair to all parties. The theory is that a minority investor should receive at least his or her pro rata share of the company’s expected cash flows upon liquidating that interest. In many states, fair value is equal to FMV that’s been calculated without consideration of marketability or control discounts. It may also exclude any appreciation or depreciation in value in anticipation of the transaction that gave rise to the lawsuit.

In divorce cases, it’s important to review statutory or case law that governs valuation standards. Typically, business valuation in a divorce is based on FMV, but state law can modify traditional FMV concepts, often in significant ways. The law varies from state to state, for instance, on whether personal or enterprise goodwill is a marital asset subject to division.

Premise of value

The premise of value refers to the assumed circumstances surrounding the valuation. For example, should the expert assume that the business will continue as a going concern? Or should he or she assume that the business will be liquidated and its assets sold? If the latter, will the assets be sold in an orderly disposition or as part of a forced liquidation?

Typically, experts assume a premise of value based on the business’s “highest and best” use unless special circumstances or the business’s actual plans dictate otherwise.

Get on the same page

These are just some of the factors to consider in valuing a business interest for litigation purposes. Others include the level of value (see the sidebar “Leveling the playing field”), the valuation date, state laws that affect owners’ rights and contractual provisions — such as buy-sell agreements, voting agreements or rights of first refusal — that have an impact on value.

It’s critical for attorneys and valuation experts to discuss these factors and ensure that all assumptions on which a valuation is based are explained in the expert’s report.

Sidebar: Leveling the playing field

The level of value on which a value is expressed frequently confuses users of valuation reports. It refers to the level of control an owner has over the business as well as the level of marketability of the interest. The more control an interest confers, the lower the risk; the more readily it can be liquidated, the more it is worth. But confusion can arise because different valuation methods reflect different levels of value. For example, when valuing a minority interest in a closely held business it may be appropriate to apply discounts for lack of control and marketability.

But discounts are not automatic. Publicly traded stock is highly marketable, so a marketability discount is usually appropriate when valuing a closely held business. But when it comes to lack of control, the answer is less obvious.

Suppose a valuator uses the guideline public company method, which values a business interest by applying market multiples (such as price-to-earnings) from comparable public companies. Some argue that publicly traded stock prices already reflect lack of control, so an additional control discount isn’t appropriate. On the other hand, because public companies tend to be professionally managed, some say lack of control has little or no impact on the value of a minority interest.

Many experts believe that the most important factor is the earnings or other economic benefits to which market multiples are applied. So, for example, if a valuator applies public company multiples to the estimated benefits a controlling owner would enjoy, a discount for lack of control would be appropriate.

The key is to understand the appropriate level of value for the subject business interest as well as the level of value inherent in any benchmark data, and to apply discounts (or premiums) only when these levels don’t match.

What is it?

A fairness opinion is a statement by a financial expert that a proposed transaction’s terms are fair to the company’s shareholders from a financial perspective. It doesn’t provide an opinion on whether the transaction is legally sound or a good business strategy.

Why get one?

Fairness opinions often are obtained in connection with M&As, particularly when public companies are involved. But they can be valuable — for both public and private companies — whenever minority shareholders claim that a transaction is unfair to them or that the company’s directors or officers are engaged in self-dealing.

 In addition to M&As, situations that may call for a fairness opinion include:

• Management buyouts,
• Recapitalizations and restructurings,
• “Going private” transactions,
• Related-party or “insider” transactions,
• Stock buybacks,
• Employee stock ownership plan (ESOP) transactions,
• Bankruptcy reorganizations, and
• Liquidations.

A fairness opinion can help avert shareholder lawsuits by assuring them that the transaction’s financial terms are fair. It also can help ensure that directors and officers are protected by the “business judgment rule.” Provided they’ve acted in good faith, the rule shields them from liability for decisions made on an informed basis and in a manner they believe is in the best interests of the company and its shareholders.

In divorce cases, it’s common for an interest in a closely held business or professional practice to be the marital estate’s most valuable asset. In many states, when the owner-spouse brings this asset to the marriage, a valuator may be called upon to distinguish between active appreciation in the business’s value (which is subject to division) and passive appreciation (which isn’t).

Appreciating the difference

Typically, when a spouse owns an interest in a closely held business before marriage, that interest is considered his or her separate property. In many states, appreciation in the value of the interest during the life of the marriage due to the owner-spouse’s efforts is considered marital (or community) property. Thus, it’s subject to division. Passive appreciation in the interest’s value during the marriage retains its character as separate property. (It’s critical that state law also be accounted for.)

Passive appreciation may result from a variety of market forces and other external factors, including:

• General economic growth,
• Industry growth,
• Financial changes, such as in interest rates, markets or credit policies,
• Legislative or regulatory changes,
• Demographic trends, and
• Consolidations and other changes in the competitive landscape.

Active appreciation, on the other hand, is attributable to the owner-spouse’s active management of the business.

Picture this

Here’s a simple example to illustrate the difference between active and passive appreciation. When Michelle married Pete, she owned a parcel of undeveloped land worth $300,000. When they divorced ten years later, the land remained undeveloped, but its value had increased to $1.3 million as a result of changes in the local real estate market. The $1 million in growth during the marriage is passive appreciation and, therefore, isn’t subject to division.

But what if Michelle had built an office building on the property and marketed the space to local businesses, so that when she and Pete divorced the property was worth $4 million? Clearly, a significant portion of the property’s increase in value would be attributable to Michelle’s efforts, constituting active appreciation that’s subject to division.

In the case of real estate, allocating the growth in value between active and passive appreciation may be relatively straightforward. In this case, if undeveloped land in the same location would be worth $1.3 million, then arguably the additional $2.7 million in appreciation would be attributable to Michelle’s active efforts.

Blurred line

The line between active and passive appreciation becomes blurred, however, when a business is involved. After determining the value of the business at the beginning and end of the marriage, a valuator might use econometrics or other statistical methods to analyze and quantify the impact of various passive factors on business growth.

Among other aspects, the valuator will consider:

1. Whether property subject to passive appreciation changes its character,
2. The degree of the success of management efforts by an owner-spouse, and
3. The record of business growth and the level of growth attributable to management efforts.

The remaining appreciation in value is classified as active, but the valuator’s job isn’t done yet. Depending on the nature of the business, the valuator may also need to determine how much of that active appreciation is attributable to the owner-spouse’s efforts and how much, if any, is attributable to the efforts of others.

The inflation myth

Owner-spouses sometimes argue that a business’s growth during marriage is attributable primarily or exclusively to inflation and, therefore, is passive. Suppose, for example, that a business is valued at $5 million at the beginning of a marriage and at $10 million when the marriage ends 25 years later. Assuming a 3% inflation rate, $5 million would be worth more than $10 million at the end of the marriage by virtue of inflation alone. Therefore, an owner-spouse might argue, the entire amount of appreciation is passive.

The fallacy of this argument is apparent when you consider that, if it were valid, all businesses would grow at least at the rate of inflation. In the real world, of course, many businesses experience stagnant growth or fail. Indeed, studies of public company stock prices show that in most cases there is little, if any, correlation between inflation and business growth.

A critical distinction

Distinguishing between a business’s active and passive appreciation can have an enormous impact on how property is distributed in a divorce. It’s important for attorneys to understand the need for sophisticated valuation techniques in making this distinction. Valuators also are instrumental in challenging simplistic arguments such as the inflation theory.

Why all the complexity? For the most part, the increasing use of fair value standards in financial reporting has put a spotlight on the accuracy of different valuation methods. The method a valuator uses can have a significant impact on the determined value of the customer relationships, so it’s important to understand their nuances.

Distinguished from goodwill

The International Glossary of Business Valuation Terms defines goodwill as “that intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.” At one time, goodwill was treated as a “wasting asset” for financial reporting purposes. In other words, it was assumed that goodwill’s value deteriorated over time. Thus, companies would capitalize goodwill and amortize it over a period of up to 40 years.

Under current accounting rules, however, goodwill is tested annually for impairment and recorded only if its fair value has dipped below its carrying amount. The value of goodwill is the portion of a business’s value that’s left over after determining the value of its tangible assets and identifiable intangible assets. It’s critical, therefore, to determine the value of identifiable intangibles, which generally are amortized over their useful lives.

Customer relationships are related to goodwill, but they are recognized as separate, depreciable assets if they have 1) an ascertainable value separate and distinct from goodwill and 2) a limited useful life that can be determined with reasonable accuracy. According to Accounting Standards Codification (ASC) 805, Business Combinations, an intangible asset is “identifiable” if either:

• It’s separable, meaning that it’s capable of being separated or divided from the entity and sold, transferred, licensed, rented, or exchanged, or
• It arises from contractual or other legal rights — regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.

Typically, customer relationships that can be valued separately from goodwill involve contractual rights, such as subscriptions, service agreements, supplier agreements, distribution agreements, licenses, leases and certain banking relationships.

It comes down to attrition

In the past, some valuators used a cost approach to value customer relationships. This means that the value was based on the cost of acquiring a new customer. Today, most valuators rely on the discounted cash flow or other income-based method to measure the future economic benefits a customer relationship is expected to produce.

One of the keys to estimating future income from existing customer relationships is to account for expected attrition over time. Several methods can be used when forecasting attrition. More sophisticated methods generally produce more accurate attrition rates and, therefore, may yield substantially different valuation results than simpler methods. Whether a more sophisticated analysis is appropriate depends on the level and detail of historical customer purchase data available.

Calculating CRA

The simplest method of forecasting attrition is constant rate attrition (CRA) analysis. The valuator analyzes historical customer purchase information, calculates an attrition rate for each period for which data is available and then develops a single, constant attrition rate for use throughout the forecast period. To develop a more accurate forecast — provided the data is available — the valuator could identify different attrition rates depending on the size of the customer relationship. For example, a bank may experience higher attrition rates for customers with smaller deposit account balances.

A more sophisticated approach involves actuarial attrition analysis, in which the valuator measures the impact of the age of a customer relationship on attrition. Like CRA analysis, actuarial analysis may also break down attrition rates by size. To develop meaningful correlations between customer ages and attrition rates, the valuator needs a significant amount of historical purchase data — generally going back at least five years.

Beyond financial reporting

Financial reporting requirements have elevated the importance of valuing customer relationships, but their value may be relevant in many contexts, including business acquisitions, tax litigation and shareholder disputes.

In addition to representing a significant component of business value, the nature and quality of customer relationships can affect business risk. For example, if a company relies on a few customers for the bulk of its revenues, the loss of just one could put it out of business. There may also be greater risk if a company’s clients are heavily concentrated in one industry or geographical area.

Valuators can take these risks into account in different ways. They might reduce income forecasts or increase the discount rate used to calculate present value.

Assessing reliability

In cases where the value of customer relationships is a significant component of business value, attorneys need to be familiar with the various valuation methods and their limitations. Even relatively small variations in attrition rates can have a big impact on value.

More sophisticated methods are generally more precise, but whether these methods are appropriate depends on the availability of historical data in sufficient volume and detail to produce reliable results.

According to the Federal Circuit, the award “relied on speculative and unreliable evidence divorced from proof of economic harm linked to the claimed invention.”

Patent infringement

ResQNet involved the plaintiff’s patented terminal emulation technology, a system that links PCs with mainframe computers. The defendant marketed a terminal emulator program, called NewLook, which was found to infringe on one of the plaintiff’s patents.

The U.S. District Court for the Southern District of New York awarded damages of $506,305 for past infringement based on a hypothetical royalty of 12.5%, plus prejudgment interest. In arriving at this royalty rate, the plaintiff’s damages expert relied on seven licenses, five of which included various nonpatented services (and may or may not have involved the patent at issue) and two of which arose from the settlement of litigation over the infringed patent.

Georgia-Pacific factors

When a patent is infringed, U.S. patent law allows the holder to recover its lost profits, which in no event are to be less than a “reasonable royalty.” Typically, a reasonable royalty is calculated based on the amount that would have been agreed to in a hypothetical negotiation occurring immediately before the infringement began.

In determining this amount, courts generally consider the 15 factors established in the landmark case of Georgia-Pacific Corp. v. U.S. Plywood Corp. Pertinent factors in this case included:

• The nature of the patented invention,
• The extent of the infringer’s use of the invention,
• Actual royalties received by the patent holder for licensing the patent,
• Rates paid by licensees for comparable patents,
• The established profitability of products that use the patented technology,
• The patent’s duration, and
• The lease term.

In ResQNet, one of the many ways the plaintiff’s evidence fell short was that the plaintiff’s expert relied exclusively on only one of the Georgia-Pacific factors: royalties received for actual licenses of the patent at issue. He dismissed the other factors, with scant explanation, as having “no real impact here.”

Speculative evidence

The specific licenses the expert relied on also proved to be a problem for the plaintiff. Five of the seven licenses furnished both software and services, such as training, maintenance, marketing and upgrades. These licenses involved high royalty rates in the 25% to 40% range. And they didn’t refer to the patent at issue or show “any other discernible link” to the technology involved in the case.

“The inescapable conclusion,” the Federal Circuit said, “is that [the plaintiff’s expert] used unrelated licenses on marketing and other services — licenses that had a rate nearly eight times greater than the straight license on the claimed technology in some cases — to push the royalty up into double figures.”

The other two licenses were “straight licenses” — that is, they were limited to the technology in question. But they were also unreliable measures of a reasonable royalty. Both licenses arose out of the settlement of patent litigation. One was a lump-sum stock payment that couldn’t be converted into a running royalty rate. The other applied an ongoing rate that averaged substantially less than 12.5%.

Noting that the hypothetical negotiation of a reasonable royalty occurs before infringement, the Federal Circuit explained that license terms arising in a litigation context are not reasonable indicators of an “established royalty” because they may be strongly influenced by a desire to settle the matter and avoid further litigation.

The Federal Circuit also found that the district court’s award was unduly influenced by the defendant’s decision not to offer expert testimony to rebut the plaintiff’s damages calculations. The plaintiff had the burden of proof, the Federal Circuit explained, and the defendant had no obligation to rebut until the plaintiff “met its burden with reliable and sufficient evidence,” which the plaintiff failed to do in this case.

Important guidance

ResQNet provides valuable guidance for lawyers involved in patent litigation, and shows the importance of considering all of the Georgia-Pacific factors in calculating a reasonable royalty, particularly when actual licenses of the technology in question are unreliable.

Moreover, it’s a good idea for defendants to provide expert rebuttal testimony, regardless of weaknesses in the plaintiff’s case. Even though such testimony is technically unnecessary if the plaintiff fails to meet its burden of proof, relying on an appeals court to prove the defendant’s point can be a costly exercise.

October 2007 valuation date

Mistretta involved the valuation of a restaurant business for purposes of equitable distribution in a marital dissolution case. The trial court used Oct. 31, 2007, as the valuation date, though final judgment wasn’t entered until Aug. 25, 2008. The court valued the business at $845,000 and ordered Mr. Mistretta to make a cash “equalization payment” to Ms. Mistretta based largely on the business’s value as of Oct. 31, 2007.

Mr. Mistretta moved for rehearing, arguing that the economic recession that began in December 2007 caused the business to sustain an almost $58,000 loss in 2008 and that this “newly discovered evidence” warranted a new trial and revaluation of the business. The trial court granted Mr. Mistretta’s motion on equitable grounds, noting that the “present recessionary economy was totally unforeseen” and that “no one could reasonably anticipate the severity of same.”

Changed circumstances not enough

The court of appeal reversed the trial court’s ruling, explaining that “newly discovered evidence” sufficient to warrant a new trial “cannot simply show some change in circumstances since the trial.” In this case, the alleged new evidence consisted of a recession that began months after the valuation date and financial results that weren’t available until well after the trial.

The court also discussed the impact of subsequent events on business valuation. A valuation involves projections of future financial results that depend “not only on known or knowable facts already in existence, but also on assumptions about the future that will not always, if ever, be entirely accurate.”

Recessions, the court said, “like other vagaries in the business cycle, are contingencies appraisers must take into account in valuing a business.” But the fact that the future turns out differently than business appraisers assumed is not a basis for a new trial.

Moreover, there was no reason to believe that a revaluation of the business would be any more reliable than the original. The trial court emphasized that the recession’s impact “was essentially unknown to . . . various experts who provided testimony,” but it didn’t explain, the appellate court observed, why those experts “were more likely to predict future economic conditions accurately on rehearing.”

For example, the appellate court said, “The parties’ experts might not have predicted the precise economic conditions on April 6, 2009, the day the order under review was entered, or, for that matter, the reported improvements in economic conditions since.”

Are subsequent events ever relevant?

Mistretta confirms that, when valuing a business, appraisers generally shouldn’t consider events that take place after the valuation date. This principle is supported in various published valuation standards.

The AICPA’s Statement on Standards for Valuation Services, for example, instructs valuators that “subsequent events are indicative of conditions that were not known or knowable at the valuation date, including conditions that arose subsequent to the valuation date. The valuation would not be updated to reflect those events or conditions.” (Different standards apply to financial reporting; see the sidebar “Accounting for subsequent events.”)

Some courts and valuation experts believe that subsequent events are properly considered in valuing a business if they were reasonably foreseeable on the valuation date or, even if they weren’t reasonably foreseeable, they provide evidence of the business’s value on the valuation date. An example of the latter might be a post–valuation-date sale of the business being valued or of a comparable interest in a guideline public company, provided market conditions haven’t materially changed since the valuation date.

Critics of this approach argue that fair market value is based on what willing buyers and sellers know or reasonably should know on the valuation date and that subsequent events, by definition, don’t fall within that category. They also point out that market conditions change on a daily basis and depend on a variety of internal and external factors, so it’s difficult to determine whether market conditions have changed (and if so, how much), even shortly after the valuation date.

Handle with care

Even in courts that accept evidence of subsequent events, the circumstances under which they’re relevant to business valuation are limited. So it’s important for you and your valuation experts to consider this issue carefully before relying on events that take place after the valuation date.