Many business valuation cases work their way through the courts each year, but only some of them have a significant impact on the profession. Here are some important excerpts from those cases.

1. Excess earnings method is alive and well.

Although the excess earnings method has its critics, it is in use and it stands up in court, especially when valuing small businesses and professional practices. It was the method one party demanded and the court approved in a New York City divorce case that centered on valuing the wife’s dental practice. “The appraiser came in with a price-to-revenue method,” but “the wife’s attorney contested the appraisal and insisted on his doing an appraisal with the excess earnings method.”

Under this method, also called the “formula” or “hybrid” method (because it combines the cost and income approaches), the market value of net tangible assets is multiplied by an appropriate rate of return to calculate earnings attributable to the tangible assets. This figure is then subtracted from total earnings to calculate earnings on the intangible assets, a number that is then divided by a capitalization rate to determine the value of the intangibles. The excess compensation method is often used as an alternative excess earnings method, whereby the compensation of the professional is compared with normalized compensation for a similar professional and the excess compensation is capitalized and added to the tangible assets to determine the professional’s interest in the practice.

The court adopted it because of the unique nature of a professional practice in New York City. It said that the method “took into account the absence of tangible assets or a leasehold and factored in the goodwill, based on three generations of dentists in [wife’s] family.”

This cases aligns with a number of other divorce cases in the last few years where this methodology has been approved by the courts and the courts really seem to like it.

A.C. v. J.O., 2013 N.Y. Misc. LEXIS 3524 (Aug. 12, 2013)

2. Courts toughen stance on patent damages.

Apportionment is the key issue in the Dynetix case, particularly the Federal Circuit’s requirement that a plaintiff’s expert find the “smallest salable unit” in developing the royalty base. However, it has become increasingly clear that finding the smallest saleable unit is not enough. The Dynetix court says that you have to dig deeper. Also, the facts in this case are critical to the court’s finding because it notes that the product at issue featuring the patented component had many other components. In fact, the patented component was optional.

It is truly difficult to get down to what is a separate salable unit. It is somewhat speculative in itself. It is interesting because in this case the expert was the plaintiff’s expert. You would think that the plaintiff who held the patent would have some idea.

In this case, the court excluded the expert—but recognized how difficult it is to do the apportionment. So the court allowed the plaintiff and the expert to update the report and come back one more time

Dynetix Design Solutions, Inc. v. Synopsis, Inc. 2013 U.S. Dist. LEXIS 120403 (Aug. 22, 2013)

3. Be prepared to explain to the court how your approach differs.

In a divorce case, the appraisers on both sides came up with very different values for the husband’s business even though both used the capitalization of net income approach. At trial, the principal issues were the determination of the cap rate and the equity risk premium. The judge decided to appoint a third appraiser because the parties’ valuation experts failed to support their approaches.

The attorneys have to shoulder some of the blame. I think that where the attorneys missed the boat on this was by allowing it to get to where a judge had to get his own appraiser. They should have used direct and cross-examination to tease out the reasons for the experts’ different choices. In other words, each expert could have been able to explain why he or she was different from the other expert as to the cap rate.

The appeals court had a difficult time reviewing the case because the husband’s attorney had failed to build up a good trial record on which to challenge the lower court. When the husband went back on appeal arguing in favor of different values, it turned out that his attorney or the expert had never attached the Ibbotson Yearbook page that the husband tried to use in his argument,” There was really very little for the appellate court to say.

This case highlights the fact that you need to support in your report all of the issues that may come up to a judge, that may necessarily make your report a little bit longer, but it is going to be something worthwhile in the long run.

Alexander v. Alexander, 2013 Mich. App. LEXIS 1490 (Sept. 10, 2013) (slip op.)

4. DCF analysis needs solid support.

This bankruptcy case centered on a failed development project. The debtor developer tried to push through a third version of its reorganization plan under the Bankruptcy Code’s cram down provisions. Creditors objected that the plan was not feasible because it was based on the improperly low valuation of a building complex that made up most of the collateral that secured the bank’s claim; it did not provide for enough money to pay the secured claim.

Even though this is primarily a real estate valuation case, it includes noteworthy business valuation and discounted cash flow issues. Ultimately, the court’s decision homed in on whose expert was right as to the appropriate cash flow projections and why.

My takeaway from this case is that regardless of whether the issue is real estate being valued or valuing a business interest, if a DCF is used, it should be supportable in its assumptions and needs to be well explained to the court. That way, the court can make an informed decision and hopefully one that is in line with the value that was submitted by the expert.

Here, the debtor and its expert ran into cash flow-related problems in their analysis and argument. The debtor’s expert was left to explain why he believed that a lease that was critical to his projections was above fair market value when the debtor itself litigated over the right to use an even higher lease. The analysis also failed to include adequate maintenance and repair costs, and other variables.

The court wants to know, if it approves this plan, is there a reasonable probability that the reorganization is going to succeed. Ultimately, the court in this case said the plan was not going to succeed and you didn’t do a good enough job of explaining why it might.

In re Civic Partners Sioux City, LLC, 2013 Bankr. LEXIS 4225 (Oct. 7, 2013)

5. Some sanity returning to Daubert analysis?

A business interruption case that was appealed at the 7th Circuit Court of Appeals for review of the district court’s Daubert decision may restore some sanity to the Daubert review process. The plaintiff had claimed losses for the collapse of its office building in Paris. The defendant’s insurance company contested the claims, and the case found its way into federal court.

The district court excluded the plaintiff’s expert under Daubert even though it approved his methodology; it simply disapproved of the data he relied on in his analysis. The 7th Circuit found it went too far. Even though the court as a gatekeeper has some leeway in determining reliability, it is not unlimited. “Reliability, however, is a primary question of the validity of the methodology employed by an expert, not the quality of the data used in applying the methodology or the conclusions produced,” the appellate court said.

I think this decision is not so much a victory for expert witnesses as it is for reason and boundaries of the application of Daubert. He is concerned that the more a court injects its own opinion as to the data an expert uses, the greater the risk of protracted litigation. The lower court excludes proper expert testimony, and one party has to appeal to stay in the litigation.

Manpower, Inc. v. Ins. Co. of Pa., LLC, 2013 U.S. App. LEXIS 20959 (Oct. 16, 2013)

6. DE Court of Chancery rejects DCF to value merger stock.

In somewhat of a departure from its usual preference for the discounted cash flow approach, the Chancery opted for the market approach in a statutory appraisal action. The suit concerned the sale of a media company that owned “iconic” entertainment properties, including “American Idol” and “So You Think You Can Dance.” Minority shareholders contended the merger price did not reflect the fair value of the stock.

Both experts performed a DCF analysis. The Chancery faced what it called a “gulf” in proposed values. Specifically, one side said $4.41 a share, and the other came up with $11.02 a share. The court said that it couldn’t take either of these values because it is all speculative, so why not take the actual merger price. The court’s approach here should not be taken as some sort of precedent for valuations as a whole. The solution fit the circumstances of the case, but probably won’t fit many others.

This was a particular type of case, a shareholder dissent case, so keep that in mind as you are looking at this.

Huff Fund Investment Partnership v. CKx, Inc., 2013 Del. Ch. LEXIS 262 (Oct. 31, 2013)

7. Experts must be paid.

This Tax Court case involved the fair market value of a decedent’s 16.67% minority membership interest in a New York City LLC whose principal holding was a commercial building. It raised procedural issues related to expert testimony and valuation issues as to the methodology and discounts, specifically the discounts for lack of control and marketability. The IRS issued a deficiency notice and the estate came back and challenged it. Not only that, but it disavowed its initial appraisal. In its response to the IRS, it attached a new appraisal and basically tried to compel the government to stipulate to the alternative, even lower, appraisal. At the same time, it made clear that it was not going to be able to present the second appraiser in court because of a fee dispute.

The IRS refused to stipulate to this new expert testimony, and the court agreed, saying the estate tried to “end run our procedural rules with respect to expert testimony”. The court’s determination left the estate without any expert testimony with which to challenge the government’s discounts.

The estate might have a point in litigating the issue over how to characterize and value the decedent’s interest. Was it a full membership interest or just an assignee interest where a hypothetical willing buyer could only obtain an assignee interest?

The takeaway from this case is that the estate placed itself in a bind when it didn’t pay the second expert. That was really a strange situation there.

Estate of Tanenblatt v. Commissioner, 2013 Tax Ct. Memo LEXIS 273 (Nov. 18, 2013)