Case Studies
Annals Of Business
Lessons and Observations from Our Consulting Practice
The Valuation Engagement that We Lost (In fact, we told the potential client that he didn’t need us.)
A business owner, one of two partners, contacted us to discuss a valuation for a partnership buy-out of their $60 million company (2022 revenue). In such circumstances, our usual practice is to first review any partnership, buy/sell, and operating agreements. We consider the conditions that are stated in the agreements, along with other information that we learn during the preliminary meeting or telephone call, to develop an estimate of our effort and to draft an engagement letter.
In this case, buried within the partnership agreement’s Paragraph 12 (A) was the valuation formula to apply during a partnership buy-out. The formula was something that the firm’s CPA could easily calculate, and the partners didn’t need our valuation services. We informed the potential client of this, and he was most pleased and grateful. Please read “The Buy/Sell Changes Everything” below for another illustration of how partnership agreements affect valuations.
The Buy/Sell Changes Everything
In this business, four partners held equal shares. Three partners were related, and their recent treatment of the fourth partner (after nearly 35 years together) told her that it was time to leave the partnership. The partners asked Dover Valuations to conduct a fair market value of the departing partner’s 25% interest. Fair market value requires, among other things, that the valuation analyst assess what a hypothetical buyer would pay for the interest in an arm’s length transaction and while having knowledge of all the relevant facts. Without certain, contractual protections, a hypothetical buyer would probably pay zero, or close to zero, to purchase a 25% interest in what is essentially a family business where the other partners could easily combine their votes and overwhelm the minority partner. And the three family members would certainly not agree to the protections that a minority investor would likely require.
Upon our examining the partnership and buy/sell agreements, we discovered that 1) the minority partner was prohibited from selling her interest to anyone outside the business, and 2) the business itself, or the other partners, were obligated to purchase her 25% interest. Therefore, our valuation became not a fair market value approach, but instead a valuation of the departing partner’s interest to the business or to the remaining three partners.
As the AICPA and the courts have stated, valuation is very fact- and circumstances-specific, and the valuation analyst must consider all pertinent elements of the particular valuation situation. In this case, the extant agreements, especially the buy/sell, greatly influenced the valuation approach and outcome.
Not Fair to the Homeowner
A homeowner felt that the town assessor had overvalued his property, resulting in higher real estate taxes. He asked Dover Analytics to investigate and possibly challenge the town’s assessment. Instead, we formulated a different strategy that demonstrated a statistical difference not in the valuation method, but in its application. By simply presenting our report to the local assessor, the homeowner received an immediate 12% (about $5.7K) property tax abatement.
The Company You Keep
A proud and prominent family, with a long history of public service and philanthropy in its home country, asked Dover Analytics to conduct due diligence analysis of a potential US private-fund investment. The family is especially concerned with protecting its good name and reputation, so our analyst closely scrutinized the fund managers’ methods for soliciting and vetting investors, among other tests and analyses. We found what we assessed as highly inadequate anti-money laundering (AML) safeguards, and Dover Analytics’ opinion was that the risks of the family becoming inadvertently and indirectly associated with fund investors of dubious character and probity were greater than normal. Fearing the scandal in their country that such an association would bring, the family declined the investment. Subsequent events confirmed our recommendations.
An Honest Man
In collaboration with a CPA firm representing the buyer, we conducted a due diligence examination of a potential business acquisition. Our examination was complicated somewhat by the target’s job tracking and invoicing system that didn’t cleanly integrate with its accounting software, but we tied all transactions through complete audit trails. This single-owner corporation had periodic, large deposits that didn’t correspond to any invoices. We questioned this, and the owner told us that he reimbursed the business for his family’s personal use of corporate credit cards. This is unusual in such a situation: Owners typically justify these expenditures in various ways and let the businesses absorb the costs. “I think that we found an honest man,” remarked an analyst. We all agreed. Keeping well-organized and “clean” books and records not only helps audit-proof a business, it also gives potential buyers clear financial pictures that build confidence and trust in the counterparty. In this case, the buyer was very pleased with his acquisition, and the seller received a good price and favorable terms for his business.
The Case of the Missing Margin
One client, a major consumer products conglomerate, had agreed to sell one of its businesses for more than $500 million. Our analyst was asked to help construct the business’ balance sheet so that the buyer could see precisely what it was purchasing. During his investigation, the analyst discovered that another of the conglomerate’s operating units had been systematically allocating many of its costs to the business that was to be sold. This had the effect of increasing the allocating unit’s margins, while artificially decreasing those of the other business.
Our analyst reported this situation to his contacts at the client company. His analysis showed that the allocating business unit would soon suffer what would appear as depressed margins because, with the sale of the other business, it no longer had a convenient place to park some of its costs, and that is exactly what happened. Although the misallocations had no effect on the firm’s consolidated results, management was not prepared for the unfavorable margin surprise in the company’s core business.
A lesson from this is that all firms must be in complete control of their costs, and that vigilant, arm’s length internal audits are more necessary as a firm’s senior management becomes further removed from daily operations.