Business Valuation –
What Tennessee Judges Need to Know
Presented by:
Robert Vance, CPA, ABV, CFF, CVA, CFP
Forensic & Valuation Services, PLC
901-507-9173
www.ForensicVal.com
[email protected]
If You Don’t Remember Anything Else Today
The Essence of a Business Valuation
A business valuation is essentially the Present Value of the
future expected benefits (cash flow)
The particular owner’s interest is being valued, not the
entire company (unless he/she owns 100%)
A closely-held business is, in reality, only worth the present
value of the future cash flow over and above a “normal”
owner compensation; a.k.a Ongoing Earning Capacity
The Ongoing Earning Capacity is the return on investment
the willing buyer “receives” by investing in this particular
business
Standard of Value in TN: Fair Market Value
Definition per IRS Revenue Ruling 59-60
“The price at which a property would change hands between a
willing buyer and a willing seller when the former is not under
any compulsion to buy and the latter is not under any
compulsion to sell and both parties have reasonable knowledge
of the relevant facts.”
Do we presently have or do we need an official “Divorce”
Standard of Value?
Standard of Value in TN: Fair Market Value
Powell v. Powell - 2003
 The Fair Market Value Standard as in IRS Rev. Rul. 59-60
does not have to be strictly followed when valuing a closelyheld business in a Tennessee divorce
 What does that mean? We must follow case law even if it is
contrary to generally accepted procedures and methods used
in non-divorce valuations such as in the application of
discounts and allocation of goodwill
124 S.W.3d 100 (Tenn. Ct. App. 2003)
Three Approaches to Valuation
Each with Underlying Methods
1) Asset Approach
 Think of a balance sheet; Identifiable Tangible & Intangible
Assets Adjusted to FMV – Liabilities
2) Market Approach
 Think of this as being similar to pricing your home for sale
using comps in the neighborhood
3) Income Approach
 Net present value of expected future benefit, usually cash
flow, with the discount rate being risk adjusted
What is Included in Each Approach?
The inclusion of both Personal and Enterprise
Goodwill is implied in the final conclusion of value
using the valuation approaches of :
Market Approach - Yes
Income Approach - Yes
Asset Approach - No
Usually all assets and debts of the business are
included with the Market and Income Approach
conclusions of value
Normalization Adjustments
Usually must be made to any set of financials or tax
returns used as a valuation basis
1. Owner’s compensation and perks
2. Personal expenses & excess fringes run through the company
3. Non-recurring and/or one-time events
4. Non-operating assets
 Real estate, excess cash, obsolete inventory, cars, airplanes,
vacation homes, yachts, etc.
The Asset Approach
Fred Jones, Jr., DDS d/b/a Mid-South Smiles Factory
Adjusted Net Asset Value Method
Unadjusted
Balance Sheet
Per Internal
Books
Adjustments
Adjusted
Balance
Sheet
Cash
Accounts Receivable
Supplies
Equipment
Total Assets
$15,000
0
0
55,000
70,000
$0
65,000
4,500
120,000
189,500
$15,000
65,000
4,500
175,000
259,500
Accounts Payable
Credit Cards
Business LOC
Payroll Taxes Due
Total Liabilities
0
0
(20,000)
(3,500)
(23,500)
(35,000)
(9,500)
0
0
(44,500)
(35,000)
(9,500)
(20,000)
(3,500)
(68,000)
Book Value a.k.a. Net Equity
$46,500
$145,000
$191,500
The Market Approach
Fred Jones, Jr., DDS d/b/a Mid-South Smiles Factory
Market Transaction Method Using The Goodwill Registry for General Dentistry
Total Value
Gross Revenues
Goodwill Registry Average Price/Rev %
Indicated Selling Price - Includes Equipment
$925,000
66.6%
$616,050
Total Goodwill Value
Gross Revenues for Year
Goodwill Registry Average GW/Gross Revenues %
Indicated Goodwill Included in Selling Price
$925,000
49.2%
$455,100
The Income Approach
Capitalization of Earnings Method
Developing an Ongoing Earning Capacity
Dec
2014
Dec
2013
Dec
2012
Dec
2011
Net Income Reported
Normalizing Adjustments:
Actual Deducted Compensation
Mean Compensation for Independent Dentists
$15,500
$12,500
$10,000
$11,500
$8,500
475,000
(240,000)
250,500
435,000
(235,000)
212,500
375,000
(225,000)
160,000
362,500
(220,000)
154,000
350,000
(205,000)
153,500
16,500
267,000
1
267,000
16,500
201,750
(15,650)
186,100
(12,097)
174,004
(43,501)
130,503
15,650
(10,000)
136,153
18,000
230,500
1
230,500
18,000
16,250
176,250
1
176,250
16,250
17,500
171,500
1
171,500
17,500
10,000
163,500
1
163,500
10,000
Adjusted Net Income
Adjusted Depreciation and Amortization
Weight
stream weight
Depreciation and Amortization
Weighted Average
Less: Ongoing Depreciation/Amortization
Taxable Base
State Taxes
6.50%
Federal Tax Base
Less: Federal Taxes
25.00%
Sub-Total
Add Back Ongoing Depreciation/Amortization
Expected Ongoing Capital Expenditures (CapEx)
Ongoing Earnings Capacity
Future cash flow over and above a “normal” owner compensation
Dec
2010
The Income Approach
Capitalization of Earnings Method
Developing an Ongoing Earning Capacity
Dec
2014
Dec
2013
Dec
2012
Dec
2011
Net Income Reported
Normalizing Adjustments:
Actual Deducted Compensation
Mean Compensation for Independent Dentists
$15,500
$12,500
$10,000
$11,500
$8,500
475,000
(240,000)
250,500
435,000
(235,000)
212,500
375,000
(225,000)
160,000
362,500
(220,000)
154,000
350,000
(205,000)
153,500
16,500
267,000
3
801,000
49,500
239,708
(16,958)
222,750
(14,479)
208,271
(52,068)
156,203
16,958
(10,000)
163,162
18,000
230,500
2
461,000
36,000
16,250
176,250
1
176,250
16,250
17,500
171,500
0
0
0
10,000
163,500
0
0
0
Adjusted Net Income
Adjusted Depreciation and Amortization
Weight
stream weight
Depreciation and Amortization
Weighted Average
Less: Ongoing Depreciation/Amortization
Taxable Base
State Taxes
6.50%
Federal Tax Base
Less: Federal Taxes
25.00%
Sub-Total
Add Back Ongoing Depreciation/Amortization
Expected Ongoing Capital Expenditures (CapEx)
Ongoing Earnings Capacity
Dec
2010
The Income Approach
Capitalization of Earnings Method
Developing an Ongoing Earning Capacity
Dec
2014
Dec
2013
Dec
2012
Dec
2011
Net Income Reported
Normalizing Adjustments:
Actual Deducted Compensation
Mean Compensation for Independent Dentists
$15,500
$12,500
$10,000
$11,500
$8,500
475,000
(240,000)
250,500
435,000
(235,000)
212,500
375,000
(225,000)
160,000
362,500
(220,000)
154,000
350,000
(205,000)
153,500
16,500
267,000
1
267,000
16,500
201,750
(15,650)
186,100
(12,097)
174,004
(43,501)
130,503
15,650
(35,000)
111,153
18,000
230,500
1
230,500
18,000
16,250
176,250
1
176,250
16,250
17,500
171,500
1
171,500
17,500
10,000
163,500
1
163,500
10,000
Adjusted Net Income
Adjusted Depreciation and Amortization
Weight
stream weight
Depreciation and Amortization
Weighted Average
Less: Ongoing Depreciation/Amortization
Taxable Base
State Taxes
6.50%
Federal Tax Base
Less: Federal Taxes
25.00%
Sub-Total
Add Back Ongoing Depreciation/Amortization
Expected Ongoing Capital Expenditures (CapEx)
Ongoing Earnings Capacity
In perpetuity!
Dec
2010
The Income Approach
Capitalization of Earnings Method
Developing a Capitalization Rate Using the Buildup Method
Risk-free Rate of Return
Common Stock Equity Risk Premium
Small Stock Risk Premium
Company Specific Premium
Depth of Management
Importance of Key Personnel
Diversification of Product Line
Financial Structure
Company Specific Premium
Net discount rate
Less Sustainable Growth
Next Year Capitalization Rate
4.0%
6.0%
9.0%
3.0%
4.0%
1.0%
1.0%
9.0%
28.0%
3.0%
25.0%
Capitalization Multiple
4.00
$136,153
0.25
=
$136,153
1
0.25
=
4.00
x
1
0.25
The Income Approach
Even
Weighting
Capitalization Of Earnings Indicated Value
Ongoing Earning Capacity
Capitalization Rate
Indicated Value, Net of Debt
Capitalization Of Earnings Indicated Value
Ongoing Earning Capacity
Capitalization Multiple
Indicated Value, Net of Debt
Heavier
Recent
Weighting
Even
Weighting
Higher
CapEx
÷
=
$136,153
25.0%
$544,611
$163,162
25.0%
$652,647
$111,153
25.0%
$444,611
x
=
$136,153
4.00
$544,611
$163,162
4.00
$652,647
$111,153
4.00
$444,611
Conclusion of Value
Fred Jones, Jr., DDS d/b/a Mid-South Smiles Factory
Conclusion of Value
Indicated
Value
Weight
Capitalization Of Earnings Method
Market Transaction Method
Adjusted Net Asset Value Method
Conclusion of Equity Value
75%
25%
0%
100%
$544,611
$616,050
$191,500
Weighted
Value
$408,458
$154,013
$0
$562,470
Personal Goodwill in a Tennessee Divorce
 Definition: The excess of the purchase price [or
value conclusion] of a company over its book value
which represents the value of goodwill as an
intangible asset (Merriam-Webster)
 Tennessee has a well-established case law history
that does not provide for the inclusion of Personal
Goodwill (a.k.a. professional goodwill) as an asset
of the marital estate, but does allow for the inclusion
of Enterprise Goodwill (a.k.a. business goodwill)
Personal Goodwill in a Tennessee Divorce
 Personal goodwill is generally not to be considered
in the valuation of professional practices and small,
closely-held businesses primarily dependent upon
the individual for success or profits
 Excellent staff, branded name that is not the owner’s
name, equipment in place, ancillary services,
superior location, etc. make profit “independently”
from the owner - like widget machines in a widget
factory
Personal Goodwill in a Tennessee Divorce
 Fair Market Value standard inherently includes both
Personal and Enterprise Goodwill when valuing with
a going concern premise
 The inclusion of both Personal and Enterprise
Goodwill is implied using the valuation Approaches
of Market and Income, but not Asset
Fred Jones, Jr., DDS
d/b/a Mid-South Smiles Factory
Mid-South
Smiles Factory
Fred Jones, Sr., DDS
Fred Jr. vs. Sr.
Who has more Enterprise Goodwill?
Jr.
Personal Goodwill in a Tennessee Divorce
Hazard (1991) - No Goodwill Allowed
 Dr. Hazard’s practice was highly specialized and very
dependent upon personal referrals from other physicians
 Goodwill in a professional practice is not a marital asset
subject to equitable distribution
 Sole practitioner professional practice is to be valued using
the “net tangible assets with ascertainable value.” Cites Smith
v. Smith
 Net Asset Value a.k.a. Net Book Value
Hazard v. Hazard, 833 S.W.2d 911 (Tn. Ct. App. 1991)
Personal Goodwill in a Tennessee Divorce
Witt (1992) - Enterprise Goodwill Allowed



If the professional practice or closely-held business is large
and diverse enough and not solely dependent on the
individual, goodwill may be considered as part of the
ownership interest
Dr. Witt’s clinic was found to have separate goodwill that was
not directly related to his professional or personal goodwill
Size Does Matter
Witt v. Witt, No. 01-A-019110CH00360, 1992 WL 52746 (Tenn. Ct. App. Mar.
20, 1992)
Personal Goodwill in a Tennessee Divorce
Eberting (2012) - Enterprise Goodwill Allowed



Orthodontia practice value at FMV by Vance at $700k;
included Enterprise (not Personal) Goodwill
Opposing expert valued practice At $224k (net book value
with no Goodwill)
Trial judge found value to be $500k, which was a value
indicated by the owner in a personal financial statement;
judge knew that any value north of $224k was including
Goodwill
Eberting v. Eberting, No. E2010-02471-COA-R3CV, 2012 WL 605512 (Tenn.
Ct. App. Feb. 27, 2012)
Personal Goodwill in a Tennessee Divorce
Hartline (2013) – No Goodwill Allowed





W’s expert used an income approach which included
enterprise goodwill; H did not
Did not brand his name separately
Confusion of professional vs. personal goodwill
terminology?
Trial: value between $468k and $500k which included
goodwill
Appellate court remanded for a value with no goodwill
Hartline v. Hartline, No. E2012-02593-COA-R3CV, 2014 WL 103801 (Tenn.
Ct. App. Jan. 13, 2014)
Personal Goodwill in a Tennessee Divorce
Hartline (2013) – No Goodwill Allowed


“..sole practitioner of an unincorporated dental practice,
whether his business could continue without him is
speculative, leading to the conclusion that the goodwill of
Husband’s practice should not be considered in valuing said
practice.”
No separation of personal from enterprise goodwill, thus
baby out with the bath water (from my analysis)
Personal Goodwill in a Tennessee Divorce
Barnes (2014) – Enterprise Goodwill Allowed





Enterprise goodwill allowed in dental practice
Practice branded with the name of Shelbyville Family
Dentistry with large staff and great location
H’s expert used income approach-$735k
Income approach provides for goodwill (enterprise &
personal)
Personal goodwill of $678k calculated using present value of
two years of Dr. Barnes’ salary plus benefits, then deducted
from the $735k value to arrive at $57k
Barnes v. Barnes, No. M2012-02085-COA-R3-CV, 2014 WL 1413931 (Tenn.
Ct. App. Apr. 10, 2014)
Personal Goodwill in a Tennessee Divorce
Barnes (2014) – Enterprise Goodwill Allowed



W’s expert used the Multi-Attribute Utility Model (“MUM”)
method although not identified as such; goodwill of 30% was
deemed personal
Goodwill Allocation: ratio of associate’s years of service of
12 ÷ Barnes’ years of 21 x goodwill of $678 = $349k (math
error; deduction should have been $387k not $349k)
Trial court used H’s expert figure of $735k less personal
goodwill of $349k leaving enterprise value of $386k
Personal Goodwill in a Tennessee Divorce
Barnes (2014) – Enterprise Goodwill Allowed



Applied a Discount for Lack of Marketability (“DLOM”) of
15% to arrive at $328k
Value upheld by appellate court, but, held that DLOM was
error based on Bertuca
Valuation should not have been impacted by the lack of
marketability of H’s interest, unless of course there was some
indication that a sale of his interest was necessary or
desirable
Allocating Personal vs. Enterprise Goodwill
Conclusion of Equity Value
Capitalization Of Earnings Method
Market Transaction Method
Adjusted Net Asset Value Method
Conclusion of Equity Value
Indicated
Value
$544,611
$616,050
$191,500
Weight
75%
25%
0%
100%
Enterprise Goodwill Component Breakdown Using a Build-Up
Conclusion of Equity Value
Less Adjusted Book Value a.k.a. Net Equity
Total Implied Goodwill (a plug figure using this build-up)
Weighted
Value
$408,458
$154,013
$0
$562,470
$562,470
(191,500)
$370,970
Allocating Personal vs. Enterprise Goodwill
Find an objective method to analyze subjective data
Multiattribute Utility Model (MUM)
Decision making matrix for applications such as:
 Placement of surplus weapons-grade plutonium
 Plant and treatment facility locations
 Restoration of contaminated ecosystems in the former Soviet
Union
 An now allocation of goodwill between personal and
enterprise
Personal Goodwill Attributes
Ability, Skill & Judgment
Lacks Transferability
Age & Health
Personal Staff
Personal Reputation
Personalized Name
Marketing & Branding
In-bound Personal Referrals
Knowledge of End User/Customer
Important Personal Nature
Total Personal Utilities
Total Personal Multiplicative Utility
Enterprise Goodwill Attributes
Enterprise Staff
Business Reputation
Business Name
Marketing & Branding
Business Locations
Years in Business
Systems & Organization
Out-bound Referrals
Repeating Revenue Stream
Total Enterprise Utilities
Total Enterprise Multiplicative Utility
Total Multiplicative Utility
1
2
3
4
5
6
7
8
9
10
1
2
3
4
5
6
7
8
9
Importance
Existence
Multiplicative
Utility
Utility
Utility
Percent
4
5
5
3
4
4
2
5
2
3
37
4
0
3
2
3
3
2
2
2
2
23
16
0
15
6
12
12
4
10
4
6
7.8%
0.0%
7.3%
2.9%
5.9%
5.9%
2.0%
4.9%
2.0%
2.9%
85
41.5%
Importance
Existence
Multiplicative
Utility
Utility
Utility
Percent
5
4
5
4
5
4
3
3
5
38
4
3
4
4
3
2
2
1
4
27
20
12
20
16
15
8
6
3
20
9.8%
5.9%
9.8%
7.8%
7.3%
3.9%
2.9%
1.5%
9.8%
120
205
58.5%
100.0%
Allocating Personal vs. Enterprise Goodwill
Enterprise Goodwill Component Breakdown Using a Build-Up
Conclusion of Equity Value
Less Adjusted Book Value a.k.a. Net Equity
Total Implied Goodwill (a plug figure using this build-up)
$562,470
(191,500)
$370,970
Allocation of Goodwill Between Personal and Enterprise
Total Implied Goodwill
Estimated Personal GW % per MUM
Estimated Personal GW $ per MUM
$370,970
41.5%
$153,817
Total Implied Goodwill
Estimated Enterprise GW % per MUM
Estimated Enterprise GW $ per MUM
Estimated "Divorce" Value Available for Equitable Distribution
Conclusion of Equity Value
Less Estimated Personal GW $ per MUM
Total "Divorce" Value
$370,970
58.5%
$217,153
$562,470
(153,817)
$408,653
Calculating Discounts and Premiums
Depend on the interest to be valued and the techniques
used to establish the value conclusion




Discount for lack of control (DLOC)
Premium for control
Discount for lack of marketability (DLOM)
Key person discount
Calculating Discounts and Premiums
Discount for Lack of Control a/k/a Minority Interest
Discount




Shares of stock or an LLC or partnership interest that is 50%
or less in total ownership is worth less per share than if 51%+
is owned by an individual
Lack of control in a closely held company implies you are at
the mercy of the controlling owner(s)
Substantial discounts may be necessary to attract an investor
to purchase a minority interest in a closely held company
Could be in the range of 15% to 50%
Calculating Discounts and Premiums
Discount for Lack of Marketability

The time required to convert an ownership interest to cash
affects the level of marketability
 Factors that affect marketability:
 Distributions of earnings
 Active market or industry roll-up
 Key person
 Number and profile of owners e.g., family owned
 Restrictions on transfer of stock
 This a real discount despite Bertuca
Business Valuation Summary
1. A business valuation is essentially the Present Value of the
future expected benefits (cash flow) over and above a
“normal” owner compensation
2. The particular owner’s interest is being valued, not the entire
company (unless he/she owns 100%)
3. The Ongoing Earning Capacity is the return on investment
the willing buyer “receives” by investing in this particular
business
4. The inclusion of both Personal and Enterprise Goodwill is
implied in the final conclusion of value using the Market &
Income Approaches
Business Valuation Summary
5. Usually all assets and debts of the business are included with
the final conclusion of value using the Market & Income
Approaches
6. Scrutinize the normalization of Owner’s compensation
7. Heavier weighting reflects the analyst’s future expectations
8. Capital Expenditure (CapEx) estimate must be based on
history or future expectations in perpetuity
9. The market comps should be close under Market Approach
10. Personal goodwill is generally not to be considered in the
valuation of professional practices and small, closely-held
businesses primarily dependent upon the individual for
success or profits
Business Valuation Summary
11. Staff, branded name, equipment, ancillary services, location,
etc. make profit “independently”
12. Enterprise goodwill has been allowed in Tennessee cases on
numerous occasions
13. A Discount for Lack of Control (DLOC) may be applicable
for a 50% or less interest
14. A Discount for Lack of Marketability (DLOM) can be a real
issue despite Bertuca
Thank You!
Robert Vance, CPA, ABV, CFF, CVA, CFP
Forensic & Valuation Services, PLC
901-507-9173
www.forensicval.com
[email protected]