50 ways to lose your reputation with valuation mistakes in court

A review of the most common mistakes made by valuation experts when defending their practices in court.

Business valuation textbooks, training manuals and conference presentations may do a good job of teaching the technical machinations of performing a business valuation. However, a valuation expert's ability to explain his or her approach to the courts is also paramount to becoming a true expert.

We have collected examples of mistakes made by valuation experts concerning the value of privately held businesses, as reported in US federal courts in tax decisions and in Canadian cases generally.

There are two sides to every story, and courts do not always get it right. But right or wrong, the commentary is instructive.

1. Lacking clear explanation and ability to replicate

Failure to provide sufficient, clear details and explanations about how you arrived at the conclusion

Another valuator should be able to assess your work and replicate it at a high level after reviewing your report – both in principle and with a reasonable but necessarily complete level of numerical accuracy and with absolute accuracy after review of your working papers.

2. Pure reliance on case law for minority and liquidity discounts

Failure to tailor the proper valuation discounts to the facts regardless whether the discount is factored in as an element of the discount rate (sometimes characterized as implicit treatment) or applied as direct adjustment to value after the enterprise level value has been determined

Pure reliance on case law for determination of valuation discounts is inadvisable, particularly when the economics, facts and circumstances of the precedent cases do not reasonably parallel those of the subject interest.

3. Failure to find available information

Failure to find information that the judge or opposing valuator finds – the KIS principle here will not save you

Careful research will go a long way to ensuring you have a sound analysis. It will show the court that you are thorough and spared little to ensure you "got it right." It will leave the opposition with less to challenge you on and quite possibly leave it second guessing its own research process.

4. Insufficient explanation of assumptions and instructions

Failure to set out and explain assumptions that you make in a valuation report or instructions received and adopted will undermine not only your work but also your credibility and perceived independence

Failure to test the reasonableness of assumptions or instructions adopted is an equally common failing.

5. Failure to explain weightings and reconciliation of various approaches to valuation

Failure to explain how you weighted alternate inputs into your conclusion of value such as multiples or discount rates can leave you exposed and searching for answers at the wrong time

Where different valuation methods yield differing indications of value, you must be clear about how you use them to arrive at your conclusion and a qualitative explanation for the weighting of the indications of value, whatever they might be.

Failing to test the reasonableness of the primary valuation method by other methods and to reconcile those results is a related failure.

6. Failing to justify capitalization or discount rates

Failure to explain the basis for your selection of a capitalization or discount rate, including providing temporal benchmarks where relevant

You cannot make assertions out of thin air; you must justify them. While you must temper the capital asset pricing model or the buildup or other methods with experience, experience alone is not enough.

7. Inadequate use of comparable company data

Failure, where guideline companies exist, to include the names of guideline companies in the valuation report

If you don't have anything to hide, then why hide anything – perception is often reality. Ensure you do your due diligence, anchor your analysis on strong comparable companies and include the names of these companies in your report.

8. Failure to think Like an investor

Parking practical business and investor perspectives at the door is not advisable. Esoteric or academic rationales, even if correct, rarely gain traction.

9. Lack of independence

Failure to be, or appear to be, independent or to be an advocate for your client is not acceptable

This is fundamental to one's credibility on the stand. Being independent and objective is the first litmus test the court imposes before your conclusion is given any weight. If you fail this test you won't even get out of the batter's box – regardless of how good your report is. The case references in the endnotes should be mandatory reading for all.

10. Inconsistency

Failure to be consistent in all matters unless good reason is given for the alternative

Selective use of information, assumptions or approaches to artificially appear consistent when in fact you are hiding bona fide, contrary information or approaches is equally problematic – and a more common problem. In the vernacular, this behavior is sometimes called "cherry-picking."

Failure to reconcile your published related views, either proactively or at a later more appropriate time, is another related failure.

11. Incorrect definitions and improper use or explanation of them

Failure to define key terms in your report can lead to unnecessary confusion and can prove to be a major distraction for the courts and a major boon for the opposing counsel

Define all key terms in a clear and concise manner or risk spending an inordinate amount of time explaining a definition instead of your conclusion.

12. Giving the hypothetical buyer wings

Failure to consider the optimal array of buyers who would notionally pay the "highest price available"

While the valuator need not identify all such buyers or quantify the premium a strategic buyer would pay, ignorance of logical buyers and their motivations and circumstances will result in an uninformed valuation.

Equally, reconcile your notional buyer with the full array, at least in your working papers or thought process, may result in your hypothetical buyer not being realistically grounded.

13. Undue reliance on the work of other experts or other studies and data

Failure to not properly consider and test the work of another expert on whom you rely, such as an industry expert or real estate appraiser

The relying valuator cannot blindly rely on the work of others, but must make some an assessment of the accuracy and completeness of the other appraiser's work appropriate to the level of opinion being given.

Conclusion

Here 13 kinds of mistakes made by valuation experts, as reported in federal courts in tax decisions, were presented. Just because one judge in one case calls something a mistake doesn't make it a mistake in all cases – context is important. The examples, however, are indeed instructive in most valuation situations.

Technical editors: Stephen Cole, managing director, and Brandon Lewis, senior associate, Duff & Phelps Canada

About the Authors

Paul Hood


Paul Hood, Esq., is with the University of Toledo Foundation. He can be reached at paul@acadiacom.net

Timothy R Lee


Timothy R. Lee, ASA, is with Mercer Capital and can be reached at leet@mercercapital.com

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