Selected Valuation and Damages Terms
Book Value Method –a valuation method that uses the net worth of a company determined by either its balance sheet assets or the replacement cost of its balance sheet assets – minus liabilities. The legal term for what accountants call the “Cost Method.”
Calculation Engagement or Report – a type of valuation report that is limited in scope to a calculation of value. Not a comprehensive analysis and does not meet standards for an expert report.
Capitalization of Earnings Method – a valuation method that assumes either that the earnings of a business constitute an annual percentage return on the value of the business or, more accurately, that the present discounted value of all of the business’s earnings into the future is the current business value. The legal term for what accountants call the “Income Method.”
Comparable Sales Method – also referred to by accountants as the Market Method, a valuation method that relies on recent sales of similarly situated businesses. Because such prices are not estimates but actualities, the comparable sales method is generally preferred as the most realistic proof of fair market value but only when it is properly available. The legal term for what accountants call the “Market Method.”
Cost of Capital – see Discount Rate
Daubert – a U.S. Supreme Court case that set the standards for courts to allow expert testimony judged by Qualifications, Reliability and Helpfulness. Daubert v. Merrell Dow Pharmaceuticals, 509 U.S. 579 (1993)
Discounted Cash Flow (DCF) Method – an “Income” method of valuation based on cash flows from future operations. There are 3 steps:
- an estimation of net cash flows that will be generated over a projected period;
- computation of a terminal or residual value equal to the future value of the cash flows beyond the projection period; and
- the application of a discount rate (estimated cost of capital) to reduce to present value the projected net cash flows and the estimated terminal or residual value.
Discount Rate – the “opportunity cost,” that is, the expected rate of return (or yield) that an investor would have to give up by investing in available alternative investments that are comparable in terms of risk and other investment characteristics. The discount rate is the cost of capital for that particular category of investment. The discount rate is determined by market conditions as of the valuation date as they apply to the specific characteristics of the subject contemplated investment.
DLOM – Discount for Lack of Marketability, also referred to an illiquidity discount, is a reduction in value based on a lack of a public market for interests in the company or for other restrictions placed on the sale of those interests.
DMIN – Discount for Minority Ownership, also referred as a discount for lack of control, is a reduction in value to reflect the fact that the owner of a minority interest cannot control the daily activities or policy decisions of an enterprise.
EBITDA – Earnings Before Interest, Taxes, Depreciation, and Amortization
Exit Multiple Method - assumes that a business will be sold for a multiple of some market metric at the end of the term certain in the DCF method. Cf. Gordon Growth Model.
Fair Market Value (FMV) – what a typical (hypothetical) willing buyer will pay to a typical (hypothetical) willing seller, with neither being under undue influence to transact and both begin fully informed of the facts.
Fair Value – the amount that will fairly compensate an owner who was involuntarily deprived of the benefit of an asset – generally, FMV without discounts. Additionally, the Financial Accounting Standards Board (FASB) offers a definition of “fair value” which is the GAAP and financial reporting equivalent of “fair market value”, as follows: “The fair value of an asset (or liability) is the amount at which that asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced liquidation sale.” (FASB No. 142 ¶23).
Franchise Disclosure Document (FDD) – a legal document that the Federal Trade Commission (FTC) requires franchisors to provide to prospective franchisees before selling a franchise. The FDD is divided into twenty-three sections or “Items”, each of which requires a franchisor to disclose certain information to assist prospective franchisees in making a well-informed decision before investing in the franchise.
Goodwill – an intangible asset arising as a result of name, reputation, customer loyalty, location, products and similar factors.
Gordon Growth Model – also known as the Perpetual Growth Model, assumes that a business will continue to generate cash flows at a constant rate forever using the formula:
Terminal Value = Final Projected Year Cash Flow X (1+Long-Term Cash Flow Growth Rate)
(Discount Rate – Long-Term Cash Flow Growth Rate)
The formula simplifies the practical problem of projecting cash flows far into the future. But the formula rests on the assumption that the cash flow of the last projected year will stabilize (with or without stable growth) and continue at the same rate (or growth rate) forever. Cf. Exit Multiple Method
Highest and Best Use - the legally permissible and reasonably feasible present use, or series of future uses, that will result in the greatest economic benefit to the owner or user of the property.
Income Method – valuation method based on the earnings power or cash generation capabilities of the enterprise being appraised.
Item 19– section of the FDD where franchisors have the option to give Financial Performance Representations (formerly known as “Earnings Claims”).
Multiple of Earnings – a corollary of the Market or Comparable Sales Method that applies an industry rule of thumb multiplier to current net income. Although popular and simple to use as a valuation tool, this shorthand method has many weaknesses and may lead to the under valuation of a company with high growth potential.
Net Present Value – the value of future earnings reduced by a discount rate.
Normalizing Adjustments – non-recurring income and/or expense items that require pro forma adjustments to the financial results for valuation purposes. Examples include excess compensation, personal expenses run through the business, and Payroll Protection Program loans.
Revenue Ruling 59-60 – IRS ruling that defines the price at which the 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, both parties having reasonable knowledge of relevant facts. See Fair Market Value
Standard or Definition of Value – defines what type of value is being estimated. The alternative standards of value generally answer the question: value to whom?
Synergistic Value or Acquisition Value – the price a particular identified buyer would be expected to pay for an asset with consideration given to any unique benefits of the asset to the identified buyer.
Tax Affecting – a valuation assumption which applies a discount to the projected cash flow of pass-through entities like S corporations or LLCs on the assumption that they should be paying corporate taxes like a C Corporation.
Terminal Value – using the DCF valuation method, the value of future cash flows at the end of a finite or infinite term. See also, Gordon Growth Model and Exit Multiple Method.
SELECTED FINANCIAL AND ESTATE PLANNING TERMS
Administrator - a fiduciary appointed by a Probate or Surrogate’s Court to oversee the estate of a decedent who dies without a will.
Buy-Sell Agreement - a legal and binding contract between shareholders, LLC members or partners which, among other things, generally provides for transfers upon the death of a business owner and the means of funding such a buyout (most frequently with life insurance).
Charitable Lead Trust – an irrevocable trust which involves a gift of property to an irrevocable trust with payments by the trust to a qualified charity for a specified term of years or for the life of (typically) the grantor. Once all the required payments have been made, the charity’s “lead” interest terminates and the trust property is distributed to designated third parties. A charitable lead annuity trust usually provides for a fixed percentage of the trust’s assets, revalued annually, to be paid to the qualified charity. In both cases, the present value of the transferred property to be distributed to designated third parties at the termination of the “lead” interest will be a taxable gift.
Charitable Remainder Trust - a charitable remainder trust involves a transfer of property to an irrevocable trust with payments by the trust to a noncharity beneficiary (typically the grantor) for a specified term of years or for the life of the grantor. Once all of the required payments have been made, the grantor’s “lead” interest terminates and the trust property will be distributed to designated qualified charities as remaindermen.
Credit Shelter Trust - a trust, generally set up in a will, which provides that an amount (the “exemption equivalent”) equal to the maximum which can pass free of federal estate taxes (currently $12,060,000) shall be set aside before any gift to the surviving spouse which qualifies for the marital deduction. The purpose is to assure that both husband and wife take full advantage of the individual estate tax exemptions (i.e. $12,060,000 each or $24,120,000 free of estate taxes for their generation).
Durable Power of Attorney (Health Care) - sometimes called a “living will” or “health care proxy,” this is a legal document which appoints an Agent to act for someone who becomes incompetent -usually because of a medical condition. This also addresses issues like life support and medical review.
Durable Power of Attorney (Financial) - a legal document which appoints an Agent to take care of the financial affairs of someone who becomes incompetent -usually because of a medical condition.
Estate Tax - an excise tax levied on the estate, rather than the beneficiaries.
Estate Freeze - a mechanism which attempts to “freeze” the value, for estate tax purposes, of an asset, and shift any future appreciation to a younger generation.
Executor - a fiduciary appointed in a will and confirmed by a Probate or Surrogate’s Court to oversee the estate of a decedent who dies with a will.
Form 706 - Federal Estate Tax Return for taxable estates (currently $12,060,000 and over) to be filed with full payment 9 months after death.
Future Interest - a postponed property right (e.g. as a remainder beneficiary).
Generation Skipping Transfer Tax - a backup estate tax mechanism which seeks to assure that each generation (i.e. grandparents, parents, and children) is subject to the estate tax as assets are transferred down through a family.
Gift Tax Exclusion - the right to give $16,000 per year per donee ($32,000 if the gift is deemed to be joint from a husband and wife) free of gift and estate taxes. In order to qualify the gift must be a “present interest”. Generally, a gift in trust does not qualify unless the trust has a “Crummy clause” (i.e. a withdrawal right) or qualifies under the Uniform Gifts to Minors Act.
GRIT - “Grantor Retained Interest Trust”. A GRIT involves the transfer of property to an irrevocable trust with the grantor retaining an income interest for a specified term of years. When the retained interest expires, the trust property will pass to a third-party remainder beneficiary. The value of the remainder interest is a taxable gift by the grantor.
Guardian - a fiduciary appointed by a Court to administer the affairs of someone under a legal disability (e.g. a minor or an incompetent).
Inheritance Tax - an excise tax levied on the recipient or beneficiary.
Intestacy - the status of dying without a valid will. In this case the assets are distributed in accordance with local law rather than any expressed wish of the decedent.
Irrevocable Trust - a trust which by its terms may not be changed. This often avoids estate tax on the appreciation of assets transferred to such trust (from the date of transfer to the date of death).
Life Insurance Trust - an irrevocable trust generally made owner and beneficiary of a life insurance policy on the life of the Grantor to avoid both income and estate taxes on the death benefits.
Marital Deduction - a transfer to a spouse which escapes the Unified Transfer Tax.
Present Interest - a current property right (e.g. as an income beneficiary).
Private Annuity/PATY - a private annuity involves the transfer (generally by the parent) of property to a transferee (generally a child or a trust for the child) in exchange for the transferee making payments to the transferor for the transferor’s lifetime. A private annuity for a term of years (PATY) is similar to a typical private annuity except that the transferee’s payments terminate upon the earlier of the transferor’s death or after a specified term of years.
Probate - the process under which a will is filed with a Probate or Surrogate’s Court (or other Court of appropriate jurisdiction) and the “probate” assets are administered. These proceedings are public records.
QTIP Trust - “Qualified Terminable Interest Property” Trust. A Trust with income to the spouse which qualifies for the marital deduction but allows the Donor to decide who gets the remaining principal upon the death of the spouse.
Revocable Trust - a trust which the Grantor may amend or revoke, at his or her whim, during life; it becomes irrevocable at death. This avoids “probate” and passes outside the terms of the will. This type of trust offers no tax benefit and is includible, in full, in the gross estate of the decedent at its fair market value on the date of death (or alternate valuation date).
Right of Election - right of a surviving spouse to contest distributions under a will if such spouse is not left his or her statutory share.
SCIN - a self-canceling installment note (SCIN) involves the sale of property to the buyer (usually a child) who issues an installment note to the seller (usually a parent). The installment note provides for the termination of the buyer’s payments upon the earlier of the seller’s death or the buyer’s payment of all required installments.
Split Purchase - a split purchase involves the acquisition by one party (generally the parent) of a life estate in the purchased asset and by another party (generally the child or a trust for the child) of a remainder interest in the purchased asset. The amount to be contributed by the life tenant and the remainder beneficiary towards the purchase price will usually be determined under an actuarial valuation method.
Trust - legal document which creates a 3-party arrangement with a (i) Donor (also called Grantor or Settlor) who gives property to a (ii) Trustee who administers it as a Fiduciary for the benefit of the (iii) Beneficiary. Often there is an Income Beneficiary and a Remainderman.
Unified Transfer Tax - an excise tax levied on the combination of gift transfers and estate transfers. The amalgamation of the former gift and estate taxes.
Will - a legal document which disposes of a decedent’s “probate” property. Must be signed in accordance with legal formalities. It is an “ambulatory” instrument (i.e. only takes effect upon death) and can always be replaced by a new will or amended in part by a “Codicil”.