Business valuation experts often rely on prospective financial statements when applying the discounted cash flow (DCF) method to value a private business interest. However, when management prepares financial projections for another purpose — such as a loan application — repurposing them to estimate fair market value for litigation purposes may raise a red flag. A recent New York statutory appraisal case provides a cautionary tale worth considering.
Unrealistic projections sink expert’s analysis
In Magarik v. Kraus USA, Inc., both parties in a buyout dispute hired business valuation professionals to estimate the fair value of the petitioning shareholder’s 24% interest in an S corporation that sold upscale plumbing fixtures. Although both experts applied the income and market approaches, their value conclusions were widely disparate.
The shareholder’s expert estimated the value of the shareholder’s interest was roughly $7 million, while the company’s expert concluded it was worth only about $1 million. The trial court rejected the valuation evidence presented by the shareholder’s expert in favor of the company’s expert’s more “credible” conclusion.
The court found numerous flaws in the assumptions the shareholder’s expert used. Specifically, his application of the income approach was based on “unrealistic and optimistic” projections from a loan application. Those projections never materialized, and they didn’t sufficiently account for the competitive nature of the online marketplace or the company’s inability to generate positive cash flow.
The shareholder’s expert’s conclusion also included the value of a brand owned by another entity over which the company had no direct control. Plus, his application of the market approach was based on public companies that weren’t reasonably related to the subject company in terms of size, ownership or marketability.
The shareholder appealed, arguing that the projections prepared for the loan application were credible because the bank approved the loan. But the appellate court affirmed the decision, finding that the trial court’s determination of fair value was “within the range of testimony presented” and “supported by the evidence” (Magarik v. Kraus USA, Inc., No. 606128-15, Sup. Ct., Nassau County, April 28, 2020, 2024 NY Slip Op 04964, October 9, 2024).
Exercise caution when using management’s projections
Courts expect business valuation experts to base their analyses on sound data and realistic assumptions. If experts fail to do so, courts may disregard all or part of their conclusions — as the Magarik case demonstrates.
When inflated projections are used to calculate business value for litigation purposes, it can severely undermine an expert’s credibility. Internal projections that management compiles for a loan application tend to present optimistic estimates of expected future performance, particularly their projected growth models. This is especially likely for start-up ventures and other businesses without a history of positive cash flows.
Valuation experts are trained to consider industry trends and market conditions before relying on information provided by company insiders. Reliable projections are supported by objective, market-based evidence that’s relevant to the subject company.
Get it right
Value conclusions are only as accurate as their underlying assumptions. Experts’ analyses will likely fall apart in court if the inputs are unreliable. Ingredients for a defensible valuation include 1) the use of experienced, credentialed experts, and 2) the application of professional skepticism when relying on financial projections and comparables. Contact us to determine what’s appropriate for your situation.
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