Avoiding Valuation Traps in Court

The two most critical caveats of any valuation case are: Know thy law—and know thy law. Those are the lessons that emerged from a recent Florida case, which focused on the valuation of an early-stage entity. The start-up company, an apparel manufacturer, had sued a supplier for allegedly “coercing” it to enter into an agreement with a textile manufacturer, which led to the loss of plaintiff’s business. In its suit for damages based on the supplier’s negligent misrepresentation and breach of fiduciary duty, plaintiff needed to prove the value of its lost business. The relevant timeline: The plaintiff began operations in February 1997; signed the third party agreement on or about October 12, 1998; and closed its doors in December 1999.

First Issue: Valuation Date

In cases such as these, the attorney determines the valuation date as well as the standard of value pursuant to local law. However, the valuator should also be aware of these laws in preparing reports. In this particular matter, plaintiff’s counsel chose and the expert utilized a valuation date of October 11, 1998, the day before the company signed the agreement with the third party manufacturer. Logically, this date allowed a determination of the plaintiff’s value “but for” the coerced agreement, as well as the company’s resulting loss of value. Opposing counsel never challenged the valuation date, and there did not appear to be any valid, presented reason to choose another.

However, the trial court found otherwise, holding that the plaintiff’s losses occurred on the date that it ceased operations in late 1999. (On review, the Court of Appeals agreed, citing local case law, prevalent in many jurisdictions, that “if a business is completely destroyed, the proper measure of damages is the market value of the business on the date of the loss.”) When the trial judge issued his finding, opposing counsel quickly moved for a directed verdict and won, as there was no evidence for lost value based on the December 1999 date.

First lesson: Although it’s hard to anticipate every curve ball that a court might toss—if there’s any legal possibility for more than one valuation date, analysts, in consultation with their attorneys, should consider preparing alternative valuations to avoid having the court reject their work.

Second Issue: Speculative Forecasts

In rejecting the expert’s report, the court also found that his reliance on forecasted future cash flows was “too speculative.” But valuation often (if not always) involves some measure of a forward-looking perspective. If historical operations don’t accurately indicate the future, analysts will commonly use the discounted cash flow (DCF) method. One challenge to any DCF is its reliance on the target’s forecasted future cash flows. A careful, well-constructed and well-supported forecast is necessary for the DCF to render a meaningful valuation; for a start-up entity, the analyst must take extra care to avoid allegations that the forecasts are “speculative.”

Second lesson: Attorneys need to know, and their appraisers need to ask, whether the “new business rule” would prevent a start-up company—one that has yet to turn a profit—from proving damages for loss of its entire value. For example, in this particular case, local Florida law held that a business can recover lost prospective profits, regardless of whether it has an established earnings record. But no case in that jurisdiction specifically addresses the recovery of lost value, and argument would rest on analogy from the lost profits case or appropriate law in other jurisdictions.

In addition, a valuator should review the AICPA’s Audit and Accounting Guide: Guide for Prospective Financial Information; although courts and appraisers are not required to follow accounting guidelines, they do provide useful support to strengthen your DCF analysis.