Business Valuation FAQ

California courts recognize three primary approaches to business valuation, each with multiple methods. The income approach values a business based on its expected future economic benefits, typically using capitalization of earnings or discounted cash flow methods. Capitalization of earnings applies a capitalization rate to normalized earnings to determine value, while discounted cash flow projects future cash flows and discounts them to present value. The market approach compares the subject business to similar businesses that have sold, using guideline public company comparisons or guideline transaction methods.

The asset approach values the business by adjusting its assets and liabilities to fair market value, commonly used for asset-intensive or holding companies. Most valuations in California litigation involve applying multiple methods and weighing the results. The appropriate method depends on the nature of the business, availability of comparable data, and purpose of the valuation. Courts consider expert testimony explaining why particular methods were selected and how they were applied.

Fair market value is the standard of value most commonly applied in California business disputes, defined as the price at which property would change hands between a willing buyer and a willing seller, neither being under compulsion to buy or sell, and both having reasonable knowledge of relevant facts. This definition comes from IRS Revenue Ruling 59-60 and is widely adopted in California case law. Fair market value assumes a hypothetical transaction between informed parties acting in their own self-interest in an open market.

It does not consider synergistic value that might be realized by a specific buyer with strategic interests. The valuation date is typically the date specified by statute or agreement, such as the date a dissolution petition was filed or the date of dissociation from a partnership. Fair market value should reflect all information reasonably available as of the valuation date. Events occurring after the valuation date are generally not considered unless they shed light on conditions existing at the valuation date.

The application of minority and marketability discounts in California business valuations depends significantly on the context and purpose of the valuation. A minority discount reduces value because the interest cannot unilaterally control business decisions, while a marketability discount reflects the difficulty of selling interests in closely held businesses compared to publicly traded securities. In shareholder buyout proceedings under Corporations Code Section 2000, California courts have generally refused to apply minority or marketability discounts, reasoning that such discounts would reward oppressive conduct by majority shareholders and allow them to squeeze out minorities at depressed values.

Similarly, in marital dissolution cases, California courts typically value community property business interests without discounts that would benefit the owning spouse. However, in other contexts such as gift and estate taxation or arm's length negotiations, discounts may be appropriate. The determination depends on the standard of value required, the purpose of the valuation, and applicable case law. Courts examine expert testimony explaining whether and how discounts were applied.

Goodwill represents the intangible value of a business exceeding the fair market value of its tangible assets, arising from factors such as reputation, customer relationships, skilled workforce, and favorable location. California law distinguishes between enterprise goodwill, which belongs to the business and is transferable, and personal goodwill, which is attributable to an individual's personal reputation and skills. In marital dissolution cases under Family Code Section 2500, enterprise goodwill is community property subject to division, while personal goodwill generally is not.

Professional practices often involve significant personal goodwill analysis. Goodwill is typically valued as part of the income or market approach, represented by earnings capacity exceeding returns on tangible assets. The capitalized excess earnings method specifically isolates goodwill by calculating earnings attributable to intangible assets after providing a return on tangible assets. Courts consider factors such as continuity of earnings, customer loyalty, brand recognition, and whether goodwill would transfer with a sale of the business. Expert testimony is typically required to value goodwill in litigation.

Comprehensive business valuation requires extensive financial and operational information. Essential documents include three to five years of financial statements, including balance sheets, income statements, and cash flow statements, preferably audited or reviewed by a CPA. Tax returns for the same period provide additional verification. Detailed general ledger and accounts receivable and payable aging reports reveal working capital needs. Asset schedules listing equipment, real estate, and inventory with original costs, accumulated depreciation, and estimates of fair market value are necessary for the asset approach.

Revenue breakdowns by customer, product line, and geographic area identify concentration risks. Employment agreements, compensation schedules, and organizational charts reveal key person dependencies. Leases, contracts, and outstanding litigation affect value assessment. Industry data and competitive analysis provide context for market approach valuations. Projections and budgets, if available, inform income approach analyses. Historical information about ownership changes, capital contributions, and distributions affects minority interest valuations. In litigation, much of this information may be obtained through formal discovery processes.

Business valuation experts play critical roles in California litigation, providing opinions on value that courts rely upon to resolve disputes. Under Evidence Code Section 720, experts must be qualified by knowledge, skill, experience, training, or education to offer opinions on specialized subjects beyond the understanding of average jurors. Credentials such as Accredited Senior Appraiser (ASA), Certified Valuation Analyst (CVA), or Accredited in Business Valuation (ABV) demonstrate specialized valuation training. Experts analyze financial data, apply appropriate valuation methods, and prepare written reports explaining their conclusions.

In litigation, experts testify at deposition and trial, explaining their analysis and defending their conclusions under cross-examination. Courts may appoint neutral experts under Evidence Code Section 730 to provide independent valuation opinions. California follows the Kelly-Frye standard for scientific evidence, though most business valuation methods are considered sufficiently established. Expert credibility depends on qualifications, independence, thoroughness of analysis, logical reasoning, and ability to explain complex concepts clearly. Parties should select experts early in litigation to guide discovery and develop valuation strategies.

Valuing professional practices in California, such as medical, dental, legal, or accounting practices, presents unique challenges due to the significant personal element involved. California courts recognize that professional practices often derive substantial value from the personal reputation, skills, and relationships of the practitioners. The capitalized excess earnings method is commonly used, calculating earnings beyond what could be earned from tangible assets and reasonable owner compensation. Normalizing adjustments are essential to determine true economic earnings, including adjusting owner compensation to market rates for similar practitioners.

The market approach may be applicable when comparable practice sales data is available, though professional practices often have limited comparable transactions. Key factors affecting professional practice value include patient or client retention rates, referral sources, staff quality and stability, practice location, equipment condition, and payer mix for healthcare practices. In marital dissolution cases, the distinction between enterprise and personal goodwill significantly affects the valuation. Courts examine whether the practice's value would survive the departure of the professional owner or is dependent on their continued personal involvement.

The valuation date is the specific point in time at which value is determined, and it significantly affects the valuation conclusion because business value changes over time. California law specifies valuation dates for various types of proceedings. For dissenter's rights under Corporations Code Section 1300, the valuation date is the day before the corporation first announced the proposed corporate action. For shareholder buyouts under Section 2000, the valuation date is typically when the dissolution petition was filed or a later date specified by the court. For partnership dissociation under Corporations Code Section 16701, the valuation date is the date of dissociation.

In marital dissolution under Family Code Section 2552, the court has discretion to select a valuation date between separation and trial that achieves equity. The valuation should reflect information reasonably known or knowable as of the valuation date. Events occurring after the valuation date are generally excluded unless they illuminate conditions existing at the valuation date. Expert reports should clearly state the valuation date and explain how it was determined.

When parties present conflicting valuations through competing experts, California courts must weigh the evidence and determine value. Courts are not required to accept either expert's conclusion and may find value at any point within the range of credible evidence or even outside if justified. Judges evaluate expert credibility by examining qualifications, methodology, assumptions, and ability to explain and defend conclusions. Courts consider whether experts applied appropriate valuation standards, used reliable data, made reasonable assumptions, and followed generally accepted valuation principles.

Internal consistency, logical reasoning, and acknowledgment of limitations strengthen expert credibility. Courts may give less weight to experts who appear biased toward their client's position or who ignore unfavorable evidence. The burden of proof typically falls on the party challenging an existing valuation or seeking to establish a particular value. In bench trials, the judge weighs expert testimony directly. In jury trials, experts educate jurors who then determine value. Settlement is often preferable when both sides face uncertainty about which valuation the court will accept.

Several common mistakes can undermine business valuations in California litigation. Failure to normalize earnings by adjusting for non-recurring items, owner perquisites, and above or below market compensation distorts income-based valuations. Using inappropriate comparable companies or transactions that differ significantly from the subject business weakens market approach valuations. Applying valuation multiples without understanding their derivation and applicability leads to unreliable conclusions. Failing to consider company-specific risk factors when determining discount rates understates or overstates risk adjustments. Double-counting the same value element in different approaches inflates value conclusions.

Ignoring working capital requirements understates the investment needed to generate projected earnings. Using financial projections without scrutinizing their reasonableness produces unreliable discounted cash flow valuations. Applying minority or marketability discounts inappropriately for the legal context can significantly misstate value. Selecting the wrong valuation date provides an inaccurate picture of value at the relevant time. Relying on unqualified experts or experts without independence undermines credibility. Engaging experienced valuation professionals and legal counsel helps avoid these pitfalls.