Don't Leave the Business Valuation to the Courts
Case: Hussain in Illinois (Appellate Court of Illinois, Second District November 7, 2023, No. 2-23-0210).
Key Issue(s): Business Valuation
Key Take Aways: By not hiring an expert, both parties left the value of the Business to be determined by the trial court. The trial court essentially used the Asset Approach to value the business, which may not have been appropriate in the circumstances. Because an expert was not retained, certain accrual accounting adjustments to the balance sheet that may have been necessary were not accounted for. Along similar lines, an expert can also serves as an advisor to steer clients away from taking weak positions or making bad decisions – Husband claiming the business has outstanding debts is a notable example of this. A good expert would be able to identify that the claim is not supported by the evidence and would be able to advise Husband and his counsel on the issue, avoiding more costly fees and wasting time.
Summary: Neither party (Husband nor Wife) provided expert testimony regarding the value of Husband’s business (the “Business”), leaving the trial court to calculate it. How did the court value it? Based on the record, the court effectively used the book value – recorded assets minus recorded liabilities. It appears from the record that the Business was on the cash basis of accounting resulting in recorded assets of cash and equivalents of approximately $191,500 and recorded liabilities limited to corporate credit card debt of approximately $70, which resulted in an approximate value of $191,430.
Husband appealed the trial court’s determination of value on the basis (a) that portions of cash represented refundable advances for customer gift cards (pending satisfactory work performed by the Business) and (b) that the business had outstanding loans.
Before continuing, the Appellate Court’s decision discusses observing instances of dishonesty in the Husband, which diminished his credibility and impacted positions held by the Courts.
Husband’s claim that Cash Represented Refundable Advances
Husband testified that his business would be pre-fund gift cards to clients. Husband explained to the Court that the gift cards are digital and obtained through an outside company. The clients deposited funds with the Business which were retained in the business checking account until such time as they were expended on gift cards[1] or the client asked for the return of the funds. Husband testified that although these funds are paid upfront and held in the business checking account, they do not constitute money "earned."
The Trial Court did not expressly address the issue of the gift cards in its calculation of the value of the business as they denied Husband’s petition to reconsider “for the reasons stated on record.” The Appellate Court affirmed that position as the Husband submitted no additional evidence to the Appellate Court, to include in the “record” referenced, leaving Appellate Court with no choice but to affirm the Trial Court’s decision.
Legal procedure aside, Husband has a valid point that receiving cash for work yet to be performed should have an offsetting liability for “unearned revenue” under GAAP accounting (emphasis added). However, the cash basis of accounting does not acknowledge such a liability, which precluded the trial court from accounting for it in their valuation. Similarly, the Husband cannot pick and choose which liabilities to recognize and which assets to ignore for the purpose of valuing his business – if the unearned revenue related to the gift card funds were to be accounted for, then revenue earned but not billed (aka accounts receivable), should be accounted for as well.
This case highlights the risk that the cash basis of accounting may not capture the economic realities of a given business – the very reason that the cash-basis of accounting is not in accordance generally accepted accounting principals.
If Husband had hired an expert, the expert may have made accrual accounting adjustments to the balance sheet such that the court-determined value would better reflect the true value of the Business.
Husband’s claim that the Business Had Outstanding Loans
The outstanding loans claimed by the Husband were not reflected on the balance sheet, calling into question the overall accuracy of the books and records. This, coupled with the Court questioning Husband’s credibility, put the Husband at a disadvantage to prevail on the claim.
There were two outstanding loans for the Business claimed by Husband: 1) a loan from Husband’s family member (“Family Loan”) and 2) an SBA loan as part of a COVID-related program (“SBA Loan”).
Family Loan: A promissory note for the principal amount of $33,500 dated August 18, 2017 from the family member was admitted into evidence. However, the 2017 tax return recorded the transaction as $20,000 investment and $13,500 loan; Wife also testified this is how Husband characterized the transaction to her when she asked him about in April of 2018. And yet, the loan had no balance on the balance sheet as of the date of valuation used by the trial court. The Appellate Court affirmed the trial court’s position that the loan was not still outstanding, stating:
Similarly, evidence regarding the repayment of the promissory note was conflicting. The promissory note required repayment of the principal and accrued interest by January 31, 2022. During proceedings held on September 28, 2022, [Husband] testified that the promissory note had not been repaid by that date, but [the family member] had agreed to an extension and the loan would be repaid "at some point in the future." At a subsequent hearing, [Husband] testified that [the family member] asked him about the promissory note in November 2022, and that in December 2022, he paid [the family member] $45,000, which amount represented "part" of the total due. [Husband], however, presented no proof of such payment, the amount remaining due, if any, or the terms of the loan extension.
We also observe that the promissory note states that interest is to be calculated yearly beginning on January 30, 2017. We question why the interest would be calculated beginning in January 2017, if the promissory note was not executed until August 2017. In light of this conflicting evidence and the trial court's assessment of [Husband's] credibility, we cannot say that the trial court's determination that the evidence was insufficient to consider the promissory note in valuing [the Business] was against the manifest weight of the evidence.
Simply put, I agree with the Courts. If the loan was still outstanding, then it should have a balance accounted for on the balance sheet even with the books kept on a cash basis of accounting.
SBA Loan: The effective date of the loan was August 29, 2020. It’s known that certain COVID-related SBA loans were forgiven for many companies. Also, it’s important to note that the loan was not recorded on the Business’s balance sheet as a liability, even though Husband claimed the loan was an outstanding obligation of the Business.
Not surprisingly, the Appellate Court was not convinced, stating:
We next address the SBA loan. The effective date of the SBA loan was August 29, 2020. The stated terms of the loan agreement provide that payments would begin 12 months from the date of the note. At the hearing on September 28, 2022, [Husband] indicated that he had not started paying back the SBA loan. [Husband] then testified that he recently received a letter that repayment would have to start. However, [Husband] testified that he did not read the letter "fully" and he did not know when the first payment would be due or any other terms of the repayment other than it had to start. [Husband] did not introduce the letter from the SBA into evidence at trial. Considering [Husband] had not started repaying the SBA loan at the time of trial, his testimony that he had not read the letter from the SBA, his failure to introduce the SBA letter into evidence, and the trial court's assessment of [Husband's] credibility, we cannot say that the trial court's finding that the evidence was insufficient to consider the SBA loan in valuing the [the Business] was against the manifest weight of the evidence.
[1] It’s not explicitly stated in the Court documents but I assume the gift cards are essentially deposits on work to be performed by the Business for the client.
Owen Sizemore, CPA, CVA
Assisting business owners with maximizing and safeguarding value while guiding them through complex financial transactions, including mergers, acquisitions, and litigation. Marine veteran.
